Southwest Airlines 2003 Annual Report Download - page 44

The Company enters into financial derivative instruments with third party institutions in “over-the-counter”
markets. Since the majority of the Company’s financial derivative instruments are not traded on a market
exchange, the Company estimates their fair values. Depending on the type of instrument, the values are
determined by the use of present value methods or standard option value models with assumptions about
commodity prices based on those observed in underlying markets. Also, since there is not a reliable forward
market for jet fuel, the Company must estimate the future prices of jet fuel in order to measure the
effectiveness of the hedging instruments in offsetting changes to those prices, as required by SFAS 133.
Forward jet fuel prices are estimated through the observation of similar commodity futures prices (such as
crude oil and heating oil) and adjusted based on historical variations to those like commodities.
Fair values for financial derivative instruments and forward jet fuel prices are both estimated prior to the time
that the financial derivative instruments settle, and the time that jet fuel is purchased and consumed,
respectively. However, once settlement of the financial derivative instruments occurs and the hedged jet fuel
is purchased and consumed, all values and prices are known and are recognized in the financial statements.
Based on these actual results once all values and prices become known, the Company’s estimates have
proved to be materially accurate. Furthermore, since the majority of the Company’s hedges settle within 12
to 24 months from the time the Company enters into the contract for the derivative financial instrument, the
estimates being made are relatively short-term.
Estimating the fair value of these fuel hedging derivatives and forward prices for jet fuel will also result in
changes in their values from period to period and thus determine how they are accounted for under SFAS
133. To the extent that the period to period change in the estimated fair value of a fuel hedging instrument
differs from a period to period change in the estimated price of the associated jet fuel to be purchased,
ineffectiveness of the fuel hedge will result, as defined by SFAS 133. This could result in the immediate
recording of charges or income, even though the derivative instrument may not expire until a future period.
Historically, the Company has not experienced significant ineffectiveness in its fuel hedges accounted for
under SFAS 133.
SFAS 133 is a complex accounting standard with stringent requirements including the documentation of a
Company hedging strategy, statistical analysis to qualify a commodity for hedge accounting both on a
historical and a prospective basis, and strict contemporaneous documentation that is required at the time each
hedge is executed by the Company. As required by SFAS 133, the Company assesses the effectiveness of
each of its individual hedges on a quarterly basis. The Company also examines the effectiveness of its entire
hedging program on a quarterly basis utilizing statistical analysis. This analysis involves utilizing regression
and other statistical analyses that compare changes in the price of jet fuel to changes in the prices of the
commodities used for hedging purposes (crude oil and heating oil).
The Company also utilizes financial derivative instruments in the form of interest rate swap agreements.
During second quarter 2003, the Company entered into interest rate swap agreements relating to its $385
million 6.5% senior unsecured notes due March 1, 2012, and $375 million 5.496% Class A-2 pass-through
certificates due November 1, 2006. Under the first interest rate swap agreement, the Company pays the
London InterBank Offered Rate (LIBOR) plus a margin every six months and receives 6.5% every six
months on a notional amount of $385 million until March 1, 2012. Under the second agreement, the
Company pays LIBOR plus a margin every six months and receives 5.496% every six months on a notional
amount of $375 million until November 1, 2006.
The Company’s interest rate swap agreements qualify as fair value hedges, as defined by SFAS 133. In
addition, these interest rate swap agreements qualify for the “shortcut” method of accounting for hedges, as
defined by SFAS 133. Under the “shortcut” method, the hedges are assumed to be perfectly effective, and
thus, there is no ineffectiveness to be recorded in earnings. The fair value of the interest rate swap
agreements, which are adjusted regularly, are recorded in the Consolidated Balance Sheet, as necessary, with
a corresponding adjustment to the carrying value of the long-term debt. The fair value of the interest rate
swap agreements, excluding accrued interest, at December 31, 2003, was a liability of approximately $18
million. This amount is recorded in “Other deferred liabilities” in the Consolidated Balance Sheet. In
accordance with fair value hedging, the offsetting entry is an adjustment to decrease the carrying value of
long-term debt. See Note 10 to the Consolidated Financial Statements.