0000092380 2008-03-31 0000092380 2008-06-30 0000092380 2008-12-31 0000092380 2009-03-31 0000092380 2008-01-01 0000092380 2009-01-01 0000092380 2009-06-30 0000092380 2009-04-01 2009-06-30 0000092380 2009-01-01 2009-06-30 0000092380 2008-04-01 2008-06-30 0000092380 2008-01-01 2008-06-30 iso4217:USD xbrli:shares 9. FINANCING TRANSACTIONS On April 29, 2009, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $332 million, to be secured by mortgages on 14 of the Company's 737-700 aircraft. On May 6, 2009, the Company borrowed the full $332 million and secured the loan with the requisite 14 aircraft mortgages. The loan matures on May 6, 2019, and is repayable quarterly in installments of principal beginning August 6, 2009. The loan bears interest at the LIBO Rate (as defined in the term loan agreement) plus 3.30 percent, and interest is payable quarterly, beginning August 6, 2009. Concurrent with its entry into the term loan agreement, the Company entered into an interest rate swap agreement that effectively fixes the interest rate on the term loan for its entire term at 6.315 percent. The Company used the proceeds from the term loan for general corporate purposes, including the repayment of the Company's revolving credit facility. During May 2009, the Company fully repaid the $400 million it had previously borrowed in 2008 under its available $600 million revolving credit facility. Therefore, as of June 30, 2009, the entire $600 million of the Company's revolving credit facility was available for borrowing. -4000000 208000000 -20000000 211000000 2616000000 2869000000 4972000000 5399000000 365000000 365000000 false 8. POSTRETIREMENT BENEFITS The following table sets forth the Company's periodic postretirement benefit cost for each of the interim periods identified: Three months ended June 30, (In millions) 2009 2008 Service cost $4 $4 Interest cost 1 1 Amortization of prior service cost 1 1 Recognized actuarial gain (1) (1) Net periodic postretirement benefit cost $5 $5 Six months ended June 30, (In millions) 2009 2008 Service cost $7 $7 Interest cost 2 2 Amortization of prior service cost 1 1 Recognized actuarial gain (1) (1) Net periodic postretirement benefit cost $9 $9 50000000 529000000 -57000000 566000000 150000000 148000000 300000000 293000000 -986000000 -1005000000 4863000000 4919000000 732000000 668000000 200000000 203000000 946000000 1368000000 1368000000 2213000000 1145000000 2982000000 4653000000 5000000 -3000000 1000000 -3000000 -1394000000 -2226000000 -3090000000 -3447000000 135000000 2336000000 420000000 3300000000 0.07 0.44 -0.05 0.48 34000000 -345000000 57000000 -307000000 -5000000 -6000000 -11000000 -14000000 128000000 105000000 7. ACCRUED LIABILITIES June 30, December 31, (In millions) 2009 2008 Retirement plans $97 $86 Aircraft rentals 109 118 Vacation pay 181 175 Advances and deposits 14 23 Fuel derivative contracts 120 246 Deferred income taxes 138 36 Workers compensation 124 122 Other 246 206 Accrued liabilities $1,029 $1,012 -199000000 1671000000 -422000000 2440000000 208000000 0 381000000 0 -125000000 1865000000 -185000000 2435000000 741 732 741 733 81000000 85000000 156000000 167000000 3094000000 2653000000 No Large Accelerated Filer 42000000 16000000 78000000 41000000 123000000 205000000 73000000 293000000 2506000000 2747000000 4758000000 5161000000 808000000 808000000 3. DIVIDENDS During the three month periods ended March 31 and June 30, 2009, dividends of $.0045 per share were declared on the 740 million shares and 741 million shares of Common Stock then outstanding, respectively. During the three month periods ended March 31 and June 30, 2008, dividends of $.0045 per share were declared on the 731 million shares and 733 million shares of Common Stock then outstanding, respectively. -377000000 -1264000000 -1014000000 -1389000000 104000000 286000000 104000000 333000000 -5000000 3000000 -1000000 3000000 -4000000 -3000000 -7000000 -6000000 0.07 0.44 -0.05 0.48 3278000000 3498000000 3073000000 2806000000 1207000000 963000000 1029000000 1012000000 204000000 380000000 13. EARLY RETIREMENT OFFER On April 16, 2009, the Company announced Freedom '09, a one-time voluntary early out program offered to eligible Employees, in which the Company offered cash bonuses, medical/dental coverage for a specified period of time, and travel privileges based on work group and years of service. The purpose of this voluntary initiative and other initiatives is to right-size headcount in conjunction with the Company's current plans to reduce its capacity by five percent in 2009, and to help reduce costs. Virtually all of the Company's Employees hired before March 31, 2008 were eligible to participate in the program. Participants' last day of work will fall between July 31, 2009 and April 15, 2010, as assigned by the Company based on the operational needs of particular work locations and departments, determined on an individual-by-individual basis. The Company did not have a target or expectation for the number of Employees expected to accept the package. Employees electing to participate in Freedom '09 were required to notify the Company of their election by June 19, 2009. However, Employees had until July 16, 2009 to rescind their election and remain with the Company. Following the deadline to rescind such election, a total of 1,404 Employees have remained as participants in Freedom '09, consisting of the following breakdown among workgroups: 439 from Customer Support and Services, 464 from Ground Operations and Provisioning, 113 Flight Attendants, 20 Pilots, 91 from Maintenance, and 277 Managerial and Administrative Employees. The Company expects the total cost incurred for Freedom '09 to be approximately $70 million. Due to the Company's mandatory service period requirement for Employees electing Freedom '09, the Company is required to spread the cost of the program over the period worked, once the period for revocation has passed. The Company may need to replace a small number of the positions with newly hired Employees to meet operational demands; however, the Company expects that most of the positions will not be filled based on the Company's recent capacity reductions. 12. TAX RATE The Company's effective tax rate was a negative 7.3 percent in second quarter 2009. This low rate was due to a $21 million adjustment ($.03 per share, diluted) necessary to achieve a revised year-to-date tax rate of 35.0 percent based on the Company's currently forecasted results for the full year 2009. 