SOUTHWEST AIRLINES CO - FORM 10-Q - October 29, 2015

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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - SOUTHWEST AIRLINES COluv-9302015xex311.htm
EX-10.1 - SUPPLEMENTAL AGREEMENT NO. 1810-LA-1501773 - SOUTHWEST AIRLINES COluv-9302015xex101.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - SOUTHWEST AIRLINES COluv-9302015xex312.htm
EX-32.1 - CERTIFICATION OF CEO AND CFO - SOUTHWEST AIRLINES COluv-9302015xex321.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2015
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________
Commission File No. 1-7259
 
 
Southwest Airlines Co.
(Exact name of registrant as specified in its charter)
TEXAS
74-1563240
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
P.O. Box 36611
 
Dallas, Texas
75235-1611
(Address of principal executive offices)
(Zip Code)
Registrant's telephone number, including area code:  (214) 792-4000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No þ

Number of shares of Common Stock outstanding as of the close of business on October 27, 2015: 650,355,108



TABLE OF CONTENTS TO FORM 10-Q





2


SOUTHWEST AIRLINES CO.
FORM 10-Q
PART I – FINANCIAL INFORMATION

Item 1. Financial Statements
Southwest Airlines Co.
Condensed Consolidated Balance Sheet
(in millions)
(unaudited)
 
September 30, 2015
 
December 31, 2014
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,740

 
$
1,282

Short-term investments
1,356

 
1,706

Accounts and other receivables
465

 
365

Inventories of parts and supplies, at cost
308

 
342

Deferred income taxes
465

 
477

Prepaid expenses and other current assets
239

 
232

Total current assets
4,573

 
4,404

 
 
 
 
Property and equipment, at cost:
 

 
 

Flight equipment
19,244

 
18,473

Ground property and equipment
3,066

 
2,853

Deposits on flight equipment purchase contracts
692

 
566

Assets constructed for others
823

 
621

 
23,825

 
22,513

Less allowance for depreciation and amortization
8,896

 
8,221

 
14,929

 
14,292

Goodwill
970

 
970

Other assets
687

 
534

 
$
21,159

 
$
20,200

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
1,235

 
$
1,203

Accrued liabilities
2,049

 
1,565

Air traffic liability
3,513

 
2,897

Current maturities of long-term debt
287

 
258

Total current liabilities
7,084

 
5,923

 
 
 
 
Long-term debt less current maturities
2,381

 
2,434

Deferred income taxes
3,111

 
3,259

Construction obligation
684

 
554

Other noncurrent liabilities
931

 
1,255

Stockholders' equity:
 

 
 

Common stock
808

 
808

Capital in excess of par value
1,330

 
1,315

Retained earnings
8,922

 
7,416

Accumulated other comprehensive loss
(903
)
 
(738
)
Treasury stock, at cost
(3,189
)
 
(2,026
)
Total stockholders' equity
6,968

 
6,775

 
$
21,159

 
$
20,200

See accompanying notes.

3


Southwest Airlines Co.
Condensed Consolidated Statement of Comprehensive Income
(in millions, except per share amounts)
(unaudited)

 
Three months ended September 30,
 
Nine months ended September 30,
 
2015
 
2014
 
2015
 
2014
OPERATING REVENUES:
 
 
 
 
 
 
 
Passenger
$
4,716

 
$
4,564

 
$
13,746

 
$
13,249

Freight
44

 
45

 
134

 
128

Special revenue adjustment
172

 
—

 
172

 
—

Other
386

 
191

 
791

 
600

Total operating revenues
5,318

 
4,800

 
14,843

 
13,977

 
 
 
 
 
 
 
 
OPERATING EXPENSES:
 

 
 

 
 

 
 

Salaries, wages, and benefits
1,699

 
1,363

 
4,725

 
4,044

Fuel and oil
936

 
1,386

 
2,818

 
4,125

Maintenance materials and repairs
259

 
248

 
729

 
734

Aircraft rentals
60

 
71

 
179

 
227

Landing fees and other rentals
303

 
289

 
887

 
849

Depreciation and amortization
258

 
238

 
751

 
687

Acquisition and integration
6

 
23

 
32

 
78

Other operating expenses
572

 
568

 
1,632

 
1,628

Total operating expenses
4,093

 
4,186

 
11,753

 
12,372

 
 
 
 
 
 
 
 
OPERATING INCOME
1,225

 
614

 
3,090

 
1,605

 
 
 
 
 
 
 
 
OTHER EXPENSES (INCOME):
 

 
 

 
 

 
 

Interest expense
31

 
31

 
92

 
97

Capitalized interest
(9
)
 
(6
)
 
(23
)
 
(18
)
Interest income
(2
)
 
(2
)
 
(5
)
 
(5
)
Other (gains) losses, net
272

 
66

 
394

 
16

Total other expenses (income)
292

 
89

 
458

 
90

 
 
 
 
 
 
 
 
INCOME BEFORE INCOME TAXES
933

 
525

 
2,632

 
1,515

PROVISION FOR INCOME TAXES
349

 
196

 
987

 
569

 
 
 
 
 
 
 
 
NET INCOME
$
584

 
$
329

 
$
1,645

 
$
946

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, BASIC
$
0.89

 
$
0.48

 
$
2.47

 
$
1.37

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, DILUTED
$
0.88

 
$
0.48

 
$
2.45

 
$
1.36

 
 
 
 
 
 
 
 
COMPREHENSIVE INCOME
$
345

 
$
126

 
$
1,480

 
$
857

 
 
 
 
 
 
 
 
WEIGHTED AVERAGE SHARES OUTSTANDING
 

 
 

 
 

 
 

Basic
655

 
683

 
665

 
690

Diluted
663

 
691

 
673

 
699

 
 
 
 
 
 
 
 
Cash dividends declared per common share
$
.075

 
$
.060

 
$
.210

 
$
.160

See accompanying notes.

