10-Q 1 luv-9302017x10q.htm 3RD QUARTER 2017 FORM 10-Q Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2017
 
or
¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________
Commission File No. 1-7259

southwestheartimagea01.jpg

Southwest Airlines Co.
(Exact name of registrant as specified in its charter)
TEXAS
74-1563240
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
P.O. Box 36611
 
Dallas, Texas
75235-1611
(Address of principal executive offices)
(Zip Code)
Registrant's telephone number, including area code:  (214) 792-4000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company ¨
 
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes ¨ No þ

Number of shares of Common Stock outstanding as of the close of business on October 30, 2017: 593,387,660




TABLE OF CONTENTS TO FORM 10-Q





2



SOUTHWEST AIRLINES CO.
FORM 10-Q
PART I – FINANCIAL INFORMATION

Item 1. Financial Statements
Southwest Airlines Co.
Condensed Consolidated Balance Sheet
(in millions)
(unaudited)
 
September 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,460

 
$
1,680

Short-term investments
1,580

 
1,625

Accounts and other receivables
579

 
546

Inventories of parts and supplies, at cost
438

 
337

Prepaid expenses and other current assets
223

 
310

Total current assets
4,280

 
4,498

 
 
 
 
Property and equipment, at cost:
 

 
 

Flight equipment
21,004

 
20,275

Ground property and equipment
4,219

 
3,779

Deposits on flight equipment purchase contracts
1,118

 
1,190

Assets constructed for others
1,460

 
1,220

 
27,801

 
26,464

Less allowance for depreciation and amortization
9,645

 
9,420

 
18,156

 
17,044

Goodwill
970

 
970

Other assets
843

 
774

 
$
24,249

 
$
23,286

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
1,124

 
$
1,178

Accrued liabilities
1,593

 
1,985

Air traffic liability
3,932

 
3,115

Current maturities of long-term debt
316

 
566

Total current liabilities
6,965

 
6,844

 
 
 
 
Long-term debt less current maturities
2,763

 
2,821

Deferred income taxes
3,697

 
3,374

Construction obligation
1,311

 
1,078

Other noncurrent liabilities
713

 
728

Stockholders' equity:
 

 
 

Common stock
808

 
808

Capital in excess of par value
1,436

 
1,410

Retained earnings
12,806

 
11,418

Accumulated other comprehensive loss
(136
)
 
(323
)
Treasury stock, at cost
(6,114
)
 
(4,872
)
Total stockholders' equity
8,800

 
8,441

 
$
24,249

 
$
23,286

See accompanying notes.

3



Southwest Airlines Co.
Condensed Consolidated Statement of Comprehensive Income
(in millions, except per share amounts)
(unaudited)

 
Three months ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
OPERATING REVENUES:
 
 
 
 
 
 
 
Passenger
$
4,745

 
$
4,669

 
$
14,403

 
$
13,971

Freight
42

 
42

 
128

 
129

Other
484

 
428

 
1,366

 
1,250

Total operating revenues
5,271

 
5,139

 
15,897

 
15,350

 
 
 
 
 
 
 
 
OPERATING EXPENSES:
 

 
 

 
 

 
 

Salaries, wages, and benefits
1,795

 
1,909

 
5,395

 
5,089

Fuel and oil
1,003

 
941

 
2,915

 
2,696

Maintenance materials and repairs
263

 
258

 
758

 
801

Aircraft rentals
51

 
56

 
158

 
174

Landing fees and other rentals
324

 
307

 
969

 
918

Depreciation and amortization
302

 
315

 
939

 
903

Other operating expenses
699

 
658

 
2,021

 
1,854

Total operating expenses
4,437

 
4,444

 
13,155

 
12,435

 
 
 
 
 
 
 
 
OPERATING INCOME
834

 
695

 
2,742

 
2,915

 
 
 
 
 
 
 
 
OTHER EXPENSES (INCOME):
 

 
 

 
 

 
 

Interest expense
28

 
31

 
84

 
93

Capitalized interest
(15
)
 
(12
)
 
(38
)
 
(34
)
Interest income
(9
)
 
(6
)
 
(24
)
 
(17
)
Other (gains) losses, net
39

 
64

 
207

 
135

Total other expenses (income)
43

 
77

 
229

 
177

 
 
 
 
 
 
 
 
INCOME BEFORE INCOME TAXES
791

 
618

 
2,513

 
2,738

PROVISION FOR INCOME TAXES
288

 
230

 
913

 
1,016

 
 
 
 
 
 
 
 
NET INCOME
$
503

 
$
388

 
$
1,600

 
$
1,722

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, BASIC
$
0.84

 
$
0.63

 
$
2.65

 
$
2.73

 
 
 
 
 
 
 
 
NET INCOME PER SHARE, DILUTED
$
0.84

 
$
0.62

 
$
2.64

 
$
2.70

 
 
 
 
 
 
 
 
COMPREHENSIVE INCOME
$
630

 
$
517

 
$
1,787

 
$
2,274

 
 
 
 
 
 
 
 
WEIGHTED AVERAGE SHARES OUTSTANDING
 
 
 

 
 

 
 

Basic
597

 
618

 
605

 
630

Diluted
598

 
625

 
606

 
638

 
 
 
 
 
 
 
 
Cash dividends declared per common share
$
.125

 
$
.100

 
$
.350

 
$
.275

See accompanying notes.

