SOUTHWEST AIRLINES CO - FORM 10-Q

Attached files

file	filename
EX-32.1 - CERTIFICATION OF CEO AND CFO - SOUTHWEST AIRLINES CO	luv-9302018xex321.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - SOUTHWEST AIRLINES CO	luv-9302018xex312.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - SOUTHWEST AIRLINES CO	luv-9302018xex311.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, 2018



	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 every Interactive Data File required to be submitted 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 such files). Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.



Large accelerated filer þ	Accelerated filer ¨
Non-accelerated filer ¨	Smaller reporting company ¨
	Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

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, 2018: 562,306,592

TABLE OF CONTENTS TO FORM 10-Q

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheet as of September 30, 2018 and December 31, 2017

Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017

Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2018 and 2017

Notes to Condensed Consolidated Financial Statements

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Item 4. Controls and Procedures

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Item 1A. Risk Factors

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Item 3. Defaults Upon Senior Securities

Item 4. Mine Safety Disclosures

Item 5. Other Information

Item 6. Exhibits

SIGNATURES

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, 2018			December 31, 2017
				As Recast
ASSETS
Current assets:
Cash and cash equivalents	$	2,104		$	1,495
Short-term investments	1,716			1,778
Accounts and other receivables	784			662
Inventories of parts and supplies, at cost	483			420
Prepaid expenses and other current assets	514			460
Total current assets	5,601			4,815

Property and equipment, at cost:
Flight equipment	21,409			21,368
Ground property and equipment	4,769			4,399
Deposits on flight equipment purchase contracts	820			919
Assets constructed for others	1,718			1,543
	28,716			28,229
Less allowance for depreciation and amortization	9,437			9,690
	19,279			18,539
Goodwill	970			970
Other assets	1,032			786
	$	26,882		$	25,110

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,224		$	1,320
Accrued liabilities	1,517			1,700
Air traffic liability	4,756			3,495
Current maturities of long-term debt	346			348
Total current liabilities	7,843			6,863

Long-term debt less current maturities	3,100			3,320
Air traffic liability - noncurrent	827			1,070
Deferred income taxes	2,553			2,119
Construction obligation	1,658			1,390
Other noncurrent liabilities	748			707
Stockholders' equity:
Common stock	808			808
Capital in excess of par value	1,485			1,451
Retained earnings	15,402			13,832
Accumulated other comprehensive income	412			12
Treasury stock, at cost	(7,954		)	(6,462		)
Total stockholders' equity	10,153			9,641
	$	26,882		$	25,110

See accompanying notes.

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,
	2018			2017			2018			2017
				As Recast						As Recast
OPERATING REVENUES:
Passenger	$	5,194		$	4,944		$	15,137		$	14,869
Freight	43			42			130			128
Other	338			317			994			891
Total operating revenues	5,575			5,303			16,261			15,888

OPERATING EXPENSES:
Salaries, wages, and benefits	1,912			1,791			5,659			5,385
Fuel and oil	1,205			1,037			3,425			3,016
Maintenance materials and repairs	283			263			814			758
Landing fees and airport rentals	337			324			1,011			969
Depreciation and amortization	301			302			870			939
Other operating expenses	739			741			2,096			2,154
Total operating expenses	4,777			4,458			13,875			13,221

OPERATING INCOME	798			845			2,386			2,667

OTHER EXPENSES (INCOME):
Interest expense	33			28			99			84
Capitalized interest	(9		)	(15		)	(29		)	(38		)
Interest income	(20		)	(9		)	(47		)	(24		)
Other (gains) losses, net	8			9			16			115
Total other expenses (income)	12			13			39			137

INCOME BEFORE INCOME TAXES	786			832			2,347			2,530
PROVISION FOR INCOME TAXES	171			304			536			920

NET INCOME	$	615		$	528		$	1,811		$	1,610

NET INCOME PER SHARE, BASIC	$	1.08		$	0.88		$	3.13		$	2.66

NET INCOME PER SHARE, DILUTED	$	1.08		$	0.88		$	3.13		$	2.66

COMPREHENSIVE INCOME	$	729		$	655		$	2,229		$	1,797

WEIGHTED AVERAGE SHARES OUTSTANDING
Basic	569			597			578			605
Diluted	569			598			579			606

Cash dividends declared per common share	$	.160		$	.125		$	.445		$	.350

See accompanying notes.

Southwest Airlines Co.

Condensed Consolidated Statement of Cash Flows

(in millions)

(unaudited)



	Three months ended						Nine months ended
	September 30,						September 30,
	2018			2017			2018			2017
				As Recast						As Recast
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	615		$	528		$	1,811		$	1,610
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization	301			302			870			939
Aircraft grounding charge	—			63			—			63
Unrealized/realized (gain) loss on fuel derivative instruments	(2		)	(42		)	(13		)	(20		)
Deferred income taxes	104			98			308			219
Changes in certain assets and liabilities:
Accounts and other receivables	(13		)	—			(109		)	(23		)
Other assets	(30		)	(64		)	(243		)	(264		)
Accounts payable and accrued liabilities	161			87			80			(157		)
Air traffic liability	52			(119		)	1,018			802
Cash collateral received from derivative counterparties	10			151			150			286
Other, net	73			(8		)	32			(89		)
Net cash provided by operating activities	1,271			996			3,904			3,366

