IBOR Reform - Proposed amendments to the financial instruments standards, IAS 39 and IFRS 9, on affected hedging relationships

The ongoing reform of short-term interest rate benchmarks, and the growing uncertainties affecting future cash flows, have persuaded the International Accounting Standards Board (“IASB”) to put forward proposed amendments to the hedge accounting requirements in IAS 39 Financial Instruments: Recognition and Measurement (“IAS 39”) and IFRS 9 Financial Instruments (“IFRS 9”) by issuing the Exposure Draft Interest rate Benchmark Reform. So, what is the background and rationale for issuing the exposure draft and the impact of the reform on the hedge accounting requirements.

Background to the exposure draft
Following the 2008 liquidity crisis and the market manipulation of short-term InterBank Offered Rates (“IBOR”), such as LIBOR or EURIBOR, the Financial Stability Board (“FSB”) issued a report in 2014 questioning the reliability of these rates. Drawing from the lessons of these events, the report recommended improving the governance of existing reference rates (including IBOR, but also very short-term rates like EONIA) and introducing alternative risk-free interest rates (RFR).

In response to these recommendations, a large-scale reform was launched, but there has been no consistent implementation in the various national and transnational jurisdictions affected. While some jurisdictions have moved towards the effective replacement of the existing interest rate benchmarks, others have left the door open to the coexistence of old and new reference rates, or have even simply maintained the old rates. These disparities are also reflected in the divergence between timetables for introducing the reforms from one jurisdiction to another and one rate to the next.

The reform therefore introduces uncertainties regarding the timing and the amount of future contractual cash flows based on these reference rates. In some cases, the replacement of existing rates by alternative rates could require amendments to affected contracts, which of course would be very onerous, particularly if the amendments needed agreement and sign-off with the counterparties, and time-consuming; the effective dates of these changes could in practice be spread over many months or even years.

Because of the uncertainties, the IASB launched a review in 2018 to consider the potential accounting impacts of the reform. Due of its scale, the project has two phases:

1. Phase I – addressing accounting issues identified in the period before the effective replacement of an existing interest rate benchmark (pre-replacement issues); and
2. Phase II – addressing accounting issues raised by the effective replacement of the interest rate benchmark (replacement issues).

The exposure draft, which was published in May 2019, forms part of phase I and proposes amendments to the hedge accounting requirements of IAS 39 and IFRS 9. The amendments are being proposed, therefore, because of the uncertainties and implications arising from the reform that are likely to cause some hedging relationships to be discontinued, such as:

• the disappearance (or the no longer “highly probable” nature) of a benchmark interest rate risk component or of the hedged cash flows;
• the amendment of hedged contracts that might lead to their derecognition; and/or
• an ineffective relationship, generated by the reform, between the hedging instrument and the hedged item.

Proposed amendments to the hedging requirements
The main aim of the proposed amendments is to relax the IAS 39 and IFRS 9 eligibility conditions for an interest rate hedging relationship, in order to avoid a situation in which a hedging relationship is discontinued or becomes ineligible solely due to the uncertainties caused by the reform of benchmark rates for future contractual cash flows. The proposed reliefs relate, firstly, to the criteria for the prospective assessments. For cash flow hedges, IAS 39 and IFRS 9 both require that if a hedged item is a future transaction, it must be “highly probable” if the hedging relationship is to be eligible. If this future transaction corresponds to cash flows based on the existing interest rate benchmarks, its “highly probable” nature may be called into question by the potential replacement of the existing reference rate by an alternative. The IASB proposes to deal with this risk by taking no account of the effects of the ongoing interest rate reform when assessing whether such a future transaction is “highly probable”.

The IASB also proposes to overlook the impact of the reform on the prospective effectiveness assessments carried out for fair value and cash flow hedges, namely:

• the prospective effectiveness assessment under IAS 39 (i.e. the changes in future values of the hedging instrument and the hedged item should offset each other such that the hedge is expected to be “highly effective” throughout its life); and
• the demonstration of an economic relationship between the hedged item and the hedging instrument under IFRS 9 (i.e. the value of the hedging instrument and the value of the hedged item will generally move in opposite directions because of the same risk, which is the hedged risk).

Another expedient is being proposed for the special case of a hedge of an interest rate risk component affected by the reform that is not contractually specified. This arrangement relates, for example, to situations where an entity establishes a fair value hedging relationship in which the hedged risk corresponds to the changes in value of a fixed-rate instrument (e.g. a fixed rate liability at 4%) in light of a benchmark interest rate (e.g. EURIBOR 3M). IAS 39 and IFRS 9 allow the hedging of a designated risk component of an item rather than the item in its entirety, provided that this risk component is separately identifiable and reliably measurable from inception and throughout the life of the hedging relationship. The exposure draft therefore proposes that an entity should apply the requirement (that the benchmark interest rate risk component hedged is separately identifiable) only at the inception of the hedging relationship, rather than continuously.

It is important to note, however, that the intention of the proposed amendments is solely to prevent the discontinuation of hedging relationships affected by the benchmark rate reform due to a failure to meet the prospective eligibility criteria, and not to eliminate the recognition of any ineffectiveness caused by the reform: the exposure draft is clear that any ineffectiveness caused by the rate reform would continue to be recognised in profit or loss.

Impact on the required disclosures – Disclosures are required to be provided to identify the hedging relationships that are affected by the proposed amendments. The IASB proposes that the quantitative disclosures for hedge accounting, as required by IFRS 7 Financial Instruments: Disclosures (“IFRS 7”), should be presented, separating the relationships affected by the amendments from other hedging relationships. The disclosures which would therefore be required are as follows:

Mandatory application

The IASB propose that this amendment must be applied retrospectively as of 1 January 2020, with early application possible (subject to EU endorsement[†]).

The amendment would apply for a limited period, ending either:

• when there is no longer any uncertainty with respect to the timing and the amount of the interest rate benchmark-based cash flows; or
• when the hedging relationship is discontinued, or when the entire amount accumulated in the cash flow hedge reserve accounted for in other comprehensive income (“OCI”) with respect to that hedging relationship is reclassified to profit or loss.

The exposure draft closed for comments on 17 June 2019. The letters received have been published on the IASB’s website and can be viewed here.

[†] Or UK endorsement following Brexit