Will the medicine cure the infection?

20 May 2019

The days of LIBOR and similar benchmark interest rates are numbered. This is causing an ‘accounting infection’, the most immediate impact of which is on hedge accounting. Earlier this month, the IASB issued a proposed ‘cure’ for IFRS accounting ills in the form of an Interest Rate Benchmark Reform Exposure Draft (‘ED’).

This ED medicine is designed to prevent the patient - hedge accounting - from contracting three key ‘symptoms’ of the accounting infection:

  • The 'highly probable' requirement for cash flow hedges - under the ED’s proposals when assessing the likelihood that a forecast transaction will occur, companies would assume contractual terms are not altered as a result of LIBOR reform
  • The prospective hedge effectiveness assessment - under the ED’s proposals companies would assume the LIBOR based cash flows of the hedging instrument and the hedged item are not altered as a result of LIBOR reform
  • Designation of a LIBOR risk component as a hedged item - under the ED’s proposals hedge accounting would continue where a LIBOR risk component met the ‘separately identifiable’ requirement to be a hedged item at inception of the hedging relationship, even if it does not meet that requirement at a later date.

On an initial read, the ED looks to be an effective treatment that will keep the hedge accounting patient going when, without the reliefs, hedges would have to be discontinued. This is likely to be welcomed by both companies and investors. However, whilst the medicine might be broad-spectrum, there are further possible symptoms the medicine doesn’t address. The IASB might consider providing further relief for these before finalising the cure:

Relief for 80-125% effectiveness test

No relief is proposed from a hedge failing IAS 39’s‘80-125%’ retrospective hedge effectiveness test due to LIBOR reform. I think this could be a particular issue where there is a timing mismatch (i.e. where a derivative hedging instrument moves to the new benchmark rate before the cash instrument it hedges, or vice versa) as this could result in the 80-125% test being failed temporarily. This would be a particular risk for hedges already experiencing ineffectiveness, so with less ‘headroom’. Further medicine to give the patient relief from this fourth symptom would be very welcome.

Fair value and other hedges

I think the ED is intended to apply to fair value hedges as well as cash flow hedges, as both are referenced. But given the widespread focus within the ED on the effect on cash flows rather than fair values, it isn’t always obvious that’s the intention - so the ED risks being a less effective cure than it could be. Similarly there are some hedges of foreign currency risks that are impacted by LIBOR reform but where it is unclear if the reliefs proposed in the ED would apply. I believe these are unintended side effects of the proposed medicine that could easily be addressed by the IASB.

End date

I found the termination point of the mandatory reliefs proposed in the ED difficult to follow. This risks the patient not being able to continue taking the medicine even when they still need it. An alternative way forward might be to remove any specific rules for an end date, as once the relief is no longer needed it will naturally fall away (much like there’s no need to tell a patient to stop taking their tablets if the bottle’s already empty).  

Other accounting issues arising from LIBOR reform

As expected, the ED only addresses hedge accounting and only those issues arising in the period before LIBOR reforms are implemented. The IASB expects to consider additional reliefs that might be needed at the time the reforms are implemented in ‘phase 2’ of its project. However, given the current speed of regulatory developments in some territories, the need for phase 2 is becoming more urgent. I would encourage the IASB to consider cures for ‘phase 2’ as soon as possible.

Overall, the medicine should treat the three key symptoms of the accounting infection that the cure is designed for, but it could be made even more effective. And, looking forward, I would welcome the IASB moving quickly to address the further symptoms highlighted above, as sufferers are invariably impatient to receive the new ‘wonder-drug’!

Sandra Thompson | Partner
Profile | Email | +44(0)7921106900

Mark Randall | Director
Profile | Email | +44 (0)7764 988946

Louise Brown | Senior Manager, UK Accounting Consulting Services - Financial Instruments,
Profile | Email |  +44 (0)7710 036431

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