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures	(454		)	(638		)	(1,384		)	(1,603		)
Assets constructed for others	(8		)	(17		)	(49		)	(113		)
Purchases of short-term investments	(678		)	(531		)	(1,607		)	(1,653		)
Proceeds from sales of short-term and other investments	531			566			1,665			1,696
Other, net	5			—			5			—
Net cash used in investing activities	(604		)	(620		)	(1,370		)	(1,673		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Employee stock plans	9			7			26			22
Reimbursement for assets constructed for others	8			17			165			113
Payments of long-term debt and capital lease obligations	(98		)	(106		)	(255		)	(534		)
Payments of cash dividends	(91		)	(75		)	(332		)	(274		)
Repayment of construction obligation	(8		)	(2		)	(22		)	(7		)
Repurchase of common stock	(500		)	(300		)	(1,500		)	(1,250		)
Other, net	3			6			(7		)	17
Net cash used in financing activities	(677		)	(453		)	(1,925		)	(1,913		)

NET CHANGE IN CASH AND CASH EQUIVALENTS	(10		)	(77		)	609			(220		)

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD	2,114			1,537			1,495			1,680

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	2,104		$	1,460		$	2,104		$	1,460

CASH PAYMENTS FOR:
Interest, net of amount capitalized	$	18		$	16		$	70		$	61
Income taxes	$	38		$	229		$	212		$	611

SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Flight equipment under capital leases	$	18		$	77		$	32		$	180
Assets constructed for others	$	46		$	39		$	126		$	127

See accompanying notes.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. BASIS OF PRESENTATION

Southwest Airlines Co. (the "Company" or "Southwest") 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.

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, 2018 and 2017 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, natural disasters, 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, and the periodic volatility of commodities used by the Company for hedging jet fuel, 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, 2018, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 2018. 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, 2017.

Effective as of January 1, 2018, the Company adopted Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers, ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, and ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities. All amounts and disclosures set forth in this Form 10-Q reflect the adoption of these ASUs. See Note 2 for further information.

The Company reclassified $51 million and $158 million from Aircraft rentals to Other operating expenses in the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017, respectively, to be comparative with the current period's presentation. Aircraft rentals expense included in Other operating expenses for the three and nine months ended September 30, 2018, was $41 million and $121 million, respectively. This reclassification had no impact on Operating income, Net income, the unaudited Condensed Consolidated Balance Sheet, or the unaudited Condensed Consolidated Statement of Cash Flows.

2. NEW ACCOUNTING PRONOUNCEMENTS

On August 29, 2018, the Financial Accounting Standards Board (the "FASB") issued ASU No. 2018-15, Intangibles—Goodwill and Other—Internal-Use Software. This new standard requires a customer in a cloud computing arrangement that is a service contract to follow the internal-use software guidance in Accounting Standards Codification ("ASC") 350-40, Accounting for Internal-Use Software, to determine which implementation costs to (i) capitalize as assets and amortize over the term of the hosting arrangement or (ii) expense as incurred. This new standard is effective for public business entities in fiscal years beginning after December 15, 2019. Early adoption is permitted, including during an interim period. Entities have the option to apply this standard prospectively to all implementation costs incurred after the date of adoption or retrospectively. The Company is evaluating this new standard, but does not expect

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

it to have a significant impact on its financial statement presentation or results.

On August 28, 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement. This standard is effective for public business entities in fiscal years beginning after December 15, 2019, and for interim periods within those years. Early adoption is permitted including during an interim period. This new standard requires changes to the disclosure requirements for fair value measurements for certain Level 3 items, and specifies that some of the changes must be applied prospectively, while others should be applied retrospectively. The Company is evaluating this new standard, but does not expect it to have a significant impact on its financial statement disclosures. See Note 8 for further information on the Company's fair value measurements.

On August 28, 2018, the FASB issued ASU No. 2018-14, Compensation—Retirement Benefits—Defined Benefit Plans—General. This new standard makes changes to the disclosure requirements for sponsors of defined benefit pension and/or other postretirement benefit plans to improve effectiveness of notes to the financial statements. This standard is effective for public business entities in fiscal years ending after December 15, 2020. Early adoption is permitted. Entities will apply this standard using a retrospective approach. The Company is evaluating this new standard, but does not expect it to have a significant impact on its financial statement disclosures.

On August 28, 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities (the "New Hedging Standard"). The New Hedging Standard amends the hedge accounting model to enable entities to better portray the economics of their risk management activities in the financial statements and enhance the transparency and understandability of hedge results. The New Hedging Standard also simplifies the application of hedge accounting in certain situations. The New Hedging Standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted in any interim or annual period. The Company elected to early adopt the New Hedging Standard as of January 1, 2018. The adoption was done on a prospective basis, as required. The most significant impacts of the New Hedging Standard on the Company's accounting are the elimination of the requirement to separately measure and record ineffectiveness for all cash flow hedges in a hedging relationship, as well as a change in classification of premium expense associated with option contracts. Such premium expense for the Company's fuel hedges was previously reflected as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income, but under the New Hedging Standard is reflected as a component of the line item to which the hedge relates, which is Fuel and oil expense. As such, the classification of premium expense for the three and nine months ended September 30, 2017, has been reclassified in order to be comparative with current period results in the accompanying unaudited Condensed Consolidated Statement of Comprehensive Income. The impact of the cumulative effect of the adjustment to move the reporting of ineffectiveness as of January 1, 2018, to Accumulated other comprehensive income (loss) ("AOCI") from Retained earnings, was a $20 million loss, net of taxes. The adoption and resulting reclassification had no impact on the Company's Net income, earnings per share, or cash flows.

