10-Q 1 luv-3312018x10q.htm 1ST QUARTER 2018 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 March 31, 2018
 
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 April 27, 2018: 579,803,228




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)
 
March 31, 2018
 
December 31, 2017
 
 
 
As Recast
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,822

 
$
1,495

Short-term investments
1,421

 
1,778

Accounts and other receivables
680

 
662

Inventories of parts and supplies, at cost
430

 
420

Prepaid expenses and other current assets
448

 
460

Total current assets
4,801

 
4,815

 
 
 
 
Property and equipment, at cost:
 

 
 

Flight equipment
21,143

 
21,368

Ground property and equipment
4,506

 
4,399

Deposits on flight equipment purchase contracts
913

 
919

Assets constructed for others
1,607

 
1,543

 
28,169

 
28,229

Less allowance for depreciation and amortization
9,396

 
9,690

 
18,773

 
18,539

Goodwill
970

 
970

Other assets
959

 
786

 
$
25,503

 
$
25,110

 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
1,243

 
$
1,320

Accrued liabilities
1,134

 
1,700

Air traffic liability
4,420

 
3,495

Current maturities of long-term debt
365

 
348

Total current liabilities
7,162

 
6,863

 
 
 
 
Long-term debt less current maturities
3,227

 
3,320

Air traffic liability - loyalty noncurrent
1,010

 
1,070

Deferred income taxes
2,216

 
2,119

Construction obligation
1,563

 
1,390

Other noncurrent liabilities
706

 
707

Stockholders' equity:
 

 
 

Common stock
808

 
808

Capital in excess of par value
1,452

 
1,451

Retained earnings
14,238

 
13,832

Accumulated other comprehensive income
78

 
12

Treasury stock, at cost
(6,957
)
 
(6,462
)
Total stockholders' equity
9,619

 
9,641

 
$
25,503

 
$
25,110

See accompanying notes.

3



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

 
Three months ended March 31,
 
2018
 
2017
 
 
 
As Recast
OPERATING REVENUES:
 
 
 
Passenger
$
4,585

 
$
4,546

Freight
42

 
42

Other
317

 
266

Total operating revenues
4,944

 
4,854

 
 
 
 
OPERATING EXPENSES:
 

 
 

Salaries, wages, and benefits
1,821

 
1,730

Fuel and oil
1,018

 
956

Maintenance materials and repairs
257

 
243

Landing fees and airport rentals
330

 
313

Depreciation and amortization
277

 
318

Other operating expenses
625

 
688

Total operating expenses
4,328

 
4,248

 
 
 
 
OPERATING INCOME
616

 
606

 
 
 
 
OTHER EXPENSES (INCOME):
 

 
 

Interest expense
32

 
29

Capitalized interest
(10
)
 
(11
)
Interest income
(12
)
 
(7
)
Other (gains) losses, net
4

 
63

Total other expenses (income)
14

 
74

 
 
 
 
INCOME BEFORE INCOME TAXES
602

 
532

PROVISION FOR INCOME TAXES
139

 
193

 
 
 
 
NET INCOME
$
463

 
$
339

 
 
 
 
NET INCOME PER SHARE, BASIC
$
0.79

 
$
0.55

 
 
 
 
NET INCOME PER SHARE, DILUTED
$
0.79

 
$
0.55

 
 
 
 
COMPREHENSIVE INCOME
$
547

 
$
350

 
 
 
 
WEIGHTED AVERAGE SHARES OUTSTANDING
 
 
 

Basic
587

 
613

Diluted
588

 
614

 
 
 
 
Cash dividends declared per common share
$
.125

 
$
.100

See accompanying notes.

4



Southwest Airlines Co.
Condensed Consolidated Statement of Cash Flows
(in millions)
(unaudited)
 
Three months ended
 
March 31,
 
2018
 
2017
 
 
 
As Recast
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
463

 
$
339

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

 
 

Depreciation and amortization
277

 
318

Unrealized/realized (gain) loss on fuel derivative instruments
(7
)
 
27

Deferred income taxes
72

 
54

Changes in certain assets and liabilities:
 

 
 

Accounts and other receivables
(15
)
 
(35
)
Other assets
(178
)
 
(81
)
Accounts payable and accrued liabilities
(501
)
 
92

Air traffic liability
866

 
918

Cash collateral received from derivative counterparties
65

 
37

Other, net
(40
)
 
(44
)
Net cash provided by operating activities
1,002

 
1,625

 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 

Capital expenditures
(409
)
 
(414
)
Assets constructed for others
(24
)
 
(49
)
Purchases of short-term investments
(200
)
 
(563
)
Proceeds from sales of short-term and other investments
560

 
556

Net cash used in investing activities
(73
)
 
(470
)
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 

Proceeds from Employee stock plans
9

 
7

Reimbursement for assets constructed for others
139

 
49

Payments of long-term debt and capital lease obligations
(82
)
 
(369
)
Payments of cash dividends
(148
)
 
(123
)
Repayment of construction obligation
(7
)
 
(2
)
Repurchase of common stock
(500
)
 
(550
)
Other, net
(13
)
 
4

Net cash used in financing activities
(602
)
 
(984
)
 
 
 
 
NET CHANGE IN CASH AND CASH EQUIVALENTS
327

 
171

 
 
 
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
1,495

 
1,680

 
 
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,822

 
$
1,851

 
 
 
 
CASH PAYMENTS FOR:
 
 
 
Interest, net of amount capitalized
$
18

 
$
27

Income taxes
$
4

 
$
6

 
 
 
 
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
 
 
 
Flight equipment under capital leases
$
14

 
$
39

Assets constructed for others
$
40

 
$
50

See accompanying notes.