4. NET INCOME (LOSS) PER SHARE The following table sets forth the computation of basic and diluted net income (loss) per share (in millions except per share amounts): Three months ended June 30, Six months ended June 30, 2009 2008 2009 2008 NUMERATOR: Net income (loss) $54 $321 $(36) $355 DENOMINATOR: Weighted-average shares outstanding, basic 741 732 741 733 Dilutive effect of Employee stock options - 5 - 3 Adjusted weighted-average shares outstanding, diluted 741 737 741 736 NET INCOME (LOSS) PER SHARE: Basic $.07 $.44 ($.05) $.48 Diluted $.07 $.44 ($.05) $.48 The Company has excluded 79 million and 56 million shares, respectively, from its calculations of net income per share, diluted, for the three months ended June 30, 2009 and 2008, and has excluded 79 million and 72 million shares, respectively, from its calculations of net income per share, diluted, for the six months ended June 30, 2009 and 2008, as they represent antidilutive stock options for the respective periods presented. -5000000 -6000000 -8000000 -6000000 -3000000 -3000000 -10000000 -10000000 237000000 209000000 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Southwest Airlines Co. (Company or Southwest) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. The unaudited condensed consolidated financial statements for the interim periods ended June 30, 2009 and 2008, include all adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. This includes all normal and recurring adjustments, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Financial results for the Company, and airlines in general, are seasonal in nature. Historically, the Company's revenues, as well as its overall financial performance, are better in its second and third fiscal quarters than in its first and fourth fiscal quarters. However, as a result of significant fluctuations in revenues and the price of jet fuel in some periods, the nature of the Company's fuel hedging program, the periodic volatility of commodities used by the Company for hedging jet fuel, and the accounting requirements of Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended (SFAS 133), the Company has experienced, and may continue to experience significant volatility in its results in certain fiscal periods. See Note 5 for further information. Operating results for the three months and six months ended June 30, 2009, are not necessarily indicative of the results that may be expected for the year ended December 31, 2009. For further information, refer to the consolidated financial statements and footnotes thereto included in the Southwest Airlines Co. Annual Report on Form 10-K for the year ended December 31, 2008. Certain prior period amounts have been reclassified to conform to the current presentation. In the unaudited Condensed Consolidated Balance Sheet as of December 31, 2008, the Company's cash collateral deposits related to fuel derivatives that have been provided to a counterparty have been adjusted to show a "net" presentation against the fair value of the Company's fuel derivative instruments. The entire portion of cash collateral deposits as of December 31, 2008, $240 million, has been reclassified to reduce "Other deferred liabilities." In the Company's 2008 Form 10-K filing, these cash collateral deposits were presented "gross" and all were included as an increase to "Prepaid expenses and other current assets." This change in presentation was made in order to comply with the requirements of Financial Accounting Standards Board (FASB) Staff Position FIN 39-1 (FIN 39-1), which was required to be adopted by the Company effective January 1, 2008. Following the Company's 2008 Form 10-K filing on February 2, 2009, the Company became aware that the requirements of FIN 39-1 had not been properly applied to its financial derivative instruments within the financial statements. The Company determined that the effect of this error was not material to its financial statements and disclosures taken as a whole, and decided to apply FIN 39-1 prospectively beginning with its first quarter 2009 Form 10-Q. Also, in the unaudited Condensed Consolidated Statement of Cash Flows for the three and six months ended June 30, 2008, the Company has reclassified certain unrealized noncash gains recorded on fuel derivative instruments and the cash collateral received from counterparties to its fuel hedging program, in order to conform to the current year presentation. These reclassifications had no impact on net cash flows provided by operations. In preparing the accompanying unaudited condensed consolidated financial statements, the Company has reviewed, as determined necessary by the Company's management, events that have occurred after June 30, 2009, up until the issuance of the financial statements, which occurred on July 23, 2009. 4000000 17000000 8000000 27000000 332000000 600000000 332000000 600000000 179000000 159000000 345000000 330000000 105000000 163000000 272000000 375000000 0000092380 Yes 0 0 0 -54000000 -28000000 -37000000 -18000000 -50000000 -4000000 135000000 -25000000 129000000 338000000 344000000 666000000 690000000 863000000 839000000 1699000000 1639000000 29000000 37000000 58000000 71000000 14027000000 14068000000 15743000000 15871000000 6. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) includes changes in the fair value of certain financial derivative instruments, which qualify for hedge accounting, and unrealized gains and losses on certain investments. The differences between net income (loss) and comprehensive income (loss) for the three and six months ended June 30, 2009 and 2008, were as follows: Three months ended June 30, (In millions) 2009 2008 Net income $54 $321 Unrealized gain (loss) on derivative instruments, net of deferred taxes of $86 and $753 138 1,209 Other, net of deferred taxes of $14 and ($1) 22 (2)Total other comprehensive income 160 1,207 Comprehensive income $214 $1,528 Six months ended June 30, (In millions) 2009 2008 Net income $(37) $355 Unrealized gain (loss) on derivative instruments, net of deferred taxes of $122 and $904 196 1,469 Other, net of deferred taxes of $16 and ($7) 26 (11)Total other comprehensive income (loss) 222 1,458 Comprehensive income $185 $1,813 A rollforward of the amounts included in "AOCI," net of taxes, is shown below for the three and six months ended June 30, 2009: Accumulated Fuel other hedge comprehensive(In millions) derivatives Other income (loss)Balance at March 31, 2009 $(888) $(34) $(922) Second quarter 2009 changes in value 42 22 64 Reclassification to earnings 96 96 Balance at June 30, 2009 $(750) $(12) $(762) Accumulated Fuel other hedge comprehensive(In millions) derivatives Other income (loss)Balance at December 31, 2008 $(946) $(38) $(984) 2009 changes in value (10) 26 16 Reclassification to earnings 206 - 206 Balance at June 30, 2009 $(750) $(12) $(762) 2. NEW ACCOUNTING PRONOUNCEMENTS On April 9, 2009, the Financial Accounting Standards Board (FASB) issued Staff Position SFAS 107-1 and Accounting Principles Board (APB) Opinion No. 28-1, "Interim Disclosures about Fair