SOUTHWEST AIRLINES CO - FORM 10-Q - October 31, 2016

Attached files

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EX-32.1 - CERTIFICATION OF CEO AND CFO - SOUTHWEST AIRLINES COluv-9302016xex321.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - SOUTHWEST AIRLINES COluv-9302016xex312.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - SOUTHWEST AIRLINES COluv-9302016xex311.htm
EX-10.6 - EXHIBIT 10.6 - SOUTHWEST AIRLINES COluv-9302016xex106.htm
EX-10.5 - EXHIBIT 10.5 - SOUTHWEST AIRLINES COluv-9302016xex105.htm
EX-10.3 - SUPPLEMENTAL AGREEMENT NO. 97 - SOUTHWEST AIRLINES COluv-9302016xex103.htm
EX-10.2 - SUPPLEMENTAL AGREEMENT NO. 96 - SOUTHWEST AIRLINES COluv-9302016xex102.htm
EX-10.1 - SUPPLEMENTAL AGREEMENT NO. 95 - SOUTHWEST AIRLINES COluv-9302016xex101.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, 2016
 
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

southwestheartimagea01.jpg

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 26, 2016: 615,597,738



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, 2016
 
December 31, 2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,966

 
$
1,583

Short-term investments
1,480

 
1,468

Accounts and other receivables
848

 
474

Inventories of parts and supplies, at cost
331

 
311

Prepaid expenses and other current assets
214

 
188

Total current assets
4,839

 
4,024

 
 
 
 
Property and equipment, at cost:
 

 
 

Flight equipment
19,978

 
19,462

Ground property and equipment
3,600

 
3,219

Deposits on flight equipment purchase contracts
1,113

 
1,089

Assets constructed for others
1,150

 
915

 
25,841

 
24,685

Less allowance for depreciation and amortization
9,295

 
9,084

 
16,546

 
15,601

Goodwill
970

 
970

Other assets
690

 
717

 
$
23,045

 
$
21,312

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
1,021

 
$
1,188

Accrued liabilities
2,146

 
2,591

Air traffic liability
3,677

 
2,990

Current maturities of long-term debt
972

 
637

Total current liabilities
7,816

 
7,406

 
 
 
 
Long-term debt less current maturities
2,323

 
2,541

Deferred income taxes
3,209

 
2,490

Construction obligation
989

 
757

Other noncurrent liabilities
661

 
760

Stockholders' equity:
 

 
 

Common stock
808

 
808

Capital in excess of par value
1,402

 
1,374

Retained earnings
10,957

 
9,409

Accumulated other comprehensive loss
(499
)
 
(1,051
)
Treasury stock, at cost
(4,621
)
 
(3,182
)
Total stockholders' equity
8,047

 
7,358

 
$
23,045

 
$
21,312

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,
 
2016
 
2015
 
2016
 
2015
OPERATING REVENUES:
 
 
 
 
 
 
 
Passenger
$
4,669

 
$
4,716

 
$
13,971

 
$
13,746

Freight
42

 
44

 
129

 
134

Special revenue adjustment
—

 
172

 
—

 
172

Other
428

 
386

 
1,250

 
791

Total operating revenues
5,139

 
5,318

 
15,350

 
14,843

 
 
 
 
 
 
 
 
OPERATING EXPENSES:
 

 
 

 
 

 
 

Salaries, wages, and benefits
1,909

 
1,699

 
5,089

 
4,725

Fuel and oil
941

 
936

 
2,696

 
2,818

Maintenance materials and repairs
258

 
259

 
801

 
729

Aircraft rentals
56

 
60

 
174

 
179

Landing fees and other rentals
307

 
303

 
918

 
887

Depreciation and amortization
315

 
258

 
903

 
751

Acquisition and integration
—

 
6

 
—

 
32

Other operating expenses
658

 
572

 
1,854

 
1,632

Total operating expenses
4,444

 
4,093

 
12,435

 
11,753

 
 
 
 
 
 
 
 
OPERATING INCOME
695

 
1,225

 
2,915

 
3,090

 
 
 
 
 
 
 
 
OTHER EXPENSES (INCOME):
 

 
 

 
 

 
 

