Three Ways Companies Can Prepare for the Libor Transition

This article first appeared on CFO

The London Interbank Offered Rate, commonly known as Libor, declined in favorability over the past decade as regulators discovered that major financial institutions were manipulating the 30-year-old benchmark for profit. In April 2018, the Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the U.S. preferred alternative to Libor. An overnight risk-free rate, SOFR is intended to provide a more reliable benchmark for financial transactions.

Though regulators have set a 2021 deadline for users of Libor to shift away from the benchmark, many companies have been slow to relinquish it. The delay is understandable; Libor impacts more than $300 trillion in financial products; its phaseout — affecting loans, leases, and countless other day-to-day activities — is daunting. Transitioning to SOFR, or any new rate, is a major transformation project with far-reaching implications for any company with financial products that are benchmarked to LIBOR.

Here are three ways that companies can expect to be affected by the transition — and how they can best prepare.

Derivatives and Hedge Accounting

The impact of the transition on derivatives will largely focus on interest rate hedges for loans with a variable interest rate tied to Libor. For derivative contracts that meet the criteria for hedge accounting, the income statement impact from the hedge and the hedged item are balanced out.

Because the purpose of hedge accounting is to reduce income statement volatility and the transition from Libor may result in hedge ineffectiveness, there may be unexpected impacts on earnings. Companies will likely need to perform complex analyses using alternative risk-free rates to prove hedge effectiveness continues to exist.

This evaluation may prove challenging if there is a lack of historical data available for alternative rates when completing the required back-testing to prove effectiveness, commonly referred to as regression analysis. As such, planning in advance could eliminate the unintended consequence that hedge accounting does not apply, resulting in the recognition of the income statement impact of both the hedge and hedged item separately.

Debt Agreements and Intercompany Loans

Many debt agreements are indexed to Libor, meaning the interest rate on the loan varies as Libor varies. Few of these agreements include an alternative rate that can be used if Libor cannot be determined, so the borrower and creditor may have to agree on an alternative risk-free rate.

Under current accounting rules, such a change would require companies to reassess each loan agreement to conclude whether debt modification or extinguishment accounting (the process of removing a liability from the balance sheet) should be applied. The latter may result in an unintended gain or loss in earnings.

However, FASB recently reached a tentative decision on the handling of changes in a contract’s reference rate. Such changes, including the Libor transition, would be accounted for as a continuation of a contract rather than the creation of a new contract if certain criteria are met. This decision will undergo a public comment period prior to approval. However, the proposal represents a significant step toward easing the accounting burden on companies.

Similarly, there are impacts associated with intercompany loans that include Libor as a base rate and that likely do not include language identifying a fall-back rate. As intercompany loans are required to be priced on an arm’s length basis for transfer pricing purposes, changing the underlying interest rate on a loan will require an updated analysis — and potentially a change in policy — to ensure the loan remains priced at arm’s length.

Financial and Valuation Models

Financial and valuation models are prevalent in the accounting and finance functions, including in financial planning, valuation of intangible assets as a result of business combinations, and valuation of financial instruments. Libor is often used as a component of the discount rate, which is a key input. The transition away from Libor will force entities to adjust their model inputs. That will potentially have accounting effects like updated fair values or downstream impacts on impairment conclusions.

As with any major change, the shift away from Libor will affect companies in different ways. Knowing how an organization is affected by the current benchmark and devising a robust strategy will be crucial to preventing disruptions and unexpected impacts on earnings. This strategy should include a complete list of affected contracts, processes, and structures and should incorporate an internal governance mechanism for overseeing the transition. Companies should begin this process immediately to lessen the impact of adopting new reference rates.