IBOR reform refers to the replacement of interest reference rates, such as LIBOR and EURIBOR with alternative benchmark rates. In August 2020, the IASB issued Interest Rate Benchmark Reform - Phase 2: Amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16. These amendments follow on from the first phase of reliefs relating to IBOR Reform issued in September 2019.
Why did the IASB need to make these amendments?
IBOR Reform brings about several potentially significant implications for entities reporting under IFRS both during the period of uncertainty prior to IBOR being replaced (pre-replacement issues), as well as at the time IBOR is replaced (replacement issues). The first phase of amendments focused solely on pre-replacement issues that relate to hedge accounting requirements. The second phase of reliefs focuses on replacement issues in relation to hedge accounting and other areas of accounting.
Which areas do the phase 2 amendments affect?
The phase two amendments affect a number of requirements in IFRS 9 Financial Instruments, IAS 39 Financial Instruments: Recognition and Measurement, IFRS 7 Financial Instruments: Disclosures, IFRS 4 Insurance Contracts and IFRS 16 Leases relating to:
- Changes in the basis for determining the contractual cash flows as a result of interest rate benchmark reform
- Hedge accounting, and
Changes in the basis for determining the contractual cash flows as a result of interest rate benchmark reform
IBOR Reform may change the basis for determining the contractual cash flows of contracts. In some cases, the contracts themselves will need to be modified to reflect this change in basis. For example, when a GBP LIBOR linked loan transitions to SONIA, the contractual terms will need to be amended to reflect this change in basis. In other cases, the contracts may not need to be explicitly modified - for example, where an existing fall back clause is triggered, or the method for calculating the interest rate benchmark is modified as a result of IBOR Reform.
Under IFRS 9, changes of this nature can sometimes result in the immediate recognition of a gain or loss. In the context of the changes required by IBOR Reform, the IASB did not consider that this would provide useful information, and therefore introduced relief under which no immediate gain or loss is recognised. Instead, entities are required to update the effective interest rate in the same way that they would account for changes in market rates of interest in respect of floating rate financial instruments.
However, it is important to note that this relief only applies to changes that are both necessary as a direct consequence of IBOR reform and where the new basis for determining the contractual cash flows is economically equivalent to the previous basis. Other changes made at the same time would need to be accounted for under the normal requirements of IFRS 9 after the entity has accounted for changes related to IBOR Reform.
In order to ensure a similar practical expedient applies for insurers and lessees that may be affected by IBOR Reform, amendments were also made to IFRS 4 and IFRS 16:
- IFRS 4 was amended to require insurers applying the temporary exemption from IFRS 9 (i.e. those insurers that continue to apply IAS 39) to apply the same practical expedient as those entities applying IFRS 9.
- IFRS 16 was amended to require lessees to use a similar practical expedient when accounting for lease modifications that change the basis for determining future lease payments as a result of IBOR Reform.
The amendments introduce a number of different reliefs from specific hedge accounting requirements in IFRS 9 and IAS 39. The IASB considered that these reliefs were necessary in order to ensure that hedge relationships were not discontinued solely as a result of the changes required by IBOR Reform.
As with the first phase of IBOR Reform amendments, there continues to be no exception from the measurement requirements applicable to hedging instruments and hedged items. This means that following the changes required by IBOR Reform, the hedging instruments and hedged items are re-measured based on the new rate in accordance with the normal requirements of IFRS 9 or IAS 39, with any hedge ineffectiveness being recognised in profit or loss accordingly.
The new reliefs introduced by this amendment apply as and when the first phase of reliefs cease to apply and are summarised in the table below.
||Description of the relief
|Hedge documentation and designation IFRS 9 & IAS 39
||Entities are required to amend their hedge designation and documentation to reflect changes required by IBOR Reform by the end of the reporting period in which the changes occur, but this will not result in those hedge relationships being discontinued. For example, if the hedged risk changes from GBP LIBOR to SONIA, the documentation, and therefore the designation, will be updated but the hedge relationship will continue as normal
|Amounts accumulated in the cash flow hedge reserve IFRS 9 & IAS 39
||The amounts accumulated in the cash flow hedge reserve are deemed to be based on the alternative benchmark rate on which the hedged future cash flows are determined. This ensures that these amounts will be reclassified to profit or loss in the same period (or periods) during which the hedged cash flows based on the alternative benchmark rate affect profit or loss. This applies both for continuing hedge relationships as well as those that have been discontinued but where amounts remain in the cash flow hedge reserve.
|Groups of items IFRS 9 & IAS 39
||For hedges of groups of items, it is likely that different items will transition to alternative benchmark rates at different times. In order to ensure that hedge accounting can be continued in these circumstances, the amendments require that hedged items are allocated to sub-groups based on the benchmark rate being hedged with the benchmark rate for each sub-group being designated as the hedged risk. This means that there could be one sub-group for which GBP LIBOR continues to be the hedged risk and another for which SONIA is the hedged risk.
|Risk components IFRS 9 & IAS 39
When an alternative benchmark rate is designated as a non-contractually specified risk component it is possible that it will not be separately identifiable, as that rate may not yet be sufficiently developed at that date. Under the amendments, it will be deemed to have met the separately identifiable requirements as long as the entity reasonably expects that it will meet the requirements within a period of 24 months from the date of first designation. It is worth noting that the 24 month period will apply to each alternative benchmark rate separately i.e. on a rate by rate basis rather than a hedge by hedge basis. As with the phase one reliefs, there is no relief in respect of the reliably measurable requirement.
|Retrospective effectiveness IAS 39 only
||When assessing the retrospective effectiveness of a hedge relationship on a cumulative basis, the amendments permit an entity (on a hedge by hedge basis) to reset the cumulative fair value changes of the hedged item and hedging instrument to zero.
The amendments also introduce new IFRS 7 disclosure requirements which are aimed at ensuring that users of financial statements can understand the effect of IBOR Reform on an entity’s financial instruments and risk management strategy. This includes qualitative information such as how the entity is managing the transition and its progress as well as quantitative information about financial instruments that have yet to transition, disaggregated by derivatives and non-derivatives as well as by significant interest rate benchmarks.
When are the amendments effective and what are the transitional arrangements?
The amendments are to be applied retrospectively in annual financial statements and interim financial reports for accounting periods beginning on or after 1 January 2021, with earlier application permitted. The amendments must be endorsed by the EU before they can be applied.
Entities are not required to restate prior periods but may choose to do so if it is possible without the use of hindsight. Hedging relationships previously discontinued solely because of changes resulting from IBOR Reform must be reinstated as long as the hedge relationship meets all other qualifying criteria for hedge accounting at the beginning of the reporting period in which the entity applies the amendments. In this context, if the hedge relationship in question had been discontinued as a result of the alternative benchmark rate not meeting the separately identifiable requirement, the 24 month period referred to in the table above is considered to start from the date of initial application of these amendments.
For those entities that choose not to restate prior periods, transitional adjustments are recognised in opening retained earnings or other component of equity at the date of initial application of the amendments.
For help and advice on financial instruments related matters please get in touch with Mark Spencer or your usual BDO contact.
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