5



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

1.    BASIS OF PRESENTATION

Southwest Airlines Co. (the "Company" or "Southwest") 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 March 31, 2018 and 2017 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, and the periodic volatility of commodities used by the Company for hedging jet fuel, 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 months ended March 31, 2018, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 2018. 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, 2017.

Effective as of January 1, 2018, the Company adopted Accounting Standards Update ("ASU") No. 2014-09: Revenue from Contracts with Customers, ASU No. 2017-07: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, and ASU No. 2017-12: Targeted Improvements to Accounting for Hedging Activities. All amounts and disclosures set forth in this Form 10-Q reflect the adoption of these ASUs. See Note 2 for further information.

The Company reclassified $54 million from Aircraft rentals to Other operating expenses in the unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2017, to be comparative with the current period's presentation. Aircraft rentals expense included in Other operating expenses for the three months ended March 31, 2018, was $40 million. This reclassification had no impact on Operating income, Net income, the unaudited Condensed Consolidated Balance Sheet, or the unaudited Condensed Consolidated Statement of Cash Flows.

2.    NEW ACCOUNTING PRONOUNCEMENTS

On February 7, 2018, the Financial Accounting Standards Board (the "FASB") issued ASU No. 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This standard gives entities the option to reclassify tax effects stranded in Accumulated other comprehensive income (loss) ("AOCI"), as a result of the Tax Cuts and Jobs Act enacted in December 2017, to Retained earnings. The guidance is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption, including adoption in an interim period, is permitted. At December 31, 2017, the Company had revalued its deferred tax AOCI balance from a deferred tax rate of 36.9 percent to a new deferred tax rate of 23.3 percent as a result of the Tax Cuts and Jobs Act. The Company adopted the standard as of January 1, 2018, and accordingly during first quarter 2018, the

6

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


Company elected to reclassify $2 million previously stranded in AOCI to Retained earnings in the accompanying unaudited Condensed Consolidated Balance Sheet.

On August 28, 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities (the "New Hedging Standard"). The New Hedging 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 New Hedging Standard also simplifies the application of hedge accounting in certain situations. The New Hedging Standard 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 Company elected to early adopt the New Hedging Standard as of January 1, 2018. The adoption was done on a prospective basis, as required. The most significant impacts of the New Hedging Standard on the Company's accounting are the elimination of the requirement to separately measure and record ineffectiveness for all cash flow hedges in a hedging relationship, as well as a change in classification of premium expense associated with option contracts. Such premium expense for the Company's fuel hedges was previously reflected as a component of Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income, but under the New Hedging Standard is reflected as a component of the line item to which the hedge relates, which is Fuel and oil expense. As such, the classification of premium expense for the three months ended March 31, 2017, has been reclassified in order to be comparative with current period results in the accompanying unaudited Condensed Consolidated Statement of Comprehensive Income. The impact of the cumulative effect of the adjustment to move the reporting of ineffectiveness as of January 1, 2018, to AOCI from Retained earnings, was a $20 million loss, net of taxes. The adoption and resulting reclassification had no impact on the Company's net income, earnings per share, or cash flows.

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 "New Retirement Standard"). The New Retirement 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. As required by the New Retirement Standard, the Company adopted this guidance retrospectively as of January 1, 2018, using a practical expedient which permitted the Company to use the amounts disclosed in its pension and other postretirement benefit plan note for the prior comparative periods as the estimation basis for applying the retrospective presentation requirements. As such, the Company reclassified $3 million of Salaries, wages, and benefits expense to Other (gains) and losses under the New Retirement Standard in the accompanying unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2017. The adoption and resulting reclassification had no impact on the Company's net income, earnings per share, or cash flows.

On February 25, 2016, the FASB issued ASU No. 2016-02, Leases (the "New Lease Standard"). The New Lease Standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The New Lease Standard 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 ("ASC 840"). 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 New Lease Standard, and currently believes the most significant impact of the New Lease Standard on its accounting will be the balance sheet impact of its aircraft operating leases, which will significantly increase assets and liabilities. As of March 31, 2018, the Company had 53

7

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


leased aircraft under operating leases and also had another 76 aircraft under operating leases that are being subleased to another airline. As of March 31, 2018, the net present value of future rents for those aircraft was approximately $900 million. This amount only includes contractual payments due to lessors, and does not consider certain items that the New Lease 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 the New Lease Standard to impact any of its existing debt covenants.

In addition, the New Lease 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 Lease Standard. See Note 7 for further information on the Company’s build-to-suit projects.

The Company is evaluating the recently affirmed proposal which provided an optional transition method for adoption of the New Lease Standard, which would allow entities to continue to apply the legacy guidance in ASC 840, including its disclosure requirements, in the comparative periods presented in the year of adoption. The Company plans to adopt the New Lease Standard on January 1, 2019, and will continue to provide updates to its plans in future periods.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (the "New Revenue Standard"), also referred to as Accounting Standards Codification 606, Revenue From Contracts With Customers ("ASC 606"), which replaces numerous revenue recognition requirements in GAAP, including industry-specific requirements, and provides companies with a single revenue recognition model for recognizing revenue from contracts with Customers. The New Revenue Standard establishes a five-step model whereby revenue is recognized as performance obligations within a contract are satisfied in an amount that reflects the consideration the Company expects to receive in exchange for satisfaction of those performance obligations, or standalone selling price. The New Revenue Standard also requires new, expanded disclosures regarding revenue recognition. See Note 5 for further information. The Company has adopted the provisions of the New Revenue Standard on January 1, 2018, using the retrospective method. As such, results for the three months ended March 31, 2017, have been recast under the New Revenue Standard in order to be comparative with current period results in the accompanying unaudited Condensed Consolidated Statements of Comprehensive Income and Cash Flows. The amounts in the accompanying unaudited Condensed Consolidated Balance Sheet as of December 31, 2017, have also been recast.

