IBOR reform, still reforming

From December 2021 many IBORs (Interbank Offered Rates) ceased and have been replaced by alternative risk free rates (RFRs). For e.g. the GBP LIBOR has been replaced with the SONIA and the EONIA has been replaced with the ESTR.

Some benchmark rates have not yet transitioned for e.g. certain USD LIBORs, which will cease from 30 June 2023, as well as the JIBAR. The JIBAR is expected to be replaced by the ZARONIA, a rate which is not yet recommended by the SARB for use in financial contracts, but is currently being published to allow for market observation while the plans and implications for the JIBAR transition is considered. 

Financial institutions, and other entities with significant exposure to the IBOR reform, have been carefully monitoring the impact on their financial instruments over the past few years. To date many of the affected contracts would have been amended (unless the contracts mention a fall-back term that already references an alternative rate), or are currently within the process of being amended, to cater for replacement rates.

The question is, what IFRS disclosures are expected where the entity’s IBOR reform transition is well underway and has already been applied to various contracts, but where there is still future uncertainty regarding the impact on certain financial instruments?

If we ignore the impact on hedge accounting for now (requiring specific, additional disclosures), what disclosure does IFRS 7 require? Entities are required to disclose information about:

• the nature and extent of risks to which the entity is exposed arising from financial instruments subject to benchmark reform; and
• how the entity manages these risks; as well as
• the entity’s progress in completing the transition; and
• how the entity is managing the transition. (IFRS 7.24I)

In order to sufficiently meet these requirements, IFRS 7 further specifies that this would include detail around:

• how the entity is managing the transition to alternative benchmark rates; and
• its progress in completing the transition at the reporting date; and
• the exposure to risk arising from financial instruments because of the transition;
• any changes to the entity’s risk management strategy as a result of the transition together with a description of these changes.

Let’s talk numbers…

• Quantitative disclosure is required about financial instruments that have yet to transition to an alternative benchmark at year-end. For e.g. certain USD LIBOR and JIBAR linked financial instruments.

The disclosure regarding the impact of the reform is primarily qualitative in nature; it is very important that these disclosures are specific to the entity and its exposure to IBOR instruments, and not ‘generic’ or ‘boilerplate’.

Is there anything specific to consider regarding the contracts that have already been successfully amended or transitioned?

The Phase 1 amendment to IFRS 9 only addressed hedge accounting, whereas the Phase 2 amendment applied to all financial instruments as well as leases that are impacted by the IBOR reform. For a quick recap on these amendments refer to our previous article, The joys of JIBAR.

The Phase 2 amendment introduced a practical expedient that allows entities to account for changes to the basis for determining contractual cash flows as a direct consequence of the benchmark reform, by applying IFRS 9 B5.4.5. In other words to account for the change in basis as a change due to a floating rate of interest.

In practice, application of the practical expedient allowed by the Phase 2 amendment may require judgement. For example, to determine whether:

• the change in the basis for determining contractual cash flows is necessary as a direct consequence of the reform; and
• whether the replacement rate is economically equivalent to the previous IBOR rate - i.e. “overall contractual cash flows (including amounts relating to interest) of the financial instrument are substantially similar before and after the changes” BC5.312. Consideration should also be given to the credit spread adjustment that is needed to compensate the difference in value between the IBOR rate and the alternative risk free rate.

The IASB stated in the basis for conclusions that they “intended ‘economic equivalence’ to be principle-based and therefore decided not to include detailed application guidance related to the assessment of that condition.” They further noted that because no ‘bright lines’ have been set, judgement needs to be applied to “assess whether the circumstances meet the economic equivalence condition”. (extracted from BC5.315) 

There may also be judgement required to assess whether any changes to financial assets as a result of using a replacement rate would impact the SPPI (solely payments of principal and interest) assessment.

Entities would also be expected to exercise judgement in determining what information and detail is necessary in order to meet the disclosure objectives for the IBOR reform as required by IFRS 7 as detailed above.

These are just a few examples, however, there are likely to be other circumstances where judgement is required. The point is to make sure that detailed disclosures are made in the financial statements where significant judgement has been applied. 

How does this impact financial instruments at fair value through profit or loss disclosures?

Some entities, such as investment funds, actively trade with their financial assets, and classify and measure these at fair value through profit or loss, including debt securities. What is required in order to comply with the IFRS 7 disclosure objective?

The value of variable rate debt instruments that are linked to a benchmark rate that has not yet been transitioned should be disclosed. For example the value of debt securities that are linked to JIBAR or US LIBOR. Although the impact will be factored into the fair value of these debt instruments, where this is expected to be material this fact should be clearly disclosed in the financial statements, as well as an explanation as to how this risk is being managed.   

Other considerations

The entity should consider whether there were any additional changes made to financial instrument contracts other than the basis for determining contractual cash flows due to the benchmark reform. Any additional changes would need to first be accounted for by applying the practical expedient, and thereafter accounted for in accordance with the applicable provisions of IFRS 9.

It is also important for the entity to make sure that their accounting policies adequately reflect the accounting treatment for financial instruments in adopting and applying the relevant IBOR reform amendments. 

Uncertainty is not an excuse for a lack of disclosure!

There may be uncertainty around future impacts, particularly where there is no identified replacement rate or where there are uncertainties around timelines for the cessation of the current rate and introduction of a replacement rate. This is not an excuse for poor quality disclosure and is certainly not an excuse to ignore the above disclosure requirements.

The users of the financial statements need to be able to understand, at a minimum, which instruments are expected to be impacted in future, what the current status is, and that there are uncertainties around the future impact – and why.

In closing, the disclosures in the financial statements are expected to evolve as the entity’s IBOR reform transition progresses to reflect the continued impact and progress to date. Careful consideration should be given to the impact and accounting treatment of any contract amendments as a result of the reform.  

Consideration has not been made regarding the impact on hedge accounting in this article. If your entity applies hedge accounting, further considerations need to be made as to how this might be impacted by the IBOR reform, bearing in mind that there are additional disclosures required.

Authors:

Justine Lewis, IFRS Manager

17 March 2023