4



Southwest Airlines Co.
Condensed Consolidated Statement of Cash Flows
(in millions)
(unaudited)
 
Three months ended
 
Nine months ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
 
 
 
Net income
$
503

 
$
388

 
$
1,600

 
$
1,722

Adjustments to reconcile net income to cash provided by (used in) operating activities:
 

 
 

 
 

 
 

Depreciation and amortization
302

 
315

 
939

 
903

Loss on asset impairment

 

 

 
21

Aircraft grounding charge
63

 

 
63

 

Unrealized/realized (gain) loss on fuel derivative instruments
(42
)
 
(67
)
 
(20
)
 
(101
)
Deferred income taxes
82

 
315

 
213

 
395

Changes in certain assets and liabilities:
 

 
 

 
 

 
 

Accounts and other receivables

 
(320
)
 
(23
)
 
(355
)
Other assets
(64
)
 
(16
)
 
(264
)
 
(61
)
Accounts payable and accrued liabilities
89

 
247

 
(156
)
 
272

Air traffic liability
(80
)
 
(77
)
 
817

 
686

Cash collateral received from derivative counterparties
151

 
114

 
286

 
230

Other, net
(8
)
 
(43
)
 
(89
)
 
(128
)
Net cash provided by operating activities
996

 
856

 
3,366

 
3,584

 
 
 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 

 
 

 
 

Capital expenditures
(638
)
 
(464
)
 
(1,603
)
 
(1,364
)
Assets constructed for others
(17
)
 
(33
)
 
(113
)
 
(70
)
Purchases of short-term investments
(531
)
 
(641
)
 
(1,653
)
 
(1,670
)
Proceeds from sales of short-term and other investments
566

 
549

 
1,696

 
1,671

Other, net

 
5

 

 

Net cash used in investing activities
(620
)
 
(584
)
 
(1,673
)
 
(1,433
)
 
 
 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 

 
 

 
 

Proceeds from Employee stock plans
7

 
6

 
22

 
23

Reimbursement for assets constructed for others
17

 
33

 
113

 
68

Payments of long-term debt and capital lease obligations
(106
)
 
(68
)
 
(534
)
 
(171
)
Payments of cash dividends
(75
)
 
(62
)
 
(274
)
 
(222
)
Repayment of construction obligation
(2
)
 
(2
)
 
(7
)
 
(6
)
Repurchase of common stock
(300
)
 
(250
)
 
(1,250
)
 
(1,450
)
Other, net
6

 
(3
)
 
17

 
(10
)
Net cash used in financing activities
(453
)
 
(346
)
 
(1,913
)
 
(1,768
)
 
 
 
 
 
 
 
 
NET CHANGE IN CASH AND CASH EQUIVALENTS
(77
)
 
(74
)
 
(220
)
 
383

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
1,537

 
2,040

 
1,680

 
1,583

 
 
 
 
 
 
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,460

 
$
1,966

 
$
1,460

 
$
1,966

 
 
 
 
 
 
 
 
CASH PAYMENTS FOR:
 
 
 
 
 
 
 
Interest, net of amount capitalized
$
16

 
$
27

 
$
61

 
$
77

Income taxes
$
229

 
$
264

 
$
611

 
$
902

 
 
 
 
 
 
 
 
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
 
 
 
 
 
 
 
Flight equipment acquired through the assumption of debt
$

 
$
20

 
$

 
$
20

Flight equipment under capital leases
$
77

 
$

 
$
180

 
$
251

Assets constructed for others
$
39

 
$
50

 
$
127

 
$
165

See accompanying notes.

5



Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)

1.    BASIS OF PRESENTATION

Southwest Airlines Co. (the "Company") operates Southwest Airlines, a major passenger airline that provides scheduled air transportation in the United States and near-international markets. The unaudited Condensed Consolidated Financial Statements include accounts of the Company and its wholly owned subsidiaries.

The accompanying unaudited Condensed Consolidated Financial Statements of the Company and its subsidiaries 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 generally accepted accounting principles in the United States ("GAAP") for complete financial statements. The unaudited Condensed Consolidated Financial Statements for the interim periods ended September 30, 2017 and 2016 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 and elimination of significant intercompany transactions. Financial results for the Company and airlines in general can be seasonal in nature. In many years, the Company's revenues, as well as its Operating income and Net income, have been better in its second and third fiscal quarters than in its first and fourth fiscal quarters. Air travel is also significantly impacted by general economic conditions, the amount of disposable income available to consumers, unemployment levels, corporate travel budgets, natural disasters, and other factors beyond the Company's control. These and other factors, such as 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 requirements related to hedge accounting, have created, and may continue to create, significant volatility in the Company's financial results. See Note 3 for further information on fuel and the Company's hedging program. Operating results for the three and nine months ended September 30, 2017, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 2017. 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, 2016.

2.    NEW ACCOUNTING PRONOUNCEMENTS

On August 28, 2017, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") No. 2017-12, Targeted Improvements to Accounting for Hedging Activities. The standard amends the hedge accounting model to enable entities to better portray the economics of their risk management activities in the financial statements and enhance the transparency and understandability of hedge results. The amendments also simplify the application of hedge accounting in certain situations. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted in any interim or annual period. The most significant impacts of this ASU on the Company's accounting will be the elimination of ineffectiveness for all cash flow hedges in a hedging relationship, as well as a change in classification of premium expense associated with option contracts. Currently, such premium expense for the Company's fuel hedges is reflected as a component of Other (gains) losses, net, in the Condensed Consolidated Statement of Income, but under the new ASU will be reflected as a component of the line item to which the hedge relates, which is Fuel and oil expense. The Company is currently considering early adoption of the ASU as of January 1, 2018.

On March 10, 2017, the FASB issued ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The standard requires employers to present the service cost component of the net periodic benefit cost in the same income statement line item as other employee compensation costs arising from services rendered during the period. The other components of net benefit cost, including amortization of prior service cost/credit, and settlement and curtailment effects, are to be included in nonoperating expenses. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The Company does not expect this to have a material impact on Operating income and expects this to have no impact on Net income. The Company will adopt this guidance as of January 1, 2018.

6

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



On January 26, 2017, the FASB issued ASU No. 2017-04, Simplifying the Test for Goodwill Impairment. The standard simplifies the accounting for goodwill impairment by removing Step 2 of the goodwill impairment test (as defined by the FASB), which requires a hypothetical purchase price allocation (implied fair value of goodwill) to measure impairment loss. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019, with early adoption permitted. The Company does not expect this ASU to have a significant impact on its financial statement presentation or results.