4


Southwest Airlines Co.
Condensed Consolidated Statement of Cash Flows
(in millions)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
 
 
 
Net income
$
584

 
$
329

 
$
1,645

 
$
946

Adjustments to reconcile net income to cash provided by (used in) operating activities:
 

 
 

 
 

 
 

Depreciation and amortization
258

 
238

 
751

 
687

Unrealized/realized (gain) loss on fuel derivative instruments
87

 
63

 
172

 
(4
)
Deferred income taxes
(82
)
 
392

 
(40
)
 
472

Changes in certain assets and liabilities:
 

 
 

 
 

 
 

Accounts and other receivables
4

 
(22
)
 
(86
)
 
(83
)
Other assets
33

 
6

 
40

 
(7
)
Accounts payable and accrued liabilities
380

 
(534
)
 
424

 
(86
)
Air traffic liability
(301
)
 
(108
)
 
617

 
806

Cash collateral received from (provided to) derivative counterparties
181

 
(98
)
 
(213
)
 
8

Other, net
(308
)
 
(26
)
 
(396
)
 
(41
)
Net cash provided by operating activities
836

 
240

 
2,914

 
2,698

 
 
 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 

 
 

 
 

Capital expenditures
(230
)
 
(406
)
 
(1,231
)
 
(1,282
)
Assets constructed for others
(32
)
 
(27
)
 
(76
)
 
(58
)
Purchases of short-term investments
(506
)
 
(415
)
 
(1,383
)
 
(2,344
)
Proceeds from sales of short-term and other investments
509

 
805

 
1,732

 
2,427

Other, net
—

 
(1
)
 
(9
)
 
(2
)
Net cash used in investing activities
(259
)
 
(44
)
 
(967
)
 
(1,259
)
 
 
 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 

 
 

 
 

Proceeds from Employee stock plans
9

 
23

 
30

 
96

Proceeds from termination of interest rate derivative instruments
—

 
—

 
12

 
—

Reimbursement for assets constructed for others
9

 
26

 
14

 
26

Payments of long-term debt and capital lease obligations
(79
)
 
(48
)
 
(170
)
 
(167
)
Payments of cash dividends
(49
)
 
(41
)
 
(180
)
 
(138
)
Repayment of construction obligation
(3
)
 
(3
)
 
(8
)
 
(8
)
Repurchase of common stock
(500
)
 
(200
)
 
(1,180
)
 
(755
)
Other, net
4

 
(3
)
 
(7
)
 
(16
)
Net cash used in financing activities
(609
)
 
(246
)
 
(1,489
)
 
(962
)
 
 
 
 
 
 
 
 
NET CHANGE IN CASH AND CASH EQUIVALENTS
(32
)
 
(50
)
 
458

 
477

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
1,772

 
1,882

 
1,282

 
1,355

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,740

 
$
1,832

 
$
1,740

 
$
1,832

 
 
 
 
 
 
 
 
CASH PAYMENTS FOR:
 
 
 
 
 
 
 
Interest, net of amount capitalized
$
33

 
$
35

 
$
86

 
$
102

Income taxes
$
409

 
$
132

 
$
975

 
$
144

 
 
 
 
 
 
 
 
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
 
 
 
 
 
 
 
Flight equipment under capital leases
$
48

 
$
31

 
$
130

 
$
94

Assets constructed for others
$
46

 
$
27

 
$
126

 
$
59

See accompanying notes.

5


Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)

1.    BASIS OF PRESENTATION

Southwest Airlines Co. (the “Company”) operates Southwest Airlines, a major passenger airline that provides scheduled air transportation in the United States and near-international markets. The unaudited Condensed Consolidated Financial Statements include accounts of the Company and its wholly owned subsidiaries, which include AirTran Holdings, LLC, the parent company of AirTran Airways, Inc. (“AirTran Airways”). On May 2, 2011 (the “acquisition date”), the Company acquired all of the outstanding equity of AirTran Holdings, Inc. (“AirTran Holdings”), the former parent company of AirTran Airways. Throughout this Form 10-Q, the Company makes reference to AirTran, which is meant to be inclusive of the following: (i) for periods prior to the acquisition date, AirTran Holdings and its subsidiaries, including, among others, AirTran Airways; and (ii) for periods on and after the acquisition date, AirTran Holdings, LLC, the successor to AirTran Holdings, and its subsidiaries, including among others, AirTran Airways. AirTran's final passenger service was on December 28, 2014. Although the vast majority of integration costs were incurred in periods prior to 2015, the Company continues to incur costs associated with the integration of AirTran, and those costs are included in Acquisition and integration costs in the accompanying unaudited Condensed Consolidated Statement of Comprehensive Income.

The accompanying unaudited Condensed Consolidated Financial Statements of the Company and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States (“GAAP”) for complete financial statements. The unaudited Condensed Consolidated Financial Statements for the interim periods ended September 30, 2015 and 2014 include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. This includes all normal and recurring adjustments and elimination of significant intercompany transactions. Financial results for the Company and airlines in general can be seasonal in nature. In many years, the Company's revenues, as well as its operating income and net income, have been better in its second and third fiscal quarters than in its first and fourth fiscal quarters. Air travel is also significantly impacted by general economic conditions, the amount of disposable income available to consumers, unemployment levels, corporate travel budgets, and other factors beyond the Company's control. These and other factors, such as the price of jet fuel in some periods, the nature of the Company's fuel hedging program, the periodic volatility of commodities used by the Company for hedging jet fuel, and the requirements related to hedge accounting, have created, and may continue to create, significant volatility in the Company's financial results. See Note 3 for further information on fuel and the Company's hedging program. Operating results for the three and nine months ended September 30, 2015, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 2015. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 2014.

2.    CHANGES IN ACCOUNTING OR ESTIMATES AND NEW ACCOUNTING PRONOUNCEMENTS

New accounting pronouncements
On February 18, 2015, the Financial Accounting Standards Board ("FASB") and the International Accounting Standards Board issued a final standard that amends the current consolidation guidance. The standard amends both the variable interest entity and voting interest entity consolidation models. The standard is effective for public reporting entities in fiscal periods beginning after December 15, 2015, and early adoption is permitted. Once adopted, the Company will need to assess the potential for entity consolidation under a new consolidation model; however, the Company does not believe this will result in changes to its previous consolidation conclusions. The Company will adopt this new standard during first quarter 2016, but does not expect it to have a significant impact.

On May 28, 2014, the FASB issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers. Following the FASB's finalization of a one year deferral of this standard, the ASU is now effective

6
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


for fiscal years, and interim periods within those years, beginning on or after December 15, 2017, with early adoption permitted for fiscal years, and interim periods within those years, beginning on or after December 15, 2016. The Company believes the most significant impact of this ASU on its accounting will be the elimination of the incremental cost method for frequent flyer accounting, which will require the Company to re-value its liability earned by Customers associated with flight points with a relative fair value approach. The Company is continuing to evaluate the new guidance and plans to provide additional information about its expected financial impact at a future date.

Changes in accounting or estimates
During July 2015, the Company executed an amended co-branded credit card agreement (“Agreement”) with Chase Bank USA, N.A. (“Chase”), through which the Company sells loyalty points and other items to Chase. The Company's Rapid Rewards program members ("Members") are able to accrue loyalty points based on purchases using the Chase co-branded Southwest Visa credit card. The Agreement materially modifies the previously existing agreement between Chase and the Company. Consideration received as part of this Agreement is subject to ASU 2009-13, "Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force".

Historically, funds received from the sale of points associated with these agreements were accounted for under the residual method. Under the residual method, the Company estimated the portion from frequent flyer points sold associated with Southwest’s co-branded Chase Visa credit card that related to free travel. The estimated amounts associated with free travel were deferred and recognized as Passenger revenue when the ultimate free travel awards were flown. Under the residual method, the Company estimated that 100 percent of the amount received from frequent flyer points sold were related to free travel.