Interest expense
31

 
31

 
93

 
92

Capitalized interest
(12
)
 
(9
)
 
(34
)
 
(23
)
Interest income
(6
)
 
(2
)
 
(17
)
 
(5
)
Other (gains) losses, net
64

 
272

 
135

 
394

Total other expenses (income)
77

 
292

 
177

 
458

 
 
 
 
 
 
 
 
INCOME BEFORE INCOME TAXES
618

 
933

 
2,738

 
2,632

PROVISION FOR INCOME TAXES
230

 
349

 
1,016

 
987

 
 
 
 
 
 
 
 
NET INCOME
$
388

 
$
584

 
$
1,722

 
$
1,645

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, BASIC
$
0.63

 
$
0.89

 
$
2.73

 
$
2.47

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, DILUTED
$
0.62

 
$
0.88

 
$
2.70

 
$
2.45

 
 
 
 
 
 
 
 
COMPREHENSIVE INCOME
$
517

 
$
345

 
$
2,274

 
$
1,480

 
 
 
 
 
 
 
 
WEIGHTED AVERAGE SHARES OUTSTANDING
 

 
 

 
 

 
 

Basic
618

 
655

 
630

 
665

Diluted
625

 
663

 
638

 
673

 
 
 
 
 
 
 
 
Cash dividends declared per common share
$
.100

 
$
.075

 
$
.275

 
$
.210

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,
 
2016
 
2015
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
 
 
 
Net income
$
388

 
$
584

 
$
1,722

 
$
1,645

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

 
 

 
 

 
 

Depreciation and amortization
315

 
258

 
903

 
751

Loss on asset impairment
—

 
—

 
21

 
—

Unrealized/realized (gain) loss on fuel derivative instruments
(67
)
 
87

 
(101
)
 
172

Deferred income taxes
315

 
(82
)
 
395

 
(40
)
Changes in certain assets and liabilities:
 

 
 

 
 

 
 

Accounts and other receivables
(320
)
 
4

 
(355
)
 
(86
)
Other assets
(16
)
 
33

 
(61
)
 
40

Accounts payable and accrued liabilities
247

 
380

 
272

 
424

Air traffic liability
(77
)
 
(301
)
 
686

 
617

Cash collateral received from (provided to) derivative counterparties
114

 
181

 
230

 
(213
)
Other, net
(43
)
 
(308
)
 
(128
)
 
(396
)
Net cash provided by operating activities
856

 
836

 
3,584

 
2,914

 
 
 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 

 
 

 
 

Capital expenditures
(464
)
 
(230
)
 
(1,364
)
 
(1,231
)
Assets constructed for others
(33
)
 
(32
)
 
(70
)
 
(76
)
Purchases of short-term investments
(641
)
 
(506
)
 
(1,670
)
 
(1,383
)
Proceeds from sales of short-term and other investments
549

 
509

 
1,671

 
1,732

Other, net
5

 
—

 
—

 
(9
)
Net cash used in investing activities
(584
)
 
(259
)
 
(1,433
)
 
(967
)
 
 
 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 

 
 

 
 

Proceeds from Employee stock plans
6

 
9

 
23

 
30

Proceeds from termination of interest rate derivative instruments
—

 
—

 
—

 
12

Reimbursement for assets constructed for others
33

 
9

 
68

 
14

Payments of long-term debt and capital lease obligations
(68
)
 
(79
)
 
(171
)
 
(170
)
Payments of cash dividends
(62
)
 
(49
)
 
(222
)
 
(180
)
Repayment of construction obligation
(2
)
 
(3
)
 
(6
)
 
(8
)
Repurchase of common stock
(250
)
 
(500
)
 
(1,450
)
 
(1,180
)
Other, net
(3
)
 
4

 
(10
)
 
(7
)
Net cash used in financing activities
(346
)
 
(609
)
 
(1,768
)
 
(1,489
)
 
 
 
 
 
 
 
 
NET CHANGE IN CASH AND CASH EQUIVALENTS
(74
)
 
(32
)
 
383

 
458

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
2,040

 
1,772

 
1,583

 
1,282

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,966

 
$
1,740

 
$
1,966

 
$
1,740

 
 
 
 
 
 
 
 
CASH PAYMENTS FOR:
 
 
 
 
 
 
 
Interest, net of amount capitalized
$
27

 
$
33

 
$
77

 
$
86

Income taxes
$
264

 
$
409

 
$
902

 
$
975

 
 
 
 
 
 
 
 
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
 
 
 
 
 
 
 
Flight equipment acquired through the assumption of debt
$
20

 
$
—

 
$
20

 
$
—

Flight equipment under capital leases
$
—

 
$
48

 
$
251

 
$
130

Assets constructed for others
$
50

 
$
46

 
$
165

 
$
126

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.