On February 25, 2016, the FASB issued ASU No. 2016-02, Leases. The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The guidance requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases (with the exception of short-term leases) at the lease commencement date and recognize expenses on the income statement in a similar manner to the current guidance in Accounting Standards Codification 840, Leases. The lease liability will be measured at the present value of the unpaid lease payments and the right-of-use asset will be derived from the calculation of the lease liability. Lease payments will include fixed and in-substance fixed payments, variable payments based on an index or rate, reasonably certain purchase options, termination penalties, fees paid by the lessee to the owners of a special-purpose entity for restructuring the transaction, and probable amounts the lessee will owe under a residual value guarantee. Lease payments will not include variable lease payments other than those that depend on an index or rate, any guarantee by the lessee of the lessor’s debt, or any amount allocated to non-lease components.

The Company has formed a project team to evaluate and implement the standard, and currently believes the most significant impact of this ASU on its accounting will be the balance sheet impact of its aircraft operating leases, which will significantly increase assets and liabilities. As of September 30, 2017, the Company had 53 leased aircraft under operating leases and also had another 76 aircraft under operating leases that are being subleased to another airline. As of September 30, 2017, the net present value of future rents for those aircraft was approximately $1.0 billion. This amount only includes contractual payments due to lessors, and does not consider certain items that the standard requires to be assessed in determining the final asset and liability to be reflected on the Company's balance sheet, such as lease renewal options and potential impairments, nor does it consider the sublease income that is due from third parties. The Company also has operating leases related to terminal operations space and other real estate leases. Although the real estate leases will also have a substantial impact to the balance sheet, the Company does not expect the leases related to terminal operations space to have a significant impact since variable lease payments, other than those based on an index or rate, are excluded from the measurement of the lease liability. The Company also does not expect the adoption of this ASU to impact any of its existing debt covenants.

In addition, the standard eliminates the current build-to-suit lease accounting guidance and could result in derecognition of build-to-suit assets and liabilities that remained on the balance sheet after the end of the construction period. The underlying leases for these facilities will be subject to evaluation under the new standard. See Note 7 for further information on the Company’s build-to-suit projects.

The Company anticipates utilizing the modified retrospective transition approach to adopt the standard, which requires application of the new guidance for all periods presented with an option to use certain practical expedients. The Company currently plans to adopt the standard as of January 1, 2018, pending successful implementation of a third-party lease accounting software and completion of remaining administrative tasks. The Company is continuing to evaluate the new guidance and plans to provide additional information in its 2017 10-K.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. Following the FASB's finalization of a one year deferral of this standard, the ASU is now effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The Company has formed a project team to evaluate and work to implement the standard, and currently believes the most significant impact of this ASU on its accounting will be the elimination of the incremental cost method for frequent flyer accounting, which will require the Company to re-value its liabilities associated with Customer flight points with a relative fair value approach, resulting in a significant increase in the liabilities. The Company's liabilities associated with these flight points were $64 million at September 30, 2017,

7

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


and the Company currently estimates that applying a relative fair value approach would increase the liabilities by approximately 20 to 25 times that value, depending on various assumptions made at the time of measurement. The adoption of the new standard is also expected to result in different income statement classification for certain types of revenues which are currently classified as Other revenues, but under the new ASU would be included in Passenger revenues. Based on the Company's full year 2016 results, the amount to be reclassified would have been approximately $600 million. However, the estimated impact of this ASU would not have had a material impact on Operating revenues and would not have impacted any of its existing debt covenants. The Company currently anticipates utilizing the full retrospective method of adoption allowed by the standard, in order to provide for comparative results in all periods presented, and will adopt the standard as of January 1, 2018. The Company is continuing to evaluate the new guidance both internally and through its participation in an industry working group, and plans to continue to provide relevant and material information prior to adoption. The Company is in the process of completing its analysis of information necessary to recast prior period results, however it does not believe there are any remaining significant implementation topics associated with the adoption of this ASU that have not yet been addressed.

3.    FINANCIAL DERIVATIVE INSTRUMENTS

Fuel contracts
Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Furthermore, jet fuel and oil typically represents one of the largest operating expenses for airlines. The Company endeavors to acquire jet fuel at the lowest possible cost and to reduce volatility in operating expenses through its fuel hedging program. Although the Company may periodically enter into jet fuel derivatives for short-term timeframes, because jet fuel is not widely traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel for time horizons longer than approximately 24 months into the future. However, the Company has found that financial derivative instruments in other commodities, such as West Texas Intermediate ("WTI") crude oil, Brent 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 financial derivative instruments for trading or speculative purposes.

The Company has used financial derivative instruments for both short-term and long-term timeframes, and primarily uses a mixture of purchased call options, collar structures (which include both a purchased call option and a sold put option), call spreads (which include a purchased call option and a sold call option), put spreads (which include a purchased put option and a sold put option), and fixed price swap agreements in its portfolio. Although the use of collar structures and swap agreements 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 or swap agreement settles. With the use of purchased call options and call spreads, the Company cannot be in a liability position at settlement, but does not have coverage once market prices fall below the strike price of the purchased call option.

For the purpose of evaluating its net cash spend for jet fuel and for forecasting its future estimated jet fuel expense, the Company evaluates its hedge volumes strictly from an "economic" standpoint and thus does not consider whether the hedges have qualified or will qualify for hedge accounting. The Company defines its "economic" hedge as the net volume of fuel derivative contracts held, including the impact of positions that have been offset through sold positions, regardless of whether those contracts qualify for hedge accounting. The level at which the Company is economically hedged for a particular period is also dependent on current market prices for that period, as well as the types of derivative instruments held and the strike prices of those instruments. For example, the Company may enter into "out-of-the-money" option contracts (including "catastrophic" protection), which may not generate intrinsic gains at settlement if market prices do not rise above the option strike price. Therefore, even though the Company may have an economic hedge in place for a particular period, that hedge may not produce any hedging gains at settlement and may even produce hedging losses depending on market prices, the types of instruments held, and the strike prices of those instruments.