Value of Financial Instruments" (FSP 107-1 and APB 28-1). FSP 107-1 amends FASB Statement No. 107, "Disclosures about Fair Values of Financial Instruments," to require disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements. APB 28-1 amends APB Opinion No. 28, "Interim Financial Reporting," to require those disclosures in all interim financial statements. FSP 107-1 and APB 28-1 are effective for interim periods ending after June 15, 2009 and the Company has adopted them in second quarter 2009. See Note 11. On April 9, 2009, the FASB issued Staff Position SFAS 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly" (FSP 157-4). FSP 157-4 provides additional guidance in estimating fair value under statement No. 157, "Fair Value Measurements" (SFAS 157), when the volume and level of transaction activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability. FSP 157-4 also provides additional guidance on circumstances that may indicate a transaction is not orderly. FSP 157-4 is effective for interim periods ending after June 15, 2009, and the Company has adopted its provisions during second quarter 2009. FSP 157-4 did not have a significant impact on the Company's financial position, results of operations, cash flows, or disclosures for second quarter 2009. On April 9, 2009, the FASB issued Staff Position SFAS 115-2 and SFAS 124-2, "Recognition and Presentation of Other-Than-Temporary Impairments" (FSP 115-2). FSP 115-2 provides guidance in determining whether impairments in debt securities are other than temporary, and modifies the presentation and disclosures surrounding such instruments. FSP 115-2 is effective for interim periods ending after June 15, 2009, and the Company has adopted its provisions for second quarter 2009. FSP 115-2 did not have a significant impact on the Company's financial position, results of operations, cash flows, or disclosures for second quarter 2009. In May 2009, the FASB issued statement No. 165, "Subsequent Events" (SFAS 165). SFAS 165 modifies the definition of what qualifies as a subsequent event-those events or transactions that occur following the balance sheet date, but before the financial statements are issued, or are available to be issued-and requires companies to disclose the date through which it has evaluated subsequent events and the basis for determining that date. The Company adopted the provisions of SFAS 165 for second quarter 2009, in accordance with the effective date. See Note 1. In June 2009, the FASB issued statement No. 167, "Amendments to FASB Interpretation No. 46(R)" (SFAS 167). Among other items, SFAS 167 responds to concerns about the application of certain key provisions of FIN 46(R), including those regarding the transparency of the involvement with variable interest entities. SFAS 167 is effective for calendar year companies beginning on January 1, 2010. The Company has not yet determined the impact that adoption of SFAS 167 will have on its financial position, results of operations, cash flows, or disclosures. -91000000 0 -91000000 0 -43000000 105000000 244000000 372000000 54000000 -324000000 124000000 -290000000 54000000 321000000 -37000000 355000000 47000000 32000000 92000000 60000000 47000000 38000000 93000000 76000000 726000000 945000000 1423000000 1745000000 481000000 802000000 10-Q 15. SUBSEQUENT EVENTS On July 1, 2009, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $124 million, to be secured by mortgages on five of the Company's 737-700 aircraft. Subsequently, the Company borrowed the full $124 million and secured this loan with the requisite five aircraft mortgages. The loan matures on July 1, 2019, and is repayable semi-annually in installments of principal beginning January 1, 2010. The loan bears interest at a fixed rate of 6.84 percent, and interest is payable semi-annually, beginning January 1, 2010. The Company used the proceeds from the term loan for general corporate purposes. 10. COMMITMENTS AND CONTINGENCIES During the first quarter and early second quarter of 2008, the Company was named as a defendant in two putative class actions on behalf of persons who purchased air travel from the Company while the Company was allegedly in violation of FAA safety regulations. Claims alleged by the plaintiffs in these two putative class actions include breach of contract, breach of warranty, fraud/misrepresentation, unjust enrichment, and negligent and reckless operation of an aircraft. The Company believes that the class action lawsuits are without merit and intends to vigorously defend itself. Also in connection with this incident, during the first quarter and early second quarter of 2008, the Company received four letters from Shareholders demanding the Company commence an action on behalf of the Company against members of its Board of Directors and any other allegedly culpable parties for damages resulting from an alleged breach of fiduciary duties owed by them to the Company. In August 2008, Carbon County Employees Retirement System and Mark Cristello filed a related Shareholder derivative action in Texas state court naming certain directors and officers of the Company as individual defendants and the Company as a nominal defendant. The derivative action claims breach of fiduciary duty and seeks recovery by the Company of alleged monetary damages sustained as a result of the purported breach of fiduciary duty, as well as costs of the action. A Special Committee appointed by the Independent Directors of the Company has been evaluating the Shareholder demands. The Company is from time to time subject to various other legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the Internal Revenue Service (IRS). The Company's management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any proposed adjustments presented to date by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow. During 2008, the City of Dallas approved the Love Field Modernization Program, an estimated $519 million project to reconstruct Dallas Love Field with modern, convenient air travel facilities. Pursuant to a Program Development Agreement with the City of Dallas, the Company is managing this project, and initial construction is expected to commence during late 2009, with completion scheduled for October 2014. Bonds are expected to be issued at a later date by the Love Field Airport Modernization Corporation (a "local government corporation" under Texas law formed by the City of Dallas) that will provide funding for this project, with repayment of the bonds being made through recurring ground rents, fees, and other revenues collected by the airport. 