The modified Agreement has the following multiple elements: travel points to be awarded; use of the Southwest Airlines’ brand and access to Rapid Reward Member lists; advertising elements; and the Company’s resource team. Under ASU 2009-13, these deliverables are accounted for separately, and allocation of consideration from the Agreement is determined based on the relative stand-alone selling price of each deliverable. As compared to the residual method, the application of ASU 2009-13 to the Agreement decreases the relative value of the air transportation deliverables that the Company records as deferred revenue (and ultimately Passenger revenues when redeemed awards are flown) and increases the relative value of the marketing-related deliverables recorded in Other revenues at the time these marketing-related deliverables are provided.

Significant management judgment was used to estimate the stand-alone selling price of each of the deliverables. The Company determined the best estimate of selling price by considering multiple inputs and methods including, but not limited to, the estimated selling price of comparable travel, discounted cash flows, brand value, published selling prices, number of points awarded, and the number of points redeemed. The Company estimated the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the multiple deliverables.

The Company records Passenger revenue related to (i) air transportation and (ii) certificates for discounted companion travel when the transportation is delivered. The other elements are recognized as Other - net revenue when earned.


7
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The Company followed the transition approach of ASU 2009-13, which required that the Company's existing deferred revenue balance, classified within Air traffic liability, be adjusted to reflect the value, on a relative selling price basis, of any undelivered element remaining at the date of contract modification. The relative selling price of the undelivered element (air transportation) is lower than the rate at which it had been deferred under the previous contract and the Company recorded a one-time, non-cash adjustment to decrease frequent flyer deferred revenue and increase Special revenue adjustment. In addition, the Agreement and the resulting application of ASU 2009-13 are expected to result in an acceleration of the timing of Operating revenues on a prospective basis relative to the Company's previous application of the residual method due to assigning a higher value to the non-transportation elements of the Agreement than under the residual method. The impacts on revenue and earnings from this change in accounting principle are as follows:

(in millions, except per share amounts)
Three months ended September 30, 2015
 
Nine months ended September 30, 2015
Passenger revenue
$
(40
)
 
$
(40
)
Special revenue adjustment
172

 
172

Other revenue
171

 
171

Operating revenues
$
303

 
$
303

Net income
$
161

 
$
161

Net income per basic share
$
0.25

 
$
0.24

Net income per diluted share
$
0.24

 
$
0.24


During fourth quarter 2014, the Company increased the amount of spoilage recorded associated with frequent flyer points sold to business partners as a result of continued monitoring of Member redemption activity and behavior under its Rapid Rewards program. Based on a sufficient amount of historical data and Member attributes observed since the new program was launched in 2011, the Company developed a predictive statistical model to analyze the amount of spoilage expected. In estimating spoilage, the Company takes into account the Member’s past behavior, as well as several factors that are expected to be indicative of the likelihood of future point redemption. These factors include, but are not limited to, tenure with program, points accrued in the program, and whether or not the Customer has a co-branded credit card. This change in estimate was recorded on a prospective basis, effective October 1, 2014. As a result of its annual update the Company will prospectively apply a slight decrease in the rate beginning as of October 1, 2015; however, the precise revenue impact will not be determinable until the actual number of point redemptions for the period is known. The Company will continue to monitor all factors that influence spoilage and Member behavior in order to determine its best estimate of expected spoilage. The impacts on revenue and earnings for the lower rate applied in fourth quarter 2014 are as follows:
(in millions, except per share amounts)
Three months ended September 30, 2015
 
Nine months ended September 30, 2015
Passenger revenue
$
30

 
$
115

Net income
$
16

 
$
61

Net income per basic share
$
0.02

 
$
0.09

Net income per diluted share
$
0.02

 
$
0.09



3.    FINANCIAL DERIVATIVE INSTRUMENTS

Fuel contracts
Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Furthermore, jet fuel and oil typically represent one of the largest operating expenses for airlines. The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses through its fuel hedging program. Although the Company may periodically enter into jet fuel derivatives for short-term timeframes, because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel for time horizons longer than approximately 24 months into the future. However, the Company has found that financial derivative instruments in other commodities, such as West Texas Intermediate (“WTI”) crude oil, Brent crude oil, and refined products, such as heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility. The Company does not purchase or hold any financial derivative instruments for trading or speculative purposes.

The Company has used financial derivative instruments for both short-term and long-term time frames and primarily uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), call spreads (which include a purchased call option and a sold call option), put spreads (which include a purchased put option and a sold put option), and fixed price swap agreements in its portfolio. Although the use of collar structures and swap agreements can reduce the overall cost of hedging, these instruments carry more risk than purchased call options in that the Company could end up in a liability position when the collar structure or swap agreement settles. With the use of purchased call options and call spreads, the Company cannot be in a liability position at settlement, but does not have coverage once market prices fall below the strike price of the purchased call option.

The Company evaluates its hedge volumes strictly from an “economic” standpoint and thus does not consider whether the hedges have qualified or will qualify for hedge accounting. The Company defines its “economic” hedge as the net volume of fuel derivative contracts held, including the impact of positions that have been offset through sold positions, regardless of whether those contracts qualify for hedge accounting. The level at which the Company is economically hedged for a particular period is also dependent on current market prices for that period, as well as the types of derivative instruments held and the strike prices of those instruments. For example, the Company may enter into “out-of-the-money” option contracts (including catastrophic protection), which may not generate intrinsic gains at settlement if market prices do not rise above the option strike price. Therefore, even though the Company may have an “economic” hedge in place for a particular period, that hedge may not produce any hedging gains at settlement and may even produce hedging losses depending on market prices, the types of instruments held, and the strike prices of those instruments.


8
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished "out of the money" and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an "economic" hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company's hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an "economic" hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. The following table provides information about the Company’s volume of fuel hedging for the years 2015 through 2018 on an “economic” basis:

 
 
Fuel hedged as of
 
 
 
 
September 30, 2015
 
Derivative underlying commodity type as of
Period (by year)
 
(gallons in millions)
 
September 30, 2015
Fourth quarter 2015
 
—

(a)
 