8

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


For the three and nine months ended September 30, 2017, the Company had fuel derivative instruments in place for up to 61 percent and 62 percent, respectively, of its fuel consumption. As of September 30, 2017, the Company also had fuel derivative instruments in place to provide coverage at varying price levels, but up to a maximum of approximately 64 percent of its remaining 2017 estimated fuel consumption, depending on where market prices settle. The following table provides information about the Company’s volume of fuel hedging on an economic basis considering current market prices:

 
 
Maximum fuel hedged as of
 
 
 
 
September 30, 2017
 
Derivative underlying commodity type as of
Period (by year)
 
(gallons in millions) (a)
 
September 30, 2017
Remainder of 2017
 
320

 
WTI crude and Brent crude oil
2018
 
1,647

 
WTI crude and Brent crude oil
2019
 
1,377

 
WTI crude and Brent crude oil
Beyond 2019
 
358

 
WTI crude oil
(a) Due to the types of derivatives utilized by the Company and different price levels of those contracts, these volumes represent the maximum economic hedge in place and may vary significantly as market prices fluctuate.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges. Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in Accumulated other comprehensive income (loss) ("AOCI") until the underlying jet fuel is consumed. See Note 4. The Company’s results are subject to the possibility that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for hedge accounting. Ineffectiveness 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 ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change. Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense. When the Company has sold derivative positions in order to effectively "close" or offset a derivative already held as part of its fuel derivative instrument portfolio, any subsequent changes in fair value of those positions are marked to market through earnings. Likewise, any changes in fair value of those positions that were offset by entering into the sold positions and were de-designated as hedges are concurrently marked to market through earnings. However, any changes in value related to hedges that were deferred as part of AOCI while designated as a hedge would remain until the originally forecasted transaction occurs. In a situation where it becomes probable that a fuel 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 during 2016, or during the nine months ended September 30, 2017.


9

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


All cash flows associated with purchasing and selling fuel derivatives are classified as Other 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 derivative instruments within the unaudited Condensed Consolidated Balance Sheet:

 
 
 
 
Asset derivatives
 
Liability derivatives
 
 
Balance Sheet
 
Fair value at
 
Fair value at
 
Fair value at
 
Fair value at
(in millions)
 
location
 
9/30/2017
 
12/31/2016
 
9/30/2017
 
12/31/2016
Derivatives designated as hedges (a)
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
23

 
$
7

 
$
36

 
$
44

Fuel derivative contracts (gross)
 
Other assets
 
85

 
126

 

 

Fuel derivative contracts (gross)
 
Accrued liabilities
 
16

 
4

 
84

 
412

Interest rate derivative contracts
 
Other noncurrent liabilities
 

 

 
18

 
35

Total derivatives designated as hedges
 
$
124

 
$
137

 
$
138

 
$
491

Derivatives not designated as hedges (a)
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
41

 
$
54

 
$
25

 
$

Fuel derivative contracts (gross)
 
Other assets
 
14

 
52

 
14

 
52

Fuel derivative contracts (gross)
 
Accrued liabilities
 
55

 
201

 
85

 
262

Interest rate derivative contracts
 
Other noncurrent liabilities
 

 

 
3

 

Total derivatives not designated as hedges
 
 
 
$
110

 
$
307

 
$
127

 
$
314

Total derivatives
 
 
 
$
234

 
$
444

 
$
265

 
$
805

(a) Represents the position of each trade before consideration of offsetting positions with each counterparty and does not include the impact of cash collateral deposits provided to or received from counterparties. See discussion of credit risk and collateral following in this Note.

In addition, the Company had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:

 
 
Balance Sheet
 
September 30,
 
December 31,
(in millions)
 
location
 
2017
 
2016
Cash collateral deposits held from counterparties for fuel
  contracts - current
 
Offset against Prepaid expenses and other current assets
 
$
3

 
$
4

Cash collateral deposits held from counterparties for fuel
  contracts - noncurrent
 
Offset against Other assets
 
1

 
6

Cash collateral deposits provided to counterparties for fuel
  contracts - current
 
Offset against Accrued liabilities
 
18

 
311

Due to third parties for fuel contracts
 
Accounts payable
 
50

 
75

 
All of the Company's fuel derivative instruments and interest rate swaps are subject to agreements that follow the netting guidance in the applicable accounting standards for derivatives and hedging. The types of derivative instruments the Company has determined are subject to netting requirements in the accompanying unaudited Condensed Consolidated Balance Sheet are those in which the Company pays or receives cash for transactions with the same counterparty and in the same currency via one net payment or receipt. For cash collateral held by the Company or provided to counterparties, the Company nets such amounts against the fair value of the Company's derivative portfolio

10

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


by each counterparty. The Company has elected to utilize netting for both its fuel derivative instruments and interest rate swap agreements and also classifies such amounts as either current or noncurrent, based on the net fair value position with each of the Company's counterparties in the unaudited Condensed Consolidated Balance Sheet.

The Company's application of its netting policy associated with cash collateral 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 outstanding derivative asset amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of noncurrent outstanding derivative instruments. If the Company's fuel derivative instruments are in a net liability position with the counterparty, cash collateral amounts provided are first netted against noncurrent outstanding derivative liability amounts associated with that counterparty until that balance is zero, and then any remainder is applied against the fair value of current outstanding derivative instruments.

The Company has the following recognized financial assets and financial liabilities resulting from those transactions that meet the scope of the disclosure requirements as necessitated by applicable accounting guidance for balance sheet offsetting:

Offsetting of derivative assets
 
(in millions)
 
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
 
September 30, 2017
 
December 31, 2016
 
Description
 
Balance Sheet location
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet
 
Gross amounts of recognized assets
 
Gross amounts offset in the Balance Sheet
 
Net amounts of assets presented in the Balance Sheet
 
Fuel derivative contracts
 
Prepaid expenses and other current assets
 
$
64

 
$
(64
)
 
$

 
$
61

 
$
(48
)
 
$
13

 
Fuel derivative contracts
 
Other assets
 
$
99

 
$
(15
)
 
$
84

(a)
$
178

 
$
(58
)
 
$
120

(a)
Fuel derivative contracts
 
Accrued liabilities
 
$
89

 
$
(89
)
 
$

(a)
$
516

 
$
(516
)
 
$

(a)
(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the unaudited Condensed Consolidated Balance Sheet in Note 5.

