Southwest Airlines 2009 Annual Report Download - page 51

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Fair value measurements
The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and
liabilities. At December 31, 2009, these included auction rate security investments, valued at $174 million, a
portion of its fuel derivative option contracts, which were a net asset of $140 million, and $8 million in other
investments.
All of the Company’s auction rate security instruments are reflected at estimated fair value in the
Consolidated Balance Sheet. In prior periods, due to the auction process which took place every 30-35 days for
most securities, quoted market prices were readily available, which would have qualified as Level 1. However,
due to events in credit markets beginning during first quarter 2008, the auctions for most of these instruments
failed, and, therefore, the Company has determined the estimated fair values of these securities utilizing a
discounted cash flow analysis or other type of valuation model as of December 31, 2009, which qualify as Level
3. The Company’s analyses consider, among other items, the collateralization underlying the security
investments, the expected future cash flows, including the final maturity, associated with the securities, and
estimates of the next time the security is expected to have a successful auction or return to par value.
In association with this estimate of fair value, the Company has recorded a temporary unrealized decline in
fair value of $17 million, with an offsetting entry to “Accumulated other comprehensive income (loss).” Given
the quality and backing of the Company’s auction rate securities held, the fact that the Company has not yet
recorded a loss on the sale of any of these instruments, and the fact that it has been able to periodically sell
instruments in the auction process, it believes it can continue to account for the estimated reduction in fair value
of its remaining securities as temporary. These conclusions will also continue to be evaluated and challenged in
subsequent periods. The Company currently believes that this temporary decline in fair value is due entirely to
liquidity issues, because the underlying assets for the majority of securities are almost entirely backed by the U.S.
Government. In addition, for the $99 million in instruments classified as available for sale, these auction rate
securities represented less than four percent of the Company’s total cash, cash equivalent, and investment
balance at December 31, 2009, which it believes allows it sufficient time for the securities to return to full value.
For the $75 million in instruments classified as trading securities, the Company has entered into an agreement
with the counterparty that allows the Company to put the instruments back to the counterparty at full par value in
June 2010. As part of this agreement, the Company has entered into a line of credit in which it has received a $75
million loan that is secured by the auction rate security instruments from that counterparty. At the time of the
first failed auctions during first quarter 2008, the Company held a total of $463 million in securities. Since that
time, the Company has been able to sell $272 million of these instruments at par value, in addition to the $75
million subject to the agreement to be sold at par in June 2010. The Company is also in discussions with other
counterparties to determine whether mutually agreeable terms can be reached regarding the effective repurchase
of its remaining securities.
The Company determines the value of fuel derivative option contracts utilizing a standard 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 quoted by its counterparties. In situations where the Company
obtains inputs via quotes from its counterparties, it verifies the reasonableness of these quotes via similar quotes
from another counterparty as of each date for which financial statements are prepared. 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. Due to the fact that certain inputs
used in determining estimated fair value of its option contracts are considered unobservable (primarily volatility),
the Company has categorized these option contracts as Level 3.
As discussed in Note 10 to the Consolidated Financial Statements, any changes in fair value of cash flow
hedges that are considered to be effective, as defined, are offset within “Accumulated other comprehensive
income (loss)” until the period in which the expected cash flow impacts earnings. Any changes in the fair value
of fuel derivatives that are ineffective, as defined, or do not qualify for special hedge accounting, are reflected in
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