Southwest Airlines 2005 Annual Report Download - page 42

expense, as required by GAAP. The Company does not to the dramatic increase in energy prices throughout
expect its transition to a new, more efficient heavy 2005, and the Company's addition of derivative instru-
maintenance program for 737-300 and 737-500 air- ments to increase its hedge positions in future years.
frames in 2006 to have an impact on the estimated Changes in the fair values of these instruments can vary
useful lives for those aircraft. See Note 2 to the Consoli- dramatically, as was evident during 2005, based on
dated Financial Statements for more information on this changes in the underlying commodity prices. Market
change. price changes can be driven by factors such as supply
and demand, inventory levels, weather events, refinery
When appropriate, the Company evaluates its capacity, political agendas, and general economic condi-
long-lived assets for impairment. Factors that would tions, among other items. The financial derivative in-
indicate potential impairment may include, but are not struments utilized by the Company primarily are a
limited to, significant decreases in the market value of combination of collars, purchased call options, and fixed
the long-lived asset(s), a significant change in the long- price swap agreements. The Company does not
lived asset's physical condition, and operating or cash purchase or hold any derivative instruments for trading
flow losses associated with the use of the long-lived purposes.
asset. While the airline industry as a whole has exper-
ienced many of these indicators, Southwest has contin- The Company enters into financial derivative in-
ued to operate all of its aircraft, generate positive cash struments with third party institutions in ""over-the-
flow, and produce profits. Consequently, the Company counter'' markets. Since the majority of the Company's
has not identified any impairments related to its existing financial derivative instruments are not traded on a
aircraft fleet. The Company will continue to monitor its market exchange, the Company estimates their fair
long-lived assets and the airline operating environment. values. Depending on the type of instrument, the values
are determined by the use of present value methods or
The Company believes it unlikely that materially standard option value models with assumptions about
different estimates for expected lives, expected residual commodity prices based on those observed in underlying
values, and impairment evaluations would be made or markets. Also, since there is not a reliable forward
reported based on other reasonable assumptions or market for jet fuel, the Company must estimate the
conditions suggested by actual historical experience and future prices of jet fuel in order to measure the effective-
other data available at the time estimates were made. ness of the hedging instruments in offsetting changes to
those prices, as required by SFAS 133. Forward jet fuel
Financial Derivative Instruments prices are estimated through the observation of similar
The Company utilizes financial derivative instru- commodity futures prices (such as crude oil, heating oil,
ments primarily to manage its risk associated with and unleaded gasoline) and adjusted based on historical
changing jet fuel prices, and accounts for them under variations to those like commodities.
Statement of Financial Accounting Standards No. 133,
Fair values for financial derivative instruments and
""Accounting for Derivative Instruments and Hedging
forward jet fuel prices are both estimated prior to the
Activities'', as amended (SFAS 133). See ""Qualitative
time that the financial derivative instruments settle, and
and Quantitative Disclosures about Market Risk'' for
the time that jet fuel is purchased and consumed,
more information on these risk management activities
respectively. However, once settlement of the financial
and see Note 10 to the Consolidated Financial State-
derivative instruments occurs and the hedged jet fuel is
ments for more information on SFAS 133, the Com-
purchased and consumed, all values and prices are
pany's fuel hedging program, and financial derivative
known and are recognized in the financial statements.
instruments.
Based on these actual results once all values and prices
SFAS 133 requires that all derivatives be marked become known, the Company's estimates have proved
to market (fair value) and recorded on the Consolidated to be materially accurate.
Balance Sheet. At December 31, 2005, the Company
was a party to over 400 financial derivative instruments, Estimating the fair value of these fuel hedging
related to fuel hedging, for year 2006 and beyond. The derivatives and forward prices for jet fuel will also result
fair value of the Company's fuel hedging financial in changes in their values from period to period and thus
derivative instruments recorded on the Company's Con- determine how they are accounted for under SFAS 133.
solidated Balance Sheet as of December 31, 2005, was To the extent that the total change in the estimated fair
$1.7 billion, compared to $796 million at December 31, value of a fuel hedging instrument differs from the
2004. The large increase in fair value primarily was due change in the estimated price of the associated jet fuel
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