2016
 
1,188

(b)
Brent crude oil, Heating oil, and Gulf Coast jet fuel
2017
 
1,294

(b)
WTI crude and Brent crude oil
2018
 
466

(b)
Brent crude oil
(a) The Company is effectively unhedged for fourth quarter 2015 at current price levels. While the Company still holds derivative contracts as of September 30, 2015, that will settle during fourth quarter 2015, the losses associated with those contracts are substantially locked in. However, if market prices were to increase or decrease significantly related to the fourth quarter 2015 positions prior to these contracts settling, the losses incurred at settlement could be slightly lower or higher than currently expected amounts during that period. 
(b) Due to the types of derivatives and commodities utilized by the Company and different price levels of those contracts, this volume represents the maximum "economic" net hedge in place. The Company's average "economic" net hedge of estimated fuel consumption covered by fuel derivative contracts is lower than this maximum volume, may vary significantly as market prices fluctuate, and begins to provide hedge coverage at price levels above current market prices.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges. Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in Accumulated other comprehensive income (loss) ("AOCI") until the underlying jet fuel is consumed. See Note 4. The Company’s results are subject to the possibility that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for hedge accounting. Ineffectiveness results when the change in the fair value of the derivative instrument exceeds the change in the value of the Company’s expected future cash outlay to purchase and consume jet fuel. To the extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income. Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense. When the Company has sold derivative positions in order to effectively “close” or offset a derivative already held as part of its fuel derivative instrument portfolio, any subsequent changes in fair value of those positions are marked to market through earnings. Likewise, any changes in fair value of those positions that were offset by entering into the sold positions and were de-designated as hedges are concurrently marked to market through earnings. However, any changes in value related to hedges that were deferred as part of AOCI while designated as a hedge would remain until the originally forecasted transaction occurs. In a situation where it becomes probable that a fuel hedged forecasted transaction will not occur, any gains and/or losses

9
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


that have been recorded to AOCI would be required to be immediately reclassified into earnings. The Company did not have any such situations occur during 2014, or during the nine months ended September 30, 2015.

In some situations, an entire commodity type used in hedging may cease to qualify for special hedge accounting treatment. As an example, from July 2013 to July 2015, the Company's routine statistical analysis performed to determine which commodities qualified for special hedge accounting treatment on a prospective basis dictated that WTI crude oil based derivatives no longer qualified for hedge accounting. This was primarily due to the fact that the correlation between WTI crude oil prices and jet fuel prices during recent periods had not been as strong as in the past, and therefore the Company could no longer demonstrate that derivatives based on WTI crude oil prices would result in effective hedges on a prospective basis. As such, the changes in fair value of all of the Company's derivatives based in WTI were recorded directly to Other (gains) losses. The Company's routine statistical analysis performed for the three months ended September 30, 2015, dictated that WTI crude oil based derivatives again qualified for hedge accounting.

All cash flows associated with purchasing and selling fuel derivatives are classified as Other operating cash flows in the unaudited Condensed Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company’s derivative instruments within the unaudited Condensed Consolidated Balance Sheet:

 
 
 
 
Asset derivatives
 
Liability derivatives
 
 
Balance Sheet
 
Fair value at
 
Fair value at
 
Fair value at
 
Fair value at
(in millions)
 
location
 
9/30/2015
 
12/31/2014
 
9/30/2015
 
12/31/2014
Derivatives designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Accrued liabilities
 
$
36

 
$
—

 
$
414

 
$
—

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
54

 
—

 
596

 
643

Interest rate derivative contracts
 
Other assets
 
6

 
13

 
—

 
—

Interest rate derivative contracts
 
Other noncurrent liabilities
 
—

 
—

 
54

 
61

Total derivatives designated as hedges
 
$
96

 
$
13

 
$
1,064

 
$
704

Derivatives not designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Accrued liabilities
 
$
1,358

 
$
1,190

 
$
1,536

 
$
1,432

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
282

 
157

 
414

 
273

Total derivatives not designated as hedges
 
 
 
$
1,640

 
$
1,347

 
$
1,950

 
$
1,705

Total derivatives
 
 
 
$
1,736

 
$
1,360

 
$
3,014

 
$
2,409

* Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from counterparties. See discussion of credit risk and collateral following in this Note.

In addition, the Company had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:


10
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
 
Balance Sheet
 
September 30,
 
December 31,
(in millions)
 
location
 
2015
 
2014
Cash collateral deposits provided to counterparties for fuel
  contracts - current
 
Offset against Accrued liabilities
 
$
15

 
$
68

Cash collateral deposits provided to counterparties for fuel
contracts - noncurrent
 
Offset against Other noncurrent liabilities
 
463

 
198

Due to third parties for fuel contracts
 
Accounts payable
 
41

 
16

 
All of the Company's fuel derivative instruments and interest rate swaps are subject to agreements that follow the netting guidance in the applicable accounting standards for derivatives and hedging. The types of derivative instruments the Company has determined are subject to netting requirements in the accompanying unaudited Condensed Consolidated Balance Sheet are those in which the Company pays or receives cash for transactions with the same counterparty and in the same currency via one net payment or receipt. For cash collateral held by the Company or provided to counterparties, the Company nets such amounts against the fair value of the Company's derivative portfolio by each counterparty. The Company has elected to utilize netting for both its fuel derivative instruments and interest rate swap agreements and also classifies such amounts as either current or noncurrent, based on the net fair value position with each of the Company's counterparties in the unaudited Condensed Consolidated Balance Sheet.

The Company's application of its netting policy associated with cash collateral differs depending on whether its derivative instruments are in a net asset position or a net liability position. If its fuel derivative instruments are in a net asset position with a counterparty, cash collateral amounts held are first netted against current outstanding derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of noncurrent outstanding derivative instruments. If the Company's fuel derivative instruments are in a net liability position with the counterparty, cash collateral amounts provided are first netted against noncurrent outstanding derivative amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of current outstanding derivative instruments.

The Company has the following recognized financial assets and financial liabilities resulting from those transactions that meet the scope of the disclosure requirements as necessitated by applicable accounting guidance for balance sheet offsetting:
Offsetting of derivative assets
(in millions)
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
September 30, 2015
 
December 31, 2014
Description
 
Balance Sheet location
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet (a)
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet (a)
Fuel derivative contracts
 
Accrued liabilities
 
$
1,409

 
$
(1,409
)
 
$
—

 
$
1,258

 
$
(1,258
)
 
$
—

Fuel derivative contracts
 
Other noncurrent liabilities
 
$
799

 
$
(799
)
 
$
—

 
$
355

 
$
(355
)
 
$
—

Interest rate derivative contracts
 
Other assets
 
$
6

 
$
—

 
$
6

 
$
13

 
$
—

 
$
13



11
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Offsetting of derivative liabilities
(in millions)
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
September 30, 2015
 
December 31, 2014
Description
 
Balance Sheet location
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet (a)
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet (a)
Fuel derivative contracts
 
Accrued liabilities
 
$
1,950

 
$
(1,409
)
 
$
541

 
$
1,432

 
$
(1,258
)
 
$
174

Fuel derivative contracts
 
Other noncurrent liabilities
 
$
1,010

 
$
(799
)
 
$
211

 
$
916

 
$
(355
)
 
$
561

Interest rate derivative contracts
 
Other noncurrent liabilities
 
$
54

 
$
—

 
$
54

 
$
61

 
$
—

 
$
61

(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the unaudited Condensed Consolidated Balance Sheet in Note 5.


