how would you disclose the first security regarding fair value in file that is attached and why? consider the following as part of your support: ? The company?s determination of whether the respective markets for the instruments were active or inactive. ? The valuation techniques (market approach, income approach or both) used by the company. ? The fair value hierarchy classification of each input to the fair value measurement and how that classification impacts the fair value hierarchy classification of the entire instrument.

FAIR VALUE APPLICATION CASE Background Information Catamount Finance Co. (CFC) is a commercial bank located in Vermont with a December 31 year-end. CFC has an investment portfolio that it manages in an effort to earn returns in excess of interest paid on bank deposits and other liabilities. CFC invests in a variety of securities to enhance returns. As of December 31, 2011, CFC's investments primarily consist of: collateralized debt obligation securities equity securities of nonpublic companies mortgage backed securities auction rate securities CFC accounts for all of its securities 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). Facts related to specific securities owned by CFC are described below. 1. Collateralized Debt Obligation (CDO) On June 1, 2011, CFC 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, 2011, CFC was able to determine the fair value of the CDO using a market-based valuation technique relying on inputs such as quoted prices in active markets for similar CDO securities that required only insignificant adjustments for differences between the CDO security held by FFC and similar CDO securities. However, since September 30, the market for CDO securities has become increasingly inactive. The inactivity was evidenced by the following two factors: Significant widening of the bid-ask spreads in the brokered markets in which the CDO securities trade. The widening of the bid-ask spreads continued throughout Q4. Progressively significant decrease in the volume of trades relative to historical levels in Q4. No recent transactions have taken place. On the basis of the above factors, CFC determines that significant adjustments to observed market transactions of similar CDO securities are required to determine fair value as of the measurement date (December 31, 2011) given the lack of recent and relevant transactions. CFC determines that any adjustments made to the observed market transactions would be based on management's assumptions regarding market values. In addition, CFC also determined that an income approach valuation technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be more representative of fair value than the market approach valuation technique used on prior measurement dates (June 30 and September 30, 2011). Specifically, CFC uses the below mentioned discount rate adjustment technique to determine fair value. CFC determines that the appropriate discount rate that should be used to discount the contractual cash flows of the CDO security is 24 percent after considering the following: The implied rate of return on September 30, 2011 (the last date on which CFC determined the market to be active for the CDO security), was 15 percent. Since September 30, CFC estimates that credit spreads have widened by approximately 200 basis points and liquidity risk premiums have increased during that period by approximately 500 basis points.1 Other risks (e.g., interest rate risk) have not changed. CFC has estimated that an indication of an appropriate rate of return for the CDO security is 22 percent. In making that determination, CFC considered all available market information (e.g., quoted prices that are not current for same/similar CDO securities, analyst/rating agency reports, current level of interest rates, information on performance of underlying collateral) that could be obtained without undue cost and effort. Two nonbinding indicative quotes for the CDO security from brokers implied a rate of return of 25 percent and 29 percent. The indicative quotes are based on the brokers' proprietary models using hypothetical assumptions instead of actual transactions. CFC concluded that 24 percent is the point within the range of relevant inputs that is most representative of fair value given that there were multiple indications of the appropriate rate of return that market participants would consider relevant in estimating fair value. Accordingly, CFC determines that the risk-adjusted discount rate appropriately reflects the entity's estimate of the assumptions that market participants would use to estimate the selling price of the asset as of the measurement date. As a result of the above assumptions, the fair value of the investment at December 31, 2011 is estimated to be $25. 2. Mortgage-Backed Security (MBS) On September 1, 2011, CFC invested in an S&P AA-rated tranche of a privately issued passthrough MBS with a stated maturity of 30 years. The underlying collateral for the MBS is subprime mortgages on residential properties. On September 30, 2011, CFC determined the fair value of the MBS using a market approach valuation technique 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, the market for the MBS has become increasingly volatile with some periods of declining activity. The volatility was evidenced through fluctuating bid-ask spreads. However, FFC 1 One basis point is the equivalent of 1/100 of one percent. Thus, 100 basis points = .01 concluded there were observable transactions for the MBS or similar MBSs and that the prices for those transactions were current and therefore did not reduce their relevance to the fair value measurement. CFC determined that the adjustments to the observed transactions required to determine fair value for its MBS are insignificant on the measurement date. As an alternative, CFC considered using a theoretical pricing model (i.e., an income approach). Theoretical pricing models must take 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. CFC recognized the inherent complexity in using an appropriate mathematical model for valuing its MBS. Because the pricing model would require the use of significant assumptions, CFC determined the fair value for its MBS using only the observed market transactions referenced above. At December 31, 2011 CFC estimated the fair value of the MBS is $75. 3. Auction Rate Securities (ARS) During 2010, CFC acquired ARS, whose underlying assets are student loans that have a term of 20 years, with the interest rate reset based on \"Dutch\" auctions that generally occur every 28 days. The ARS were initially marketed to CFC as cash equivalents, as the rate setting mechanism of ARS is designed primarily to provide liquidity and economic characteristics similar to those of short-term investments. While ARS are designed to behave similar to short-term investments, when demand for ARS 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 2011, demand for ARS (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 the fourth quarter, CFC received the maximum interest rate on its ARS. (The maximum interest rate is predefined in the ARS agreement and is higher than the rate CFC would have otherwise received if sufficient demand for the ARS existed during the auctions.) CFC anticipates that the failed auctions may persist and the company's investment in ARS will continue to pay the maximum interest rate. The auctions continue to be conducted as scheduled. In prior periods, CFC used a market approach based on observable market transactions to fair value its ARS, 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, CFC did not observe any market transactions during Q4 2011. As a result, as of December 31, 2011, FFC used a discounted cash flow model (i.e., an income approach) to value its ARS holdings. CFC believes that the discounted cash flow model is a widely accepted method to fair value the ARS investment 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 discount. At December 31, 2011 the model resulted in a fair value of $50. 4. Equity Security of a Nonpublic Company In 2009, CFC 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.2 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, CFC considered the following factors to determine if a single or multiple valuation technique should be adopted: Availability and reliability of data CFC had sufficient data to support both the income and market approach. Comparative levels of the alternative approaches in the fair value hierarchy When using a market approach to fair value its investment in X, CFC would need to make significant entity-specific adjustments to observable market transactions (i.e., riskadjustments for illiquidity, uncertainty of X's stock relative 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), CFC 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, CFC believes that market participants use multiple techniques (income and market approaches) to determine bid prices for similar investments. CFC also used both approaches in 2010 when pricing its investment in X. Considering this information, in 2008 CFC determined that it would use both a market and income approach (weighted equally) to fair value its investment in X. FFC has applied a consistent approach during 2011. Its estimate of fair value on that date is $30. Required: Prepare a two page (max) memo that provides the controller of CFC with the appropriate fair value footnote disclosure as of December 31, 2011. Provide clear evidence in the memo that you understand what each security really is and reference appropriate authoritative guidance. Also, 2 Note that the security does not have a readily determinable fair value and thus is not in the scope of Statement 115. However, FFC has elected the fair value option for the security in accordance with Statement 159 and thus accounts for the investment at fair value with changes in fair value recorded through earnings. bring enough copies of your footnote disclosure for everyone. A name will be drawn from the \"hat\" and that person will present their disclosure to the class and discuss the rational for their choices accordingly.. You should consider the following as part of your support: The company's determination of whether the respective markets for the instruments were active or inactive. The valuation techniques (market approach, income approach or both) used by the company. The fair value hierarchy classification of each input to the fair value measurement and how that classification impacts the fair value hierarchy classification of the entire instrument