Callaway 2001 Annual Report Download - page 40

Callaway Golf Company
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wholly-owned foreign subsidiaries, and anticipated sales by the Company’s
wholly-owned European subsidiary for certain euro-denominated transac-
tions. To achieve hedge accounting, contracts must reduce the foreign curren-
cy exchange rate risk otherwise inherent in the amount and duration of the
hedged exposures and comply with established company risk management
policies. Pursuant to its foreign exchange hedging policy, the Company may
hedge anticipated transactions and certain firm commitments and the related
receivables and payables denominated in foreign currencies using forward
foreign currency exchange rate contracts and put or call options. Foreign cur-
rency derivatives are used only to the extent considered necessary to meet the
Company’s objectives of minimizing variability in the Company’s operating
results arising from foreign exchange rate movements. Hedging contracts
generally mature within twelve months.
At December 31, 2001 and 2000, the Company had approximately $157.0 mil-
lion and $118.2 million, respectively, of foreign exchange contracts outstand-
ing. Of the total contracts outstanding at December 31, 2001 and 2000,
approximately $122.6 million and $107.8 million, respectively, were designat-
ed as cash flow hedges. The Company estimates the fair values of derivatives
based on quoted market prices or pricing models using current market rates,
and records all derivatives on the balance sheet at fair value. At December 31,
2001 and 2000, the net fair value of foreign currency-related derivatives des-
ignated as cash flow hedges or fair value hedges were recorded as net current
assets of $8.8 million and net current liabilities of $1.6 million, respectively.
For derivative instruments that are designated and qualify as cash flow
hedges, the effective portion of the gain or loss on the derivative instrument
is initially recorded in accumulated other comprehensive income as a sepa-
rate component of shareholders’ equity and subsequently reclassified into
earnings in the period during which the hedged transaction is recognized in
earnings. The Company began utilizing cash flow hedges in the fourth quar-
ter of 2000. During 2001 and 2000, the Company reclassified $2.9 million
and $0, respectively, of gains into earnings related to the release of the effec-
tive portion of gains on contracts designated as cash flow hedges. As of
December 31, 2001, the Company expects to reclassify $6.4 million of
deferred net gains into earnings within the next twelve months. During 2001
and 2000, no gains or losses were reclassified into earnings as a result of the
discontinuance of any cash flow hedges.
The ineffective gain or loss for derivative instruments that are designated and
qualify as cash flow hedges is reported in “interest and other income, net”
immediately. For foreign currency contracts designated as cash flow hedges,
hedge effectiveness is measured using the spot rate. Changes in the spot-for-
ward differential are excluded from the test of hedging effectiveness and are
recorded currently in earnings as a component of interest and other income,
net. Assessments of hedge effectiveness are performed using the dollar offset
method and applying a hedge effectiveness ratio between 80% and 125%. Given
that both the hedging item and the hedging instrument are evaluated using the
same spot rate, the Company anticipates the hedges to be highly effective. The
effectiveness of each derivative is assessed monthly. During the years ended
December 31, 2001 and 2000, a net gain of $2.0 million and a net loss of $0.2
million, respectively, were recorded in interest and other income, net represent-
ing the ineffective portion of the Company’s derivative instruments.
At December 31, 2001 and 2000, the Company had approximately $34.4 mil-
lion and $10.4 million of foreign contracts used to hedge balance sheet expo-
sures outstanding. The gains and losses on foreign currency contracts used to
hedge balance sheet exposures are recognized in interest and other income,
net in the same period as the remeasurement gain and loss of the related for-
eign currency denominated assets and liabilities and thus offset these gains
and losses. During 2001 and 2000, the Company recorded net realized and
unrealized gains on contracts used to hedge balance sheet exposures of $4.5
million and $5.3 million, respectively.
Sensitivity analysis is the measurement of potential loss in future earnings of
market sensitive instruments resulting from one or more selected hypothet-
ical changes in interest rates or foreign currency values. The Company used
a sensitivity analysis model to quantify the estimated potential effect of unfa-
vorable movements of 10% in foreign currencies to which the Company was
exposed at December 31, 2001 through its derivative financial instruments.
The sensitivity analysis model is a risk analysis tool and does not purport to
represent actual losses in earnings that will be incurred by the Company, nor
does it consider the potential effect of favorable changes in market rates. It
also does not represent the maximum possible loss that may occur. Actual
future gains and losses will differ from those estimated because of changes or
differences in market rates and interrelationships, hedging instruments and
hedge percentages, timing and other factors.
The estimated maximum one-day loss in earnings from the Company’s for-
eign-currency derivative financial instruments, calculated using the sensitivi-
ty analysis model described above, is $15.3 million at December 31, 2001. The
Company believes that such a hypothetical loss from its derivatives would be
offset by increases in the value of the underlying transactions being hedged.
Electricity Price Fluctuations During the second quarter of 2001, the
Company entered into the Enron Contract to manage electricity costs in the
volatile California energy market. This derivative did not qualify for hedge
accounting treatment under SFAS No. 133. Therefore, the Company recog-
nized the changes in the estimated fair value of the contract based on current
market rates as unrealized energy derivative losses. During the fourth quar-
ter of 2001, the Company notified the energy supplier that, among other
things, the energy supplier was in default of the energy supply contract and
that based upon such default, and for other reasons, the Company was ter-
minating the energy supply contract. As a result, the Company adjusted the
estimated value of this contract through the date of termination, at which
time the terminated contract ceased to represent a derivative instrument in
accordance with SFAS No. 133. Because the contract is terminated and nei-
ther party to the contract is performing pursuant to the terms of the con-
tract, the Company no longer records future valuation adjustments for
changes in electricity rates. The Company continues to reflect the derivative
valuation account on its balance sheet, subject to periodic review, in accor-
dance with SFAS No. 140, “Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities.” See “Supply of
Electricity and Energy Contracts” above.
Interest Rate Fluctuations Additionally, the Company is exposed to inter-
est rate risk from its Amended Credit Agreement and Accounts Receivable
Facility (see Notes 4 and 5 to the Company’s Consolidated Financial
Statements) which are indexed to the London Interbank Offering Rate and
Redwood Receivables Corporation Commercial Paper Rate. No amounts
were advanced or outstanding under these facilities at December 31, 2001.
Notes 4 and 5 to the Company’s Consolidated Financial Statements outline
the principal amounts, if any, and other terms required to evaluate the
expected cash flows and sensitivity to interest rate changes.