12
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2015 and 2014:

Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective portion)
 
(Gain) loss reclassified from AOCI into income (effective portion) (a)
 
(Gain) loss recognized in income on derivatives (ineffective portion) (b)
 
Three months ended
 
Three months ended
 
Three months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2015
 
2014
 
2015
 
2014
 
2015
 
2014
Fuel derivative contracts
$
315

*
$
214

*
$
79

*
$
4

*
$
—

 
$
11

Interest rate derivatives
3

*
(2
)
*
3

*
4

*
—

 
(2
)
Total
$
318

 
$
212

 
$
82

 
$
8

 
$
—

 
$
9

*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective portion)
 
(Gain) loss reclassified from AOCI into income (effective portion)(a)
 
(Gain) loss recognized in income on derivatives (ineffective portion)(b)
 
Nine months ended
 
Nine months ended
 
Nine months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2015
 
2014
 
2015
 
2014
 
2015
 
2014
Fuel derivative contracts
$
330

*
$
104

*
$
166

*
$
3

*
$
(15
)
 
$
(31
)
Interest rate derivatives
6

*
2

*
9

*
10

*
(2
)
 
(3
)
Total
$
336

 
$
106

 
$
175

 
$
13

 
$
(17
)
 
$
(34
)
*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives not in cash flow hedging relationships
 
(Gain) loss
 
 
 
recognized in income on
 
 
 
derivatives
 
 
 
Three months ended
 
Location of (gain) loss
 
September 30,
 
recognized in income
(in millions)
2015
 
2014
 
on derivatives
Fuel derivative contracts
$
239

 
$
39

 
Other (gains) losses, net


13
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Derivatives not in cash flow hedging relationships
 
(Gain) loss
 
 
 
recognized in income on
 
 
 
derivatives
 
 
 
Nine months ended
 
Location of (gain) loss
 
September 30,
 
recognized in income
(in millions)
2015
 
2014
 
on derivatives
Fuel derivative contracts
$
330

 
$
(1
)
 
Other (gains) losses, net

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended September 30, 2015 and 2014 of $33 million and $15 million, respectively, and the nine months ended September 30, 2015 and 2014 of $81 million and $49 million, respectively. These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income.

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties. Included in the Company’s cumulative net unrealized losses from fuel hedges as of September 30, 2015, recorded in AOCI, were approximately $471 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2015.

Interest rate swaps
The Company is party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. Two of the Company's interest rate swap agreements qualify for the “shortcut” method of accounting for hedges, which dictates that the hedges are assumed to be perfectly effective, and, thus, there is no ineffectiveness to be recorded in earnings. For the Company’s interest rate swap agreements that do not qualify for the "shortcut" method of accounting, ineffectiveness is required to be measured at each reporting period. The ineffectiveness associated with all of the Company’s, including AirTran’s, interest rate hedges for all periods presented was not material.

In February 2015, the Company terminated the fixed-to-floating interest rate swap agreements related to its $300 million 5.75% unsecured notes due 2016. The effect of this termination is such that the interest associated with the debt prospectively reverts back to its original fixed rate. As a result of the approximate $12 million gain realized on this transaction, which will be amortized over the remaining term of the corresponding unsecured notes, and based on projected interest rates at the date of termination, the Company does not believe its future interest expense associated with these unsecured notes will significantly differ from the expense it would have recorded had the unsecured notes remained at floating rates.

Credit risk and collateral
Credit exposure related to fuel derivative instruments is represented by the fair value of contracts that are an asset to the Company at the reporting date. At such times, these outstanding instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company has not experienced any significant credit loss as a result of counterparty nonperformance in the past. To manage credit risk, the Company selects and periodically reviews counterparties based on credit ratings, limits its exposure with respect to each counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty. At September 30, 2015, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on the counterparty credit rating. The Company also had agreements with counterparties in which cash deposits, letters of credit, and/or pledged aircraft are required to be posted as collateral whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The

14
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2015, at which such postings are triggered:

 
Counterparty (CP)
 
 
(in millions)
A
 
B
 
C
 
D
 
E
 
F
 
Other (a)
 
Total
Fair value of fuel derivatives
$
(514
)
 
$
(179
)
 
$
(153
)
 
$
(206
)
 
$
(108
)
 
$
(37
)
 
$
(33
)
 
$
(1,230
)
Cash collateral held (by) CP
(238
)
 
(50
)
 
(39
)
 
(146
)
 
—

 
(5
)
 
—

 
(478
)
Aircraft collateral pledged to CP
(210
)
 
(90
)
 
—

 
—

 
—

 
—

 
—

 
(300
)
Letters of credit (LC)
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Option to substitute LC for aircraft
(200) to (600)(h)
 
(100) to (500)(d)
 
N/A
 
(150) to (550)(d)
 
N/A
 
N/A
 
 
 
 
Option to substitute LC for cash
N/A
 
>(500)(e)
 
(225) to (275)(e)
 
(75) to (150) or >(550)(e)
 
(g)
 
(g)
 
 
 
 
If credit rating is investment
grade, fair value of fuel
derivative level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(50) to (200) or >(600)
 
(50) to (100) or >(500)
 
>(125)
 
(75) to (150) or >(550)
 
>(125)
 
>(50)
 
 
 
 
Cash is received from CP
>50
 
>150
 
>175(c)
 
>250
 
>75
 
>50
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(200) to (600)(f)
 
(100) to (500)(d)
 
N/A
 
(150) to (550)(d)
 
N/A
 
N/A
 
 
 
 
If credit rating is non-investment
grade, fair value of fuel derivative level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(0) to (200) or >(600)
 
(0) to (100) or >(500)
 
(b)
 
(0) to (150) or >(550)
 
(b)
 
(b)
 
 
 
 
Cash is received from CP
(b)
 
(b)
 
(b)
 
(b)
 
(b)
 
(b)
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(200) to (600)
 
(100) to (500)
 
N/A
 
(150) to (550)
 
N/A
 
N/A
 
 
 
 
(a) Individual counterparties with fair value of fuel derivatives <$30 million.
(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.
(c) Thresholds may vary based on changes in credit ratings within investment grade.
(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral.
(e) The Company has the option of providing cash or letters of credit as collateral.
(f) The Company has the option of providing cash or pledging aircraft as collateral.
(g) The Company has the option to substitute letters of credit for 100 percent of cash collateral requirement.
(h) The Company has the option of providing letters of credit in addition to aircraft collateral if the appraised value of the aircraft does not meet the collateral requirements.