The most significant impact of the New Revenue Standard relates to the accounting for the Company’s loyalty program. The New Revenue Standard eliminated the incremental cost method for loyalty program accounting, which was previously allowed in prior accounting guidance. The Company is now required to account for the liability for points earned using a relative fair value approach.

The New Revenue Standard also resulted in different income statement classification for certain types of revenues (primarily ancillary revenues) which were previously classified as Other revenues, but under the New Revenue Standard are included in Passenger revenues, and certain expenses, which were previously classified as Other operating expenses, but under the New Revenue Standard are offset against Passenger revenues.


8

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


The following table provides the impact of applying the New Revenue Standard to the Company’s previously reported balances as of December 31, 2017:

 
Balance as of December 31, 2017
(in millions)
As Reported
 
New Revenue Standard
 
As Recast
Accrued liabilities
$
1,777

 
$
(77
)
 
$
1,700

Air traffic liability
3,460

 
35

 
3,495

Air traffic liability - loyalty noncurrent

 
1,070

 
1,070

Deferred income taxes
2,358

 
(239
)
 
2,119

Retained earnings
14,621

 
(789
)
 
13,832


The impacts of applying the New Revenue Standard, the New Retirement Standard, and the New Hedging Standard to the Company’s unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2017, are as follows:

 
Three months ended March 31, 2017
(in millions), except per share amounts
As Reported
 
New Revenue Standard
 
New Retirement Standard
 
New Hedging Standard
 
As Recast
Passenger revenue
$
4,424

 
$
122

 
$

 
$

 
$
4,546

Other revenue
417

 
(151
)
 

 

 
266

Salaries, wages, and benefits
1,733

 

 
(3
)
 

 
1,730

Fuel and oil expense
922

 

 

 
34

 
956

Other operating expenses (a)
696

 
(8
)
 

 

 
688

Other (gains) losses, net
94

 

 
3

 
(34
)
 
63

Provision for income taxes
202

 
(9
)
 

 

 
193

Net income
351

 
(12
)
 

 

 
339

Net income per share, basic
0.57

 
(0.02
)
 

 

 
0.55

Net income per share, diluted
0.57

 
(0.02
)
 

 

 
0.55


(a) The Company reclassified $54 million from Aircraft rentals to Other operating expenses in the unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2017, to be comparative with current period's presentation. See Note 1 for further information.


9

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


The impact of applying the New Revenue Standard to the Company’s unaudited Condensed Consolidated Statement of Cash Flows for the three months ended March 31, 2017, are as follows (amounts may not recalculate due to rounding):
 
Three months ended March 31, 2017
(in millions)
As Reported
 
New Revenue Standard
 
As Recast
Net income
$
351

 
$
(12
)
 
$
339

Deferred income taxes
62

 
(9
)
 
54

Changes in certain assets and liabilities
874

 
21

 
894

Net cash provided by operating activities
1,625

 

 
1,625



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.


10

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


For the three months ended March 31, 2018, the Company had fuel derivative instruments in place for up to 84 percent of its fuel consumption. As of March 31, 2018, the Company also had fuel derivative instruments in place to provide coverage at varying price levels, but up to a maximum of approximately 76 percent of its remaining 2018 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
 
 
 
 
March 31, 2018
 
Derivative underlying commodity type as of
Period (by year)
 
(gallons in millions) (a)
 
March 31, 2018
Remainder of 2018
 
1,235

 
WTI crude and Brent crude oil
2019
 
1,377

 
WTI crude and Brent crude oil
2020
 
867

 
WTI crude and Brent crude oil
2021
 
340

 
WTI crude oil
2022
 
88

 
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. The Company adopted the New Hedging Standard as of January 1, 2018. See Note 2 for further information on this adoption. Under the New Hedging Standard, all periodic changes in fair value of the derivatives designated as hedges are recorded in AOCI until the underlying jet fuel is consumed. See Note 4. Prior to the adoption of the New Hedging Standard, ineffectiveness resulted when the change in the fair value of the derivative instrument exceeded 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 were ineffective, the ineffective portion was recorded to Other (gains) losses, net, in the unaudited Condensed Consolidated Statement of Comprehensive Income in the period of the change. The Company's results are subject to the possibility that the derivatives will no longer qualify for hedge accounting, in which case any change in the fair value of derivative instruments since the last reporting period would be recorded in 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 2017, or during the three months ended March 31, 2018.