3000000 7000000 4000000 13000000 5146000000 4953000000 13690000000 13722000000 10661000000 11040000000 741447409 -400000000 0 -400000000 0 1203000000 1185000000 2347000000 2645000000 -15000000 -71000000 -57000000 -116000000 2493000000 2664000000 4899000000 5106000000 1223000000 1215000000 1849000000 1769000000 1252000000 435000000 Yes 2009-06-30 Form 10Q 190000000 191000000 373000000 333000000 5082000000 4831000000 -187000000 -223000000 -272000000 -587000000 -6000000 -97000000 -28000000 -167000000 --12-31 14027000000 14068000000 5. FINANCIAL DERIVATIVE INSTRUMENTS Fuel Contracts Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Jet fuel and oil (including related taxes) consumed during the three months ended June 30, 2009 and 2008, represented approximately 29 percent and 35 percent of the Company's operating expenses, respectively. The Company's operating expenses have been extremely volatile in recent years due to dramatic increases and declines in energy prices. The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses. Because jet fuel is not traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel. However, the Company has found that financial derivative instruments in other commodities, such as crude oil, and refined products such as heating oil and unleaded gasoline, can be useful in decreasing its exposure to jet fuel price volatility. The Company does not purchase or hold any derivative financial instruments for trading purposes. The Company has used financial derivative instruments for both short-term and long-term time frames, and typically uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), and fixed price swap agreements in its portfolio. Generally, when prices are lower, the Company prefers to use fixed price swap agreements and purchased call options. However, when prices are higher, the Company uses more collar structures due to the high cost of purchased call options and the increased risk associated with fixed price swaps. Although the use of collar structures can reduce the overall cost of hedging, these instruments carry more risk than purchased call options in that the Company could end up in a liability position when the collar structure settles. With the use of purchased call options, the Company cannot be in a liability position at settlement. The following table provides information about the Company's volume of fuel hedging for the first half of 2009, and its portfolio as of June 30, 2009, for future periods. These hedge volumes are strictly from an "economic" standpoint and thus do not reflect whether the hedges qualified or will qualify for special hedge accounting as defined in SFAS 133. The Company defines its "economic" hedge as the total volume of fuel derivative contracts held, including the net impact of positions that have been effectively "settled" through offsetting positions, regardless of whether those contracts qualify for hedge accounting as defined in SFAS 133. Fuel hedged as Approximate % of June 30, 2009 of jet fuelPeriod (by year) (gallons in millions) consumption2009 518 37% *2010 653 47% *2011 211 15% *2012 93 7% *2013 98 7% * Period (by quarter for 2009) First quarter 2009 15 4%Second quarter 2009 185 50%Third quarter 2009 144 40% *Fourth quarter 2009 174 52% ** Forecasted Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges, as defined in SFAS 133. Under SFAS 133, all derivatives designated as hedges that meet certain requirements are granted special hedge accounting treatment. Generally, utilizing the special hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective, as defined, are recorded in "Accumulated other comprehensive income (loss)" ("AOCI") until the underlying jet fuel is consumed. See Note 6 for further information on "AOCI." The Company is exposed to the risk that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for special hedge accounting. Ineffectiveness, as defined, results when the change in the fair value of the derivative instrument exceeds the change in the value of the Company's expected future cash outlay to purchase and consume jet fuel. To the extent that the periodic changes in the fair value of the derivatives are not effective, that ineffectiveness is recorded to "Other (gains) losses, net" in the statement of operations. Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last period is recorded to "Other (gains) losses, net" in the statement of operations in the period of the change; however, in accordance with SFAS 133, any amounts previously recorded to "AOCI" would remain there until such time as the original forecasted transaction occurs, then would be reclassified to "Fuel and oil" expense. In a situation where it becomes probable that a hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to "AOCI" would be required to be immediately reclassified into earnings. The Company did not have any such situations occur for the three or six months ended June 30, 2009 or 2008. Ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related commodities. Due to the volatility in markets for crude oil and related products, the Company is unable to predict the amount of ineffectiveness each period, including the loss of hedge accounting, which could be determined on a derivative by derivative basis or in the aggregate for a specific commodity. This may result, and has resulted, in increased volatility in the Company's financial results. Factors that have and may continue to lead to ineffectiveness and unrealized gains and losses on derivative contracts include: the significant fluctuation in energy prices, the number of derivative positions the Company holds, significant weather events that have affected refinery capacity and the production of refined products, and the volatility of the different types of products the Company uses in hedging. The number of instances in which the Company has discontinued hedge accounting for specific hedges and for specific refined products, such as unleaded gasoline, has increased recently, primarily due to these reasons. However, even though these derivatives may not qualify for SFAS 133 special hedge accounting, the Company continues to hold the instruments as it believes they continue to afford the Company the opportunity to minimize jet fuel costs. SFAS 133 is a complex accounting standard with stringent requirements, including the documentation of a Company hedging strategy, statistical analysis to qualify a commodity for hedge accounting both on a historical and a prospective basis, and strict contemporaneous documentation that is required at the time each hedge is designated by the Company. As required by SFAS 133, the Company assesses the effectiveness of each of its individual hedges on a quarterly basis. The Company also examines the effectiveness of its entire hedging program on a quarterly basis utilizing statistical analysis. This analysis involves utilizing regression and other statistical analyses