On March 10, 2017, the FASB issued ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (the "New Retirement Standard"). The New Retirement Standard requires employers to present the service cost component of the net periodic benefit cost in the same income statement line item as other Employee compensation costs arising from services rendered during the period. The other components of net benefit cost, including amortization of prior service cost/credit, and settlement and curtailment effects, are to be included in nonoperating expenses. As required by the New Retirement Standard, the Company adopted this guidance retrospectively as of January 1, 2018, using a practical expedient which permitted the Company to use the amounts disclosed in its pension and other postretirement benefit plan note for the prior comparative periods as the estimation basis for applying the retrospective presentation requirements. As such, the Company reclassified $4 million and $10 million of Salaries, wages, and benefits expense to Other (gains) and losses under the New Retirement Standard in the accompanying unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017, respectively. The adoption and resulting reclassification had no impact on the Company's Net income, earnings per share, or cash flows.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

On February 25, 2016, the FASB issued ASU No. 2016-02, Leases (the "New Lease Standard"). The New Lease Standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The New Lease Standard requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases (with the exception of short-term leases) at the lease commencement date and recognize expenses on the income statement in a similar manner to the current guidance in ASC 840, Leases ("ASC 840"). The lease liability will be measured at the present value of the unpaid lease payments and the right-of-use asset will be derived from the calculation of the lease liability. Lease payments will include fixed and in-substance fixed payments, variable payments based on an index or rate, reasonably certain purchase options, termination penalties, fees paid by the lessee to the owners of a special-purpose entity for restructuring the transaction, and probable amounts the lessee will owe under a residual value guarantee. Lease payments will not include variable lease payments other than those that depend on an index or rate, any guarantee by the lessee of the lessor’s debt, or any amount allocated to non-lease components.

The Company established a project team to evaluate and implement the New Lease Standard, and currently believes the most significant impact of the New Lease Standard on its accounting will be the balance sheet impact of its aircraft operating leases, which the Company expects will significantly increase assets and liabilities. As of September 30, 2018, the Company had 51 leased aircraft under operating leases in its active fleet and also had another 76 aircraft under operating leases that are being subleased to another airline. As of September 30, 2018, the net present value of future rents for those aircraft was approximately $775 million. This amount only includes contractual payments due to lessors, and does not consider certain items that the New Lease Standard requires to be assessed in determining the final asset and liability to be reflected on the Company's balance sheet, such as lease renewal options and potential impairments, nor does it consider the sublease income that is due from third parties. The Company also has operating leases related to terminal operations space and other real estate leases. Although the real estate leases will also have a substantial impact to the balance sheet, the Company does not expect the leases related to terminal operations space to have a significant impact since variable lease payments, other than those based on an index or rate, are excluded from the measurement of the lease liability. The Company also does not expect the adoption of the New Lease Standard to impact any of its existing debt covenants.

In addition, the New Lease Standard eliminates the current build-to-suit lease accounting guidance and is expected to result in derecognition of build-to-suit assets and liabilities that remained on the balance sheet after the end of the construction period. See Note 7 for further information on the Company’s build-to-suit projects. However, given the Company's guarantee associated with the bonds issued to fund the Dallas Love Field Modernization Program (the "LFMP"), the Company believes that the remaining debt service amounts as of the adoption date would be considered a minimum rental payment under the New Lease Standard, and therefore will be recorded as a lease liability on the balance sheet and will be reduced through future debt service payments made in 2019 and beyond. The underlying leases for all of these facilities will be subject to evaluation under the New Lease Standard.

The Company plans to elect the package of practical expedients available under the transition provisions of the New Lease Standard, including (i) not reassessing whether expired or existing contracts contain leases, (ii) lease classification, and (iii) not revaluing initial direct costs for existing leases. Also, the Company plans to elect the practical expedient which will allow aggregation of non-lease components with the related lease components when evaluating accounting treatment. Lastly, the Company currently plans to apply the modified retrospective adoption method, utilizing the simplified transition option available in the New Lease Standard, which allows entities to continue to apply the legacy guidance in ASC 840, including its disclosure requirements, in the comparative periods presented in the year of adoption. The Company plans to adopt the New Lease Standard on January 1, 2019, and will continue to provide updates to its plans in future periods.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (the "New Revenue Standard"), also referred to as ASC 606, Revenue From Contracts With Customers ("ASC 606"), which replaces numerous revenue recognition requirements in GAAP, including industry-specific requirements, and provides companies with a single revenue recognition model for recognizing revenue from contracts with Customers. The New Revenue Standard establishes a five-step model whereby revenue is recognized as performance obligations within a

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

contract are satisfied in an amount that reflects the consideration the Company expects to receive in exchange for satisfaction of those performance obligations, or standalone selling price. The New Revenue Standard also requires new, expanded disclosures regarding revenue recognition. See Note 5 for further information. The Company adopted the provisions of the New Revenue Standard effective January 1, 2018, using the full retrospective method. As such, results for the three and nine months ended September 30, 2017, have been recast under the New Revenue Standard in order to be comparative with current period results in the accompanying unaudited Condensed Consolidated Statements of Comprehensive Income and Cash Flows. The amounts in the accompanying unaudited Condensed Consolidated Balance Sheet as of December 31, 2017, have also been recast.