11

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
 
3/31/2018
 
12/31/2017
 
3/31/2018
 
12/31/2017
Derivatives designated as hedges (a)
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
145

 
$
112

 
$

 
$

Fuel derivative contracts (gross)
 
Other assets
 
195

 
136

 

 

Interest rate derivative contracts
 
Other noncurrent liabilities
 

 

 
24

 
20

Total derivatives designated as hedges
 
$
340

 
$
248

 
$
24

 
$
20

Derivatives not designated as hedges (a)
 
 
 
 
 
 
 
 
 
 
Fuel derivative contracts (gross)
 
Prepaid expenses and other current assets
 
$
23

 
$
35

 
$
23

 
$
35

Interest rate derivative contracts
 
Accrued liabilities
 

 

 
1

 
1

Interest rate derivative contracts
 
Other noncurrent liabilities
 

 

 

 
1

Total derivatives not designated as hedges
 
 
 
$
23

 
$
35

 
$
24

 
$
37

Total derivatives
 
 
 
$
363

 
$
283

 
$
48

 
$
57

(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.

The following table presents the amounts recorded on the unaudited Condensed Consolidated Balance Sheet related to fair value hedges:

Balance Sheet location of hedged item
 
Carrying amount of the hedged liabilities
 
Cumulative amount of fair value hedging adjustment included in the carrying amount of the hedged liabilities (a)
 
 
March 31,
 
March 31,
(in millions)
 
2018
 
2017
 
2018
 
2017
Long-term debt less current maturities
 
$
784

 
$
793

 
$
5

 
$
15

(a) At March 31, 2018 and 2017, these amounts include the cumulative amount of fair value hedging adjustments remaining for which hedge accounting has been discontinued of $21 million and $22 million, respectively.


12

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


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
 
March 31,
 
December 31,
(in millions)
 
location
 
2018
 
2017
Cash collateral deposits held from counterparties for fuel
  contracts - current
 
Offset against Prepaid expenses and other current assets
 
$
60

 
$
15

Cash collateral deposits held from counterparties for fuel
  contracts - noncurrent
 
Offset against Other assets
 
20

 

Due to third parties for fuel contracts
 
Accounts payable
 

 
29

Receivable from third parties for fuel contracts
 
Accounts and other receivables
 
9

 

 
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 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 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)
 
 
 
 
 
March 31, 2018
 
December 31, 2017
 
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
 
$
168

 
$
(83
)
 
$
85

 
$
147

 
$
(50
)
 
$
97

 
Fuel derivative contracts
 
Other assets
 
$
195

 
$
(20
)
 
$
175

(a)
$
136

 
$

 
$
136

(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 9.


13

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


Offsetting of derivative liabilities
 
(in millions)
 
 
 
 
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
(i)
 
(ii)
 
(iii) = (i) + (ii)
 
 
 
 
 
March 31, 2018
 
December 31, 2017
 
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
 
$
83

 
$
(83
)
 
$

 
$
50

 
$
(50
)
 
$

 
Fuel derivative contracts
 
Other assets
 
$
20

 
$
(20
)
 
$

(a)
$

 
$

 
$

(a)
Interest rate derivative contracts
 
Accrued liabilities
 
$
1

 
$

 
$
1

 
$
1

 
$

 
$
1

 
Interest rate derivative contracts
 
Other noncurrent liabilities
 
$
24

 
$

 
$
24

(a)
$
21

 
$

 
$
21

(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 9.


14

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


The following tables present the impact of derivative instruments and their location within the unaudited Condensed Consolidated Statement of Comprehensive Income for the three months ended March 31, 2018 and 2017:
Location and amount of (gain) loss recognized in income on cash flow and fair value hedging relationships
 
 
Three months ended March 31, 2018
 
Three months ended March 31, 2017
(in millions)
 
Fuel and oil
 
Interest expense
 
Fuel and oil
 
Interest expense
Total
 
$
4

 
$
10

 
$
139

 
$
8

 
 
 
 
 
 
 
 
 
Loss on cash flow hedging relationships:
 
 
 
 
 
 
 
 
     Commodity contracts:
 
 
 
 
 
 
 
 
          Amount of loss reclassified from AOCI into income
 
4

 

 
139

 

     Interest contracts:
 
 
 
 
 
 
 
 
          Amount of loss reclassified from AOCI into income
 

 
2

 

 
3

 
 
 
 
 
 
 
 
 
Impact of fair value hedging relationships:
 
 
 
 
 
 
 
 
     Interest contracts:
 
 
 
 
 
 
 
 
          Hedged items
 

 
6

 

 
6

          Derivatives designated as hedging instruments
 

 
2

 

 
(1
)

Derivatives designated and qualified in cash flow hedging relationships
 
(Gain) loss recognized in AOCI on derivatives
 
(Gain) loss recognized in income on derivatives
(ineffective portion) (a)
 
Three months ended
 
Three months ended
 
March 31,
 
March 31,
(in millions)
2018
 
2017
 
2018
 
2017
Fuel derivative contracts
$
(78
)
*
$
79

*
$

 
$
14

Interest rate derivatives
(1
)
*

*

 

Total
$
(79
)
 
$
79

 
$

 
$
14

*Net of tax
(a) Amounts are included in Other (gains) losses, net.

Derivatives not designated as hedges
 
 
 
 
 
(Gain) loss
recognized in income on
derivatives
 
 
 
 
 
 
Three months ended
 
Location of (gain) loss
 recognized in income
on derivatives
 
March 31,
 
(in millions)
2018
 
2017
 
Fuel derivative contracts
$

 
$
51

 
Other (gains) losses, net
Interest rate derivatives
(1
)
 
(1
)
 
Interest expense
 
$
(1
)
 
$
50

 
 


15

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


The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended March 31, 2018 and 2017 of $34 million and $34 million, respectively. These amounts are recognized through changes in fair value within AOCI for designated hedges, and are ultimately recorded as a component of Fuel and oil in the unaudited Condensed Consolidated Statement of Comprehensive Income during the period the contracts settle.

