Family Finance Co. (FFC), a publicly traded commercial bank located in South Carolina, has a December 31 year-end and has adopted the provisions of Accounting Standards Update (ASU) 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities. 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, 20X2, FFC’s investments primarily consist of (1) collateralized debt obligation (CDO) securities, (2) mortgage-backed securities (MBSs), (3) auction-rate securities (ARSs), (4) equity securities of nonpublic companies, (5) “plain vanilla” interest rate swaps that FFC uses to hedge its exposure to variable interest rates on its corporate debt, and (6) a fixed-for-float fuel swap held for investment purposes. All cash payments made under these instruments are in U.S. dollars.

FFC accounts for its equity investments at fair value with changes in fair value reflected in earnings and debt securities as either trading securities or available-for-sale securities (with changes in fair value recorded through net income or other comprehensive income (OCI), respectively). 1 FFC has not elected the ASC 321 practical expedient for the investment in the nonpublic company. Because FFC uses the interest rate swap in a cashflow 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.

Instrument 1 — Collateralized Debt Obligation

On June 1, 20X2, FFC invested in an S&P AA-rated tranche of a CDO. The underlying collateral for the CDO is a pool of U.S. Treasury and corporate bonds. Before September 30, 20X2, FFC was able to measure the fair value of the CDO by using a market-based valuation technique that relies on inputs such as quoted prices in active markets for similar CDO securities and requires only insignificant adjustments for differences between the CDO security held by FFC and similar CDO securities.

Instrument 2 — Mortgage-Backed Security

On September 1, 20X2, FFC invested in an S&P AA-rated tranche of a privately issued pass-through MBS (i.e., nonagency) with a stated maturity of 30 years. The underlying collateral for the MBS is subprime mortgages on residential properties.

On September 30, 20X2, FFC measured the fair value of the MBS using a market approach valuation technique that was based on inputs that did not require a significant adjustment. These inputs included quoted prices in active markets for similar MBSs with insignificant adjustments for differences between the MBS held by FFC and similar securities.

In Q4 20X2, the market for the MBS became increasingly volatile with some periods of declining activity. The volatility was evidenced through fluctuating bid-ask spreads. However, FFC concluded that (1) there were observable transactions for the MBS or similar MBSs and (2) the prices for those transactions were current and therefore did not reduce their relevance to the fair value measurement. On the basis of the evidence, FFC determined that the observed transactions were orderly and that the adjustments to the observed transactions required to measure fair value for its MBS are insignificant on the measurement date.

As an alternative, FFC considered using a theoretical income-approach pricing model. Such a pricing model takes into account the relationship between interest rates and loan prepayment speeds. Mortgage prepayments are usually made because either a home is sold or the homeowner is refinancing to a new mortgage, presumably with a lower interest rate. Since these two sources of risk (interest rate and prepayment) are linked, this relationship must be factored into the model. FFC recognized that there would be substantial complexity in using an appropriate mathematical model for valuing its MBS.

FFC measured the fair value for its MBS by using only the observed market transactions referenced above because the alternative pricing model was inherently complex and would require significant assumptions.

Instrument 3 — Auction-Rate Security

During 20X1, 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” auctions3 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 20X2, 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 expects 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.

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 value. 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 20X2. As a result, as of December 31, 20X2, FFC used a discounted cash flow model (i.e., 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.

Instrument 4 — Equity Investment in a Nonpublic Company

• In 20X1, FFC invested in the common stock of Company X, a privately held clothing retailer that operates in a niche market of the baby clothing industry. Quoted prices are not available for X’s stock. 4 Most of X’s competitors are either privately held or subsidiaries of larger publicly traded clothing retailers. Company X is similar to two other organizations whose shares are thinly traded in an observable market. In determining an appropriate approach for measuring the fair value of its equity investment in X, FFC considered the following factors to establish whether a single or multiple valuation techniques should be adopted:

• Availability and reliability of data — FFC had sufficient data to support both the income and market approaches.

