Southwest Airlines 2009 Annual Report Download - page 52

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earnings within “Other (gains)/losses, net”, in the period of the change. Because the Company has extensive
historical experience in valuing the derivative instruments it holds, and such experience is continually evaluated
against its counterparties each period when such instruments expire and are settled for cash, the Company
believes it is unlikely that an independent third party would value the Company’s derivative contracts at a
significantly different amount than what is reflected in the Company’s financial statements. In addition, the
Company also has bilateral credit provisions in some of its counterparty agreements, which provide for parties
(or the Company) to provide cash collateral when the fair values of fuel derivatives with a single party exceeds
certain threshold levels. Since this cash collateral is based on the estimated fair value of the Company’s
outstanding fuel derivative contracts, this provides further validation to the Company’s estimate of fair values.
Frequent flyer accounting
The Company utilizes estimates in its recognition of liabilities associated with its frequent flyer program.
These estimates include the liability associated with frequent flyer awards that have been issued, are outstanding,
and are expected to be redeemed at a future date, and amounts associated with frequent flyer credits sold to
companies participating in its Rapid Rewards frequent flyer program.
A Customer must earn a minimum of 16 frequent flyer credits in order to attain a round-trip award, and
these credits cannot be utilized for any other type of product or service from the Company. In addition, once
earned, a frequent flyer credit remains “active” and in the Customer’s account for up to 24 months before
expiration. Once a Customer earns their 16th frequent flyer credit, a round-trip award is automatically issued to
the Customer, which can then be utilized for any destination available on Southwest, for up to a twelve month
period before it expires. This “standard” award is subject to seat restrictions depending on the availability on a
particular flight. If a Customer accumulates two standard awards, they can be converted into a “Freedom
Award,” which is free of seat restrictions except for a limited number of “Black-out” dates around major
holidays.
The Company utilizes the incremental cost method of accounting for frequent flyer awards issued from
flight credits earned in the Company’s Rapid Rewards frequent flyer program. As such, the Company records a
liability and reduction of Passenger revenue for the estimated incremental cost of providing free travel at the time
an award is earned. The liability recorded by the Company represents the total number of awards expected to be
redeemed by Customers. The estimated incremental cost of an award includes direct passenger costs such as fuel,
food, and other operational costs, but does not include any contribution to overhead or profit. The Company does
not record a liability for partially earned Customer awards, although it expects that a portion of these partially
earned awards will eventually turn into full awards. At December 31, 2009, the Company had approximately
10.3 million full or partial awards outstanding, of which approximately 7.9 million were partially earned awards.
Considering historical and expected future spoilage of both flight credits and awards, the Company estimates that
a liability associated with partially earned awards would not be material to the Company’s financial position at
December 31, 2009, utilizing the incremental cost method of accounting for such awards.
The Company also sells frequent flyer credits and related services to companies participating in its frequent
flyer program. Funds received from the sale of flight segment credits are accounted for under the residual
method. Under this method, the Company has estimated that approximately 75 percent of the amount received
per flight segment credit sold relates to free travel, and the remaining 25 percent associated with items such as
access to the Company’s frequent flyer program population for marketing/solicitation purposes, use of the
Company’s logo on co-branded credit cards, and other trademarks, designs, images, etc. of the Company for use
in marketing materials. This apportionment of value between free travel and marketing services is estimated
based on several factors, including fares, the habits of Customers in redeeming awards for free travel, and the
contractual rate paid by companies for the flight segment credits. The amount estimated to be associated with
free travel has historically been in a range of 75 percent to 82 percent. The estimated amounts associated with
travel are deferred and recognized as “Passenger revenue” when the travel is estimated to be flown, along with
the portion that expires unused. For the portion of funds received that is deemed not to be associated with future
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