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 gains from fuel hedges as of March 31, 2018, recorded in AOCI, were approximately $17 million in unrealized gains, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to March 31, 2018.

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. The New Hedging Standard also addresses targeted improvements to special hedge accounting for interest rate hedges. Though the Company will not be making any changes to the accounting for its current interest rate hedges as of the January 2018 adoption date, the New Hedging Standard provides the Company with more opportunities to achieve special hedge accounting for potential interest rate hedges in the future. 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 March 31, 2018, 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.


16

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 March 31, 2018, at which such postings are triggered:

 
Counterparty (CP)
 
 
(in millions)
A
 
B
 
C
 
D
 
E
 
F
 
Other (a)
 
Total
Fair value of fuel derivatives
$
116

 
$
67

 
$
77

 
$
39

 
$
17

 
$
11

 
$
13

 
$
340

Cash collateral held from CP
80

 

 

 

 

 

 

 
80

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)(e)
 
(125) to (150) or >(550)(e)

 
>(125)
 
>(65)(e)
 
 
 
 
Cash is received from CP
>50(e)
 
>150(e)
 
>250(e)
 
>75(e)
 
>100(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 <$9 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.


17

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 months ended March 31, 2018 and 2017 were as follows:

 
Three months ended March 31,
(in millions)
2018
 
2017
NET INCOME
$
463

 
$
339

Unrealized gain on fuel derivative instruments, net of
  deferred taxes of $25 and $5
81

 
9

Unrealized gain on interest rate derivative instruments, net of
  deferred taxes of $- and $1
3

 
2

Total other comprehensive income
$
84

 
$
11

COMPREHENSIVE INCOME
$
547

 
$
350


A rollforward of the amounts included in AOCI is shown below for the three months ended March 31, 2018:
(in millions)
Fuel derivatives
 
Interest rate derivatives
 
Defined benefit plan items
 
Other
 
Deferred tax
 
Accumulated other
comprehensive income (loss)
Balance at December 31, 2017
$
3

 
$
(7
)
 
$
(9
)
 
$
33

 
$
(8
)
 
$
12

ASU 2017-12 adoption adjustment (a)
(26
)
 

 

 

 
6

 
(20
)
ASU 2018-02 stranded AOCI adoption adjustment (b)

 

 

 

 
2

 
2

Changes in fair value
102

 
1

 

 

 
(24
)
 
79

Reclassification to earnings
4

 
2

 

 

 
(1
)
 
5

Balance at March 31, 2018
$
83

 
$
(4
)
 
$
(9
)
 
$
33

 
$
(25
)
 
$
78

(a) The Company adopted the New Hedging Standard as of January 1, 2018. See Note 2 for further information on this adoption.
(b) The Company adopted the Reclassification of Certain Tax Effects from AOCI as of January 1, 2018. See Note 2 for further information on this adoption.

The following table illustrates the significant amounts reclassified out of each component of AOCI for the three months ended March 31, 2018:

Three months ended March 31, 2018
(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
 
$
4

 
Fuel and oil expense
 
 
1

 
Less: Tax expense
 
 
$
3

 
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
 
$
5

 
Net of tax


18

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


5.    REVENUE

Passenger Revenues
The Company’s contracts with its Customers primarily consist of its tickets sold, which are initially deferred as Air traffic liability. Passenger revenue associated with tickets is recognized when the performance obligation to the Customer is satisfied, which is primarily when travel is provided.

Revenue is categorized by revenue source as the Company believes it best depicts the nature, amount, timing, and uncertainty of revenue and cash flow. The following table provides the components of Passenger revenue for the three months ended March 31, 2018 and 2017 (in millions):

 
Three months ended March 31,
(in millions)
2018
 
2017
Passenger non-loyalty
$
3,948

 
$
3,907

Passenger loyalty - air transportation
491

 
507

Passenger ancillary sold separately
146

 
132

   Total passenger revenues
$
4,585

 
$
4,546


Passenger non-loyalty includes all revenues from Passengers related to flights paid for primarily with cash or credit card. All Customers purchasing a ticket on Southwest Airlines are generally able to check up to two bags at no extra charge (with certain exceptions as stated in the Company's published Contract of Carriage), and the Company also does not charge a fee for a Customer to make a change to their flight after initial purchase, although fare differences may apply. Passenger loyalty - air transportation primarily consists of the revenue associated with award flights taken by frequent flyer program members upon redemption of frequent flyer points. Passenger ancillary sold separately includes any ancillary fees charged separately, such as in-flight purchases, EarlyBird Check-In®, and Upgraded Boarding.

Air traffic liability primarily represents tickets sold for future travel dates, funds that are past flight date and remain unused, but are expected to be used in the future, and the Company’s liability for frequent flyer benefits that are expected to be redeemed in the future. The majority of the Company’s tickets sold are nonrefundable. Southwest has a No Show policy that applies to fares that are not canceled or changed by a Customer at least ten minutes prior to a flight's scheduled departure. Refundable tickets that are sold but not flown on the travel date and canceled in accordance with the No Show policy can also be reused for another flight, up to a year from the date of sale. A small percentage of tickets (or partial tickets) expire unused. The Company estimates the amount of tickets that expire unused and recognizes such amounts in Passenger revenue using the redemption method once the scheduled flight date has lapsed. Based on the Company's revenue recognition policy, revenue is recorded at the flight date for a Customer who does not change his/her itinerary and loses his/her funds as the Company has then fulfilled its performance obligation. Amounts collected from passengers for ancillary services are also recognized when the service is provided, which is typically the flight date.

