Topgolf Callaway Brands Corp. - 10-Q filing on 2016-11-07

Derivatives and Hedging

9 Months Ended

Sep. 30, 2016

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Note 13. Derivatives and Hedging

In the normal course of business, the Company is exposed to gains and losses resulting from fluctuations in foreign currency exchange rates relating to transactions of its international subsidiaries. As part of its strategy to manage the level of exposure to the risk of fluctuations in foreign currency exchange rates, the Company uses designated cash flow hedges and non-designated hedges in the form of foreign currency forward contracts to mitigate the impact of foreign currency translation on transactions that are denominated primarily in Japanese Yen, British Pounds, Euros, Canadian Dollars, Australian Dollars and Korean Won.

The Company accounts for its foreign currency forward contracts in accordance with ASC Topic 815, “Derivatives and Hedging” (“ASC Topic 815”). ASC Topic 815 requires the recognition of all derivative instruments as either assets or liabilities on the balance sheet, the measurement of those instruments at fair value and the recognition of changes in the fair value of derivatives in earnings in the period of change, unless the derivative qualifies as a designated cash flow hedge that offsets certain exposures. Certain criteria must be satisfied in order for derivative financial instruments to be classified and accounted for as a cash flow hedge. Gains and losses from the remeasurement of qualifying cash flow hedges are recorded as a component of other comprehensive income and released into earnings as a component of cost of goods sold or net sales during the period in which the hedged transaction takes place. Gains and losses on the ineffective portion of hedges (hedges that do not meet accounting requirements due to ineffectiveness) and derivatives that are not elected for hedge accounting treatment are immediately recorded in earnings as a component of other income (expense).

Foreign currency forward contracts are used only to meet the Company’s objectives of minimizing variability in the Company’s operating results arising from foreign exchange rate movements. The Company does not enter into foreign currency forward contracts for speculative purposes. The Company utilizes counterparties for its derivative instruments that it believes are credit-worthy at the time the transactions are entered into and the Company closely monitors the credit ratings of these counterparties.

The following table summarizes the fair value of the Company's foreign currency forward contracts as well as the location of the asset and/or liability on the consolidated condensed balance sheets at September 30, 2016 and December 31, 2015 (in thousands):



	Asset Derivatives
	September 30, 2016			December 31, 2015
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as cash flow hedging instruments:
Foreign currency forward contracts	Other current assets	$	215	Other current assets	$	520

Derivatives not designated as hedging instruments:
Foreign currency forward contracts	Other current assets	$	1,193	Other current assets	$	160



	Liability Derivatives
	September 30, 2016			December 31, 2015
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Derivatives designated as cash flow hedging instruments:
Foreign currency forward contracts	Accounts payable and accrued expenses	$	1,172	Accounts payable and accrued expenses	$	296

Derivatives not designated as hedging instruments:
Foreign currency forward contracts	Accounts payable and accrued expenses	$	3,960	Accounts payable and accrued expenses	$	46

The Company's foreign currency forward contracts are subject to a master netting agreement with each respective counterparty bank and are therefore net settled at their maturity date. Although the Company has the legal right of offset under the master netting agreements, the Company elected not to present these contracts on a net settlement amount basis, and are therefore presented on a gross basis on the accompanying consolidated condensed balance sheets at September 30, 2016 and December 31, 2015.

Cash Flow Hedging Instruments

Beginning in January 2015, the Company entered into foreign currency forward contracts designated as qualifying cash flow hedges to help mitigate the Company's foreign currency exposure on intercompany sales of inventory to its foreign subsidiaries. These contracts generally mature within 12 to 15 months from their inception. At September 30, 2016 and December 31, 2015, the notional amounts of the Company's foreign currency forward contracts designated as cash flow hedge instruments were approximately $34,278,000 and $55,938,000, respectively. The reporting of gains and losses on these cash flow hedging instruments depends on whether the gains or losses are effective at offsetting changes in the cash flows of the underlying hedged items. The Company uses the hypothetical derivative method to measure the effectiveness of the foreign currency forward contracts and evaluates the effectiveness on a quarterly basis. The effective portion of the gains and losses on the hedging instruments are recorded in other comprehensive income until recognized in earnings during the period that the hedged transactions take place. Any ineffective portion of the gains and losses from the hedging instruments is recognized in earnings immediately. The Company would discontinue hedge accounting prospectively if (i) it is determined that the derivative is no longer effective in offsetting changes in the cash flows of a hedged item, (ii) when the derivative expires or is sold, terminated, or exercised, (iii) if it becomes probable that the forecasted transaction being hedged by the derivative will not occur, (iv) if a hedged firm commitment no longer meets the definition of a firm commitment, or (v) if it is determined that designation of the derivative as a hedge instrument is no longer appropriate. The Company estimates the fair value of its foreign currency forward contracts based on pricing models using current market rates. These contracts are classified under Level 2 of the fair value hierarchy (see Note 12).

