Southwest Airlines 2006 Annual Report Download - page 47

The Company is also party to an interest rate swap
agreement relating to its $350 million 5.25% senior
unsecured notes due 2014, in which the floating rate is
set at the beginning of each six month period. Under this
agreement, the Company pays LIBOR plus a margin
every six months and receives 5.25% every six months on
a notional amount of $350 million until 2014. The
average floating rate paid under this agreement during
2006 was 5.69 percent.
The Company’s interest rate swap agreements qual-
ify 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 Bal-
ance Sheet, as necessary, with a corresponding adjust-
ment to the carrying value of the long-term debt. The fair
value of the interest rate swap agreements, excluding
accrued interest, at December 31, 2006, was a liability
of approximately $30 million. The comparable fair value
of these same agreements at December 31, 2005, was a
liability of $31 million. The long-term portion of these
amounts are recorded in “Other deferred liabilities” in
the Consolidated Balance Sheet for each respective year.
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.
The Company believes it is unlikely that materially
different estimates for the fair value of financial derivative
instruments, and forward jet fuel prices, would be made or
reported based on other reasonable assumptions or con-
ditions suggested by actual historical experience and
other data available at the time estimates were made.
Share-Based Compensation
The Company has share-based compensation plans
covering the majority of its Employee groups, including
plans adopted via collective bargaining, a plan covering
the Company’s Board of Directors, and plans related to
employment contracts with one Executive Officer of the
Company. Prior to January 1, 2006, the Company
accounted for stock-based compensation utilizing the
intrinsic value method in accordance with the provisions
of Accounting Principles Board Opinion No. 25
(APB 25), “Accounting for Stock Issued to Employees”
and related Interpretations. Accordingly, no compensa-
tion expense was recognized for fixed option plans
because the exercise prices of Employee stock options
equaled or exceeded the market prices of the underlying
stock on the dates of grant. However, prior to adoption of
SFAS 123R, share-based compensation had been
included in pro forma disclosures in the financial state-
ment footnotes for periods prior to 2006.
Effective January 1, 2006, the Company adopted
the fair value recognition provisions of SFAS No. 123R,
“Share-Based Payment” using the modified retrospective
transition method. Among other items, SFAS 123R
eliminates the use of APB 25 and the intrinsic value
method of accounting, and requires companies to recog-
nize the cost of Employee services received in exchange
for awards of equity instruments, based on the grant date
fair value of those awards, in the financial statements.
Under the modified retrospective method, compen-
sation cost is recognized in the financial statements
beginning with the effective date, based on the require-
ments of SFAS 123R for all share-based payments
granted after that date, and based on the requirements
of SFAS 123 for all unvested awards granted prior to the
effective date of SFAS 123R. In addition, results for prior
periods have been retroactively adjusted utilizing the pro
forma disclosures in those prior financial statements,
except as noted. As part of this revision, the Company
recorded cumulative share-based compensation expense
of $409 million for the period 1995-2005, resulting in a
reduction to Retained earnings in the accompanying
Consolidated Balance Sheet as of December 31, 2005.
This adjustment, along with the creation of a net
Deferred income tax asset in the amount of $130 million,
resulted in an offsetting increase to Capital in excess of
par value in the amount of $539 million in the accom-
panying Consolidated Balance Sheet as of December 31,
2005. The Deferred tax asset represents the portion of the
cumulative expense related to stock options that will
result in a future tax deduction.
The Company estimates the fair value of stock
option awards on the date of grant utilizing a modified
Black-Scholes option pricing model. The Black-Scholes
option valuation model was developed for use in estimat-
ing the fair value of short-term traded options that have
no vesting restrictions and are fully transferable. How-
ever, certain assumptions used in the Black-Scholes
model, such as expected term, can be adjusted to incor-
porate the unique characteristics of the Company’s stock
option awards. Option valuation models require the input
of somewhat subjective assumptions including expected
stock price volatility and expected term. For 2005 and
2006, the Company has relied on observations of both
historical volatility trends, implied future volatility
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