Initial spoilage estimates for both tickets and funds available for future use are routinely adjusted and ultimately finalized once the tickets expire, which is typically twelve months after the original purchase date. Spoilage estimates are based on the Company's Customers' historical travel behavior as well as assumptions about the Customers' future travel behavior. Assumptions used to generate spoilage estimates can be impacted by several factors including, but not limited to: fare increases, fare sales, changes to the Company's ticketing policies, changes to the Company’s refund, exchange and unused funds policies, seat availability, and economic factors.

Frequent Flyer Program
The Company records a frequent flyer liability for the relative fair value of providing free travel under its frequent flyer program for all points earned from flight activity or sold to companies participating in the Company’s frequent flyer program as business partners. The frequent flyer liability is a performance obligation that is satisfied when a

19

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


member redeems points for travel or other goods and services, or upon spoilage of the points. Points earned from flight activity are valued at their relative standalone selling price by applying fair value based on historical redemption patterns. Points earned from business partner activity are valued using a relative fair value methodology based on the contractual rate which partners pay to Southwest to award Rapid Rewards points to the business partner’s customers. The terms for these agreements are no more than 10 years in length. The Company’s liability for frequent flyer benefits include a portion that are expected to be redeemed during the following twelve months (classified as a component of Air traffic liability), and a portion that are not expected to be redeemed during the following twelve months (classified as Air traffic liability - loyalty noncurrent). The Company continually updates this analysis and adjusts the split between current and non-current liabilities as appropriate.

In order to determine the value of each frequent flyer point, certain assumptions must be made at the time of measurement, which include the following:

Allocation of Passenger Revenue - Revenues from Passengers related to travel who also earn Rapid Rewards Points has been allocated between flight and Rapid Rewards Points based on each obligation’s relative standalone selling price. The Company utilizes historical earning patterns to assist in this allocation.
Fair Value of Rapid Rewards Points is determined from the base fare value of tickets which were purchased using prior point redemptions for travel and other products and services, which the Company believes to be indicative of the fair value of points as perceived by Customers and representative of the value of each point at the time of redemption. The Company’s booking site allows a Customer to toggle between fares utilizing either cash or point redemptions, which provide the Customer with an approximation of the equivalent value of their points. The value can differ however, based on demand, the amount of time prior to the flight, and other factors. The fare mix during the period measured represents a constraint, which could result in the assumptions above changing at the measurement date, as fare classes can have different coefficients used to determine the total frequent flyer points needed to purchase an award ticket. The mixture of these fare classes could cause the fair value per point to increase or decrease.

For points that are expected to expire unused, the Company recognizes spoilage in accordance with the redemption method. The Company utilizes historical behavioral data to develop a predictive statistical model to analyze the amount of spoilage expected for points sold to business partners and earned through flight. The Company continues to evaluate expected spoilage at least annually and applies appropriate adjustments in the fourth quarter of each year, which impacts revenue recognition prospectively through the redemption method. In most historical periods, the impact of changes in the estimated spoilage rate has not resulted in material changes to revenue recognition. However, due to the size of the Company’s liability for frequent flyer benefits as a result of the elimination of the incremental cost method of accounting for flight points, changes in Customer behavior and/or expected future redemption patterns could result in more significant variations in Passenger revenue under the New Revenue Standard.

ASC 606 requires the Company to allocate consideration received to performance obligations based on relative fair value of those obligations. The Company has a co-branded credit card agreement (“Agreement”) with Chase Bank USA, N.A. (“Chase”), through which the Company sells loyalty points and other items to Chase. At inception of this Agreement, the Company estimated the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the deliverables (travel points to be awarded, and marketing components, which consist of use of the Southwest Airlines’ brand and access to Rapid Rewards Member lists, advertising elements, and use of the Company’s resource team). The Company has elected the transition provision within ASC 606 to reflect the aggregate effect of historical modifications to the Agreement when (i) identifying the satisfied and unsatisfied performance obligations, (ii) determining the transaction price, and (iii) allocating the transaction price to the satisfied and unsatisfied performance obligation. The Company records Passenger revenue related to air travel when the travel is delivered. The marketing elements are recognized as Other revenue when earned following the sales-based royalty method.


20

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


As performance obligations to Customers are satisfied, the related revenue is recognized. The events that result in revenue recognition that are associated with performance obligations identified as a part of the Rapid Rewards Program are as follows:

Tickets and Rapid Rewards Points - When a flight occurs, the related performance obligation is satisfied and the related value provided by the Customer, whether from purchased tickets or Rapid Rewards Points, is recognized as revenue.
Frequent flyer points redeemed for goods and/or services other than travel - Rapid Rewards Members have the option to redeem points for goods and services offered through a third party vendor, who acts as principal. The performance obligation related to the purchase of these goods and services is satisfied when the good and/or service is delivered to the Customer.
Marketing Royalties - As part of its Agreement with Chase, Southwest provides certain deliverables, including use of the Southwest Airlines’ brand, access to Rapid Rewards Member lists, advertising elements, and the Company’s resource team. These performance obligations are satisfied each month that the Agreement is active.

