Southwest Airlines 2003 Annual Report Download - page 42

are based on historical experiences and changes in the business environment. However, actual results may
differ from estimates under different conditions, sometimes materially. Critical accounting policies and
estimates are defined as those that are both most important to the portrayal of the Company’s financial
condition and results and require management’s most subjective judgments. The Company’s most critical
accounting policies and estimates are described below.
Revenue Recognition
As described in Note 1 to the Consolidated Financial Statements, tickets sold for passenger air travel are
initially deferred as “Air traffic liability.” Passenger revenue is recognized and air traffic liability is reduced
when the service is provided (i.e., when the flight takes place). “Air traffic liability” represents tickets sold
for future travel dates and estimated future refunds and exchanges of tickets sold for past travel dates. The
Company’s air traffic liability balance at December 31, 2003 was $462 million.
Estimating the amount of tickets that will be refunded, exchanged, or forfeited involves some level of
subjectivity and judgment. The majority of the Company’s tickets sold are nonrefundable, which is the
primary source of forfeited tickets. According to the Company’s “Contract of Carriage”, tickets that are sold
but not flown on the travel date can be reused for another flight, up to a year from the date of sale, or can be
refunded (if the ticket is refundable). A small percentage of tickets (or partial tickets) expire unused. Fully
refundable tickets are rarely forfeited. “Air traffic liability” includes an estimate of the amount of future
refunds and exchanges, net of forfeitures for all unused tickets once the flight date has passed. These
estimates are based on historical experience over many years. The Company and members of the airline
industry have consistently applied this accounting method to estimate revenue from forfeited tickets at the
date travel is provided. Estimated future refunds and exchanges included in the air traffic liability account
are constantly evaluated based on subsequent refund and exchange activity to validate the accuracy of the
Company’s estimates with respect to forfeited tickets.
Events and circumstances outside of historical fare sale activity or historical Customer travel patterns, as
noted above, can result in actual refunds, exchanges, or forfeited tickets differing significantly from
estimates. The Company evaluates its estimates within a narrow range of acceptable amounts. If actual
refunds, exchanges, or forfeiture experience results in an amount outside of this range, estimates and
assumptions are reviewed and adjustments to “Air traffic liability” and to “Passenger revenue” are recorded
as necessary. Additional factors that may affect estimated refunds and exchanges include, but may not be
limited to, the Company’s refund and exchange policy, the mix of refundable and nonrefundable fares, and
promotional fare activity. The Company’s estimation techniques have been consistently applied from year to
year; however, as with any estimates, actual refund and exchange activity may vary from estimated amounts.
Furthermore, the Company believes it is unlikely that materially different estimates for future refunds,
exchanges, and forfeited tickets would be reported based on other reasonable assumptions or conditions
suggested by actual historical experience and other data available at the time estimates were made.
Following September 2001 and through 2002, the Company experienced fluctuations in estimated refunds
and exchanges, and correspondingly, forfeited tickets, due to many of the factors described above.
Following the terrorist events of September 11, 2001, and the subsequent temporary shutdown of U.S. air
space, Southwest temporarily suspended its normal refund policy in order to provide the highest Service to
the Company’s Customers, including the refunding of nonrefundable tickets upon Customer request. As a
result, the Company experienced refunds during September 2001 and through December 2001 far above
historical refund levels and in excess of the Company’s contractual obligations. In evaluating passenger
revenue through third quarter 2001, based on these unusually high refund levels, the Company estimated that
approximately $30 million of these refunds related to revenue previously recognized for estimated forfeited
tickets. As a result, the Company reduced third quarter 2001 “Passenger revenue” by $30 million and
restored “Air traffic liability”, accordingly.
Subsequent to third quarter 2001 and through second quarter 2002, the Company experienced a higher than
historical mix of discount, nonrefundable ticket sales. The Company also experienced changes in Customer
travel patterns resulting from various factors, including new airport security measures, concerns about further
terrorist attacks, and an uncertain economy. Consequently, the Company recorded $36 million in additional
passenger revenue in second quarter 2002 as Customers required fewer refunds and exchanges, resulting in
more forfeited tickets. During 2003, refund, exchange, and forfeiture activity returned to more historic, pre-
September 11, 2001, patterns.