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, 2016 and 2015 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, 2016, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 2016. 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, 2015.

2.    NEW ACCOUNTING PRONOUNCEMENTS AND CHANGES IN ACCOUNTING OR ESTIMATES

New accounting pronouncements
On August 26, 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-15, Statement of Cash Flows. The standard is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted. The Company is evaluating the new guidance, but does not expect it to have a significant impact on its financial statement presentation or results.

On June 16, 2016, the FASB issued ASU No. 2016-13, Accounting for Credit Losses. The new standard requires the use of an “expected loss” model on certain types of financial instruments. The standard also amends the impairment model for available-for-sale debt securities and requires estimated credit losses to be recorded as allowances instead of reductions to amortized cost of the securities. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019, with early adoption permitted. The Company is evaluating the new guidance, but does not expect it to have a significant impact on its financial statement presentation or results.


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


On February 25, 2016, the FASB issued ASU No. 2016-02, Leases. The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The Company believes the most significant impact of this ASU on its accounting will be the presentation of operating leases with durations greater than twelve months, with certain exceptions, on the balance sheet. The Company is evaluating the new guidance and plans to provide additional information about its expected financial impact at a future date.

On May 28, 2014, the FASB issued 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 for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted for fiscal years, and interim periods within those years, beginning after December 15, 2016. The Company currently 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 associated with flight points earned by Customers with a relative fair value approach, based on estimated selling price, resulting in a significant increase in the liability. 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 second quarter 2016, the Company early adopted ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, with an effective date as of January 1, 2016. The prospective method of adoption of this standard resulted in the recognition of $7 million of excess tax benefits to the Company's income tax provision for the nine months ended September 30, 2016, all of which was recorded during second quarter 2016.
The Company sells frequent flyer points and related services to companies participating in its frequent flyer program. Historically, funds received from the sale of points associated with these agreements were accounted for under the residual method. Under this method, the Company estimated the portion of the amounts received from the sale of frequent flyer points that related to free travel and these amounts were deferred and recognized as Passenger revenue when the ultimate free travel awards were flown. On July 1, 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. This material modification triggered an accounting change under ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements, which has been recorded on a prospective basis. The impact of the accounting change is that 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 deliverables (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). The Company records passenger revenue related to air transportation and certificates for discounted companion travel when the transportation is delivered. The other elements are recognized as Other revenue when earned.


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


The Company followed the transition approach of ASU No. 2009-13, which required that the Company adjust the existing deferred revenue balance, classified within Air traffic liability, 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) was lower than the rate at which it had been deferred under the residual method. The estimated impacts on revenue and earnings associated with the Agreement and this change in accounting principle for the nine months ended September 30, 2016, which only include amounts through June 30, 2016 as the impact of the accounting change for third quarter 2016 was comparable to that recognized in third quarter 2015, are as follows:

(in millions, except per share amounts)
Nine months ended September 30, 2016
Passenger revenue
$
(120
)
Other revenue
381

Operating revenues
$
261

Net income
$
139

Net income per basic share
$
0.22

Net income per diluted share
$
0.22


During first quarter 2016, the Company made the decision to further simplify its operations and resolve uncertainty surrounding Federal Aviation Administration ("FAA") pilot training requirements for flying both its Boeing 737-300 ("Classic") and Boeing 737-8 aircraft. The Company expects to begin operating 737-8s once all Classic aircraft are retired. These decisions have resulted in the Company accelerating the retirement of its less-efficient Classic fleet to no later than third quarter 2017, versus the original scheduled retirement of this fleet that had extended out to 2021. This change in retirement dates is considered a change in estimate and has been accounted for on a prospective basis as of the dates the decisions were finalized. Therefore, the Company has recorded and will record accelerated depreciation expense over the remainder of the useful lives for each Classic aircraft and related parts. See Note 7 for further information regarding the Company's aircraft fleet.