Offsetting of derivative liabilities
 
(in millions)
 
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
 
September 30, 2017
 
December 31, 2016
 
Description
 
Balance Sheet location
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet
 
Gross amounts of recognized liabilities
 
Gross amounts offset in the Balance Sheet
 
Net amounts of liabilities presented in the Balance Sheet
 
Fuel derivative contracts
 
Prepaid expenses and other current assets
 
$
64

 
$
(64
)
 
$

 
$
48

 
$
(48
)
 
$

 
Fuel derivative contracts
 
Other assets
 
$
15

 
$
(15
)
 
$

(a)
$
58

 
$
(58
)
 
$

(a)
Fuel derivative contracts
 
Accrued liabilities
 
$
169

 
$
(89
)
 
$
80

(a)
$
674

 
$
(516
)
 
$
158

(a)
Interest rate derivative contracts
 
Other noncurrent liabilities
 
$
21

 
$

 
$
21

(a)
$
35

 
$

 
$
35

(a)

11

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the unaudited Condensed Consolidated Balance Sheet in Note 5.

The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three and nine months ended September 30, 2017 and 2016:

Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective
 portion)
 
(Gain) loss reclassified from AOCI into income (effective
portion) (a)
 
(Gain) loss recognized in income on derivatives
(ineffective portion) (b)
 
Three months ended
 
Three months ended
 
Three months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2017
 
2016
 
2017
 
2016
 
2017
 
2016
Fuel derivative contracts
$
(29
)
*
$
19

*
$
94

*
$
141

*
$
8

 
$
(4
)
Interest rate derivatives

*
(2
)
*
2

*
2

*

 
(2
)
Total
$
(29
)
 
$
17

 
$
96

 
$
143

 
$
8

 
$
(6
)
*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives, which are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives (effective portion)
 
(Gain) loss reclassified from AOCI into income (effective portion)(a)
 
(Gain) loss recognized in income on derivatives (ineffective portion)(b)
 
Nine months ended
 
Nine months ended
 
Nine months ended
 
September 30,
 
September 30,
 
September 30,
(in millions)
2017
 
2016
 
2017
 
2016
 
2017
 
2016
Fuel derivative contracts
$
104

*
$
(62
)
*
$
282

*
$
484

*
$
29

 
$
(3
)
Interest rate derivatives
1

*
4

*
6

*
7

*

 
(3
)
Total
$
105

 
$
(58
)
 
$
288

 
$
491

 
$
29

 
$
(6
)
*Net of tax
(a) Amounts related to fuel derivative contracts and interest rate derivatives, which are included in Fuel and oil and Interest expense, respectively.
(b) Amounts are included in Other (gains) losses, net.

Derivatives not in cash flow hedging relationships
 
 
 
 
 
(Gain) loss
recognized in income on
derivatives
 
 
 
 
 
 
Three months ended
 
Location of (gain) loss
 recognized in income
on derivatives
 
September 30,
 
(in millions)
2017
 
2016
 
Fuel derivative contracts
$
(4
)
 
$
35

 
Other (gains) losses, net
Interest rate derivatives
(1
)
 

 
Interest expense
 
$
(5
)
 
$
35

 
 

12

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)



Derivatives not in cash flow hedging relationships
 
(Gain) loss
 
 
 
recognized in income on
 
 
 
derivatives
 
 
 
Nine months ended
 
Location of (gain) loss
 
September 30,
 
recognized in income
(in millions)
2017
 
2016
 
on derivatives
Fuel derivative contracts
$
80

 
$
23

 
Other (gains) losses, net
Interest rate derivatives

(3
)
 

 
Interest expense
 
$
77

 
$
23

 
 

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended September 30, 2017 and 2016 of $34 million and $34 million, respectively, and the nine months ended September 30, 2017 and 2016 of $102 million and $117 million, respectively. These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income.

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties. Included in the Company’s cumulative net unrealized losses from fuel hedges as of September 30, 2017, recorded in AOCI, were approximately $118 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to September 30, 2017.

Interest rate swaps
The Company is party to certain interest rate swap agreements that are accounted for as either fair value hedges or cash flow hedges, as defined in the applicable accounting guidance for derivative instruments and hedging. Several of the Company's interest rate swap agreements qualify for the "shortcut" method of accounting for hedges, which dictates that the hedges are assumed to be perfectly effective, and, thus, there is no ineffectiveness to be recorded in earnings. For the Company’s interest rate swap agreements that do not qualify for the "shortcut" method of accounting, ineffectiveness is required to be measured at each reporting period. The ineffectiveness associated with all of the Company’s interest rate swap agreements for all periods presented was not material.

Credit risk and collateral
Credit exposure related to fuel derivative instruments is represented by the fair value of contracts that are an asset 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 periodically reviews counterparties based on credit ratings, limits its exposure with respect to each counterparty, and monitors the market position of the fuel hedging program and its relative market position with each counterparty. At September 30, 2017, the Company had agreements with all of its active counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount based on the counterparty credit rating. The Company also had agreements with counterparties in which cash deposits, letters of credit, and/or pledged aircraft are required to be posted as collateral whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. In certain cases, the Company has the ability to substitute among these different forms of collateral at its discretion.


