Southwest Airlines 2005 Annual Report Download - page 61

SOUTHWEST AIRLINES CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Ì (Continued)
to the ineffectiveness of its hedges. During 2003, the on actual and forward rates at December 31, 2005.
Company recognized approximately $16 million of ad- Under the second agreement, the Company pays
ditional income in ""Other (gains) losses, net,'' related LIBOR plus a margin every six months and receives
to the ineffectiveness of its hedges. During 2005, 2004, 5.496% every six months on a notional amount of
and 2003, the Company recognized approximately $375 million until 2006. Based on actual and forward
$35 million, $24 million, and $29 million of net rates at December 31, 2005, the average floating rate
expense, respectively, related to amounts excluded from paid under this agreement during 2005 is estimated to
the Company's measurements of hedge effectiveness, in be 6.73 percent.
""Other (gains) losses, net''. During 2004, the Company entered into an inter-
During 2005, 2004, and 2003, the Company est rate swap agreement relating to its $350 million
recognized gains in ""Fuel and oil'' expense of $890 mil- 5.25% senior unsecured notes due 2014. Under this
lion, $455 million, and $171 million, respectively, from agreement, the Company pays LIBOR plus a margin
hedging activities. At December 31, 2005 and 2004, every six months and receives 5.25% every six months
approximately $83 million and $51 million, respec- on a notional amount of $350 million until 2014. The
tively, due from third parties from expired derivative floating rate is set in advance. The average floating rate
contracts, is included in ""Accounts and other receiv- paid under this agreement during 2005 was
ables'' in the accompanying Consolidated Balance 3.82 percent.
Sheet. The fair value of the Company's financial deriva- The primary objective for the Company's use of
tive instruments at December 31, 2005, was a net asset interest rate hedges is to reduce the volatility of net
of approximately $1.7 billion. The current portion of interest income by better matching the repricing of its
these financial derivative instruments, $640 million, is assets and liabilities. Concurrently, the Company's in-
classified as ""Fuel hedge contracts'' and the long-term terest rate hedges are also intended to take advantage of
portion, $1.1 billion, is classified as ""Other assets'' in market conditions in which short-term rates are signifi-
the Consolidated Balance Sheet. The fair value of the cantly lower than the fixed longer term rates on the
derivative instruments, depending on the type of instru- Company's long-term debt. The Company's interest
ment, was determined by the use of present value rate swap agreements qualify as fair value hedges, as
methods or standard option value models with assump- defined by SFAS 133. The fair value of the interest rate
tions about commodity prices based on those observed swap agreements, which are adjusted regularly, are
in underlying markets. recorded in the Consolidated Balance Sheet, as neces-
As of December 31, 2005, the Company had sary, with a corresponding adjustment to the carrying
approximately $890 million in unrealized gains, net of value of the long-term debt. The fair value of the
tax, in ""Accumulated other comprehensive income interest rate swap agreements, excluding accrued inter-
(loss)'' related to fuel hedges. Included in this total are est, at December 31, 2005, was a liability of approxi-
approximately $327 million in net unrealized gains that mately $31 million. The long-term portion of this
are expected to be realized in earnings during 2006. amount is recorded in ""Other deferred liabilities'' in the
Consolidated Balance Sheet and the current portion is
Interest Rate Swaps reflected in ""Accrued liabilities''. In accordance with
fair value hedging, the offsetting entry is an adjustment
During 2003, the Company entered into interest to decrease the carrying value of long-term debt. See
rate swap agreements relating to its $385 million Note 7.
6.5% senior unsecured notes due 2012 and $375 million
5.496% Class A-2 pass-through certificates due 2006. Outstanding financial derivative instruments ex-
The floating rate paid under each agreement is set in pose the Company to credit loss in the event of nonper-
arrears. Under the first agreement, the Company pays formance by the counterparties to the agreements.
the London InterBank Offered Rate (LIBOR) plus a However, the Company does not expect any of the
margin every six months and receives 6.5% every six counterparties to fail to meet their obligations. The
months on a notional amount of $385 million until credit exposure related to these financial instruments is
2012. The average floating rate paid under this agree- represented by the fair value of contracts with a positive
ment during 2005 is estimated to be 6.46 percent based fair value at the reporting date. To manage credit risk,
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