The estimated impacts on expense and earnings from this change in assumption for the three and nine months ended September 30, 2016 are as follows:

(in millions, except per share amounts)
Three months ended September 30, 2016
 
Nine months ended September 30, 2016
Depreciation and amortization expense
$
31

 
$
94

Net income
$
(17
)
 
$
(50
)
Net income per basic share
$
(0.03
)
 
$
(0.08
)
Net income per diluted share
$
(0.03
)
 
$
(0.08
)

The estimated impact to Depreciation and amortization expense from this change in assumption for fourth quarter 2016 is an approximate increase of $29 million.

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 represents 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

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


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 timeframes 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.

For the three months ended September 30, 2016, the Company had fuel derivative instruments in place for up to 58 percent of its fuel consumption. As of September 30, 2016, the Company also had fuel derivative instruments in place to provide coverage at varying price levels, but up to a maximum of approximately 72 percent of its remaining 2016 estimated fuel consumption, depending on where market prices settle. The following table provides information about the Company’s volume of fuel hedging for the years 2016 through 2018 on an “economic” basis:

 
 
Maximum fuel hedged as of
 
 
 
 
September 30, 2016
 
Derivative underlying commodity type as of
Period (by year)
 
(gallons in millions) (a)
 
September 30, 2016
Fourth quarter 2016
 
357

 
Brent crude oil and Gulf Coast jet fuel
2017
 
1,281

 
WTI crude and Brent crude oil
2018
 
744

 
Brent crude oil
(a) Due to the types of derivatives utilized by the Company and different price levels of those contracts, these volumes represent the maximum economic hedge in place and may vary significantly as market prices fluctuate.

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

9
Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(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 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 2015, or during the nine months ended September 30, 2016.

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
 
9/30/2016
 
12/31/2015
 
9/30/2016
 
12/31/2015
Derivatives designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
—

 
$
2

 
$
—

 
$
—

Fuel derivative contracts (gross)
 
Other assets
 
8

 
2

 
—

 
—

Fuel derivative contracts (gross)
 
Accrued liabilities
 
22

 
107

 
513

 
526

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
84

 
55

 
137

 
658

Interest rate derivative contracts
 
Other assets
 
13

 
2

 
—

 
—

Interest rate derivative contracts
 
Other noncurrent liabilities
 
—

 
—

 
36

 
49

Total derivatives designated as hedges
 
$
127

 
$
168

 
$
686

 
$
1,233

Derivatives not designated as hedges*
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
13

 
$
39

 
$
7

 
$
26

Fuel derivative contracts (gross)
 
Other assets
 
3

 
5

 
—

 
—

Fuel derivative contracts (gross)
 
Accrued liabilities
 
333

 
1,395

 
526

 
1,854

Fuel derivative contracts (gross)
 
Other noncurrent liabilities
 
134

 
330

 
136

 
352

Total derivatives not designated as hedges
 
 
 
$
483

 
$
1,769

 
$
669

 
$
2,232

Total derivatives
 
 
 
$
610

 
$
1,937

 
$
1,355

 
$
3,465

* 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
 
2016
 
2015
Cash collateral deposits held from counterparties for fuel
  contracts - current
 
Offset against Prepaid expenses and other current assets
 
$
6

 
$
—

Cash collateral deposits held from counterparties for fuel
  contracts - noncurrent
 
Offset against Other assets
 
9

 
—

Cash collateral deposits provided to counterparties for fuel
  contracts - current
 
Offset against Accrued liabilities
 
530

 
235

Cash collateral deposits provided to counterparties for fuel
contracts - noncurrent
 
Offset against Other noncurrent liabilities
 
90

 
600

Due to third parties for fuel contracts
 
Accounts payable
 
94

 
46

 
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 asset 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 liability 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:

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


Offsetting of derivative assets
(in millions)
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
September 30, 2016
 