15
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


4.    COMPREHENSIVE INCOME

Comprehensive income includes changes in the fair value of certain financial derivative instruments that qualify for hedge accounting, unrealized gains and losses on certain investments, and actuarial gains/losses arising from the Company’s postretirement benefit obligation. The differences between Net income and Comprehensive income for the three and nine months ended September 30, 2015 and 2014, were as follows:

 
Three months ended September 30,
(in millions)
2015
 
2014
NET INCOME
$
584

 
$
329

Unrealized loss on fuel derivative instruments, net of
  deferred taxes of ($139) and ($124)
(236
)
 
(210
)
Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $- and $3
—

 
6

Other, net of deferred taxes of ($2) and $1
(3
)
 
1

Total other comprehensive loss
$
(239
)
 
$
(203
)
COMPREHENSIVE INCOME
$
345

 
$
126


 
Nine months ended September 30,
(in millions)
2015
 
2014
NET INCOME
$
1,645

 
$
946

Unrealized loss on fuel derivative instruments, net of
  deferred taxes of ($97) and ($60)
(164
)
 
(101
)
Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $2 and $4
3

 
8

Other, net of deferred taxes of ($1) and $4
(4
)
 
4

Total other comprehensive loss
$
(165
)
 
$
(89
)
COMPREHENSIVE INCOME
$
1,480

 
$
857


A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2015:
(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at June 30, 2015
$
(1,063
)
 
$
(40
)
 
$
41

 
$
8

 
$
390

 
$
(664
)
Changes in fair value
(501
)
 
(5
)
 
—

 
(5
)
 
190

 
(321
)
Reclassification to earnings
126

 
5

 
—

 
—

 
(49
)
 
82

Balance at September 30, 2015
$
(1,438
)
 
$
(40
)
 
$
41

 
$
3

 
$
531

 
$
(903
)

(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at December 31, 2014
$
(1,177
)
 
$
(45
)
 
$
41

 
$
8

 
$
435

 
$
(738
)
Changes in fair value
(525
)
 
(10
)
 
—

 
(5
)
 
200

 
(340
)
Reclassification to earnings
264

 
15

 
—

 
—

 
(104
)
 
175

Balance at September 30, 2015
$
(1,438
)
 
$
(40
)
 
$
41

 
$
3

 
$
531

 
$
(903
)


16
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The following tables illustrate the significant amounts reclassified out of each component of AOCI for the three and nine months ended September 30, 2015:

Three months ended September 30, 2015
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components
 
 
Unrealized loss on fuel derivative instruments
 
$
126

 
Fuel and oil expense
 
 
47

 
Less: Tax Expense
 
 
$
79

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
5

 
Interest expense
 
 
2

 
Less: Tax Expense
 
 
$
3

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
82

 
Net of tax

Nine months ended September 30, 2015
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components
 
 
Unrealized loss on fuel derivative instruments
 
$
264

 
Fuel and oil expense
 
 
98

 
Less: Tax Expense
 
 
$
166

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
15

 
Interest expense
 
 
6

 
Less: Tax Expense
 
 
$
9

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
175

 
Net of tax

5.    SUPPLEMENTAL FINANCIAL INFORMATION
Other assets (in millions)
September 30, 2015
 
December 31, 2014
Derivative contracts
$
6

 
$
13

Intangible assets (a)
469

 
363

Non-current investments
40

 
35

Other
172

 
123

Other assets
$
687

 
$
534

(a) Intangible assets primarily consist of acquired leasehold rights to certain airport owned gates at Chicago’s Midway International Airport, takeoff and landing slots (a “slot” is the right of an air carrier, pursuant to regulations of the Federal Aviation Administration (“FAA”), to operate a takeoff or landing at a specific time at certain airports) at certain domestic slot-controlled airports, and certain intangible assets recognized from the AirTran acquisition. The increase in Intangible assets during 2015 was primarily due to the acquisition of two additional airport gate rights at Dallas Love Field, which were subleased from United Airlines. The purchase price paid for these airport gate rights was included as a component of Capital expenditures in the accompanying unaudited Condensed Consolidated Statement of Cash Flows.

17
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Accounts payable (in millions)
September 30, 2015
 
December 31, 2014
Accounts payable trade
$
170

 
$
123

Salaries payable
340

 
160

Excise and other tax withholdings payable
157

 
163

Aircraft maintenance payable
162

 
314

Fuel payable
46

 
85

Other payables
360

 
358

Accounts payable
$
1,235

 
$
1,203


Accrued liabilities (in millions)
September 30, 2015
 
December 31, 2014
ProfitSharing and savings plans
$
506

 
$
374

Aircraft and other lease related obligations
86

 
159

Vacation pay
310

 
292

Health
77

 
84

Derivative contracts
541

 
174

Workers compensation
181

 
165

Property and income taxes
129

 
81

Other
219

 
236

Accrued liabilities
$
2,049

 
$
1,565


Other noncurrent liabilities (in millions)
September 30, 2015
 
December 31, 2014
Postretirement obligation
$
179

 
$
169

Non-current lease-related obligations
164

 
193

Other deferred compensation
171

 
174

Deferred gains from sale and leaseback of aircraft
45

 
53

Derivative contracts
265

 
622

Other
107

 
44

Other noncurrent liabilities
$
931

 
$
1,255


For further details on fuel derivative and interest rate derivative contracts, see Note 3.

Other Operating Expenses
Other operating expenses consist of distribution costs, advertising expenses, personnel expenses, professional fees, and other operating costs, none of which individually exceed 10 percent of Operating expenses.

6.    LEASES

On July 9, 2012, the Company signed an agreement with Delta Air Lines, Inc. and Boeing Capital Corp. to lease or sublease all 88 of AirTran's Boeing 717-200 aircraft (“B717s”) to Delta at agreed-upon lease rates. The first converted B717 was delivered to Delta in September 2013, and as of September 30, 2015, the Company had delivered a total of 80 B717s to Delta. As the Company has previously disclosed, all B717s remaining at the Company were grounded on December 28, 2014. The Company currently expects the remaining eight B717s to be converted and delivered to Delta by early 2016. A total of 76 of the B717s are on operating lease, ten are owned, and two are on capital lease.

The Company has paid and will continue to pay the majority of the costs to convert the aircraft to the Delta livery and perform certain maintenance checks prior to the delivery of each aircraft. The agreement to pay these conversion and maintenance costs for the leased aircraft is a “lease incentive” under applicable accounting guidance. The sublease terms for the 76 B717s on operating lease and the two B717s on capital lease coincide with the Company's remaining

18
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


lease terms for these aircraft from the original lessor, which range from approximately three to nine years. The leasing of the ten B717s owned by the Company is subject to certain conditions, and the lease terms are for up to seven years, after which Delta has the option to purchase the aircraft at the then-prevailing market value. The Company accounts for the lease and sublease transactions with Delta as operating leases, sales type leases, and direct financing leases. The ten owned B717s will be accounted for as sales type leases, the two B717s classified by the Company as capital leases will be accounted for as direct financing leases, and the remaining 76 subleases will be accounted for as operating leases. With respect to the 80 B717s delivered to Delta as of September 30, 2015, the Company had 73 operating leases, five sales type leases, and two direct financing leases. There are no contingent payments and no significant residual value conditions associated with the transaction.