13

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of September 30, 2017, at which such postings are triggered:

 
Counterparty (CP)
 
 
(in millions)
A
 
B
 
C
 
D
 
E
 
F
 
Other (a)
 
Total
Fair value of fuel derivatives
$
(42
)
 
$
(3
)
 
$
16

 
$
10

 
$
4

 
$
3

 
$
2

 
$
(10
)
Cash collateral held from (by) CP
(18
)
 

 

 

 
4

 

 

 
(14
)
Aircraft collateral pledged to CP

 

 

 

 

 

 

 

Letters of credit (LC)

 

 

 

 

 

 

 

Option to substitute LC for aircraft
(200) to (600)(b)
 
(100) to (500)(c)
 
(150) to (550)(c)
 
(150) to (550)(c)
 
N/A
 
N/A
 
 
 
 
Option to substitute LC for cash
N/A
 
>(500)(c)
 
(75) to (150) or >(550)(c)
 
(125) to (150) or >(550)(d)

 
(d)
 
N/A
 
 
 
 
If credit rating is investment
grade, fair value of fuel
derivative level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(50) to (200) or >(600)
 
(50) to (100) or >(500)
 
(75) to (150) or >(550)
 
(125) to (150) or >(550)

 
>(100)
 
>(65)
 
 
 
 
Cash is received from CP
>50(e)
 
>150(e)
 
>250(e)
 
>75(e)
 
>0(e)
 
>30(e)
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(200) to (600)(f)
 
(100) to (500)(c)
 
(150) to (550)(c)
 
(150) to (550)(c)

 
N/A
 
N/A
 
 
 
 
If credit rating is non-investment
grade, fair value of fuel derivative level at which:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash is provided to CP
(0) to (200) or >(600)
 
(0) to (100) or >(500)
 
(0) to (150) or >(550)
 
(0) to (150) or >(550)

 
(g)
 
(g)
 
 
 
 
Cash is received from CP
(g)
 
(g)
 
(g)
 
(g)
 
(g)
 
(g)
 
 
 
 
Aircraft or cash can be pledged to
  CP as collateral
(200) to (600)
 
(100) to (500)
 
(150) to (550)
 
(150) to (550)
 
N/A
 
N/A
 
 
 
 
(a) Individual counterparties with fair value of fuel derivatives <$2 million.
(b) The Company has the option of providing letters of credit in addition to aircraft collateral if the appraised value of the aircraft does not meet the collateral requirements.
(c) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral.
(d) The Company has the option to substitute letters of credit for 100 percent of cash collateral requirement.
(e) Thresholds may vary based on changes in credit ratings within investment grade.
(f) The Company has the option of providing cash or pledging aircraft as collateral.
(g) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.


14

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


4.    COMPREHENSIVE INCOME

Comprehensive income includes changes in the fair value of certain financial derivative instruments that qualify for hedge accounting, unrealized gains and losses on certain investments, and actuarial gains/losses arising from the Company’s postretirement benefit obligation. The differences between Net income and Comprehensive income for the three and nine months ended September 30, 2017 and 2016 were as follows:

 
Three months ended September 30,
(in millions)
2017
 
2016
NET INCOME
$
503

 
$
388

Unrealized gain on fuel derivative instruments, net of
  deferred taxes of $73 and $72
123

 
122

Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $- and $2
2

 
4

Other, net of deferred taxes of $2 and $2
2

 
3

Total other comprehensive income
$
127

 
$
129

COMPREHENSIVE INCOME
$
630

 
$
517


 
Nine months ended September 30,
(in millions)
2017
 
2016
NET INCOME
$
1,600

 
$
1,722

Unrealized gain on fuel derivative instruments, net of
  deferred taxes of $105 and $321
178

 
546

Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $2 and $1
5

 
3

Other, net of deferred taxes of $2 and $2
4

 
3

Total other comprehensive income
$
187

 
$
552

COMPREHENSIVE INCOME
$
1,787

 
$
2,274


A rollforward of the amounts included in AOCI is shown below for the three and nine months ended September 30, 2017:
(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at June 30, 2017
$
(412
)
 
$
(13
)
 
$
(14
)
 
$
22

 
$
154

 
$
(263
)
Changes in fair value
45

 

 

 
4

 
(18
)
 
31

Reclassification to earnings
151

 
2

 

 

 
(57
)
 
96

Balance at September 30, 2017
$
(216
)
 
$
(11
)
 
$
(14
)
 
$
26

 
$
79

 
$
(136
)

(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at December 31, 2016
$
(499
)
 
$
(18
)
 
$
(14
)
 
$
20

 
$
188

 
$
(323
)
Changes in fair value
(165
)
 
(1
)
 

 
6

 
59

 
(101
)
Reclassification to earnings
448

 
8

 

 

 
(168
)
 
288

Balance at September 30, 2017
$
(216
)
 
$
(11
)
 
$
(14
)
 
$
26

 
$
79

 
$
(136
)


15

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The following tables illustrate the significant amounts reclassified out of each component of AOCI for the three and nine months ended September 30, 2017:

Three months ended September 30, 2017
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of
Comprehensive Income
AOCI components
 
 
Unrealized loss on fuel derivative instruments
 
$
151

 
Fuel and oil expense
 
 
57

 
Less: Tax expense
 
 
$
94

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
2

 
Interest expense
 
 

 
Less: Tax expense
 
 
$
2

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
96

 
Net of tax

Nine months ended September 30, 2017
(in millions)
 
Amounts reclassified from AOCI
 
Affected line item in the unaudited Condensed Consolidated Statement of
Comprehensive Income
AOCI components
 
 
Unrealized loss on fuel derivative instruments
 
$
448

 
Fuel and oil expense
 
 
166

 
Less: Tax Expense
 
 
$
282

 
Net of tax
Unrealized loss on interest rate derivative instruments
 
$
8

 
Interest expense
 
 
2

 
Less: Tax Expense
 
 
$
6

 
Net of tax
 
 
 
 
 
Total reclassifications for the period
 
$
288

 
Net of tax



16

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


5. SUPPLEMENTAL FINANCIAL INFORMATION
(in millions)
September 30, 2017
 
December 31, 2016
Derivative contracts
$
84

 
$
120

Intangible assets, net
416

 
426

Capital lease receivable
79

 
90

Non-current prepaid maintenance
113

 
6

Other
151

 
132

Other assets
$
843

 
$
774


(in millions)
September 30, 2017
 
December 31, 2016
Accounts payable trade
$
165

 
$
138

Salaries payable
175

 
200

Taxes payable
180

 
184

Aircraft maintenance payable
33

 
26

Fuel payable
139

 
95

Other payables
432

 
535

Accounts payable
$
1,124

 
$
1,178


(in millions)
September 30, 2017
 
December 31, 2016
ProfitSharing and savings plans
$
450

 
$
645

Aircraft and other lease related obligations
41

 
55

Permanently grounded aircraft liability
31

(a)