December 31, 2015
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
 
Prepaid expenses and other current assets
 
$
13

 
$
(13
)
 
$
—

 
$
41

 
$
(26
)
 
$
15

Fuel derivative contracts
 
Other assets
 
$
11

 
$
(9
)
 
$
2

 
$
7

 
$
—

 
$
7

Fuel derivative contracts
 
Accrued liabilities
 
$
885

 
$
(885
)
 
$
—

 
$
1,737

 
$
(1,737
)
 
$
—

Fuel derivative contracts
 
Other noncurrent liabilities
 
$
308

 
$
(273
)
 
$
35

 
$
985

 
$
(985
)
 
$
—

Interest rate derivative contracts
 
Other assets
 
$
13

 
$
—

 
$
13

 
$
2

 
$
—

 
$
2


Offsetting of derivative liabilities
(in millions)
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
September 30, 2016
 
December 31, 2015
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
 
Prepaid expenses and other current assets
 
$
13

 
$
(13
)
 
$
—

 
$
26

 
$
(26
)
 
$
—

Fuel derivative contracts
 
Other assets
 
$
9

 
$
(9
)
 
$
—

 
$
—

 
$
—

 
$
—

Fuel derivative contracts
 
Accrued liabilities
 
$
1,039

 
$
(885
)
 
$
154

 
$
2,380

 
$
(1,737
)
 
$
643

Fuel derivative contracts
 
Other noncurrent liabilities
 
$
273

 
$
(273
)
 
$
—

 
$
1,010

 
$
(985
)
 
$
25

Interest rate derivative contracts
 
Other noncurrent liabilities
 
$
36

 
$
—

 
$
36

 
$
49

 
$
—

 
$
49

(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, 2016 and 2015:

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)
2016
 
2015
 
2016
 
2015
 
2016
 
2015
Fuel derivative contracts
$
19

*
$
315

*
$
141

*
$
79

*
$
(4
)
 
$
—

Interest rate derivatives
(2
)
*
3

*
2

*
3

*
(2
)
 
—

Total
$
17

 
$
318

 
$
143

 
$
82

 
$
(6
)
 
$
—

*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives, which 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)
2016
 
2015
 
2016
 
2015
 
2016
 
2015
Fuel derivative contracts
$
(62
)
*
$
330

*
$
484

*
$
166

*
$
(3
)
 
$
(15
)
Interest rate derivatives
4

*
6

*
7

*
9

*
(3
)
 
(2
)
Total
$
(58
)
 
$
336

 
$
491

 
$
175

 
$
(6
)
 
$
(17
)
*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives, which 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
 recognized in income
on derivatives
 
September 30,
 
(in millions)
2016
 
2015
 
Fuel derivative contracts
$
35

 
$
239

 
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
recognized in income
 on derivatives
 
September 30,
 
(in millions)
2016
 
2015
 
Fuel derivative contracts
$
23

 
$
330

 
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, 2016 and 2015 of $34 million and $33 million, respectively, and the nine months ended September 30, 2016 and 2015 of $117 million and $81 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, 2016, recorded in AOCI, were approximately $401 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2016.

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. Several 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 interest rate hedges for all periods presented was not material.

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, 2016, 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. In certain cases, the Company has the ability to substitute among these different forms of collateral at its discretion. For example, at September 30, 2016, the Company had chosen to provide all of its collateral in the form of cash postings, although it could have chosen to provide aircraft and/or letters of credit for a significant portion of its collateral posted.


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


The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2016, at which such postings are triggered:
 
Counterparty (CP)
 
 
(in millions)
A
 
B
 
C
 
D
 
E
 
F
 
Other (a)
 
Total
Fair value of fuel derivatives
$
(414
)
 
$
(118
)
 
$
(4
)
 
$
(169
)
 
$
(33
)
 
$
15

 
$
1

 
$
(722
)
Cash collateral held from (by) CP
(399
)
 
(77
)
 
—

 
(144
)
 
—

 
15

 
—

 
(605
)
Aircraft collateral pledged to CP
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Letters of credit (LC)
—

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Option to substitute LC for aircraft
(200) to (600)(h)
 
(100) to (500)(d)
 
