June 13, 2019 - This article provides an overview of the accounting issues associated with Libor transition. Each section discusses a problem and its proposed solution. The LSTA will continue to monitor for the solutions’ completion and will update you accordingly. 

Modification of loan terms

Problem: When the terms of a loan are adjusted, both the creditor and debtor have to perform FASB-required tests to determine whether the loan will be considered a modified loan or a new loan. If it is considered a new loan, the loan is recorded at fair value, and corresponding changes in book value flow through to the income statement. This test must be performed for each loan in an organization’s loan portfolio. For those with many Libor-based loans on their books, Libor transition could lead to a significant amount of work, and possibly financial statement volatility as well, depending on how many loans have to be recorded at fair value. 

Potential solution: The ARRC is seeking guidance from FASB on how to treat loans at the time of Libor transition. The preferred solution is for the FASB to allow market participants to classify all Libor-based loans as modified at the date of transition. 

Hedge Accounting

Problem: For a hedge to be considered a cash-flow hedge, the hedger must demonstrate that future interest payments are probable of occurring and that the hedge is likely to be effective. If the hedger fails to meet these criteria, it must de-designate the hedge, carry the hedging derivative on the balance sheet at fair value, and reflect changes in derivative value in the income statement. Libor transition could prevent hedgers from continuing to meet one or both of these criteria. 

Potential solution: The SEC has indicated that Libor-based cash flows are probable in the future because the hedge documentation “implicitly considers the rate that would replace Libor.” The ARRC is seeking accounting firm approval that alternative historical rate curve data may be used as proxies for SOFR curve data in the event that a sufficient amount of historical data is not available or is unreliable. FASB guidance on whether alternative rate curves may be used in determining the appropriateness of a hedging relationship is not required. 

Embedded Derivatives

Problem: Issuers must determine whether SOFR fallback language creates an embedded derivative. An embedded derivative is a term that affects a contract’s cash flows in a manner similar to the way a derivative would. Embedded derivatives must be evaluated for financial statement impact. Embedded derivatives bifurcated from their host instrument must be recorded at fair value on the balance sheet, with changes in fair value being recorded over time. If it is determined that SOFR fallback language creates embedded derivatives, this could lead to financial statement volatility. 

Potential solution: The ARRC is seeking FASB guidance providing clarification that contractual changes required to effectuate change from Libor to SOFR would not require embedded derivative analysis.

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