The most significant impact of the New Revenue Standard relates to the accounting for the Company’s loyalty program. The New Revenue Standard eliminated the incremental cost method for loyalty program accounting, which was previously allowed in prior accounting guidance. The Company now accounts for the liability for frequent flyer points earned through flight activity using a relative fair value approach.

The New Revenue Standard also resulted in different income statement classification for certain types of revenues (primarily ancillary revenues) which were previously classified as Other revenues, but under the New Revenue Standard are included in Passenger revenues, and certain expenses, which were previously classified as Other operating expenses, but under the New Revenue Standard are offset against Passenger revenues.

The following table provides the impact of applying the New Revenue Standard to the Company’s previously reported balances as of December 31, 2017:



	Balance as of December 31, 2017
(in millions)	As Reported		New Revenue Standard			As Recast
Accrued liabilities	$	1,777	$	(77	)	$	1,700
Air traffic liability	3,460		35			3,495
Air traffic liability - noncurrent	—		1,070			1,070
Deferred income taxes	2,358		(239		)	2,119
Retained earnings	14,621		(789		)	13,832

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

The impacts of applying the New Revenue Standard, the New Retirement Standard, and the New Hedging Standard to the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017, are as follows (amounts may not recalculate due to rounding):



	Three months ended September 30, 2017
(in millions), except per share amounts	As Reported		New Revenue Standard			New Retirement Standard			New Hedging Standard			As Recast
Passenger revenue	$	4,745	$	199		$	—		$	—		$	4,944
Other revenue	484		(167		)	—			—			317
Salaries, wages, and benefits	1,795		—			(4		)	—			1,791
Fuel and oil expense	1,003		—			—			34			1,037
Other operating expenses	750		(9		)	—			—			741
Other (gains) losses, net	39		—			4			(34		)	9
Provision for income taxes	288		16			—			—			304
Net income	503		25			—			—			528
Net income per share, basic	0.84		0.04			—			—			0.88
Net income per share, diluted	0.84		0.04			—			—			0.88



	Nine months ended September 30, 2017
(in millions), except per share amounts	As Reported		New Revenue Standard			New Retirement Standard			New Hedging Standard			As Recast
Passenger revenue	$	14,403	$	466		$	—		$	—		$	14,869
Other revenue	1,366		(475		)	—			—			891
Salaries, wages, and benefits	5,395		—			(10		)	—			5,385
Fuel and oil expense	2,915		—			—			102			3,016
Other operating expenses	2,179		(25		)	—			—			2,154
Other (gains) losses, net	207		—			10			(102		)	115
Provision for income taxes	913		6			—			—			920
Net income	1,600		10			—			—			1,610
Net income per share, basic	2.65		0.01			—			—			2.66
Net income per share, diluted	2.64		0.02			—			—			2.66

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

The impacts of applying the New Revenue Standard to the Company’s unaudited Condensed Consolidated Statement of Cash Flows for the three and nine months ended September 30, 2017, are as follows:



	Three months ended September 30, 2017
(in millions)	As Reported			New Revenue Standard			As Recast
Net income	$	503		$	25		$	528
Deferred income taxes	82			16			98
Changes in certain assets and liabilities	(55		)	(41		)	(96		)
Net cash provided by operating activities	996			—			996



	Nine months ended September 30, 2017
(in millions)	As Reported		New Revenue Standard			As Recast
Net income	$	1,600	$	10		$	1,610
Deferred income taxes	213		6			219
Changes in certain assets and liabilities	374		(16		)	358
Net cash provided by operating activities	3,366		—			3,366

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 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.

For the purpose of evaluating its net cash spend for jet fuel and for forecasting its future estimated jet fuel expense, 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

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

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 each of the three and nine months ended September 30, 2018, the Company had fuel derivative instruments in place for up to 80 percent of its fuel consumption. As of September 30, 2018, the Company also had fuel derivative instruments in place to provide coverage at varying price levels, but up to a maximum of approximately 79 percent of its remaining 2018 estimated fuel consumption, depending on where market prices settle. The following table provides information about the Company’s volume of fuel hedging on an economic basis considering current market prices:



	Maximum fuel hedged as of
	September 30, 2018	Derivative underlying commodity type as of
Period (by year)	(gallons in millions) (a)	September 30, 2018
Remainder of 2018	412	WTI crude and Brent crude oil
2019	1,377	WTI crude and Brent crude oil
2020	867	WTI crude and Brent crude oil
2021	466	WTI crude and Brent crude oil
2022	88	WTI 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. The Company adopted the New Hedging Standard as of January 1, 2018. See Note 2 for further information on this adoption. Under the New Hedging Standard, all periodic changes in fair value of the derivatives designated as hedges are recorded in AOCI until the underlying jet fuel is consumed. See Note 4. Prior to the adoption of the New Hedging Standard, ineffectiveness resulted when the change in the fair value of the derivative instrument exceeded 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 were ineffective, the ineffective portion was recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change.