N/A
 
(150) to (550)(d)
 
(150) to (550)(d)
 
N/A
 
 
 
 
Option to substitute LC for cash
N/A
 
>(500)(e)
 
(225) to (275)(e)
 
(75) to (150) or >(550)(e)
 
(125) to (150) or >(550)(e)

 
(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) to (150) or >(550)

 
>(100)
 
 
 
 
Cash is received from CP
>50(c)
 
>150(c)
 
>175(c)
 
>250(c)
 
>75(c)
 
>0(c)
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(200) to (600)(f)
 
(100) to (500)(d)
 
N/A
 
(150) to (550)(d)
 
(150) to (550)(d)

 
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)
 
(0) to (150) or >(550)

 
(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)
 
(150) to (550)
 
N/A
 
 
 
 
(a) Individual counterparties with fair value of fuel derivatives <$2 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, 2016 and 2015 were as follows:

 
Three months ended September 30,
(in millions)
2016
 
2015
NET INCOME
$
388

 
$
584

Unrealized gain (loss) on fuel derivative instruments, net of
  deferred taxes of $72 and ($139)
122

 
(236
)
Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $2 and $-
4

 
—

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

 
(3
)
Total other comprehensive income (loss)
$
129

 
$
(239
)
COMPREHENSIVE INCOME
$
517

 
$
345


 
Nine months ended September 30,
(in millions)
2016
 
2015
NET INCOME
$
1,722

 
$
1,645

Unrealized gain (loss) on fuel derivative instruments, net of
  deferred taxes of $321 and ($97)
546

 
(164
)
Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $1 and $2
3

 
3

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

 
(4
)
Total other comprehensive income (loss)
$
552

 
$
(165
)
COMPREHENSIVE INCOME
$
2,274

 
$
1,480



A rollforward of the amounts included in AOCI, net of taxes, is shown below for the three and nine months ended September 30, 2016:
(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at June 30, 2016
$
(993
)
 
$
(32
)
 
$
22

 
$
6

 
$
369

 
$
(628
)
Changes in fair value
(30
)
 
3

 
—

 
5

 
8

 
(14
)
Reclassification to earnings
224

 
3

 
—

 
—

 
(84
)
 
143

Balance at September 30, 2016
$
(799
)
 
$
(26
)
 
$
22

 
$
11

 
$
293

 
$
(499
)


(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at December 31, 2015
$
(1,666
)
 
$
(30
)
 
$
22

 
$
6

 
$
617

 
$
(1,051
)
Changes in fair value
98

 
(7
)
 
—

 
5

 
(35
)
 
61

Reclassification to earnings
769

 
11

 
—

 
—

 
(289
)
 
491

Balance at September 30, 2016
$
(799
)
 
$
(26
)
 
$
22

 
$
11

 
$
293

 
$
(499
)

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, 2016:

Three months ended September 30, 2016
(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
 
$
224

 
Fuel and oil expense
 
 
83

 
Less: Tax Expense
 
 
$
141

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
3

 
Interest expense
 
 
1

 
Less: Tax Expense
 
 
$
2

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
143

 
Net of tax

Nine months ended September 30, 2016
(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
 
$
769

 
Fuel and oil expense
 
 
285

 
Less: Tax Expense
 
 
$
484

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
11

 
Interest expense
 
 
4

 
Less: Tax Expense
 
 
$
7

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
491

 
Net of tax

5.    SUPPLEMENTAL FINANCIAL INFORMATION
(in millions)
September 30, 2016
 
December 31, 2015
Intangible assets, net
$
430

 
$
464

Non-current investments
35

 
40

Other
225

 
213

Other assets
$
690

 
$
717


(in millions)
September 30, 2016
 
December 31, 2015
Accounts payable trade
$
148

 
$
178

Salaries payable
149

 
173

Taxes payable
165

 
179

Aircraft maintenance payable
25

 
168

Fuel payable
66

 
48

Other payables
468

 
442

Accounts payable
$
1,021

 
$
1,188



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


(in millions)
September 30, 2016
 
December 31, 2015
ProfitSharing and savings plans
$
517

 
$
655

Aircraft and other lease related obligations
52

 
74

Vacation pay
339

 
309

Accrued union bonuses (a)
533

 
329

Health
90

 
86

Derivative contracts
154

 
643

Workers compensation
179

 
187

Property and income taxes
63

 
62

Other
219

 
246

Accrued liabilities
$
2,146

 
$
2,591

(a) As part of the ongoing negotiations with various union contract groups during 2016, the Company has recorded a liability for estimated bonuses that would be paid out to union members upon ratification of labor agreements. The liability excludes certain immaterial benefit costs that are included as a component of Accounts payable. The amount accrued is subject to change based on subsequent negotiations, and any changes would be recorded on a prospective basis.

