4.	Derivative Financial Instruments and Fair Value Measurement

Interest Rate Swap Contracts

The Company's risk management objectives are to ensure that business and financial exposures to risk that have been identified and measured are minimized using the most effective and efficient methods to reduce, transfer and, when possible, eliminate such exposures. Operating decisions contemplate associated risks and management strives to structure proposed transactions to avoid or reduce risk whenever possible.

The Company has assessed its vulnerability to certain business and financial risks, including interest rate risk associated with its variable-rate long-term debt. To mitigate this risk, the Company entered into a five-year interest rate swap contract with Bank of America, N.A. (“BofA”) with a total notional value of $9.3 million (as of June 30, 2011) to hedge the variability of interest payments associated with its variable-rate borrowings under its term loan with BofA (“Term Loan”). Through this swap agreement, the Company pays interest at a fixed rate of 4.48% and receives interest at a floating-rate of the one-month LIBOR. Since the interest rate swap hedges the variability of interest payments on variable rate debt with similar terms, it qualifies for cash flow hedge accounting treatment under ASC Topic 815, Derivatives and Hedging (“ASC 815”). As of June 30, 2011, unrealized net losses of $737,000 were recorded in accumulated other comprehensive loss as a result of this hedge. The effective portion of the gain or loss on the derivative is reclassified into interest expense in the same period during which the Company records interest expense associated with the Term Loan. There was no hedge ineffectiveness recognized for the three and six month periods ended June 30, 2011, respectively.

	Balance Sheet Location	June 30, 2011		December 31, 2010
		(in thousands)

Derivative instruments in liability positions:

Derivatives designated as hedging instruments under ASC 815

Interest rate swap contract	Non-current liabilities - derivative financial instruments	$	737	$	849

Total derivatives		$	737	$	849

The interest rate swap contract is secured by substantially all of the Company's personal property and by the real properties located at 924 North Russell Street, Portland, Oregon and 14300 NE 145th Street, Woodinville, Washington (“collateral”) under the loan agreement with BofA. The Company's subsidiaries, Kona and Kona Brewing Co., LLC, have unconditionally guaranteed the Company's obligations to BofA arising under the interest rate swap agreement.

Fair Value Measurements

The recorded values of the Company's financial instruments, with the exception of its debt obligations, are considered to approximate the fair values of the financial instruments, in all material respects, as the Company's receivables and payables are recorded at amounts expected to be realized and paid and the Company's derivative financial instruments are carried at fair value. At June 30, 2011 the total carrying value and fair value of the Company's debt obligations, including the current portion, was $18.3 million and $18.6 million, respectively. At December 31, 2010, the total carrying value and fair value of the Company's debt obligations, including the current portion, was $27.1 million and $27.7 million, respectively.

Under the three-tier fair value hierarchy established in ASC 820, Fair Value Measurements and Disclosures, the inputs used in measuring fair value are prioritized as follows:

Level 1:

Observable inputs (unadjusted) in active markets for identical assets and liabilities;

Level 2:

Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets and inputs other than quoted prices that are observable for the asset or liability;

Level 3:

Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity or data for the asset or liability.

The Company has assessed its assets and liabilities that are measured and recorded at fair value within the above hierarchy and that assessment is as follows:

	Fair Value Hierarchy Assessment
	Level 1		Level 2		Level 3		Total
	(in thousands)
June 30, 2011
Derivative financial instruments - interest rate swap contracts	$	-	$	737	$	-	$	737

December 31, 2010
Derivative financial instruments - interest rate swap contracts	$	-	$	849	$	-	$	849