that compare changes in the price of jet fuel to changes in the prices of the commodities used for hedging purposes. All cash flows associated with purchasing and selling derivatives are classified as operating cash flows in the unaudited Condensed Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company's hedging instruments within the unaudited Condensed Consolidated Balance Sheet (in millions): Asset Derivatives Liability Derivatives Balance Sheet Location Fair Value at 6/30/09 Fair Valueat 12/31/08 Fair Value at 6/30/09 Fair Value at 12/31/08 Derivatives designated as hedging instruments under SFAS 133 Fuel derivative contracts (gross)* Accrued liabilities $92$94 $71 $19Fuel derivative contracts (gross)* Other deferred liabilities 11240 142 522Interest rate derivative contracts Other assets 50 83- -Interest rate derivative contracts Other deferred liabilities -- - 3 Total derivatives designated as hedging instruments under SFAS 133 $254 $217 $213$544 Derivatives not designated as hedging instruments under SFAS 133Fuel derivative contracts (gross)* Accrued liabilities $403$387 $596 $708Fuel derivative contracts (gross)* Other deferred liabilities 308266 864 530 Total derivatives not designated as hedging instruments under SFAS 133 $711 $653$1,460 $1,238 Total derivatives $965 $870 $1,673$1,782* Does not include the impact of cash collateral deposits provided tocounterparties. See discussionof credit risk and collateral following in this Note. In addition, the Company also had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet (in millions): Balance Sheet June 30, December 31, Location 2009 2008Cash collateral deposits provided Offset against Otherto counterparty - noncurrent deferred liabilities 374 240Cash collateral deposits provided Offset against Accrued to counterparty - current liabilities 51 -Due to third parties for settled fuel contracts Accrued liabilities 18 16Net unrealized losses from fuel Accumulated otherhedges, net of tax comprehensive loss 750 946 The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2009 and 2008 (in millions): Derivatives in SFAS 133 Cash Flow Hedging Relationships Amount of (Gain) Loss Recognized in AOCI on Derivative (EffectivePortion) Amount of (Gain) Loss Reclassified from AOCI intoIncome (Effective Portion)(a) Amount of (Gain) LossRecognized in Income on Derivatives (ineffective portion) (b) Three months ended June 30, Three monthsended June 30, Three months ended June 30, 2009 2008 2009 2008 20092008 Fuel derivative contracts $(42) * $(1,493) * $96 * $(284)* $(25) $20Interest ratederivatives 20 * - - - - -- Total $(62) $(1,493) $96 $(284)$(25) $20* Net of tax(a) Amounts related to fuel derivative contracts and interest rate derivativesare included in Fuel and oil and Interest expense, respectively.(b) Amounts are included in Other (gains) losses, net. Derivatives in SFAS 133 Cash Flow Hedging Relationships Amount of (Gain) Loss Recognized in AOCI on Derivative (EffectivePortion) Amount of (Gain) Loss Reclassified from AOCI intoIncome (Effective Portion)(a) Amount of (Gain) LossRecognized in Income on Derivatives (ineffective portion) (b) Six months ended June 30, Six months endedJune 30, Six months ended June 30, 2009 2008 2009 2008 20092008 Fuel derivative contracts $10 * $(1,923) * $206 * $(454)* $(9) $26Interest ratederivatives (25) * - - - - -- Total $(15) $(1,923) $206 $(454)$(9) $26* Net of tax(a) Amounts related to fuel derivative contracts and interest rate derivativesare included in Fuel and oil and Interest expense, respectively.(b) Amounts are included in Other (gains) losses, net.Derivatives not in SFAS 133 Cash Flow Hedging Relationships Amount of (Gain) Loss Recognized in Income on Derivatives Three months ended June 30, Location of(Gain) Loss Recognized in Income 2009 2008 on Derivatives Fuel derivative contracts $19 $(381) Other (gains)losses, net Derivatives not in SFAS 133 Cash Flow Hedging Relationships Amount of (Gain) Loss Recognized in Income on Derivatives Six months ended June 30, Location of(Gain) Loss Recognized in Income 2009 2008 on Derivatives Fuel derivative contracts $(8) $(365) Other (gains)losses, net The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended June 30, 2009 and 2008, respectively, of $37 million and $14 million, and during the six months ended June 30, 2009 and 2008, respectively, of $69 million and $27 million. These amounts are excluded from the Company's measurement of effectiveness for related hedges. The fair value of the derivative instruments, depending on the type of instrument, was 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. Included in the Company's total net unrealized losses from fuel hedges as of June 30, 2009, are approximately $280 million in unrealized losses, net of taxes, that are expected to be realized in earnings during the twelve months following June 30, 2009. In addition, as of June 30, 2009, the Company had already recognized cumulative net losses due to ineffectiveness and derivatives that do not qualify for hedge accountingtotaling $43 million, net of taxes. These losses were recognized in the three months ended June 30, 2009, and prior periods, and are reflected in "Retained earnings" as of June 30, 2009, but the underlying derivative instruments will not expire/settle until subsequent periods of 2009 or future periods. Interest rate swaps The Company is party to 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 is to better match the repricing of its assets and liabilities. Under each of these interest rate swap agreements, the Company pays the London InterBank Offered Rate (LIBOR) plus a margin every six months on the notional amount of the debt, and receives payments based on the fixed stated rate of the notes every six months until the date the notes become due. 