Note 5 - Fair Value of Financial Instruments

ASC 820, Fair Value Measurements, clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability.

As a basis for determining the fair value of certain of our assets and liabilities, we follow a three-tier fair value hierarchy which prioritizes the inputs used in measuring fair value as follows: (Level I) observable inputs such as quoted prices in active markets; (Level II) inputs other than the quoted prices in active markets that are observable either directly or indirectly; and (Level III) unobservable inputs in which there is little or no market data which requires us to develop our own assumptions. This hierarchy requires us to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value. Our financial assets and financial liabilities that are measured at fair value on a recurring basis consist of cash equivalents, marketable securities and interest rate swaps.

As of December 31, 2016 and 2015, the fair value hierarchy for our financial assets and financial liabilities that are carried at fair value was as follows, and unrealized gains (losses) on financial assets and liabilities presented in the table below for all periods presented were less than $1.0 million (in thousands):

	December 31, 2016								December 31, 2015
	Fair Value		Level I		Level II		Level III		Fair Value		Level I		Level II		Level III
Money market funds	$	2,226,322	$	2,226,322	$	—	$	—	$	297,810	$	297,810	$	—	$	—
U.S. treasury bills		—		—		—		—		16,664		16,664		—		—
Interest rate swaps		1,490		—		1,490		—		—		—		—		—
Total	$	2,227,812	$	2,226,322	$	1,490	$	—	$	314,474	$	314,474	$	—	$	—

All of our cash equivalents and current restricted cash, which are comprised primarily of money market funds, are classified within Level I of the fair value hierarchy because they are valued using quoted market prices or market prices for identical securities. Our restricted short-term marketable securities are classified within Level I of the fair value hierarchy.

We have classified the interest rate swaps within Level II because their fair values are determined using alternative pricing sources or models that utilized market observable inputs, including current and forward interest rates.

During the years ended December 31, 2016 and 2015, there were no transfers between the levels of the fair value hierarchy.

Derivative Financial Instruments

Cash Flow Hedges

In November 2015, we implemented a program to hedge the foreign currency exposure risk related to certain forecasted inventory purchases denominated in Japanese yen. The derivative instruments we use are foreign currency forward contracts and are designated as cash flow hedges with maturity dates of 12 months or less. We do not enter into derivative contracts for trading or speculative purposes.

The bank counterparties in all contracts expose Tesla to credit-related losses in the event of their nonperformance. However, to mitigate that risk, Tesla only contracts with counterparties who meet the Company’s minimum requirements under its counterparty risk assessment process. Tesla monitors ratings, credit spreads, and potential downgrades on at least a quarterly basis. Based on our on-going assessment of counterparty risk, the Company will adjust its exposure to various counterparties. We generally enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. However, we do not have any master netting arrangements in place with collateral features.

We document each hedge relationship and assess its initial effectiveness at the inception of the hedge contract and we measure its ongoing effectiveness on a quarterly basis using regression analysis. During the term of an effective hedge contract, we record gains and losses within accumulated other comprehensive income (loss). We reclassify these gains or losses to costs of automotive revenues in the period the related finished goods inventory is sold or as cost of automotive leasing revenue over the depreciation period for those sales accounted for as leases. Although our contracts are considered effective hedges, we may experience small amounts of ineffectiveness due to timing differences between our actual inventory purchases and the settlement date of the related foreign currency forward contracts. We have recorded no amounts related to hedge ineffectiveness within other income (expense), net in our Consolidated Statements of Operations, during the years ended December 31, 2016 and 2015.

There were no outstanding hedging contracts as of December 31, 2016. The net notional amount of these contracts was $322.6 million at December 31, 2015. Outstanding contracts are recognized as either assets or liabilities on the Consolidated Balance Sheet at fair value within prepaid expenses and other current assets or within accrued liabilities and other, depending on our net position. The net gain of $5.6 million in accumulated other comprehensive income (loss) as of December 31, 2016, is expected to be recognized to costs of automotive sales in the period the related finished goods inventory is sold or over the depreciation period for those sales accounted for as leases in the next twelve months. The total fair values of foreign currency contracts designated as cash flow hedges as of December 31, 2016 and December 31, 2015 was zero and $7.3 million and was determined using Level II inputs and recorded in prepaid expenses and other current assets on our Consolidated Balance Sheets. During the year ended December 31, 2016, we reclassified $44.9 million of gains from accumulated other comprehensive income (loss) into cost of automotive revenue. No amounts were reclassified from accumulated other comprehensive income (loss) into earnings for the year ended December 31, 2015.

Interest Rate Swaps

SolarCity enters into fixed-for-floating interest rate swap agreements to swap variable interest payments on certain debt for fixed interest payments, as required by its lenders. These interest rate swaps are not designated as hedging instruments. Accordingly, all interest rate swaps are recognized at fair value on our Consolidated Balance Sheets within other assets or other long-term liabilities, with any changes in fair value recognized as other income (expense), net in our Consolidated Statements of Operations and with any cash flows recognized as investing activities in our Consolidated Statements of Cash flows. As of December 31, 2016, the aggregate notional amount of these interest rate swaps, the gross asset at fair value, and the gross liability at fair value was $789.6 million, $10.6 million, and $12.1 million, respectively. During the year ended December 31, 2016, we recognized $7.0 million of gains related to these interest rate swaps.

Fair Value Disclosure

Our financial instruments that are not re-measured at fair value include accounts receivable, customer notes receivable, rebates receivable, accounts payable, accrued liabilities, customer deposits, convertible senior notes, participation interest, solar asset-backed notes, solar loan-backed notes, Solar Bonds and long-term debt. The carrying values of these financial instruments other than customer notes receivable, convertible senior notes, the participation interest, solar asset-backed notes, Solar Bonds, and long-term debt approximated their fair value.

We estimate the fair value of convertible senior notes based on a commonly accepted valuation methodology and market-based risk measurements that are indirectly observable, such as credit risk (Level II). In addition, we estimate the fair value of customer notes receivable, the participation interest, solar asset-backed notes, solar loan-backed notes and Solar Bonds based on rates currently offered for instruments with similar maturities and terms (Level III). The following table presents their estimated fair values and their carrying values (in thousands):

	December 31, 2016				December 31, 2015
	Carrying Value		Fair Value		Carrying Value		Fair Value
MyPower customer notes receivable	$	513,002	$	513,002		—		—
Convertible senior notes		2,957,288		3,205,641	$	2,505,868	$	3,423,257
Participation interest		16,713		15,025		—		—
Solar asset-backed notes		442,764		428,551		—		—
Solar loan-backed notes		137,024		132,129		—		—