• Comparative levels of the alternative approaches in the fair value hierarchy — When using a market approach to measure the fair value of its investment in X, FFC would need to make significant entity-specific adjustments to observable market transactions (i.e., risk-adjustments for illiquidity, uncertainty of X’s future financial performance in relation to its comparables, and other adjustments to reflect business model differences between X and its comparables). Similarly, when measuring fair value using an income approach (on the basis of discounted cash flows), FFC would be required to use significant entity-specific assumptions in forecasting X’s future cash flows.

• Views of market participants on the relevance of valuation techniques — Through discussions with valuation specialists, FFC believes that market participants use multiple techniques (income and market approaches) to determine bid prices for similar investments. FFC also used both approaches in 20X1 when pricing its investment in X. On the basis of this information, in 20X1 FFC determined that it would use both market and income approaches (weighted equally) to measure the fair value of its investment in X. FFC has applied a consistent approach during 20X2.

Instrument 5 — Interest Rate Swap

In January 20X1, FFC executed a “plain-vanilla” over-the-counter (OTC) fixed-for-float interest rate (IR) swap as an economic hedge of its cash flow variability to changes in the London Interbank Offered Rate (LIBOR) on its six-year variable-rate term note. The terms of the IR swap require FFC to pay a fixed rate and receive a floating rate (threemonth LIBOR). The IR swap net cash settles on a quarterly basis. If the fixed rate exceeds the floating rate, FFC makes a net payment to the counterparty, and if the floating rate exceeds the fixed rate, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 20X2), the remaining life of the IR swap was four years.

FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing IR swaps. Key inputs into the valuation model are the LIBOR yield curve and an adjustment, if any, for nonperformance risk, which is the risk that a party to the contract will not satisfy its obligation (also known as a credit valuation adjustment (CVA)). FFC obtained a quoted LIBOR yield curve for the entire term of the IR swap. In addition, FFC concluded that no CVA was necessary on the basis of (1) the creditworthiness of both FFC and the IR swap counterparty and (2) credit enhancements related to the IR swap by virtue of the International Swap Dealers Association agreement between FFC and the IR swap counterparty.

An active OTC market exists for IR swaps having the same underlying (three-month LIBOR) and tenor (five years) as FFC’s IR swap.

Instrument 6 — Fuel Swap — Gasoline

In January 20X2, FFC entered into a four-year fixed-for-float OTC fuel swap. The terms of the fuel swap require FFC to pay a fixed price and receive a floating price from the counterparty according to the monthly average of a U.S. unleaded gasoline price published on the last day of the month by an independent source. The fuel swap settles annually on the last business day of each calendar year. If the fixed price exceeds the floating price (i.e., the 12-month average of the immediately preceding 12 months’ (January through December) published unleaded gasoline prices), FFC makes a net payment to the counterparty; if the floating price exceeds the fixed price, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 20X2), the remaining life of the fuel swap was three years.

FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing fuel swaps. Key inputs into the valuation model are the forward U.S. unleaded gasoline price curve and a CVA, if any.

An inactive OTC market exists for fuel swaps having the same underlying (U.S. unleaded gasoline) and tenor (three years) as FFC’s fuel swap. FFC was able to obtain an independently quoted U.S. unleaded gasoline forward price curve for one of the three years remaining under the swap. For the last two years of the swap, FFC used a forward curve obtained from a third-party pricing service. The third-party pricing service constructs the forward curve by using a proprietary model that incorporates fundamental economic factors such as physical constraints (e.g., capacity of current and future refining plants) and projected global supply and demand. As of the measurement date, the third party has not observed U.S. unleaded gasoline swap transactions with tenors beyond one year. In addition, FFC has calculated a CVA using unobservable inputs (and the counterparty was recently downgraded by S&P).

Required:

1. What are the accounting concepts at the center of the case?

2. What is the authoritative guidance to use in the analyses?

3. What are the major points of contention in the case?