The Company's results are subject to the possibility that the derivatives will no longer qualify for hedge accounting, in which case any change in the fair value of derivative instruments since the last reporting period would be recorded in 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 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 2017, or during the nine months ended September 30, 2018.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

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	9/30/2018		12/31/2017		9/30/2018		12/31/2017
Derivatives designated as hedges (a)
Fuel derivative contracts (gross)	Prepaid expenses and other current assets	$	348	$	112	$	—	$	—
Fuel derivative contracts (gross)	Other assets	350		136		—		—
Interest rate derivative contracts	Other noncurrent liabilities	—		—		22		20
Total derivatives designated as hedges		$	698	$	248	$	22	$	20
Derivatives not designated as hedges (a)
Fuel derivative contracts (gross)	Prepaid expenses and other current assets	$	—	$	35	$	—	$	35
Interest rate derivative contracts	Accrued liabilities	—		—		—		1
Interest rate derivative contracts	Other noncurrent liabilities	—		—		—		1
Total derivatives not designated as hedges		$	—	$	35	$	—	$	37
Total derivatives		$	698	$	283	$	22	$	57

(a) 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.

The following table presents the amounts recorded on the unaudited Condensed Consolidated Balance Sheet related to fair value hedges:



Balance Sheet location of hedged item	Carrying amount of the hedged liabilities				Cumulative amount of fair value hedging adjustment included in the carrying amount of the hedged liabilities (a)
	September 30,				September 30,
(in millions)	2018		2017		2018		2017
Long-term debt less current maturities	$	783	$	796	$	3	$	17

(a) At September 30, 2018 and 2017, these amounts include the cumulative amount of fair value hedging adjustments remaining for which hedge accounting has been discontinued of $20 million and $21 million, respectively.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

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



	Balance Sheet	September 30,		December 31,
(in millions)	location	2018		2017
Cash collateral deposits held from counterparties for fuel contracts - current	Offset against Prepaid expenses and other current assets	$	148	$	15
Cash collateral deposits held from counterparties for fuel contracts - noncurrent	Offset against Other assets	17		—
Due to third parties for fuel contracts	Accounts payable	—		29
Receivable from third parties for fuel contracts	Accounts and other receivables	25		—

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 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, 2018								December 31, 2017
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			Gross amounts of recognized assets		Gross amounts offset in the Balance Sheet			Net amounts of assets presented in the Balance Sheet
Fuel derivative contracts	Prepaid expenses and other current assets	$	348	$	(148	)	$	200		$	147	$	(50	)	$	97
Fuel derivative contracts	Other assets	$	350	$	(17	)	$	333	(a)	$	136	$	—		$	136	(a)

(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 9.

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, 2018								December 31, 2017
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			Gross amounts of recognized liabilities		Gross amounts offset in the Balance Sheet			Net amounts of liabilities presented in the Balance Sheet
Fuel derivative contracts	Prepaid expenses and other current assets	$	148	$	(148	)	$	—		$	50	$	(50	)	$	—
Fuel derivative contracts	Other assets	$	17	$	(17	)	$	—	(a)	$	—	$	—		$	—	(a)
Interest rate derivative contracts	Accrued liabilities	$	—	$	—		$	—		$	1	$	—		$	1
Interest rate derivative contracts	Other noncurrent liabilities	$	22	$	—		$	22	(a)	$	21	$	—		$	21	(a)

(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 9.

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, 2018 and 2017:



Location and amount of (gain) loss recognized in income on cash flow and fair value hedging relationships
	Three months ended September 30, 2018					Three months ended September 30, 2017
(in millions)	Fuel and oil			Interest expense		Fuel and oil		Interest expense
Total	$	(20	)	$	9	$	151	$	7

(Gain) loss on cash flow hedging relationships:
Commodity contracts:
Amount of (gain) loss reclassified from AOCI into income	(20		)	—		151		—
Interest contracts:
Amount of loss reclassified from AOCI into income	—			1		—		2

Impact of fair value hedging relationships:
Interest contracts:
Hedged items	—			6		—		6
Derivatives designated as hedging instruments	—			2		—		(1		)



Location and amount of (gain) loss recognized in income on cash flow and fair value hedging relationships
	Nine months ended September 30, 2018					Nine months ended September 30, 2017
(in millions)	Fuel and oil			Interest expense		Fuel and oil		Interest expense
Total	$	(32	)	$	26	$	447	$	23

(Gain) loss on cash flow hedging relationships:
Commodity contracts:
Amount of (gain) loss reclassified from AOCI into income	(32		)	—		447		—
Interest contracts:
Amount of loss reclassified from AOCI into income	—			4		—		8

Impact of fair value hedging relationships:
Interest contracts:
Hedged items	—			17		—		17
Derivatives designated as hedging instruments	—			5		—		(2		)

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



Derivatives designated and qualified in cash flow hedging relationships
	(Gain) loss recognized in AOCI on derivatives								(Gain) loss recognized in income on derivatives (ineffective portion) (a)
	Three months ended								Three months ended
	September 30,								September 30,
(in millions)	2018				2017				2018		2017
Fuel derivative contracts	$	(122	)	*	$	(29	)	*	$	—	$	8

*Net of tax

(a) Amounts are included in Other (gains) losses, net.



Derivatives designated and qualified in cash flow hedging relationships
	(Gain) loss recognized in AOCI on derivatives							(Gain) loss recognized in income on derivatives (ineffective portion)(a)
	Nine months ended							Nine months ended
	September 30,							September 30,
(in millions)	2018				2017			2018		2017
Fuel derivative contracts	$	(428	)	*	$	104	*	$	—	$	29
Interest rate derivatives	(2		)	*	1		*	—		—
Total	$	(430	)		$	105		$	—	$	29

*Net of tax

(a) Amounts are included in Other (gains) losses, net.



