The two-phase project on IBOR reform
Considering the ongoing market developments, the International Accounting Standards Board (IASB) has finalised its two-phase project on IBOR reform. Phase 1 amendments to IFRS Standards address the uncertainty that could arise prior to IBOR cessation. Phase 2 amendments, published in August 2020, address financial reporting issues that will arise upon the actual switch from existing interest benchmark rates (IBORs) to alternative benchmark rates (RFRs).
The IASB identified the need to support market participants applying IFRS Standards when changes are required as a result of the reform, especially in the following accounting areas:
a) Changes to contractual cash flows of financial instruments
b) Hedge accounting
Changes to contractual cash flows of financial instruments
Amending contractual terms, altering the calculation methodology of an interest rate benchmark or activating fallback provisions as a result of the reform could change the contractual cash flows of a financial instrument. Without any amendment to the existing requirements in IFRS 9, firms would have to assess whether these changes would result in a derecognition or modification event. Therefore, the IASB decided to provide a practical expedient so a company does not have to derecognise or adjust the carrying amount of financial instruments for changes required by the reform, but instead revise the effective interest rate on a prospective basis.
Transitioning to RFRs could have an extensive impact on hedge accounting and potentially disrupt hedge accounting arrangements. Therefore, the IASB provided additional temporary exceptions from applying specific hedge accounting requirements. The objective of the hedge accounting reliefs described in this article is to support companies applying hedge accounting without triggering discontinuation events solely due to changes required by the reform.
The amendments introduce an exception that allows companies to continue applying hedge accounting despite amending the formal designation and hedge documentation to reflect changes required by the reform.
The relief allows companies to designate the non-contractually specified risk component provided they can meet the separately identifiable requirement within a 24-month period from the date of designation.
IFRS 9 and IAS 39 require the cash flow hedge reserve to be reclassified to profit or loss when the hedged cash flows are no longer highly probable. With the IASB amendments, when an entity transitions to a new interest rate and amends the description of the hedged item to reflect changes required by the reform, the amounts accumulated in the cash flow hedge reserve prior to this change will not have to be reclassified in profit and loss. Instead, the cash flow hedge reserve is deemed to be based on the alternative benchmark rate.
When hedging group of items, companies may encounter a situation where some items are referenced to IBORs and others to RFRs. The relief provided allows the allocation of hedged items to subgroups based on the benchmark rate being hedged, while the qualifying criteria for hedged items are separately applied to each subgroup.
- Retrospective assessment in IAS 39
During Phase 1, entities could still apply hedge accounting even if they failed to meet the retrospective effectiveness test. This relief ends once there is no uncertainty arising as a result of the reform in a hedge relationship. The IASB provided an optional relief for entities performing the retrospective effectiveness test on a cumulative basis so that they may reset to zero the cumulative fair value changes after ceasing to apply the Phase 1 relief.
For Phase 2, companies are required to disclose information about the nature and extent of risks arising from the reform and how they manage the transition to alternative benchmark rates along with quantitative information about non-derivative financial assets, non-derivative financial liabilities and derivatives, disaggregated by significant interest rate benchmark.
The short period between the issuance of the amendments and the effective date on 1 January 2021 reflects the urgency of the changes that need to be made and gives market participants the tools to navigate the IBOR transition process early on before IBOR discontinuation is imminent.