Callaway 2002 Annual Report Download - page 57

54 CALLAWAY GOLF COMPANY
in the spot-forward differential are excluded from the test of
hedging effectiveness and are recorded currently in earnings
as a component of interest and other income, net. During the
years ended December 31, 2002, 2001 and 2000, the Company
recorded net gains of $376,000 and $1,988,000 and a net loss of
$174,000, respectively, as a result of changes in the spot-
forward differential. 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 hedged 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 quarterly.
At December 31, 2002, 2001 and 2000, the notional amounts of
the Company’s foreign exchange contracts used to hedge
outstanding balance sheet exposures were approximately
$49,939,000, $34,411,000 and $10,457,000, respectively. The
gains and losses on foreign currency contracts used to hedge
balance sheet exposures are recognized in interest and other
income in the same period as the remeasurement gain and
loss of the related foreign currency denominated assets and
liabilities and thus offset these gains and losses. During the
years ended December 31, 2002, 2001 and 2000, the Company
recorded net losses of $8,148,000 and net gains of $4,473,000
and $5,299,000, respectively, due to net realized and
unrealized gains and losses on contracts used to hedge
balance sheet exposures.
Energy Derivative
In the second quarter of 2001, the Company entered into a long-term,
fixed-price, fixed-capacity, energy supply contract as part of a
comprehensive strategy to ensure the uninterrupted supply of
electricity while capping costs in the volatile California
electricity market. The contract was originally effective
through May 2006. This derivative did not qualify for hedge
accounting treatment under SFAS No. 133. Therefore, the
Company recognized in earnings the changes in the estimated
fair value of the contract based on current market rates as
unrealized energy derivative losses. During the fourth quarter 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 terminating the energy supply
contract. As a result, the Company adjusted the estimated fair
value of this contract through the date of termination. As the
contract
is terminated and neither party to the contract is
performing pursuant to the terms of the contract, the terminated
contract
ceased to represent a derivative instrument in accor-
dance with SFAS No. 133. The Company, therefore, 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
accordance with SFAS No. 140, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of
Liabilities.” Any non-cash unrealized gains to be recognized
upon extinguishment of the derivative valuation account would
be reported as non-operating income.
As of the date of termination of the energy supply contract, the
derivative valuation account reflected $19,922,000 of unrealized
losses resulting from changes in the estimated fair value of the
contract. The fair value of the contract was estimated at the
time of termination based on market prices of electricity for
the remaining period covered by the contract. The net differ-
ential between the contract price and estimated market prices
for future periods was applied to the volume stipulated in the
contract and discounted on a present value basis to arrive at
the estimated fair value of the contract at the time of termination.
The estimate was highly subjective because quoted market
rates directly relevant to the Company’s local energy market
and for periods extending beyond a 10 to 12-month horizon
were not quoted on a traded market. In making the estimate,
the Company instead had to rely upon near-term market
quotations and other market information to determine an estimate
of the fair value of the contract. In management’s opinion,
there are no available contract valuation methods that provide
a reliable single measure of the fair value of the energy derivative
because of the lack of quoted market rates directly relevant to
the terms of the contract and because changes in subjective
input assumptions can materially affect the fair value
estimates. See Note 12 for a discussion of contingencies
related to the termination of the Company’s derivative
energy supply contract.