The accounting for this transaction is based on the guidance provided for lease transactions. For the components of this transaction finalized in third quarter 2012 and with respect to which the lease inception has been deemed to occur, the Company recorded a charge of approximately $137 million during third quarter 2012. The charge represented the remaining estimated cost, at the scheduled date of delivery of each B717 to Delta (including the conversion, maintenance, and other contractual costs to be incurred), of the Company's lease of the 76 B717s that are accounted for as operating leases, net of the future sublease income from Delta and the remaining unfavorable aircraft lease liability established as of the acquisition date. The charges recorded by the Company for this transaction were included as a component of Acquisition and integration costs in the Company's unaudited Condensed Consolidated Statement of Comprehensive Income and were included as a component of Other, net in Cash flows from operating activities in the Company's unaudited Condensed Consolidated Statement of Cash Flows, and the corresponding liability for this transaction is included as a component of Current liabilities in the Company's unaudited Condensed Consolidated Balance Sheet. A rollforward of the Company's B717 lease/sublease liability for 2015 and 2014 is shown below:

(in millions)
 
B717 lease/sublease liability
Balance at December 31, 2013
 
$
122

Lease/sublease accretion
 
5

Lease/sublease expense adjustment
 
22

Lease/sublease payments, net (a)
 
(86
)
Balance at December 31, 2014
 
$
63

Lease/sublease accretion
 
1

Lease/sublease expense adjustment
 
5

Lease/sublease payments, net (a)
 
(39
)
Balance at September 30, 2015
 
$
30

(a) Includes lease conversion cost payments

7.    COMMITMENTS AND CONTINGENCIES

Fort Lauderdale-Hollywood International Airport
In December 2013, the Company entered into an agreement with Broward County, Florida, which owns and operates Fort Lauderdale-Hollywood International Airport, to oversee and manage the design and construction of the airport's Terminal 1 Modernization Project at a cost not to exceed $295 million. In addition to significant improvements to the existing Terminal 1, the project includes the design and construction of a new five-gate Concourse A with an international processing facility. Funding for the project will come directly from Broward County sources, but will flow through the Company in its capacity as manager of the project. Major construction on the project began during third quarter 2015 and is estimated to be completed during 2017. The Company believes that due to its agreed upon role in overseeing and managing the project, it is considered the owner of the project for accounting purposes. As such, during construction the Company records expenditures as Assets constructed for others in the unaudited Condensed Consolidated Balance Sheet, along with a corresponding outflow within Assets constructed for others in the unaudited Condensed Consolidated Statement of Cash Flows, and an increase to Construction obligation (with a corresponding cash inflow from Financing activities in the unaudited Condensed Consolidated Statement of Cash Flows) as reimbursements are

19
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


received from Broward County. As of September 30, 2015, the Company had recorded construction costs related to the project of $17 million.
Houston William P. Hobby Airport
The Company entered into a Memorandum of Agreement (“MOA”) with the City of Houston (“City”), effective June 2012, to expand the existing Houston Hobby airport facility. As provided in the MOA, the Company and the City have entered into an Airport Use and Lease Agreement (“Lease”) to control the execution of this expansion and the financial terms thereof. Per the MOA and Lease, this project provides for a new five-gate international terminal with international passenger processing facilities, expansion of the existing security checkpoint, and upgrades to the Southwest Airlines ticket counter area. The project was estimated to cost $156 million, and the Company agreed to provide the funding for, as well as management over, the project. In return, the capital cost portion of the rent the Company pays for the international facility will be waived from the initial occupancy until the expiration of the Lease. However, after completion of the project, the City has the option to buy out the Company's investment at the then-unamortized cost of the facility. This purchase would trigger payment of the previously waived capital cost component of rents owed the City. Additionally, some portion of the project is expected to qualify for rental credits that would be utilized upon completion of the facility against the Company’s lease payments at the airport. Construction began during third quarter 2013 and was effectively completed in October 2015, on time and under budget, at which time the Company began operating from the new facility.

As a result of its significant involvement in the Houston Hobby project, the Company has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction, and has determined that it is the owner of the facility for accounting purposes during the construction period. As such, during construction, the Company records expenditures as Assets constructed for others in the unaudited Condensed Consolidated Balance Sheet, along with a corresponding outflow within Assets constructed for others, in the unaudited Condensed Consolidated Statement of Cash Flows. As of September 30, 2015, the Company had recorded construction costs related to Houston Hobby of $128 million.

Los Angeles International Airport
In March 2013, the Company executed a lease agreement with Los Angeles World Airports (“LAWA”), which owns and operates Los Angeles International Airport. Under the lease agreement, which was amended in June 2014, the Company is overseeing and managing the design, development, financing, construction and commissioning of the airport's Terminal 1 Modernization Project (the “Project”) at a cost not to exceed $526 million. The Project is being funded primarily using the Regional Airports Improvement Corporation ("RAIC"), which is a quasi-governmental special purpose entity that acts as a conduit borrower under a syndicated credit facility provided by a group of lenders. Loans made under the credit facility are being used to fund the development of the Project, and the outstanding loans will be repaid with the proceeds of LAWA’s payments to purchase completed Project phases. The Company has guaranteed the obligations of the RAIC under the credit facility. Construction on the Project began during 2014 and is estimated to be completed during 2018. The Company believes that due to its agreed upon role in overseeing and managing the Project, it is considered the owner of the Project for accounting purposes. LAWA will reimburse the Company for the non-proprietary renovations, while the Company will not be reimbursed for proprietary renovations. As a result, all of the costs incurred to fund the Project are included within Assets constructed for others and all amounts that have been or will be reimbursed will be included within Construction obligation on the accompanying unaudited Condensed Consolidated Balance Sheet. As of September 30, 2015, the Company had recorded construction costs related to the Project of $151 million, which were classified and included in Assets constructed for others and as Construction obligation in the accompanying unaudited Condensed Consolidated Balance Sheet.
Dallas Love Field
During 2008, the City of Dallas approved the Love Field Modernization Program (“LFMP”), a project to reconstruct Dallas Love Field with modern, convenient air travel facilities. Pursuant to a Program Development Agreement with the City of Dallas and the Love Field Airport Modernization Corporation (or “LFAMC,” a Texas non-profit “local government corporation” established by the City of Dallas to act on the City of Dallas' behalf to facilitate the development of the LFMP), the Company managed this project. Major construction commenced during 2010, and the project was effectively completed by December 31, 2014. The project consists of the complete replacement of gate facilities with

20
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


a new 20-gate facility, including infrastructure, systems and equipment, aircraft parking apron, fueling system, roadways and terminal curbside, baggage handling systems, passenger loading bridges and support systems, and other supporting infrastructure. New ticketing and check-in areas opened during fourth quarter 2012, 12 new gates and new concessions opened in 2013, and the remaining gates opened during October 2014.