The components of Air traffic liability, including contract liabilities based on tickets sold, unused funds available to the Customer, and frequent flyer points available for redemption, net of expected spoilage, as of March 31, 2018 and December 31, 2017 were as follows (in millions):

 
Balance as of
(in millions)
March 31, 2018
 
December 31, 2017
Air traffic liability - passenger travel and ancillary passenger services
$
2,631

 
$
1,898

Air traffic liability - loyalty program
2,799

 
2,667

   Total Air traffic liability
$
5,430

 
$
4,565


The balance in Air traffic liability – passenger travel and ancillary passenger services also includes unused funds that are available for use by Customers that are not currently associated with a ticket, but represent funds available for use to purchase a ticket for a flight that occurs prior to their expiration. These funds are typically created as a result of a prior ticket cancellation or exchange. These performance obligations are expected to have a duration of twelve months or less; therefore, the Company has elected the provision within ASC 606 to not disclose the amount of the remaining transaction price and its expected timing of recognition for passenger tickets. Recognition of revenue associated with the Company’s frequent flyer liability can be difficult to predict, as the number of award seats available to members is not currently restricted and they could chose to redeem their points at any time that a seat is available. The performance obligations classified as a current liability related to the Company’s frequent flyer program were estimated based on expected redemptions utilizing historical redemption patterns, and forecasted flight availability, fares, and coefficients. The entire balance classified as Air traffic liability – loyalty noncurrent relates to frequent flyer points that were estimated to be redeemed in periods beyond 12 months following the representative balance sheet date. The Company expects the majority of frequent flyer points to be redeemed within two years.

Air traffic liability includes consideration received for ticket and loyalty related performance obligations which have not been satisfied as of a given date. A rollforward of the amounts included in Air traffic liability as of March 31, 2018 and 2017 are as follows (in millions):

 
Air traffic liability
Balance at December 31, 2017
$
4,565

   Current period sales (passenger travel, ancillary services, flight loyalty, and partner loyalty)
5,403

   Revenue from amounts included in contract liability opening balances (a)
(1,827
)
   Revenue from current period sales (a)
(2,711
)
Balance at March 31, 2018
$
5,430


21

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


(a) Does not include certain ancillary revenues that are purchased on the day of travel, which do not flow through Air traffic liability.

 
Air traffic liability
Balance at December 31, 2016
$
4,221

   Current period sales (passenger travel, ancillary services, flight loyalty, and partner loyalty)
5,415

   Revenue from amounts included in contract liability opening balances (a)
(1,701
)
   Revenue from current period sales (a)
(2,796
)
Balance at March 31, 2017
$
5,139

(a) Does not include certain ancillary revenues that are purchased on the day of travel, which do not flow through Air traffic liability.

All performance obligations related to freight services sold are completed within twelve months or less; therefore, the Company has elected the provision within ASC 606 to not disclose the amount of the remaining transaction price and its expected timing of recognition for freight shipments.

Other revenues primarily consist of marketing royalties associated with the Company’s co-branded Chase® Visa credit card, but also include commissions and advertising associated with Southwest.com®. All amounts classified as Other revenues are paid monthly, coinciding with the Company fulfilling its deliverables; therefore, the Company has elected the provision within ASC 606 to not disclose the amount of the remaining transaction price and its expected timing of recognition for such services provided.

In the three months ended March 31, 2018 and 2017, the Company recognized, in Other operating revenue, $271 million and $231 million, respectively, related to the marketing, advertising, and other travel-related benefits of the revenue associated with various partner agreements including, but not limited to, the Agreement with Chase.

The Company is also required to collect certain taxes and fees from Customers on behalf of government agencies and remit these back to the applicable governmental entity on a periodic basis. These taxes and fees include foreign and U.S. federal transportation taxes, federal security charges, and airport passenger facility charges. These items are collected from Customers at the time they purchase their tickets, but are not included in Passenger revenue. The Company records a liability upon collection from the Customer and relieves the liability when payments are remitted to the applicable governmental agency.    


22

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


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 March 31,
 
2018
 
2017
NUMERATOR:
 
 
 
Net income
$
463

 
$
339

 
 
 
 
DENOMINATOR:
 

 
 

Weighted-average shares outstanding, basic
587

 
613

Dilutive effect of Employee stock options and restricted stock units
1

 
1

Adjusted weighted-average shares outstanding, diluted
588

 
614

 
 
 
 
NET INCOME PER SHARE:
 

 
 

Basic
$
0.79

 
$
0.55

Diluted
$
0.79

 
$
0.55


7.    COMMITMENTS AND CONTINGENCIES

Commitments
The Company has contractual obligations and commitments primarily with regard to future purchases of aircraft, repayment of debt, and lease arrangements. As of March 31, 2018, the Company had firm orders with Boeing in place for 236 737 MAX 8 aircraft, 30 737 MAX 7 aircraft, and 17 737-800 aircraft, as well as options for 115 737 MAX 8 aircraft. The Company's capital commitments associated with these firm orders are as follows: $866 million remaining in 2018, $900 million in 2019, $1.4 billion in 2020, $1.7 billion in 2021, $1.2 billion in 2022, and $5.1 billion thereafter.
 
