The London Interbank Offered Rates (LIBOR) and other similar rates like Euribor have long been the key interest rates used in financial markets and are commonly used as a reference rate for loan agreements, swap contracts, mortgages, bonds and other financial instruments.
In addition, LIBOR can be found in leasing and servicing contracts, commercial contracts and often forms the basis for discount rates used for a variety of valuations used by businesses. LIBOR is derived from banks being asked to estimate their cost of borrowing and, due to its subjective nature, has historically been prone to manipulation. This has caused regulators across the globe to find alternatives. In the UK there will be a cessation of LIBOR from the end of 2021. In this article we consider some of the issues this raises for businesses that have contracts referenced to LIBOR both from a cashflow and an accounting perspective.
What should businesses be doing to prepare for LIBOR reform?
The first step is to take stock of all the areas in the business where LIBOR is referenced, eg in a contract or in a financial model. This could include:
- Loan and other financing agreements, including interest rate swaps (don’t forget intercompany loan agreements);
- Commercial arrangements, such as customer or supply contracts (think about late payment clauses);
- Lease agreements; and
- Internal models such as impairment models, business models or cashflow forecasts.
It is important to understand what the fall-back provisions are in your contracts in the event that LIBOR is unavailable. LIBOR is not the same as the alternative rates and therefore businesses should be engaging with banks and other counterparties to understand the impact of alternatives being proposed. The fall-back provision may well directly affect your interest payments. If possible, contracts should be re-negotiated. The preference expressed by the UK regulator is for contracts to be converted, with fall-backs only being used as a last resort.
It will also be necessary to think about the impact on your business cashflow and valuation models. LIBOR is a forward-looking rate that gives certainty over cash payments at the end of the payment, whereas alternative rates are backward-looking and therefore could impact any forecast cashflows and reduce certainty.
What is the impact on financial reporting?
Under both UK GAAP and International Financial Reporting Standards (IFRS), LIBOR transition has been addressed in two stages. The first stage ensured continuity of hedging relationships through the uncertain period of transition. Hedging relationships often exist whereby the volatility arising from a variable rate loan is offset by an interest rate swap, effectively converting the variable rate loan to a fixed rate. Without any amendments to standards, the change in reference rate could result in the discontinuation of hedging relationships, leading to large transfers to profit and loss. This has been addressed by allowing reporters to assume that the relationship continues uninterrupted throughout the transition period.
The second, more widespread, issue is related to modifications of financial instruments. Under accounting standards, modifications to the terms of financial instruments such as loans need to be assessed to determine whether the change to contractual cashflows is so substantial that it results in derecognition. To avoid this happening, accounting standards have been amended to include a practical expedient where contractual changes or changes to cash flows are as a direct consequence of LIBOR transition and where the new basis for determining contractual cashflows is ‘economically equivalent’ to the previous basis. Any such changes are permitted to be taken into account by updating the effective interest rate of the instrument without adjusting the carrying amount in the financial statements. It should be noted that any other changes, such as extending the term, would not be covered by this expedient.
For IFRS reporters, there are additional impacts. Companies that are party to a lease contract linked to LIBOR have further reliefs available to prevent changes being treated as a lease modification. New disclosures will, however, be required on how the company is managing LIBOR transition, including information on the risks to which it is exposed and its transition progress.
Businesses should be aware that the end date for LIBOR transition is fast approaching and take stock of the potential exposures, including in forecasting cashflows. Existing contracts should be reviewed to determine whether renegotiation is required or whether fall-back provisions are adequate. Amendments to financial reporting standards will assist in ensuring a smooth transition, but businesses should ensure that any renegotiation of contracts is covered by the practical expedients offered.
For further information on the LIBOR transition, or advice on how your business will be affected, please get in touch with your usual Saffery partner, or contact Anna Hicks.