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. The Company also entered into interest rate swap agreements concurrent with its entry into a twelve-year, $600 million floating-rate term loan agreement during 2008, and a ten-year, $332 million floating-rate term loan agreement during May 2009. Under these swap agreements, which are accounted for as cash flow hedges, the interest rates on the term loans are effectively fixed for their entire term at 5.223 percent and 6.64 percent, respectively, and ineffectiveness is required to be measured each reporting period. The fair values of the interest rate swap agreements, which are adjusted regularly, have been aggregated by counterparty for classification in the unaudited Condensed Consolidated Balance Sheet. Credit risk and collateral The Company's credit exposure related to fuel derivative instruments is represented by the fair value of contracts with a net positive fair value to the Company at the reporting date. At such times, these outstanding instruments expose the Company to credit loss in the event of nonperformance by the counterparties to the agreements. However, the Company has not experienced any significant credit loss as a result of counterparty nonperformance in the past. To manage credit risk, the Company selects and will periodically review counterparties based on credit ratings, limits its exposure to a single counterparty, and monitors the market position of the program and its relative market position with each counterparty. At June 30, 2009, the Company had agreements with all of its counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount or credit ratings fall below certain levels. Based on the Company's current agreement with two of these counterparties, cash deposits are required to be posted whenever the net fair value of derivatives associated with those counterparties exceed specific thresholds. If the threshold is exceeded, cash is either posted by the counterparty if the value of derivatives is an asset to the Company, or posted by the Company if the value of derivatives is a liability to the Company. Under one of the Company's counterparty agreements, as amended, until January 1, 2010, if the Company becomes obligated to post collateral for obligations in amounts of up to $300 million and in excess of $700 million, the Company is required to post cash collateral; however, if the Company becomes obligated to post collateral for obligations in amounts between $300 million and $700 million, the Company has pledged 20 of its Boeing 737-700 aircraft as collateral in lieu of cash. At June 30, 2009, the fair value of fuel derivative instruments with this counterparty was a net liability of $302 million, and the Company had posted $300 million in cash collateral deposits with the counterparty, with the remaining $2 million secured by specified aircraft. If the fair value of fuel derivative instruments with this counterparty were in a net asset position, the counterparty is required to post cash collateral to the Company on a dollar-for-dollar basis for amounts in excess of $40 million. This agreement does not contain any triggers that would require additional cash to be posted by the Company outside of further changes in the fair value of the fuel derivative instruments held with the counterparty. However, if the fair value of fuel derivative instruments with this counterparty were in a net asset position, and the counterparty's credit rating were to be lowered to specified levels, the counterparty could be required to post cash collateral to the Company on a dollar-for-dollar basis related to the first $40 million of assets held. Under another of the Company's counterparty agreements, the Company is obligated to post collateral related to fuel derivative liabilities as follows: (i) if the obligation is up to $125 million, the Company posts cash collateral, (ii) if the obligation is between $125 million and $625 million, the Company has pledged 29 Boeing 737-700 aircraft, and (iii) if the obligation exceeds $625 million, the Company must post cash or letters of credit as collateral. The Company pledged 29 of its Boeing 737-700 aircraft to cover the collateral posting band in clause (ii). As of June 30, 2009, the fair value of fuel derivative instruments with this counterparty was a net liability of $399 million, and the Company had posted $125 million in cash collateral deposits to this counterparty, with the remaining $274 million secured by pledged aircraft. This agreement also provides for the counterparty to post cash collateral to the Company on a dollar-for-dollar basis for any net positive fair value of fuel derivative instruments in excess of $150 million held by the Company from that counterparty. This agreement does not contain any triggers that would require additional cash to be posted by the Company outside of further changes in the fair value of the fuel derivative instruments held with the counterparty. However, if the fair value of fuel derivative instruments with this counterparty were in a net asset position, and the counterparty's credit rating were to be lowered to specified levels, the counterparty would be required to post cash collateral to the Company on a dollar-for-dollar basis related to the first $150 million of assets held. As of June 30, 2009, other than described above, the Company did not have any fuel hedging agreements with counterparties in which cash collateral is required to be posted based on the Company's current investment grade credit rating. However, additional fuel hedging agreements contain a provision whereby each party has the right to terminate and settle all outstanding fuel contracts if the other party's credit rating falls below investment grade. Upon this occurrence, the party in a net liability position could subsequently be required to post cash collateral if a mutual alternative agreement could not be reached. At June 30, 2009, the Company's estimated fair value of fuel derivative contracts with one counterparty containing this provision was a liability of $101 million, including $29 million that will settle by the end of 2009. Due to the Company's current fuel hedging agreements with counterparties, in the Company's judgement, it does not have significant exposure to future cash collateral requirements. As an example, even if market prices for the commodities used in the Company's fuel hedging activities were to decrease by 50 percent from current market prices, given the Company's current fuel hedge portfolio and its investment grade credit rating, it would not have to provide additional cash collateral to its current counterparties. The Company classifies its cash collateral provided to counterparties in accordance with the provisions of FIN 39-1. FIN 39-1 requires an entity to select a policy of how it records the offset rights to reclaim cash collateral associated with the related derivative fair value of the assets or liabilities of such derivative instruments. Entities may either select a "net" or a "gross" presentation. The Company has elected to present its cash collateral utilizing a net presentation, in which cash collateral amounts held or provided have been netted against the fair value of outstanding derivative instruments. The Company's policy differs depending on whether its derivative instruments are in a net asset position or a net liability position. If its fuel derivative instruments are in a net asset position with a counterparty, cash collateral amounts held are first netted against current derivative amounts (those that will settle during the twelve months following the balance sheet date) associated with that counterparty until that balance is zero, and then any remainder would be applied against the fair value of noncurrent outstanding derivative instruments (those that will settle beyond one year following the balance sheet date.) If its fuel derivative instruments are in a net liability position with a counterparty, cash collateral amounts provided are first netted against noncurrent derivative amounts associated with that counterparty untilthat balance is zero, and then any remainder would be applied against the fair value of current outstanding derivative instruments. At June 30, 2009, of the $425 million in cash collateral deposits posted with counterparties under its bilateral collateral provisions, $374 million has been netted against noncurrent fuel derivative instruments within "Other deferred liabilities" and $51 million has been netted against current fuel derivative instruments within "Accrued liabilities" in the unaudited Condensed Consolidated Balance Sheet. 