(in millions)
September 30, 2016
 
December 31, 2015
Postretirement obligation
$
215

 
$
201

Non-current lease-related obligations
135

 
165

Other deferred compensation
195

 
179

Deferred gains from sale and leaseback of aircraft
33

 
43

Derivative contracts
1

 
74

Other
82

 
98

Other noncurrent liabilities
$
661

 
$
760


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 exceeded 10 percent of Operating expenses.


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


6.    NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share (in millions, except per share amounts):
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
NUMERATOR:
 
 
 
 
 
 
 
Net income
$
388

 
$
584

 
$
1,722

 
$
1,645

Incremental income effect of interest on 5.25% convertible notes
1

 
1

 
2

 
3

Net income after assumed conversion
$
389

 
$
585

 
$
1,724

 
$
1,648

 
 
 
 
 
 
 
 
DENOMINATOR:
 

 
 

 
 

 
 

Weighted-average shares outstanding, basic
618

 
655

 
630

 
665

Dilutive effect of Employee stock options and restricted stock units
1

 
2

 
2

 
2

Dilutive effect of 5.25% convertible notes
6

 
6

 
6

 
6

Adjusted weighted-average shares outstanding, diluted
625

 
663

 
638

 
673

 
 
 
 
 
 
 
 
NET INCOME PER SHARE:
 

 
 

 
 

 
 

Basic
$
0.63

 
$
0.89

 
$
2.73

 
$
2.47

Diluted
$
0.62

 
$
0.88

 
$
2.70

 
$
2.45



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. Pursuant to an addendum entered into during 2016, the cost of the project is not to exceed $333 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 substantially completed by mid-2017. The Company has determined 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 received from Broward County. As of September 30, 2016, the Company had recorded construction costs related to the project of $92 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 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 provided a new five-gate international terminal with international passenger processing facilities, expansion of the security checkpoint, and upgrades to the Southwest Airlines ticket counter area. Construction was effectively completed in October 2015, at which time the Company began operating from the new facility. The project's final cost was approximately $150 million, of which $22 million was considered

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


proprietary and thus not classified as Assets constructed for others. The Company provided the funding for, as well as management over, the project. In return, the capital cost portion of the rent the Company owes for the international facility is being waived from the initial occupancy until the expiration of the Lease. However, the City has the option at any time during the term of the Lease to reimburse 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, a small portion of the project qualified for rental credits that have been utilized against the Company’s 2016 lease payments at the airport.

As a result of its significant involvement in the Houston Hobby project, the Company determined that it is the owner of the facility for accounting purposes. As such, during construction, the Company recorded 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.

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 has determined 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 (through the RAIC credit facility) for the non-proprietary renovations, while proprietary renovations will not be reimbursed. As a result, $313 million of costs incurred as of September 30, 2016, 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.
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 was effectively completed by December 31, 2014. This project consisted of the complete replacement of gate facilities with 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.

Although the City of Dallas received commitments from various sources that helped to fund portions of this LFMP project, including the FAA, the Transportation Security Administration, and the City of Dallas' Aviation Fund, the majority of the funds used were from the issuance of bonds. The Company guaranteed principal and interest payments on $456 million of such bonds issued by the LFAMC. As of September 30, 2016, $439 million of principal remained outstanding.