Vacation pay
348

 
355

Contract ratification bonuses
69

 
188

Health
93

 
96

Derivative contracts
80

 
158

Workers compensation
174

 
183

Property and income taxes
79

 
68

Other
228

 
237

Accrued liabilities
$
1,593

 
$
1,985


(in millions)
September 30, 2017
 
December 31, 2016
Postretirement obligation
$
274

 
$
256

Non-current lease-related obligations
94

 
125

Permanently grounded aircraft liability
18

(a)

Other deferred compensation
225

 
204

Derivative contracts
21

 
35

Other
81

 
108

Other noncurrent liabilities
$
713

 
$
728


(a) These amounts represent the current and noncurrent portion of the Company's cease-use liability recorded during third quarter 2017, as a result of the Company grounding its remaining leased Boeing 737-300 aircraft on September 29, 2017. The liability reflects the remaining net lease payments due and certain lease return requirements that may have to be performed on these leased aircraft prior to their return to the lessors as of the cease-use date, but does not include the write–off of approximately $15 million in net prepaid rents associated with the aircraft at the grounding

17

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


date, which were included in the $63 million charge recorded. This loss related to the grounding of the Classic fleet was recorded to Other operating expenses in the unaudited Condensed Consolidated Statement of Comprehensive Income during third quarter 2017.

For further details on fuel derivative and interest rate derivative contracts, see Note 3.

Other Operating Expenses
Other operating expenses consist of distribution costs, advertising expenses, personnel expenses, professional fees, and other operating costs, none of which individually exceeded 10 percent of Operating expenses.

6.    NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share (in millions, except per share amounts):
 
Three months ended September 30,
 
Nine months ended September 30,
 
2017
 
2016
 
2017
 
2016
NUMERATOR:
 
 
 
 
 
 
 
Net income
$
503

 
$
388

 
$
1,600

 
$
1,722

Incremental income effect of interest on 5.25% convertible notes

 
1

 

 
2

Net income after assumed conversion
$
503

 
$
389

 
$
1,600

 
$
1,724

 
 
 
 
 
 
 
 
DENOMINATOR:
 

 
 

 
 

 
 

Weighted-average shares outstanding, basic
597

 
618

 
605

 
630

Dilutive effect of Employee stock options and restricted stock units
1

 
1

 
1

 
2

Dilutive effect of 5.25% convertible notes

 
6

 

 
6

Adjusted weighted-average shares outstanding, diluted
598

 
625

 
606

 
638

 
 
 
 
 
 
 
 
NET INCOME PER SHARE:
 

 
 

 
 

 
 

Basic
$
0.84

 
$
0.63

 
$
2.65

 
$
2.73

Diluted
$
0.84

 
$
0.62

 
$
2.64

 
$
2.70


7.    COMMITMENTS AND CONTINGENCIES

Fort Lauderdale-Hollywood International Airport
In December 2013, the Company entered into an agreement with Broward County, Florida, which owns and operates Fort Lauderdale-Hollywood International Airport ("FLL"), to oversee and manage the design and construction of the airport's Terminal 1 Modernization Project. Pursuant to an addendum entered into during 2016, the cost of the project is not to exceed $333 million. In addition to significant improvements to the existing Terminal 1, the project includes the design and construction of a new five-gate Concourse A with an international processing facility. Funding for the project comes directly from Broward County aviation sources, but flows through the Company in its capacity as manager of the project. Major construction on the project began during third quarter 2015. Construction of Concourse A was completed during second quarter 2017, and construction on Terminal 1 is expected to be completed later this year. The Company has determined that due to its agreed upon role in overseeing and managing the project, it is considered the owner of the project for accounting purposes. As such, during construction the Company records expenditures as Assets constructed for others ("ACFO") in the unaudited Condensed Consolidated Balance Sheet, along with a corresponding outflow within Assets constructed for others in the unaudited Condensed Consolidated Statement of Cash Flows, and an increase to Construction obligation (with a corresponding cash inflow from Financing activities in the unaudited Condensed Consolidated Statement of Cash Flows) as reimbursements are received from Broward County.
Los Angeles International Airport
In March 2013, the Company executed a lease agreement (the "T1 Lease") with Los Angeles World Airports ("LAWA"), which owns and operates Los Angeles International Airport ("LAX"). Under the T1 Lease, which was amended in June 2014 and September 2017, the Company is overseeing and managing the design, development, financing, construction, and commissioning of the airport's Terminal 1 Modernization Project at a cost not to exceed $526 million (including proprietary renovations, or $510 million excluding proprietary renovations). In October 2017, the Company executed a separate lease agreement with LAWA (the "T1.5 Lease"). The Company intends to oversee and manage the design, development, financing, construction, and commissioning of a passenger processing facility between Terminal 1 and

18

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


2 ("Terminal 1.5"), but there is a scenario under the T1.5 Lease where the Company could be responsible for constructing just the site improvements for Terminal 1.5. Terminal 1.5 will house ticketing, baggage claim, passenger screening and a bus gate at a cost not to exceed $479 million for site improvements and non-proprietary improvements.
These projects are being funded primarily using the Regional Airports Improvement Corporation (the "RAIC"), which is a quasi-governmental special purpose entity that acts as a conduit borrower under syndicated credit facilities provided by groups of lenders. Loans made under the separate credit facilities for the Terminal 1 project and the Terminal 1.5 project are being used to fund the development of each of these projects, and the outstanding loans will be repaid with the proceeds of LAWA’s payments to purchase completed construction phases. The Company has guaranteed the obligations of the RAIC under each of the credit facilities of the respective lease agreements. As of September 30, 2017, there was no guarantee outstanding for the Terminal 1.5 project, and the Company's outstanding remaining guaranteed obligation under the credit facility for the Terminal 1 project was $299 million.
Construction on the Terminal 1 project began during 2014 and is estimated to be completed during 2018. Construction on the Terminal 1.5 project began during third quarter 2017 and is estimated to be completed during 2020. The Company has determined that due to its agreed upon role in overseeing and managing these projects, it is considered the owner of these projects for accounting purposes. LAWA is reimbursing the Company (through the RAIC credit facilities) for the site improvements and non-proprietary improvements, while proprietary improvements will not be reimbursed. As a result, the costs incurred to fund these projects are included within ACFO and all amounts that have been or will be reimbursed will be included within Construction obligation on the accompanying unaudited Condensed Consolidated Balance Sheet.
Dallas Love Field
During 2008, the City of Dallas approved the Love Field Modernization Program ("LFMP"), a project to reconstruct Dallas Love Field with modern, convenient air travel facilities. Pursuant to a Program Development Agreement with the City of Dallas and the Love Field Airport Modernization Corporation (or "LFAMC," a Texas non-profit "local government corporation" established by the City of Dallas to act on the City of Dallas' behalf to facilitate the development of the LFMP), the Company managed this project.

