Southwest Airlines 2006 Annual Report Download - page 67

before income taxes (net of profitsharing), and net
earnings for the year ended December 31, 2006, were
reduced by $68 million and $41 million, respectively,
compared to the previous accounting method under
APB 25. Net income per share, basic and diluted were
reduced by $.05 and $.05 for the year ended Decem-
ber 31, 2006, compared to the previous accounting
method under APB 25. As a result of the SFAS 123R
retroactive application, for the year ended December 31,
2005, net income was reduced by $55 million, net income
per share, basic was reduced by $.08, and net income per
share, diluted was reduced by $.06. For the year ended
December 31, 2004, net income was reduced by $89 mil-
lion, net income per share, basic was reduced by $.12, and
net income per share, diluted was reduced by $.10.
Prior to the adoption of SFAS 123R, the Company
was required to record benefits associated with the tax
deductions in excess of recognized compensation cost as
an operating cash flow. However, SFAS 123R requires
that such benefits be recorded as a financing cash inflow
and corresponding operating cash outflow. In the accom-
panying Consolidated Statement of Cash Flows for years
ended December 31, 2005, and 2004, the respective
$47 million, and $23 million tax benefits classified as
financing cash flows (and corresponding operating cash
outflows) have been conformed to the current year
presentation.
Stock Plans
The Company has stock plans covering Employees
subject to collective bargaining agreements (collective
bargaining plans) and stock plans covering Employees
not subject to collective bargaining agreements (other
Employee plans). None of the collective bargaining plans
were required to be approved by shareholders. Options
granted to Employees under collective bargaining plans
are non-qualified, granted at or above the fair market
value of the Company’s Common Stock on the date of
grant, and generally have terms ranging from six to twelve
years. Neither Executive Officers nor members of the
Company’s Board of Directors are eligible to participate
in any of these collective bargaining plans. Options
granted to Employees through other Employee plans
are both qualified as incentive stock options under the
Internal Revenue Code of 1986 and non-qualified stock
options, granted at the fair market value of the Compa-
ny’s Common Stock on the date of grant, and have ten-
year terms. All of the options included under the heading
of “Other Employee Plans” have been approved by
shareholders, except the plan covering non-management,
non-contract Employees, which had options outstanding
to purchase 5.5 million shares of the Company’s Com-
mon Stock as of December 31, 2006. Although the
Company does not have a formal policy per se, upon
option exercise, the Company will typically issue Trea-
sury stock, to the extent such shares are available.
Vesting terms for the collective bargaining plans
differ based on the grant made, and have ranged in length
from immediate vesting to vesting periods in accordance
with the period covered by the respective collective bar-
gaining agreement. For “Other Employee Plans,”
options vest and become fully exercisable over three, five,
or ten years of continued employment, depending upon
the grant type. For grants in any of the Company’s plans
that are subject to graded vesting over a service period,
Southwest recognizes expense on a straight-line basis over
the requisite service period for the entire award. None of
the Company’s grants include performance-based or
market-based vesting conditions, as defined.
The fair value of each option grant is estimated on the date of grant using a modified Black-Scholes option pricing
model. The following weighted-average assumptions were used for grants made under the fixed option plans for the
current and prior year:
2006 2005 2004
Wtd-average risk-free interest rate ................................... 4.6% 4.1% 3.1%
Expected life of option (years) ..................................... 5.0 4.7 4.0
Expected stock volatility.......................................... 26.0% 26.2% 34.0%
Expected dividend yield .......................................... 0.07% 0.09% 0.11%
The Black-Scholes option valuation model was
developed for use in estimating the fair value of short-
term traded options that have no vesting restrictions and
are fully transferable. In addition, option valuation models
require the input of somewhat subjective assumptions
including expected stock price volatility. For 2006 and
2005, the Company has relied on observations of both
historical volatility trends as well as implied future vol-
atility observations as determined by independent third
parties. For both 2006 and 2005 stock option grants, the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)