Southwest Airlines 2010 Annual Report Download - page 63

All of the Company’s auction rate security instruments are reflected at estimated fair value in the
Consolidated Balance Sheet. In prior periods, due to the auction process which took place every 30-35 days for
most securities, quoted market prices were readily available, which would have qualified as Level 1. However,
due to events in credit markets beginning during first quarter 2008, the auctions for most of these instruments
failed, and, therefore, the Company has determined the estimated fair values of these securities utilizing a
discounted cash flow analysis or other type of valuation model, which qualify the instruments as Level 3. The
Company’s analyses consider, among other items, the collateralization underlying the security investments, the
expected future cash flows, including the final maturity, associated with the securities, and estimates of the next
time the security is expected to have a successful auction or return to par value.
In association with this estimate of fair value, the Company has recorded a temporary unrealized decline in
fair value of $17 million, with an offsetting entry to Accumulated other comprehensive income (loss). Given the
quality and backing of the Company’s auction rate securities held, the fact that the Company has not yet recorded
a loss on the sale of any of these instruments, and the fact that it has been able to periodically sell instruments in
the auction process, it believes it can continue to account for the estimated reduction in fair value of its remaining
securities as temporary. These conclusions will also continue to be evaluated and challenged in subsequent
periods. The Company currently believes that this temporary decline in fair value is due entirely to liquidity
issues, because the underlying assets for the majority of securities are almost entirely backed by the U.S.
Government. In addition, these auction rate securities represented less than three percent of the Company’s total
cash, cash equivalent, and investment balance at December 31, 2010, which the Company believes allows it
sufficient time for the auction rate securities to return to full value. At the time of the first failed auctions during
first quarter 2008, the Company held a total of $463 million in auction rate securities. Since that time, the
Company has been able to sell $353 million of these instruments at par value. The Company also remains in
discussions with its remaining counterparties to determine whether mutually agreeable terms can be reached
regarding the effective repurchase of its remaining securities.
The Company determines the value of fuel derivative option contracts utilizing a standard option pricing
model based on inputs that are either readily available in public markets, can be derived from information
available in publicly quoted markets, or are quoted by its counterparties. In situations where the Company
obtains inputs via quotes from its counterparties, it verifies the reasonableness of these quotes via similar quotes
from another counterparty as of each date for which financial statements are prepared. The Company has
consistently applied these valuation techniques in all periods presented and believes it has obtained the most
accurate information available for the types of derivative contracts it holds. Due to the fact that certain inputs
used in determining estimated fair value of its option contracts are considered unobservable (primarily volatility),
the Company has categorized these option contracts as Level 3.
As discussed in Note 10 to the Consolidated Financial Statements, any changes in fair value of cash flow
hedges that are considered to be effective, as defined, are offset within Accumulated other comprehensive
income (loss) until the period in which the expected cash flow impacts earnings. Any changes in the fair value of
fuel derivatives that are ineffective, as defined, or that do not qualify for hedge accounting, are reflected in
earnings within Other (gains) losses, net, in the period of the change. Because the Company has extensive
historical experience in valuing the derivative instruments it holds, and such experience is continually evaluated
against its counterparties each period when such instruments expire and are settled for cash, the Company
believes it is unlikely that an independent third party would value the Company’s derivative contracts at a
significantly different amount than what is reflected in the Company’s financial statements. In addition, the
Company also has bilateral credit provisions in some of its counterparty agreements, which provide for parties
(or the Company) to provide cash collateral when the fair value of fuel derivatives with a single party exceeds
certain threshold levels. Since this cash collateral is based on the estimated fair value of the Company’s
outstanding fuel derivative contracts, this provides further validation to the Company’s estimate of fair values.
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