In conjunction with the Company's significant presence at Dallas Love Field, the Company agreed to manage the majority of the LFMP project. Based on the pertinent factors in place at the time the agreement was made, the Company utilized the accounting guidance provided for lessees involved in asset construction. As of September 30, 2016, the Company had recorded LFMP construction costs of $538 million within Assets constructed for others and had recorded a liability of $525 million within Construction obligation in its unaudited Condensed Consolidated Balance Sheet. Upon completion of different phases of the LFMP project, the Company placed the associated assets in service and began depreciating the assets over their estimated useful lives. In addition, upon the effective completion of construction,

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


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 are being reduced primarily through the Company's airport rental payments to the City of Dallas as the construction costs of this project are passed through to the Company via recurring airport rates and charges. A portion of these payments are reflected as Repayment of construction obligation in the unaudited Condensed Consolidated Statement of Cash Flows. The imputed interest rate associated with construction obligation was nominal for the three and nine months ended September 30, 2016 and the year ended December 31, 2015.

During 2015, the City of Dallas issued additional bonds for the construction of a new parking garage at Dallas Love Field. The Company has not guaranteed the principal or interest payments on these bonds, but remains the accounting owner of this project. As of September 30, 2016, the Company had recorded LFMP parking construction expenditures of $59 million within Assets constructed for others with a corresponding increase to Construction obligation on the accompanying unaudited Condensed Consolidated Balance Sheet.

Contractual Obligations and Contingent Liabilities and Commitments

The Company has contractual obligations and commitments primarily with regard to future purchases of aircraft, repayment of debt, and lease arrangements. During third quarter 2016, the Company exercised four 737-800 options for 2018. As of September 30, 2016, the Company had firm deliveries and options for Boeing 737-700, 737-800, 737-7, and 737-8 aircraft as follows:

 
The Boeing Company
737
 
 
 
 
 
-800 Firm Orders
-800 Options
-7
Firm
Orders
-8
Firm
Orders
 
-8 Options
 
Additional -700s
Total
 
2016
38
—
—
—
 
—
 
23
61
(2)
2017
39
—
—
14
 
—
 
14
67
 
2018
16
14
—
13
 
—
 
4
47
 
2019
—
—
15
—
 
5
 
—
20
 
2020
—
—
14
—
 
8
 
—
22
 
2021
—
—
1
13
 
18
 
—
32
 
2022
—
—
—
15
 
19
 
—
34
 
2023
—
—
—
34
 
23
 
—
57
 
2024
—
—
—
41
 
23
 
—
64
 
2025
—
—
—
40
 
36
 
—
76
 
2026
—
—
—
—
 
36
 
—
36
 
2027
—
—
—
—
 
23
 
—
23
 
Total
93
14
30
170
(1)
191
(1)
41
539
 
(1) The Company has flexibility to substitute 737-7 in lieu of 737-8 aircraft beginning in 2019.
(2) Includes 25 737-800s and 19 737-700s delivered as of September 30, 2016. The 19 737-700s are classified as capital leases and have increased the Company's future capital lease obligations by $6 million remaining in 2016, $29 million in 2017, $29 million in 2018, $28 million in 2019, $27 million in 2020, and $176 million thereafter.

The Company's capital commitments associated with the firm orders and additional aircraft in the above aircraft table are as follows: $281 million in fourth quarter 2016, $1.1 billion in 2017, $775 million in 2018, $614 million in 2019, $821 million in 2020, and $6.1 billion thereafter.


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


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 Internal Revenue Service ("IRS"). The Company's management does not expect that the outcome of 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, 2016, 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), 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. 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 deferred compensation plans, which consist of mutual funds that are publicly traded and for which market prices are readily available. These plans are non-qualified deferred compensation plans designed to hold contributions in excess of limits established by the Internal Revenue Code of 1986, as amended. The distribution timing and payment amounts under these plans are made based on the participant’s distribution election and plan balance. Assets related to the funded portions of the

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


deferred compensation plans are held in a rabbi trust, and the Company remains liable to these participants for the unfunded portion of the plans. The Company records changes in the fair value of the assets in the Company’s earnings.

The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2016, and December 31, 2015:

 
 
 
 
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, 2016
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,706

 
$
1,706

 
$
—

 
$
—

Commercial paper
 
250

 
—

 
250

 
—

Certificates of deposit
 
10

 
—

 
10

 
—

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,198

 
1,198

 
—

 
—

Certificates of deposit
 
282

 
—

 
282