Derivatives not designated as hedges

	(Gain) loss recognized in income on derivatives
	(Gain) loss recognized in income on derivatives
	Three months ended					Location of (gain) loss recognized in income on derivatives
	September 30,
(in millions)	2018		2017
Fuel derivative contracts	$	—	$	(4	)	Other (gains) losses, net
Interest rate derivatives	—		(1		)	Interest expense
	$	—	$	(5	)



Derivatives not designated as hedges
	(Gain) loss
	recognized in income on
	derivatives
	Nine months ended						Location of (gain) loss
	September 30,						recognized in income
(in millions)	2018			2017			on derivatives
Fuel derivative contracts	$	—		$	80		Other (gains) losses, net
Interest rate derivatives	(2		)	(3		)	Interest expense
	$	(2	)	$	77

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during each of the three months ended September 30, 2018 and 2017 of $34 million, and during the nine months ended September 30, 2018 and 2017 of $101 million and $102 million, respectively. These amounts are recognized through changes in fair value within AOCI for designated hedges, and are ultimately recorded as a component of Fuel and oil in the unaudited Condensed Consolidated Statement of Comprehensive Income during the period the contracts settle.

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 gains from fuel hedges as of September 30, 2018, recorded in AOCI, were approximately $198 million in unrealized gains, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2018.

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. The New Hedging Standard also addresses targeted improvements to special hedge accounting for interest rate hedges. Though the Company will not be making any changes to the accounting for its current interest rate hedges as of the January 2018 adoption date, the New Hedging Standard provides the Company with more opportunities to achieve special hedge accounting for potential interest rate hedges in the future. 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 swap agreements 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, 2018, 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.

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, 2018, at which such postings are triggered:

Counterparty (CP)

(in millions)

Other (a)

Total

Fair value of fuel derivatives

222

156

161

698

Cash collateral held from CP

165

—

165

Aircraft collateral pledged to CP

—

Letters of credit (LC)

—

Option to substitute LC for aircraft

(200) to (600)(b)

N/A

(150) to (550)(c)

N/A

Option to substitute LC for cash

N/A

(75) to (150) or >(550)(c)

(125) to (150) or >(550)(d)

(d)

N/A

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)

(75) to (150) or >(550)(e)

(125) to (150) or >(550)(e)

>(125)

>(70)(e)

Cash is received from CP

>50(e)

>150(e)

>250(e)

>125(e)

>100(e)

>70(e)

Aircraft or cash can be pledged to

CP as collateral

(200) to (600)(f)

N/A

(150) to (550)(c)

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)

(g)

(0) to (150) or >(550)

(g)

Cash is received from CP

(g)

Aircraft or cash can be pledged to

CP as collateral

(200) to (600)

N/A

(150) to (550)

N/A

(a) Individual counterparties with fair value of fuel derivatives <$20 million.

(b) 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.

(d) The Company has the option to substitute letters of credit for 100 percent of cash collateral requirement.

(e) Thresholds may vary based on changes in credit ratings within investment grade.

(f) The Company has the option of providing cash or pledging aircraft as collateral.

(g) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.

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, 2018 and 2017 were as follows:



	Three months ended September 30,
(in millions)	2018		2017
NET INCOME	$	615	$	528
Unrealized gain on fuel derivative instruments, net of deferred taxes of $32 and $73	107		123
Unrealized gain on interest rate derivative instruments, net of deferred taxes of $- and $-	1		2
Other, net of deferred taxes of $1 and $2	6		2
Total other comprehensive income	$	114	$	127
COMPREHENSIVE INCOME	$	729	$	655



	Nine months ended September 30,
(in millions)	2018		2017
NET INCOME	$	1,811	$	1,610
Unrealized gain on fuel derivative instruments, net of deferred taxes of $123 and $105	404		178
Unrealized gain on interest rate derivative instruments, net of deferred taxes of $1 and $2	5		5
Other, net of deferred taxes of $1 and $2	9		4
Total other comprehensive income	$	418	$	187
COMPREHENSIVE INCOME	$	2,229	$	1,797

A rollforward of the amounts included in AOCI is shown below for the three and nine months ended September 30, 2018:



(in millions)	Fuel derivatives			Interest rate derivatives			Defined benefit plan items			Other		Deferred tax			Accumulated other comprehensive income (loss)
Balance at June 30, 2018	$	365		$	(2	)	$	(9	)	$	36	$	(92	)	$	298
Changes in fair value	159			—			—			7		(38		)	128
Reclassification to earnings	(20		)	1			—			—		5			(14		)
Balance at September 30, 2018	$	504		$	(1	)	$	(9	)	$	43	$	(125	)	$	412

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)



(in millions)	Fuel derivatives			Interest rate derivatives			Defined benefit plan items			Other		Deferred tax			Accumulated other comprehensive income (loss)
Balance at December 31, 2017	$	3		$	(7	)	$	(9	)	$	33	$	(8	)	$	12
ASU 2017-12 adoption adjustment (a)	(26		)	—			—			—		6			(20		)
ASU 2018-02 stranded AOCI adoption adjustment (b)	—			—			—			—		2			2
Changes in fair value	559			2			—			10		(132		)	439
Reclassification to earnings	(32		)	4			—			—		7			(21		)
Balance at September 30, 2018	$	504		$	(1	)	$	(9	)	$	43	$	(125	)	$	412

(a) The Company adopted the New Hedging Standard as of January 1, 2018. See Note 2 for further information on this adoption.

