Southwest Airlines 2007 Annual Report Download - page 61

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governmental entity on a periodic basis. These taxes and
fees include U.S. federal transportation taxes, federal
security charges, and airport passenger facility charges.
These items are collected from Customers at the time
they purchase their tickets, but are not included in Pas-
senger revenue. The Company records a liability upon
collection from the Customer and relieves the liability
when payments are remitted to the applicable govern-
mental agency.
Frequent Flyer Program
The Company records a liability for the estimated
incremental cost of providing free travel under its Rapid
Rewards frequent flyer program at the time an award is
earned. The estimated incremental cost includes direct
passenger costs such as fuel, food, and other operational
costs, but does not include any contribution to overhead
or profit.
The Company also sells frequent flyer credits and
related services to companies participating in its Rapid
Rewards frequent flyer program. Funds received from the
sale of flight segment credits are accounted for under the
residual value method. Under this method, the Company
has determined the portion of funds received for sale of
flight segment credits that relate to free travel, currently
estimated at 75 percent of the amount received per flight
segment credit sold. These amounts are deferred and
recognized as “Passenger revenue” when the ultimate free
travel awards are flown or the credits expire unused. The
remaining 25 percent of the amount received per flight
segment credit sold, which is assumed not to be associated
with future travel, includes items such as access to the
Company’s frequent flyer program population for mar-
keting/solicitation purposes, use of the Company’s logo
on co-branded credit cards, and other trademarks,
designs, images, etc. of Southwest for use in marketing
materials. This remaining portion is recognized in
“Other revenue” in the period earned.
Advertising
The Company expenses the costs of advertising as
incurred. Advertising expense for the years ended
December 31, 2007, 2006, and 2005 was $191 million,
$182 million, and $173 million, respectively.
Share-Based Employee Compensation
The Company has stock-based compensation plans
covering the majority of its Employee groups, including a
plan covering the Company’s Board of Directors and
plans related to employment contracts with the Executive
Chairman of the Company. The Company accounts for
stock-based compensation utilizing the fair value recog-
nition provisions of SFAS No. 123R, “Share-Based Pay-
ment.” See Note 13.
Financial Derivative Instruments
The Company accounts for financial derivative
instruments utilizing Statement of Financial Accounting
Standards No. 133 (SFAS 133), “Accounting for Deriv-
ative Instruments and Hedging Activities,” as amended.
The Company utilizes various derivative instruments,
including crude oil, unleaded gasoline, and heating oil-
based derivatives, to attempt to reduce the risk of its
exposure to jet fuel price increases. These instruments
primarily consist of purchased call options, collar struc-
tures, and fixed-price swap agreements, and upon proper
qualification are accounted for as cash-flow hedges, as
defined by SFAS 133. The Company has also entered
into interest rate swap agreements to convert a portion of
its fixed-rate debt to floating rates. These interest rate
hedges are accounted for as fair value hedges, as defined
by SFAS 133.
Since the majority of the Company’s financial deriv-
ative 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 instru-
ments in offsetting changes to those prices, as required by
SFAS 133. Forward jet fuel prices are estimated through
utilization of a statistical-based regression equation with
data from market forward prices of like commodities.
This equation is then adjusted for certain items, such as
transportation costs, that are stated in the Company’s fuel
purchasing contracts with its vendors.
For the effective portion of settled hedges, as defined
in SFAS 133, the Company records the associated gains
or losses as a component of Fuel and oil expense in the
Consolidated Statement of Income. For amounts repre-
senting ineffectiveness, as defined, or changes in fair value
of derivative instruments for which hedge accounting is
not applied, the Company records any gains or losses as a
component of Other (gains) losses, net, in the Consol-
idated Statement of Income. Amounts that are paid or
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)