Southwest Airlines 2008 Annual Report Download - page 56

At times, the Company also utilizes financial
derivative instruments in the form of interest rate swap
agreements. Prior to 2008, the Company had entered
into interest rate swap agreements related to its $385
million 6.5% senior unsecured notes due 2012, its $350
million 5.25% senior unsecured notes due 2014, its
$300 million 5.125% senior unsecured notes due 2017,
and its $100 million 7.375% senior unsecured
debentures due 2027. The primary objective for the
Company’s use of these interest rate hedges was to
reduce the volatility of net interest income by better
matching the repricing of its assets and liabilities. These
interest rate swap agreements qualify 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.
During 2008, the Company entered into an interest
rate swap agreement concurrent with its entry into a
twelve-year, $600 million floating-rate Term Loan
Agreement. Under this swap agreement, which is
accounted for as a cash flow hedge, the interest rate on
the term loan is essentially fixed for its entire term at
5.223 percent and ineffectiveness is required to be
measured each reporting period.
The fair values of the Company’s interest rate
swap agreements are adjusted regularly and are
recorded in the Consolidated Balance Sheet. If the
interest rate hedge is accounted for as a fair value hedge,
the corresponding offsetting adjustment is to the
carrying value of the long-term debt. For the interest
rate hedge accounted for as a cash flow hedge, the
corresponding offsetting adjustment is to “Accumulated
other comprehensive income (loss)”, net of appropriate
taxes. The total fair value of all interest rate swap
agreements, excluding accrued interest, at December 31,
2008, was an asset of approximately $81 million. The
total fair value of the swap agreements held at
December 31, 2007, was an asset of $16 million. 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 conditions suggested by actual historical
experience and other data available at the time estimates
were made.
Share-Based Compensation
The Company has previously awarded share-
based compensation pursuant to 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 the Chairman Emeritus of
the Company.
The Company accounts for share-based
compensation in accordance with SFAS No. 123R,
“Share-Based Payment,” which requires companies
to recognize 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. 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 estimating the fair value of
short-term traded options that have no vesting
restrictions and are fully transferable. However,
certain assumptions used in the Black-Scholes model,
such as expected term, can be adjusted to incorporate
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. In
estimating expected stock price volatility at the time
of a particular stock option grant, the Company relies
on observations of historical volatility trends, implied
future volatility observations as determined by
independent third parties, and implied volatility from
traded options on the Company’s stock. For 2008,
2007, and 2006 option grants, the Company has
consistently utilized a weighted-average approach
that calculates expected volatility using two-thirds
implied volatility and one-third historical volatility.
In determining the expected term of the option
grants, the Company has observed the actual terms of
prior grants with similar characteristics, the actual
vesting schedule of the grant, and assessed the
expected risk tolerance of different optionee groups.
Other assumptions required for estimating fair
value with the Black-Scholes model are the expected
risk-free interest rate and expected dividend yield of
the Company’s stock. The risk-free interest rates used
were actual U.S. Treasury zero-coupon rates for
bonds matching the expected term of the option on
the date of grant. The expected dividend yield of the
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