IBOR Reform – Comparing LIBOR vs SONIA following the IASB’s (phase 1) amendments to IFRS 9, IAS 39 and IFRS 7

Last week, the International Accounting Standards Board (“IASB”) issued amendments to the financial instruments standards, IFRS 9 Financial Instruments (“IFRS 9”), IAS 39 Financial Instruments: Recognition and Measurement (“IAS 39”) and IFRS 7 Financial Instruments: Disclosures (“IFRS 7”), setting out changes to some of the hedge accounting requirements in order to provide temporary relief to companies during the period of uncertainty being faced from the IBOR reform.

Here we look at what exactly is driving the changes, what the amendments mean for hedge accounting purposes and what forthcoming changes we are expecting to see.

What’s driving the amendments by the IASB – Comparing LIBOR vs SONIA

Following the LIBOR scandal and the subsequent recommendations from the Financial Stability Board (“FSB”) (refer to our previous blog for more information), LIBOR benchmark rates are set to be replaced in the sterling markets by an alternative risk-free rate: SONIA (Sterling Overnight Indexed Average) from 2021. Some of the key practical differences between LIBOR and SONIA include:

• LIBOR is published for seven different lengths of interest period (i.e. 3-month, 6-month, 12-month etc.), whereas SONIA, is a single overnight rate;
• LIBOR is forward-looking (hence there is a separate rate for the seven different forward-looking time periods), whereas SONIA is a backward-looking rate; and
• LIBOR is calculated to reflect bank credit risk, therefore, the rate for each of the seven different time periods for which LIBOR is available reflect the banks’ credit risk associated with that time period (i.e. 3-month LIBOR could generally be expected to be lower than 6-month LIBOR, which in turn would be expected to be lower than 12-month LIBOR etc.).  SONIA, by contrast, does not look at future periods of time and so is an almost entirely risk-free rate.

The impending demise of LIBOR clearly gives rise to commercial issues, notably because of its backward-looking nature.  For example, whereas the interest payable on a LIBOR-linked instrument is known at the start of each applicable period until the next reset date, the amount payable on a SONIA-lined instrument is not known until the end of the time period.  As calculations cannot be carried out in advance, the use of SONIA might make it difficult for borrowers to prepay principal or refinance their facilities mid-interest period, because the amount to prepay won’t be known.

The replacement of existing LIBOR rates with the new SONIA rate clearly, therefore, has implications for accounting and financial reporting because of the need to change contracts of yesteryear that did not foresee the demise of LIBOR, and this is what has been driving the IASB’s project since 2018. The project has been split into two phases, and it is the completion of the first phase that has led to the amendments to IFRS 9, IAS 39 and IFRS 7 so far:

• Phase 1: Pre-replacement issues, i.e. those issues that affect accounting and financial reporting in periods before existing benchmarks are replaced; and
• Phase 2: Replacement issues, i.e. those accounting and financial reporting issues that may arise when the benchmark rates are replaced.

What the amendments mean for hedge accounting purposes

Phase 1 identified three separate aspects of hedge accounting as potentially being affected by the replacement of LIBOR with SONIA:

• “Highly probable” requirement – In order for companies to apply hedge accounting, under both IFRS 9 and IAS 39, for a forecast transaction (such as variable interest) that transaction must be “highly probable”.  At some point, however, forecast LIBOR-based cash flows may no longer be considered highly probable because the contracts referencing the LIBOR payment, or receipt, is likely to need amending with the result that the future cash flow will be determined by reference to SONIA rather than LIBOR;
• Prospective assessments – Companies must undertake a prospective assessment of the hedging relationship in order to meet the hedge accounting requirements for cash flow hedges and fair value hedges.  Under IFRS 9, there needs to be an economic relationship between the hedged item and the hedging instrument, and under IAS 39, changes in the fair value of the hedged item and hedging instrument must be expected to offset each other with a tolerance range of 80-125% and hence be “highly effective”.  These prospective assessments could be affected due to the uncertainties arising from the reform; and 
• Designation of a risk component – A risk component (or a portion) must be separately identifiable to achieve hedge accounting. The impending discontinuation of LIBOR rates could result in the designated interest rate risk exposure not existing throughout the remaining duration of many hedging relationships.

The amendments to IFRS 9 and IAS 39 therefore overcome these three problems. Firstly, companies must assume that the designated forecast cash flows in a hedging relationship will not be altered solely as a result of the benchmark interest rate reform, so that it can be assumed the hedged item continues to be highly probable.  Secondly, companies must assume that the interest rate benchmark on which the hedging instrument and hedged item are based will not be altered, so that prospective assessments are not adversely affected solely as a result of the interest rate benchmark reform (i.e. for IAS 39, if the effectiveness testing results fell outside of the 80-125% range then the testing should be ignored).  And thirdly, for hedges of the benchmark component of interest rate risk affected by the reform, the requirement to separately identify a risk component (or a portion) should only be undertaken on hedge inception, rather than continuously throughout the life of the hedge.  These reliefs, which are mandatory to avoid any potential for cherry-picking hedging relationships to be discontinued, are designed to overcome the immediate financial reporting challenges facing companies that make use of hedge accounting during the period of uncertainty from the reform.

The amendments also set out enhanced disclosures that must be provided, under IFRS 7, in respect of hedging relationships affected by the amendments:

• the significant interest rate benchmarks to which a company’s hedging relationships are exposed;
• the extent of the risk exposure a company manages that is directly affected by the interest rate benchmark reform;
• how a company is managing the process to transition to alternative benchmark rates;
• a description of significant assumptions or judgements a company made in applying the relief; and
• the nominal amount of the hedging instruments in those hedging relationships.

What forthcoming changes are we expecting to see

The IASB is now turning its attention to phase 2 of the project.  It is expected that the following accounting issues will need addressing as and when LIBOR is replaced with SONIA:

• assessing whether changes to loan contracts will be accounted for as modification or derecognition events;
• the extent to which hedge accounting can continue as a result of consequential changes to the designated hedged risk and the required changes to hedge documentation; and
• how to deal with any immediate changes to fair value of either the hedging instrument or hedged item.  Even though phase 1 provided relief from the prospective test of hedge effectiveness, it did not consider any relief that may be needed from the 80-125% retrospective test for those entities, which have chosen to continue with IAS 39 model for hedge accounting.  Revisions to the contractual terms of the hedged item and hedging instrument (to reference SONIA rather than LIBOR) may not necessarily occur contemporaneously if they are with different counterparties.

The amendments from phase 1 are effective for accounting periods beginning on or after 1 January 2020, with early application permitted (subject to EU endorsement, or UK endorsement post Brexit). It is also anticipated that amendments resulting from phase 2 will progress quickly to enable companies to deal with potential issues on a timely basis.