In October 2018, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU), No. 2018-16 Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. The objective of this standard is to permit the use of the OIS rate based on SOFR as a U.S. Benchmark interest rate for hedge accounting purposes under Topic 815.

Many variable rate loans and other debt instruments use the London Interbank Offered Rate (LIBOR) to set the interest rate. If an entity holds debt, a line of credit, or an interest rate swap based on LIBOR, those entities will most likely begin to see a shift toward other benchmark rates in the next year.

The ASU applies to all entities that elect to apply hedge accounting to benchmark interest rate hedges under Topic 815.

Main Provisions of ASU No. 2018-16

Prior to the issuance of ASU 2018-16, there were four rates that an entity could use as a U.S. benchmark interest rate for hedge accounting purposes:

  1. Interest rates on direct Treasury obligations of the US government (UST)
  2. LIBOR swap rate
  3. Overnight Index Swap (OIS) Rate which is based on the Federal Funds Effective Rate
  4. Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate

Upon adoption of ASU No. 2018-16, SOFR OIS Rate is a fifth option that can be used for hedge accounting purposes.

Because of concerns about the sustainability of LIBOR, the Alternative Reference Rates Committee (ARRC) was formed by the Federal Reserve Board to identify an alternative to the US dollar (USD) LIBOR. In 2017, ARRC chose SOFR, which is a volume-weighted median interest rate that is calculated daily based on overnight transactions from the prior day’s trading activity in specified segments of the US Treasury repurchase market as its preferred reference rate. ASU 2018-16 was issued as a result of this transition from LIBOR to SOFR as the best practices reference rate.

By including the OIS rate based on SOFR as an acceptable benchmark interest rate during the early stages of the transition, this standard will facilitate the LIBOR to SOFR transition and provide time for companies to prepare for changes related to interest rate risk hedging strategies for both risk management and hedge accounting purposes.

While an entity would have to disclose the implementation of ASU 2018-16 in the year of adoption, this ASU would not require any additional recurring disclosures. The FASB concluded any recurring disclosures regarding the addition of a new benchmark rate would be unnecessary. This approach is consistent with past additions of new benchmark rates in the US.

The ASU does not address changes to existing hedging relationships upon a transition to the SOFR OIS from LIBOR, but the FASB is currently assessing the need for a project to consider certain transition relief provisions for existing hedging relationships, as additional time will likely be needed to fully consider the impact of transitioning away from LIBOR financial instruments to SOFR.

Effective Date of ASU No. 2018-16

The ASU is required to be adopted at the same time as ASU 2017-12 Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. For public companies, ASU 2017-12 is effective for fiscal years beginning after December 31, 2018. For all other entities, the ASU is effective for fiscal years beginning after December 31, 2019. Early adoption is permitted. An entity should apply a prospective method transition for qualifying new or designated hedging relationship entered into on or after the date of adoption.

A best practice for entities is to discuss with their lenders any expected changes to interest rates of their debt or hedging instruments. This will ensure that entities can prepare for any changes in their interest payments or future cash flow projections.

If you have any questions related to the implementation of this ASU, please contact one of LBMC’s accounting and audit experts below:

Michelle Schmidt, Senior Manager