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Why there are accounting consequences to interest rate reform

David Bradbery

Director, Financial Services, Ernst & Young LLP

3 minute read 23 Oct 2020
Related topics
Assurance
IFRS
CFO agenda

Accounting standards have been amended to prevent disruption caused by the introduction of new interest rate benchmarks.

The way in which interest rates are set came under scrutiny following the 2008 financial crisis, when evidence arose to show that widely used interest rate indices, such as the London Interbank Offer Rate (LIBOR), required reform.

In response, the Financial Stability Board mandated financial markets’ regulators around the world to review and reform the way interest rate indices are set. As a result, many interest rate indices will cease and be replaced from the end of 2021.

Financial markets regulators determined that interest rates must be based more closely on actual transactions rather than relying on banks’ judgement. This required that some interest rate indices be reformed and others, such as Sterling LIBOR, be replaced with the Sterling Overnight Index Average (SONIA).

Transactions that previously referenced an old interest rate index must therefore be updated. This requires revisions to a large number of loan agreements, derivative contracts and all other agreements referencing an interest rate index that is being replaced.

There are potential accounting consequences in making this type of change. The normal accounting for when a contract is amended would require the recognition of gains and losses on companies’ income statements. Stakeholders raised concerns that the accounting effects on companies could be more significant than warranted by the actual economic effect of changing the interest rate index, which, in most cases, is minimal.

Following the 2008 financial crisis, evidence arose to show that widely used interest rate indices, such as LIBOR, required reform.  Financial markets’ regulators around the world therefore decided to review and reform the way interest rate indices are set.

How EY can help

The International Accounting Standards Board (IASB) initiated a project in 2018 to review and amend the accounting standards so that the effects of interest rate benchmark reform on companies’ financial reporting is appropriate.


The IASB divided its work into two phases. Phase one, completed in September 2019, dealt with the effects of the reform during the period leading up to instruments transitioning from an old interest rate index to a new one. Phase two, completed in August 2020, addressed the accounting issues that arise once instruments complete the transition to a new interest rate.


Phase two amendments relate to the modification of financial assets, financial liabilities and lease liabilities, specific hedge accounting requirements and disclosure requirements. The amendments allow that for cash instruments such as loans and debt securities, the switch to a new interest rate is accounted for as a change in a floating rate of interest. New disclosure requirements mean that entities must report their exposure to those interest rate indices being replaced.

Summary

Interest rate indices are undergoing review and reform. This will have accounting consequences, and so accounting standards are also being reviewed. An EY publication examines the changes and warns that time is running out for entities considering early adoption of the amendments for a December 2020 year end.
 

About this article

David Bradbery

Director, Financial Services, Ernst & Young LLP

Shares insights on emerging accounting issues involving financial instruments for a global audience. Enjoys tennis, cycling and camping with his family.
Related topics
Assurance
IFRS
CFO agenda

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.