Southwest Airlines 2011 Annual Report Download - page 72

discounted cash flow analysis or other type of valuation model, which qualify the instruments 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 $14 million, with an offsetting entry to AOCI. 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 back to the issuer, 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, these auction rate
securities represented less than two percent of the Company’s total cash, cash equivalents, and investment
balance at December 31, 2011, which the Company believes allows it sufficient time for the auction rate
securities to return to full value. At the time of the first failed auctions during first quarter 2008, the Company
held a total of $463 million in auction rate securities. Since that time, the Company has been able to redeem $382
million of these instruments at par value.
The Company determines the fair value of fuel derivative 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 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 AOCI until the period in which the
expected future cash flow impacts earnings. Any changes in the fair value of fuel derivatives that are ineffective,
as defined, or that do not qualify for hedge accounting, are reflected in 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
value 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
Southwest and AirTran utilize estimates in the recognition of liabilities associated with their respective
frequent flyer programs. These estimates primarily include the liability associated with frequent flyer member
account balances that are expected to be redeemed for travel or other products at a future date, and frequent flyer
awards that have been issued, are outstanding, and are expected to be redeemed at a future date. Frequent flyer
account balances include points/credits earned through flights taken, points sold to Customers, or points/credits
earned through business partners participating in the Company’s frequent flyer program.
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