Fair Value Hierarchy Essay

1260 Words Apr 26th, 2014 6 Pages
Memorandum to: Accounting department of family finance co. from: Daisy subject: fair value hierarchy date: december 15, 2012
Introduction
Family Finance Co. (FFC), a publicly traded commercial bank, invests in a variety of securities in order to enhance returns greater than interest paid on bank deposits and other liabilities. The primary investments of FFC are collateralized debt obligation, mortgage-backed securities, auction-rate securities, equity securities in nonpublic companies, interest rate swaps, and a fuel swap for gasoline. FFC measures the derivative at fair value, presenting the portion of the fair value change by using the fair value hierarchy. This memo will present the appropriate classification in the fair value
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FFC measured the fair value by using the theoretical income-approach pricing model. Because this model takes into account the relationship between interest rates and loan prepayment speeds to better adapt to the Mortgage-Backed Security. Instrument 3 —Auction-Rate Security The fair value measurement of the Auction-Rate Security investment shall be categorized within Level 3 of the fair value hierarchy. According to ASC 820-10-35-52, “Level 3 inputs are unobservable inputs for the asset or liability”. Because of the continued deterioration in liquidity for the segment of the ARS market, FFC did not observe any market transactions during Q4 2012. As a result, there are just unobservable inputs for ARS to measure its fair value. According to ASC 820-10-35-53, “unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk”. Certain inputs to the valuation model are not market based, including estimates of coupon rates and credit risk assumptions. In this way, the fair value measurement of this ARS belongs to Level 3 inputs. FFC used a market approach to make measurement of its ARS holdings based on observable market transactions, thus, the securities’ par value is approximated which is consistent with characteristics of Level 3 inputs. Instrument 4 —Equity Investment in a Nonpublic Company The fair value

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