(b) The Company adopted the Reclassification of Certain Tax Effects from AOCI as of January 1, 2018, which allowed the Company to reclassify to Retained earnings any tax effects stranded in AOCI as a result of the Tax Cuts and Jobs Act enacted in December 2017.

The following tables illustrate the significant amounts reclassified out of each component of AOCI for the three and nine months ended September 30, 2018:



Three months ended September 30, 2018
(in millions)	Amounts reclassified from AOCI			Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components	Amounts reclassified from AOCI
Unrealized gain on fuel derivative instruments	$	(20	)	Fuel and oil expense
	(5		)	Less: Tax expense
	$	(15	)	Net of tax
Unrealized loss on interest rate derivative instruments	$	1		Interest expense
	—			Less: Tax expense
	$	1		Net of tax

Total reclassifications for the period	$	(14	)	Net of tax



Nine months ended September 30, 2018
(in millions)	Amounts reclassified from AOCI			Affected line item in the unaudited Condensed Consolidated Statement of Comprehensive Income
AOCI components	Amounts reclassified from AOCI
Unrealized gain on fuel derivative instruments	$	(32	)	Fuel and oil expense
	(8		)	Less: Tax Expense
	$	(24	)	Net of tax
Unrealized loss on interest rate derivative instruments	$	4		Interest expense
	1			Less: Tax Expense
	$	3		Net of tax

Total reclassifications for the period	$	(21	)	Net of tax

5. REVENUE

Passenger Revenues

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

The Company’s contracts with its Customers primarily consist of its tickets sold, which are initially deferred as Air traffic liability. Passenger revenue associated with tickets is recognized when the performance obligation to the Customer is satisfied, which is primarily when travel is provided.

Revenue is categorized by revenue source as the Company believes it best depicts the nature, amount, timing, and uncertainty of revenue and cash flow. The following table provides the components of Passenger revenue recognized for the three and nine months ended September 30, 2018 and 2017:



	Three months ended September 30,				Nine months ended September 30,
(in millions)	2018		2017		2018		2017
Passenger non-loyalty	$	4,417	$	4,182	$	12,969	$	12,733
Passenger loyalty - air transportation	623		616		1,702		1,724
Passenger ancillary sold separately	154		146		466		412
Total passenger revenues	$	5,194	$	4,944	$	15,137	$	14,869

Passenger non-loyalty includes all revenues recognized from Passengers related to flights paid for primarily with cash or credit card. All Customers purchasing a ticket on Southwest Airlines are generally able to check up to two bags at no extra charge (with certain exceptions as stated in the Company's published Contract of Carriage), and the Company also does not charge a fee for a Customer to make a change to their flight after initial purchase, although fare differences may apply. Passenger loyalty - air transportation primarily consists of the revenue recognized associated with award flights taken by frequent flyer program members upon redemption of frequent flyer points. Passenger ancillary sold separately includes any revenue recognized associated with ancillary fees charged separately, such as in-flight purchases, EarlyBird Check-In^®, and Upgraded Boarding.

Air traffic liability primarily represents tickets sold for future travel dates, funds that are past flight date and remain unused, but are expected to be used in the future, and the Company’s liability for frequent flyer benefits that are expected to be redeemed in the future. The majority of the Company’s tickets sold are nonrefundable. Southwest has a No Show policy that applies to fares that are not canceled or changed by a Customer at least ten minutes prior to a flight's scheduled departure. Refundable tickets that are sold but not flown on the travel date and canceled in accordance with the No Show policy can also be reused for another flight, up to a year from the date of sale. A small percentage of tickets (or partial tickets) expire unused. The Company estimates the amount of tickets that expire unused and recognizes such amounts in Passenger revenue using the redemption method once the scheduled flight date has lapsed. Based on the Company's revenue recognition policy, revenue is recorded at the flight date for a Customer who does not change his/her itinerary and loses his/her funds as the Company has then fulfilled its performance obligation. Amounts collected from passengers for ancillary services are also recognized when the service is provided, which is typically the flight date.

Initial spoilage estimates for both tickets and funds available for future use are routinely adjusted and ultimately finalized once the tickets expire, which is typically twelve months after the original purchase date. Spoilage estimates are based on the Company's Customers' historical travel behavior as well as assumptions about the Customers' future travel behavior. Assumptions used to generate spoilage estimates can be impacted by several factors including, but not limited to: fare increases, fare sales, changes to the Company's ticketing policies, changes to the Company’s refund, exchange and unused funds policies, seat availability, and economic factors.

Frequent Flyer Program

The Company records a frequent flyer liability for the relative fair value of providing free travel under its frequent flyer program for all points earned from flight activity or sold to companies participating in the Company’s frequent flyer program as business partners. The frequent flyer liability is a performance obligation that is satisfied when a member redeems points for travel or other goods and services, or upon spoilage of the points. Points earned from flight activity are valued at their relative standalone selling price by applying fair value based on historical redemption

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

patterns. Points earned from business partner activity are valued using a relative fair value methodology based on the contractual rate which partners pay to Southwest to award Rapid Rewards points to the business partner’s customers. The terms for these agreements are no more than 10 years in length. The Company’s liability for frequent flyer benefits include a portion that are expected to be redeemed during the following twelve months (classified as a component of Air traffic liability), and a portion that are not expected to be redeemed during the following twelve months (classified as Air traffic liability - noncurrent). The Company continually updates this analysis and adjusts the split between current and non-current liabilities as appropriate.

