Fair Value Hierarchy Family Finance Co. (FFC), a publicly traded commercial bank located in South Carolina, has a December 31 year-end. FFC invests in a variety of securities to enhance returns, managing its investment portfolio in an effort to earn returns greater than interest paid on bank deposits and other liabilities. As of December 31, 2012, FFC's investments on auction-rate securities (ARSs)m cash payments made under these instruments are in U.S. dollars. FFC accounts for its investments at fair value with changes in fair value reflected either in earnings (for trading securities) or other comprehensive income (OCI) (for available for-sale securities). Because FFC uses the interest rate swap in a cash-flow hedge, it measures the derivative at fair value, presenting the portion of the fair value change that effectively offsets cash flow variability on its corporate debt in OCI and the remainder in earnings. Facts related to specific securities and derivatives owned by FFC are described below Auction-Rate Security During 2009, FFC acquired ARSs, whose underlying assets are student loans that have a term of 20 years, with the interest rate reset on the basis of "Dutch" auctionsl that generally occur every 28 days. The ARSs were initially marketed to FFC as cash equivalents because the rate-setting mechanism of ARSs is designed primarily to provide liquidity and economic characteristics similar to those of short-term investments. Although ARSs are designed to exhibit behavior similar to that of short-term investments, when demand for ARSs decreases and there is insufficient interest in the Dutch auction, a failed auction occurs and investors are unable to liquidate their positions through the auction process. During Q4 2012, demand for ARSs (with student loans as underlying assets) significantly decreased as investor confidence in these investment products and the performance of the underlying loans diminished. The lack of demand resulted in numerous auction failures and a limited secondary market for these securities. As a result of the failed auctions in Q4, FFC received the maximum interest rate on its ARSs. (The maximum interest rate is predefined in the ARS agreement and is higher than the rate FFC would have otherwise received if sufficient demand for the ARSs existed during the auctions.) FFC anticipates that the failed auctions may persist and the company's investment in ARSs will continue to pay the maximum interest rate. The auctions continue to be conducted as scheduled. 1 The interest rate on an ARS is determined through a Dutch" auction process. Refer to the Appendix, "Pricing and Valuation of Securities: Introduction to Common Types of Securities," Section 9, "Auction Rate Security," for additional details on the Dutch auction process. Case 11-2(a): Fair Value Hierarchy Page 4 Copyright 2009 Deloitte Development LLC All Rights Reserved. In prior periods, FFC used a market approach that was based on observable market transactions to fair value its ARS holdings, which had resulted in a fair value approximating the securities' par valuc. However, because of the continued deterioration in liquidity for the segment of the ARS market backed by student loans, FFC did not observe any market transactions during Q4 2012. As a result, as of December 31, 2012, FFC used a discounted cash flow model (i.c., an income approach) to value its ARS holdings. FFC believes that the discounted cash flow model is a widely accepted method for measuring the fair value of ARS investments in the current environment. Certain inputs to the valuation model that are significant to the overall valuation are not market based, including estimates of future coupon rates if auction failures continue, prepayment speed assumptions, credit risk assumptions (including performance of underlying collateral), and illiquidity discounts. Required: Determine the a referenced in the case as of December 31,2012. Provide support from ppropri ate classification in the fair value hierarchy for each of the instruments appropriate authoritative uidance. Consider the following: Question 3: The classification in the fair value hierarchy for each input into the fair value measurement and how those classifications affect classification in the fair value hierarchy of the entire instrument. Fair Value Hierarchy Family Finance Co. (FFC), a publicly traded commercial bank located in South Carolina, has a December 31 year-end. FFC invests in a variety of securities to enhance returns, managing its investment portfolio in an effort to earn returns greater than interest paid on bank deposits and other liabilities. As of December 31, 2012, FFC's investments on auction-rate securities (ARSs)m cash payments made under these instruments are in U.S. dollars. FFC accounts for its investments at fair value with changes in fair value reflected either in earnings (for trading securities) or other comprehensive income (OCI) (for available for-sale securities). Because FFC uses the interest rate swap in a cash-flow hedge, it measures the derivative at fair value, presenting the portion of the fair value change that effectively offsets cash flow variability on its corporate debt in OCI and the remainder in earnings. Facts related to specific securities and derivatives owned by FFC are described below Auction-Rate Security During 2009, FFC acquired ARSs, whose underlying assets are student loans that have a term of 20 years, with the interest rate reset on the basis of "Dutch" auctionsl that generally occur every 28 days. The ARSs were initially marketed to FFC as cash equivalents because the rate-setting mechanism of ARSs is designed primarily to provide liquidity and economic characteristics similar to those of short-term investments. Although ARSs are designed to exhibit behavior similar to that of short-term investments, when demand for ARSs decreases and there is insufficient interest in the Dutch auction, a failed auction occurs and investors are unable to liquidate their positions through the auction process. During Q4 2012, demand for ARSs (with student loans as underlying assets) significantly decreased as investor confidence in these investment products and the performance of the underlying loans diminished. The lack of demand resulted in numerous auction failures and a limited secondary market for these securities. As a result of the failed auctions in Q4, FFC received the maximum interest rate on its ARSs. (The maximum interest rate is predefined in the ARS agreement and is higher than the rate FFC would have otherwise received if sufficient demand for the ARSs existed during the auctions.) FFC anticipates that the failed auctions may persist and the company's investment in ARSs will continue to pay the maximum interest rate. The auctions continue to be conducted as scheduled. 1 The interest rate on an ARS is determined through a Dutch" auction process. Refer to the Appendix, "Pricing and Valuation of Securities: Introduction to Common Types of Securities," Section 9, "Auction Rate Security," for additional details on the Dutch auction process. Case 11-2(a): Fair Value Hierarchy Page 4 Copyright 2009 Deloitte Development LLC All Rights Reserved. In prior periods, FFC used a market approach that was based on observable market transactions to fair value its ARS holdings, which had resulted in a fair value approximating the securities' par valuc. However, because of the continued deterioration in liquidity for the segment of the ARS market backed by student loans, FFC did not observe any market transactions during Q4 2012. As a result, as of December 31, 2012, FFC used a discounted cash flow model (i.c., an income approach) to value its ARS holdings. FFC believes that the discounted cash flow model is a widely accepted method for measuring the fair value of ARS investments in the current environment. Certain inputs to the valuation model that are significant to the overall valuation are not market based, including estimates of future coupon rates if auction failures continue, prepayment speed assumptions, credit risk assumptions (including performance of underlying collateral), and illiquidity discounts. Required: Determine the a referenced in the case as of December 31,2012. Provide support from ppropri ate classification in the fair value hierarchy for each of the instruments appropriate authoritative uidance. Consider the following: Question 3: The classification in the fair value hierarchy for each input into the fair value measurement and how those classifications affect classification in the fair value hierarchy of the entire instrument