As of September 30, 2016, the Company recorded a net loss of $3,345,000 in other comprehensive income (loss) related to its hedging activities. Of this amount, for the three and nine months ended September 30, 2016, net losses of $607,000 and $879,000, respectively, were relieved from other comprehensive income and recognized in cost of goods sold for the underlying intercompany sales that were recognized, and net losses of $202,000 and $758,000, respectively, were relieved from other comprehensive income and recognized in net sales for the underlying third party sales. There were no ineffective gains or losses recognized during the nine months ended September 30, 2016. Forward points of $118,000 were expensed as incurred for the nine months ended September 30, 2016. Based on the current valuation, the Company expects to reclassify net losses of $1,152,000 from accumulated other comprehensive income (loss) into net earnings during the next 12 months.

The Company recognized net gains of $1,018,000 and $1,130,000 in cost of goods sold for the three and nine months ended September 30, 2015, respectively, and $62,000 and $683,000 in other income (expense) for the three and nine months ended September 30, 2015, respectively, as a result of hedge ineffectiveness.

The following tables summarize the net effect of all cash flow hedges on the consolidated condensed financial statements for the three and nine months ended September 30, 2016 (in thousands):



	Gain (Loss) Recognized in Other Comprehensive Income (Loss) (Effective Portion)
	Three Months Ended September 30,					Nine Months Ended September 30,
Derivatives designated as cash flow hedging instruments	2016		2015			2016			2015
Foreign currency forward contracts	$	331	$	(156	)	$	(3,345	)	$	1,999



	Gain (Loss) Reclassified from Other Comprehensive Income into Earnings (Effective Portion)
	Three Months Ended September 30,					Nine Months Ended September 30,
Derivatives designated as cash flow hedging instruments	2016			2015		2016			2015
Foreign currency forward contracts	$	(809	)	$	1,018	$	(1,637	)	$	1,130



	Gain Recognized in Other Income (Expense) (Ineffective Portion)
	Three Months Ended September 30,				Nine Months Ended September 30,
Derivatives designated as cash flow hedging instruments	2016		2015		2016		2015
Foreign currency forward contracts	$	—	$	590	$	—	$	1,211

The following table details the amounts reclassified from accumulated other comprehensive loss to cost of goods sold, as well as changes in foreign currency translation for the nine months ended September 30, 2016. Amounts are in thousands.



Accumulated other comprehensive loss, December 31, 2015	$	(11,813	)
Change in fair value of derivative instruments	(3,345		)
Amounts reclassified from accumulated other comprehensive income to cost of goods sold	879
Amounts reclassified from accumulated other comprehensive income to net sales	758
Foreign currency translation adjustments	4,195
Accumulated other comprehensive loss, September 30, 2016, before tax	(9,326		)
Income tax expense related to items of other comprehensive income	31
Less: Comprehensive income attributable to non-controlling interest	76
Accumulated other comprehensive loss, September 30, 2016, after tax and non-controlling interest	$	(9,219	)

Foreign Currency Forward Contracts Not Designated as Hedging Instruments

The Company uses foreign currency forward contracts that are not designated as qualified hedging instruments to mitigate certain balance sheet exposures (payables and receivables denominated in foreign currencies), as well as gains and losses resulting from the translation of the operating results of the Company’s international subsidiaries into U.S. dollars for financial reporting purposes. These contracts generally mature within 12 months from their inception. At September 30, 2016 and December 31, 2015, the notional amounts of the Company’s foreign currency forward contracts not designated as hedging instruments used to help mitigate the exposures discussed above were approximately $78,078,000 and $43,098,000, respectively. The increase in foreign currency forward contracts reflects the general timing of when the Company enters into these contracts. The Company estimates the fair values of foreign currency forward contracts based on pricing models using current market rates, and records all derivatives on the balance sheet at fair value with changes in fair value recorded in the statement of operations. The foreign currency contracts are classified under Level 2 of the fair value hierarchy (see Note 12).

The following table summarizes the location of net gains and losses in the consolidated condensed statements of operations that were recognized during the three and nine months ended September 30, 2016 and 2015, respectively (in thousands):



	Location of Net Gain (Loss) Recognized in Income on Derivative Instruments	Amount of Net Gain (Loss) Recognized in Income on Derivative Instruments
Derivatives not designated as hedging instruments		Three Months Ended September 30,					Nine Months Ended September 30,
Derivatives not designated as hedging instruments		2016			2015		2016			2015
Foreign currency forward contracts	Other income (expense), net	$	(50	)	$	637	$	(9,908	)	$	978

In addition, for the three and nine months ended September 30, 2016, the Company recognized net foreign currency gains related to transactions with its foreign subsidiaries of $1,244,000 and $3,909,000, respectively. For the three and nine months ended September 30, 2015, the Company recognized net foreign currency losses related to transactions with its foreign subsidiaries of $527,000 and $1,254,000, respectively.