1000000 0 1000000 0 3000000 5000000 6000000 9000000 73000000 -324000000 130000000 -273000000 -3000000 -5000000 -8000000 -12000000 -762000000 -984000000 94000000 73000000 4984514098 14. SALE AND LEASEBACK TRANSACTIONS On April 2, 2009, the Company closed the first tranche of a two tranche sale and leaseback transaction with a third party aircraft lessor for the sale and leaseback of six of the Company's Boeing 737-700 aircraft. In the first tranche, the Company sold three of its Boeing 737-700 aircraft for approximately $105 million and immediately leased the aircraft back for approximately 12 years. On May 19, 2009, the Company sold an additional three of its Boeing 737-700 aircraft for approximately the same amount and upon similar terms as in the first tranche. These two sale and leaseback transactions resulted in deferred gains of $20 million, which will be amortized over the terms of the leases. All of the leases from these sale-leasebacks are accounted for as operating leases. Under the terms of the lease agreements, the Company will continue to operate and maintain the aircraft. Payments under the lease agreements will be reset every six months based on changes in the six-month LIBO rate. The lease agreements contain standard termination events, including termination upon a breach of the Company's obligations to make rental payments and upon any other material breach of the Company's obligations under the leases, and standard maintenance and return condition provisions. Upon a termination of the lease upon a breach by the Company, the Company would be liable for standard contractual damages, possibly including damages suffered by the lessor in connection with remarketing the aircraft or while the aircraft is not leased to another party. 11. FAIR VALUE MEASUREMENTS The Company adopted SFAS 157 as of January 1, 2008. SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions. As of June 30, 2009, the Company held certain items that are required to be measured at fair value on a recurring basis. These included cash equivalents, short-term investments, certain noncurrent investments, interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities. Cash equivalents consist of short-term, highly liquid, income-producing investments, all of which have maturities of 90 days or less, including money market funds, U.S. Government obligations, and obligations of U.S. Government backed agencies. Short-term investments consist of short-term, highly liquid, income-producing investments, which have maturities of greater than 90 days but less than one year, including U.S. Government obligations, obligations of U.S. Government backed agencies, and certain auction rate securities. Derivative instruments are related to the Company's fuel hedging program and interest rate hedges. Noncurrent investments consist of certain auction rate securities, primarily those collateralized by student loan portfolios, which are guaranteed by the U.S. Government. Other available-for-sale securities primarily consist of investments associated with the Company's Excess Benefit Plan. The Company's fuel derivative instruments consist of over-the-counter (OTC) contracts, which are not traded on a public exchange. These contracts include both swaps as well as different types of option contracts. See Note 5 for further information on the Company's derivative instruments and hedging activities. The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2. The Company determines the value of 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 financial institutions that trade these contracts. In situations where the Company obtains inputs via quotes from financial institutions, it verifies the reasonableness of these quotes via similar quotes from another financial institution as of each date for which financial statements are prepared. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. 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 of the inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. The Company's interest rate derivative instruments also consist of OTC swap contracts. The inputs used to determine the fair values of these contracts are obtained in quoted public markets. The Company has consistently applied these valuation techniques in all periods presented. The Company's investments associated with its Excess Benefit Plan consist of mutual funds that are publicly traded and for which market prices are readily available. All of the Company's auction rate security instruments are reflected at estimated fair value in the unaudited Condensed Consolidated Balance Sheet. At June 30, 2009, approximately $109 million of these instruments are classified as available for sale securities and $83 million are classified as trading securities. The $83 million classified as trading securities are subject to an agreement the Company entered into in December 2008, as discussed below, and are included in "Short-term investments" in the unaudited Condensed Consolidated Balance Sheet. In periods when an auction process successfully takes place every 30-35 days, quoted market prices would be readily available, which would qualify as Level 1 under SFAS 157. However, due to events in credit markets beginning during first quarter 2008, the auction events for most of these instruments failed, and, therefore, the Company has subsequently determined the estimated fair values of these securities utilizing a discounted cash flow analysis or other type of valuation model. In addition, during fourth quarter 2008, the Company performed a valuation of its auction rate security instruments and considered these valuations in determining estimated fair values of other similar instruments within its portfolio. 