Although the City of Dallas received commitments from various sources that helped to fund portions of this LFMP project, including the Federal Aviation Administration ("FAA"), the Transportation Security Administration, and the City of Dallas' Aviation Fund, the majority of the funds used were from the issuance of bonds. The Company guaranteed principal and interest payments on $456 million of such bonds issued by the LFAMC. As of September 30, 2017, $432 million of principal remained outstanding. The Company utilized the accounting guidance provided for lessees involved in asset construction. Upon completion of different phases of the LFMP project, the Company has placed the associated assets in service and has begun depreciating the assets over their estimated useful lives. The corresponding LFMP liabilities are being reduced primarily through the Company's airport rental payments to the City of Dallas as the construction costs of this project are passed through to the Company via recurring airport rates and charges. Major construction was effectively completed by December 31, 2014. During second quarter 2017, the City of Dallas approved using the remaining bond funds for additional terminal construction projects which began during second quarter and are expected to be completed in 2018.

During 2015, the City of Dallas issued additional bonds for the construction of a new parking garage at Dallas Love Field. The Company has not guaranteed the principal or interest payments on these bonds, but remains the accounting owner of this project due to its incorporation into the LFMP agreements.


19

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


Construction costs recorded in ACFO for the Company's various projects as of September 30, 2017, and December 31, 2016, were as follows:

 
 
September 30, 2017
 
December 31, 2016
(in millions)
 
ACFO
ACFO,
Net (b)
Construction Obligation
 
ACFO
ACFO,
Net (b)
Construction Obligation
FLL Terminal
(a)
$
245

$
244

$
245

 
$
132

$
132

$
132

LAX Terminal 1
(a)
417

404

417

 
344

336

344

LFMP - Terminal
 
540

474

517

 
538

486

522

LFMP - Parking Garage
(a)
132

132

132

 
80

80

80

HOU International Terminal
(c)
126

119


 
126

122


 
 
$
1,460

$
1,373

$
1,311

 
$
1,220

$
1,156

$
1,078

(a) Projects still in progress.
(b) Net of accumulated depreciation.
(c) Project completed in 2015 at Houston William P. Hobby Airport ("HOU").

Contingencies
The Company is from time to time subject to various 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 of any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.

8.    FAIR VALUE MEASUREMENTS

Accounting standards pertaining to fair value measurements establish 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 September 30, 2017, 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 (primarily treasury bills and certificates of deposit), interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities. The majority of the Company’s short-term investments consist of instruments classified as Level 1. However, the Company has certificates of deposit, commercial paper, and Eurodollar deposits that are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.

The Company’s fuel and interest rate derivative instruments consist of over-the-counter contracts, which are not traded on a public exchange. Fuel derivative instruments include swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely of swap agreements. See Note 3 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’s Treasury Department, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an 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 provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain inputs used to determine

20

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. 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.

Included in Other available-for-sale securities are the Company’s investments associated with its deferred compensation plans, which consist of mutual funds that are publicly traded and for which market prices are readily available. These plans are non-qualified deferred compensation plans designed to hold contributions in excess of limits established by the Internal Revenue Code of 1986, as amended. The distribution timing and payment amounts under these plans are made based on the participant’s distribution election and plan balance. Assets related to the funded portions of the deferred compensation plans are held in a rabbi trust, and the Company remains liable to these participants for the unfunded portion of the plans. The Company records changes in the fair value of the assets in the Company’s earnings.


21

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at September 30, 2017, and December 31, 2016:

 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
September 30, 2017
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,025

 
$
1,025

 
$

 
$

Commercial paper
 
420

 

 
420

 

Certificates of deposit
 
15

 

 
15

 

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,344

 
1,344

 

 

Certificates of deposit
 
236

 

 
236

 

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
12

 

 
12

 

Option contracts (b)
 
164

 

 

 
164

Option contracts (c)
 
58

 

 

 
58

Other available-for-sale securities
 
101

 
101

 

 

Total assets
 
$
3,375

 
$
2,470

 
$
683

 
$
222

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
$
(27
)
 
$

 
$
(27
)
 
$

Option contracts (b)
 
(76
)
 

 

 
(76
)
     Option contracts (c)
 
(141
)
 

 

 
(141
)
Interest rate derivatives (see Note 3)
 
(21
)
 

 
(21
)
 

Total liabilities
 
$
(265
)
 
$

 
$
(48
)
 
$
(217
)
(a) Cash equivalents are primarily composed of money market investments.
(b) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net asset. See Note 3.
(c) In the unaudited Condensed Consolidated Balance Sheet amounts are presented as a net liability. See Note 3.


22

Southwest Airlines Co.
Notes to Condensed Consolidated Financial Statements
(unaudited)


 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
December 31, 2016
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,344

 
$
1,344

 
$

 
$

Commercial paper
 
325

 

 
325

 

Certificates of deposit
 
11

 

 
11

 

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,345

 
1,345

 

 

Certificates of deposit
 
280

 

 
280

 

Fuel derivatives:
 
 
 
 
 
 
 
 
Swap contracts (c)
 
42

 

 
42

 

Option contracts (b)
 
239

 

 

 
239

Option contracts (c)
 
163

 

 

 
163

Other available-for-sale securities
 
83

 
83

 

 

Total assets
 
$
3,832

 
$
2,772

 
$
658

 
$
402

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
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