In order to determine the value of each frequent flyer point, certain assumptions must be made at the time of measurement, which include the following:

•

Allocation of Passenger Revenue - Revenues from Passengers, related to travel, who also earn Rapid Rewards Points have been allocated between flight (recognized as revenue when transportation is provided) and Rapid Rewards Points (deferred until points are redeemed or spoil) based on each obligation’s relative standalone selling price. The Company utilizes historical earning patterns to assist in this allocation.

•

Fair Value of Rapid Rewards Points - Determined from the base fare value of tickets which were purchased using prior point redemptions for travel and other products and services, which the Company believes to be indicative of the fair value of points as perceived by Customers and representative of the value of each point at the time of redemption. The Company’s booking site allows a Customer to toggle between fares utilizing either cash or point redemptions, which provides the Customer with an approximation of the equivalent value of their points. The value can differ however, based on demand, the amount of time prior to the flight, and other factors. The fare mix during the period measured represents a constraint, which could result in the assumptions above changing at the measurement date, as fare classes can have different coefficients used to determine the total frequent flyer points needed to purchase an award ticket. The mixture of these fare classes could cause the fair value per point to increase or decrease.

For points that are expected to expire unused, the Company recognizes spoilage in accordance with the redemption method. The Company utilizes historical behavioral data to develop a predictive statistical model to analyze the amount of spoilage expected for points sold to business partners and earned through flight. The Company continues to evaluate expected spoilage at least annually and applies appropriate adjustments in the fourth quarter of each year, which impacts revenue recognition prospectively through the redemption method. In most historical periods, the impact of changes in the estimated spoilage rate has not resulted in material changes to revenue recognition. However, due to the size of the Company’s liability for frequent flyer benefits as a result of the elimination of the incremental cost method of accounting for flight points, changes in Customer behavior and/or expected future redemption patterns could result in more significant variations in Passenger revenue under the New Revenue Standard.

ASC 606 requires the Company to allocate consideration received to performance obligations based on the relative fair value of those obligations. The Company has a co-branded credit card agreement (“Agreement”) with Chase Bank USA, N.A. (“Chase”), through which the Company sells loyalty points and certain marketing components, which consist of the use of Southwest Airlines’ brand and access to Rapid Rewards Member lists, licensing and advertising elements, and the use of the Company’s resource team. 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 two performance obligations identified in the Agreement, which have been characterized as a transportation component and a marketing component (which includes loyalty points and ancillary benefits). The allocations utilized are reviewed to determine if adjustment is necessary any time there is a modification to the Agreement. The Company records Passenger revenue related to loyalty point redemptions for air travel when the travel is delivered. The marketing elements are recognized as Other revenue when earned following the sales-based royalty method, as intellectual property was determined to be the predominant component of this performance obligation in the Agreement.

The Company has elected the transition provision within ASC 606 to reflect the aggregate effect of historical modifications to the Agreement on January 1, 2018, when (i) identifying the satisfied and unsatisfied performance obligations, (ii) determining the transaction price, and (iii) allocating the transaction price to the satisfied and unsatisfied

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

performance obligations. When applying the full retrospective adoption provisions of ASC 606, the Company determined the transaction price for all satisfied and unsatisfied performance obligations in the Agreement and performed a single allocation of the transaction price to those performance obligations, based on the relative selling prices on January 1, 2016. In applying this transition provision, the Company evaluated the historical modifications of the Agreement and did not identify any new performance obligations throughout the periods prior to adoption of the new standard. The Company did not believe it was reasonably possible to quantitatively estimate the impact of applying this transition provision to contract modifications prior to January 1, 2016.

As performance obligations to Customers are satisfied, the related revenue is recognized. The events that result in revenue recognition that are associated with performance obligations identified as a part of the Rapid Rewards Program are as follows:


•	Tickets and Rapid Rewards Points - When a flight occurs, the related performance obligation is satisfied and the related value provided by the Customer, whether from purchased tickets or Rapid Rewards Points, is recognized as revenue.


•	Frequent flyer points redeemed for goods and/or services other than travel - Rapid Rewards Members have the option to redeem points for goods and services offered through a third party vendor, who acts as principal. The performance obligation related to the purchase of these goods and services is satisfied when the good and/or service is delivered to the Customer.


•	Marketing Royalties - As part of its Agreement with Chase, Southwest provides certain deliverables, including use of the Southwest Airlines’ brand, access to Rapid Rewards Member lists, advertising elements, and the Company’s resource team. These performance obligations are satisfied each month that the Agreement is active.

The components of Air traffic liability, including contract liabilities based on tickets sold, unused funds available to the Customer, and frequent flyer points available for redemption, net of expected spoilage, within the unaudited Condensed Consolidated Balance Sheet were as follows:



	Balance as of
(in millions)	September 30, 2018		December 31, 2017
Air traffic liability - passenger travel and ancillary passenger services	$	2,635	$	1,898
Air traffic liability - loyalty program	2,948		2,667
Total Air traffic liability	$	5,583	$	4,565

SOUTHWEST AIRLINES CO - FORM 10-Q - October 30, 2018

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