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 full par value. These securities were also compared, when possible, to other securities not owned by the Company, but with similar characteristics. In association with this estimate of fair value, the Company has recorded a temporary unrealized decline in fair value of $11 million, with an offsetting entry to "AOCI." 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 these auction rate securities held by the Company are almost entirely backed by the U.S. Government. In addition, for the $109 million in instruments classified as available for sale, these auction rate securities represented approximately five percent of the Company's total cash, cash equivalent, and investment balance at June 30, 2009. Considering the relative significance of these securities in comparison to the Company's liquid assets and other sources of liquidity, the Company has no current intention of selling these securities nor does it expect to be required to sell these securities before a recovery in their cost basis. For the $83 million in instruments classified as trading securities, the Company is party to an agreement with the counterparty that allows the Company to put the instruments back to the counterparty at full par value in June 2010. In conjunction with this agreement, the Company has applied the provisions of SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities" to this put option. Part of this agreement also contains a line of credit in which the Company can borrow up to $83 million as a loan from the counterparty that would be secured by the auction rate security instruments from that counterparty. There were no borrowings under this provision as of June 30, 2009. Both the put option and the auction rate instruments are being marked to market through earnings each period; however, these adjustments offset and had minimal impact on net earnings for the three and six months ended June 30, 2009. At the time of the first failed auctions during first quarter 2008, the Company held a total of $463 million in securities. Since that time, the Company has been able to sell $260 million of these instruments at par value in addition to the $83 million subject to the agreement to be settled at par in June 2010. During first quarter 2009, the Company also entered into a $46 million line of credit agreement with another counterparty secured by approximately $92 million (par value) of its remaining auction rate security instruments purchased through that counterparty. This agreement allows the Company the ability to draw against the line of credit secured by the auction rate security instruments from that counterparty. As of June 30, 2009, the Company had no borrowings against that available line of credit. The Company remains in discussions with its other counterparties to determine whether mutually agreeable decisions can be reached regarding the effective repurchase of its remaining securities. The Company has continued to earn interest on virtually all of its auction rate security instruments. Any future fluctuation in fair value related to these instruments that the Company deems to be temporary, including any recoveries of previous temporary write-downs, would be recorded to "AOCI." If the Company determines that any future valuation adjustment was other than temporary, it would record a charge to earnings as appropriate. The following items are measured at fair value on a recurring basis subject to the disclosure requirements of SFAS 157 at June 30, 2009: Fair Value Measurements at Reporting Date Using Quoted Prices in Significant Active Markets for Significant Other Unobservable Identical Assets Observable Inputs InputsDescription June 30, 2009 (Level 1) (Level 2) (Level 3)Assets (in millions) Cash equivalents $946 $946 $- $- Short-term investments 1,252 1,222 - 103 Noncurrent investments (a) 89 - - 89 Interest rate derivatives 50 - 50 - Fuel derivatives (b) 915 - 338 577 Other available-for-sale securities 33 25 - 8 Total assets $3,285 $2,193 $388 $777 Liabilities Fuel derivatives (b) $(1,678) $(964) $(714)(a) Included in "Other assets" in the unaudited Condensed Consolidated Balance Sheet. (b) In the unaudited Condensed Consolidated Balance Sheet, amounts are presented as a net liability, and are also net of $425 million in cash collateral provided to counterparties. The following table presents the Company's activity for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in SFAS 157 for the three months ended June 30, 2009: Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Fuel Auction Rate Other (in millions) Derivatives Securities (a) Securities Total Balance at December 31, 2008 $(864) $200 $8 $(656) Total gains or (losses) (realized or unrealized) Included in earnings 473 - - 473 Included in other comprehensive income (23) - - (23) Purchases and settlements (net) 277 (8) - 269 Balance at June 30, 2009 $(137) $192 (b) $8 $63 The amount of total gains or (losses) for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at June 30, 2009 $466 $- $- $466 (a) Includes those classified as short-term investments and noncurrent investments. (b) Includes $83 million classified as trading securities. All settlements from fuel derivative contracts that are deemed "effective," as defined in SFAS 133, are included in "Fuel and oil" expense in the period the underlying fuel is consumed in operations. Any "ineffectiveness" associated with derivative contracts, as defined in SFAS 133, including amounts that settled in the current period (realized), and amounts that will settle in future periods (unrealized), is recorded in earnings immediately, as a component of "Other (gains) losses, net." See Note 5 for further information on SFAS 133 and hedging. Gains and losses (realized and unrealized) included in earnings related to other investments for the three and six months ended June 30, 2009, are reported in "Other operating expenses." The carrying amounts and estimated fair values of the Company's long-term debt and fuel derivative contracts at June 30, 2009 were as follows: (In millions) Carrying value Estimated fair value 10.5% Notes due 2011 $400 $432 French Credit Agreements due 2012 24 24 6.5% Notes due 2012 400 409 5.25% Notes due 2014 373 347 5.75% Notes due 2016 300 270 5.125% Notes due 2017 333 288 French Credit Agreements due 2017 84 84 Term Loan Agreement due 2019 332 336 Term Loan Agreement due 2020 570 481 Pass Through Certificates 458 473 7.375% Debentures due 2027 114 107 Fuel derivative contracts* (763) (763) * Does not include the impact of cash collateral deposits provided to counterparties. See Note 5. The estimated fair values of the Company's publicly held long-term debt were based on quoted market prices. 43000000 599000000 172000000 529000000 -7000000 -6000000 -41000000 -25000000 741 737 741 736 1921000000 1904000000 Southwest Airlines Co.