Although the City of Dallas has received commitments from various sources that are helping to fund portions of the LFMP project, including the FAA, the Transportation Security Administration, and the City of Dallas' Aviation Fund, the majority of the funds used are from the issuance of bonds. During fourth quarter 2010, $310 million of such bonds were issued by the LFAMC, and the Company has guaranteed principal and interest payments on the bonds. An additional tranche of such bonds totaling $146 million was issued during second quarter 2012, and the Company has guaranteed the principal and interest payments on these bonds as well. The Company currently expects that as a result of the funding commitments from the above mentioned sources and the bonds that have been issued thus far, no further bond issuances and related guarantees from the Company will be required to complete the LFMP project.

In conjunction with the Company's significant presence at Dallas Love Field and other factors, the Company agreed to manage the LFMP project. Based on these facts, the Company has evaluated its ongoing accounting requirements in consideration of accounting guidance provided for lessees involved in asset construction. The Company has recorded and will continue to record an asset and corresponding obligation for the cost of the LFMP project as the construction of the facility occurs. As of September 30, 2015, the Company had recorded LFMP gross construction costs, including capitalized interest, of $527 million within Assets constructed for others and had recorded a net liability of $516 million within Construction obligation in its unaudited Condensed Consolidated Balance Sheet. Upon completion of different phases of the LFMP project, the Company has placed the associated assets in service and has begun depreciating the assets over their estimated useful lives. In addition, upon the effective completion of construction, the Company noted the project assets did not meet the qualifications for sale and leaseback accounting due to the Company's continuing involvement with the facility, as defined; therefore, for financial reporting purposes, these assets will remain on the Company's books until the bonds issued by the City of Dallas are repaid. The corresponding LFMP liabilities will be reduced primarily through the Company's airport rental payments to the City of Dallas as the construction costs of the project are passed through to the Company via recurring airport rates and charges. These payments are reflected as Repayment of construction obligation in the unaudited Condensed Consolidated Statement of Cash Flows.

Contingencies
The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the IRS. The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.


8.    FAIR VALUE MEASUREMENTS

Accounting standards pertaining to fair value measurements establish a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

As of September 30, 2015, the Company held certain items that are required to be measured at fair value on a recurring basis. These included cash equivalents, short-term investments (primarily treasury bills and certificates of deposit), certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities. The majority of the Company’s short-term investments consist of instruments classified as Level 1. However, the Company has certificates of deposit, commercial paper, and Eurodollar time deposits that are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets. Noncurrent investments consist of certain auction rate securities, primarily those collateralized by student loan portfolios, which are guaranteed by the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.

The Company’s fuel and interest rate derivative instruments consist of over-the-counter contracts, which are not traded on a public exchange. Fuel derivative instruments include swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely of swap agreements. See Note 3 for further information on the Company’s derivative instruments and hedging activities. The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2. The Company’s Treasury Department, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an option pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.

Included in Other available-for-sale securities are the Company’s investments associated with its excess benefit plan which consist of investment funds for which market prices are readily available. This plan is a non-qualified deferred compensation plan designed to hold Employee contributions in excess of limits established by Section 415 of the Internal Revenue Code of 1986, as amended. Payments under this plan are made based on the participant’s distribution election and plan balance. Assets related to the funded portion of the deferred compensation plan are held in a rabbi trust, and the Company remains liable to these participants for the unfunded portion of the plan. The Company records changes in the fair value of the asset in the Company’s earnings.

All of the Company’s auction rate security instruments, totaling $27 million (net) at September 30, 2015, are classified as available-for-sale securities and are reflected at their estimated fair value in the unaudited Condensed Consolidated

21
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Balance Sheet. The Company’s Treasury Department determines the estimated fair values of these securities utilizing a discounted cash flow analysis. The Company has performed, and routinely updates, a valuation for each of its auction rate security instruments, considering, among other items, the collateralization underlying the security investments, the expected future cash flows, including the final maturity, associated with the securities, estimates of the next time the security is expected to have a successful auction or return to full par value, forecasted reset rates based on the LIBOR or the issuer’s net loan rate, and a counterparty credit spread. To validate the reasonableness of the Company’s discounted cash flow analyses, the Company compares its valuations to third party valuations on a quarterly basis.

The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2015, and December 31, 2014:

 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
September 30, 2015
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,528

 
$
1,528

 
$
—

 
$
—

Commercial paper
 
125

 
—

 
125

 
—

Certificates of deposit
 
25

 
—

 
25

 
—

Eurodollar time deposits
 
62

 
—

 
62

 
—

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,149

 
1,149

 
—

 
—

Certificates of deposit
 
207

 
—

 
207

 
—

Noncurrent investments (b)
 
 
 
 
 
 
 
 
Auction rate securities
 
27

 
—

 
—

 
27

Interest rate derivatives
 
6

 
—

 
6

 
—

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
818

 
—

 
818

 
—

Option contracts (c)
 
912

 
—

 
—

 
912

Other available-for-sale securities
 
62

 
62

 
—

 
—

Total assets
 
$
4,921

 
$
2,739

 
$
1,243

 
$
939

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
$
(679
)
 
$
—

 
$
(679
)
 
$
—

Option contracts (c)
 
(2,281
)
 
—

 
—

 
(2,281
)
Interest rate derivatives
 
(54
)
 
—

 
(54
)
 
—

Total liabilities
 
$
(3,014
)
 
$
—

 
$
(733
)
 
$
(2,281
)
(a) Cash equivalents are primarily composed of money market investments.
(b) Noncurrent investments are included in Other assets in the unaudited Condensed Consolidated Balance Sheet.
(c) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net liability.


22
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
December 31, 2014
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,110

 
$
1,110

 
$
—

 
$
—

Commercial paper
 
70

 
—

 
70

 
—

Certificates of deposit
 
4

 
—

 
4

 
—

Eurodollar time deposits
 
98

 
—

 
98

 
—

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,450

 
1,450

 
—

 
—

Certificates of deposit
 
256

 
—

 
256

 
—

Noncurrent investments (b)
 
 
 
 
 
 
 
 
Auction rate securities
 
27

 
—

 
—

 
27

Interest rate derivatives
 
13

 
—

 
13

 
—

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
455

 
—

 
455

 
—

Option contracts (c)
 
892

 
—

 
—

 
892

Other available-for-sale securities
 
68

 
63

 
—

 
5

Total assets
 
$
4,443

 
$
2,623

 
$
896

 
$
924

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
$
(365
)
 
$
—

 
$
(365
)
 
$
—

Option contracts (c)
 
(1,983
)