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 has come 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 by mid-2018. 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.
Houston William P. Hobby Airport
In fourth quarter 2015, the Company effectively completed construction on a new international terminal at Houston William P. Hobby Airport ("HOU"). The project final cost was approximately $150 million, and the Company provided the funding for, as well as management over, the project. In first quarter 2018, the Company received a reimbursement from the City of Houston of $116 million for the investment and updates made to HOU, representing the remaining unamortized net book value of the project as of the reimbursement date. With the reimbursement received, the Company

23

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


has created a Construction obligation in the unaudited Condensed Consolidated Balance Sheet along with an inflow within the Reimbursement for Assets constructed for others in the unaudited condensed Consolidated Statement of Cash Flows. The Construction obligation will be reduced primarily through the Company's airport rental payments to the City of Houston as the construction costs of this project are passed through to the Company via recurring airport rate charges.

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 will oversee and manage the design, development, financing, construction, and commissioning of a passenger processing facility between Terminals 1 and 2 (the "Terminal 1.5 Project"). The Terminal 1.5 Project is expected to include 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 Modernization 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 March 31, 2018, the Company's outstanding remaining guaranteed obligations under the credit facilities for the Terminal 1 Modernization Project and Terminal 1.5 Project were $143 million and $46 million, respectively.
Construction on the Terminal 1 Modernization 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 the 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 March 31, 2018, $424 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

24

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


using the remaining bond funds for additional terminal construction projects, which were effectively completed in March 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.

Construction costs recorded in ACFO for the Company's various projects as of March 31, 2018, and December 31, 2017, were as follows:

 
 
March 31, 2018
 
December 31, 2017
(in millions)
 
ACFO
ACFO,
Net (a)
Construction Obligation (b)
 
ACFO
ACFO,
Net (a)
Construction Obligation (b)
FLL Terminal
(c)
$
282

$
279

$
281

 
$
258

$
256

$
258

LAX Terminal 1
(c)
450

432

447

 
433

417

433

LAX Terminal 1.5
(c)
42

42

42

 
31

31

31

LFMP Terminal
 
543

470

513

 
543

474

516

LFMP Parking Garage
(c)
164

164

164

 
152

152

152

HOU International Terminal
 
126

117

116

 
126

118


 
 
$
1,607

$
1,504

$
1,563

 
$
1,543

$
1,448

$
1,390

(a) Net of accumulated depreciation.
(b) Construction obligation will be reduced through future facility rent payments. These future payments are not fixed per the lease agreement, but are variable and fluctuate based on various market and other factors outside the control of the Company.
(c) Projects still in progress.

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 March 31, 2018, 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 time 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 currently consist solely of option contracts, whereas interest rate derivatives consist solely of swap agreements. See Note 3 for further information on the Company’s derivative

25

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


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 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.


26

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 March 31, 2018, and December 31, 2017:

 
 
 
 
Fair value measurements at reporting date using:
 
 
 
 
Quoted prices in
active markets
for identical assets
 
Significant
other observable
inputs
 
Significant
unobservable
inputs
Description
 
March 31, 2018
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,500

 
$
1,500

 
$

 
$

Commercial paper
 
285

 

 
285

 

Certificates of deposit
 
12

 

 
12

 

Time deposits
 
25

 

 
25

 

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,144

 
1,144

 

 

Certificates of deposit
 
277

 

 
277

 

Fuel derivatives:
 
 
 
 
 
 
 
 
Option contracts (b)
 
363

 

 

 
363

Other available-for-sale securities
 
122

 
122

 

 

Total assets
 
$
3,728

 
$
2,766

 
$
599

 
$
363

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Option contracts (b)
 
(23
)
 

 

 
(23
)
Interest rate derivatives (see Note 3)
 
(25
)
 

 
(25
)
 

Total liabilities
 
$
(48
)
 
$

 
$
(25
)
 
$
(23
)
(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.



27

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, 2017
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets
 
(in millions)
Cash equivalents
 
 
 
 
 
 
 
 
Cash equivalents (a)
 
$
1,133

 
$
1,133

 
$

 
$

Commercial paper
 
350

 

 
350

 

Certificates of deposit
 
12

 

 
12

 

Short-term investments:
 
 
 
 
 
 
 
 
Treasury bills
 
1,491

 
1,491

 

 

Certificates of deposit
 
287

 

 
287

 

Fuel derivatives:
 
 
 
 
 
 
 
 
Option contracts (b)
 
283

 

 

 
283

Other available-for-sale securities
 
107

 
107

 

 

Total assets
 
$
3,663

 
$
2,731

 
$
649

 
$
283

Liabilities
 
 
 
 
 
 
 
 
Fuel derivatives:
 
 
 
 
 
 
 
 
Option contracts (b)
 
(35
)
 

 

 
(35
)
Interest rate derivatives (see Note 3)
 
(22
)
 

 
(22
)
 

Total liabilities
 
$
(57
)
 
$

 
$
(22
)
 
$
(35
)
(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.

The Company had no transfers of assets or liabilities between any of the above levels during the three months ended March 31, 2018, or the year ended December 31, 2017. The Company did not have any assets or liabilities measured at fair value on a nonrecurring basis as of the three months ended March 31, 2018, or the year ended December 31, 2017. The following table presents the Company’s activity for items measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2018:

Fair value measurements using significant unobservable inputs (Level 3)
(in millions)
Fuel derivatives
 
Balance at December 31, 2017
$
248

 
Total gains (realized or unrealized) included in other comprehensive income
101

 
Purchases
18

(a)
Settlements
(27
)
 
Balance at March 31, 2018
$
340

 
(a) The purchase of fuel derivatives are recorded gross based on the structure of the derivative instrument and whether a contract with multiple derivatives is purchased as a single instrument or separate instruments.

The significant unobservable input used in the fair value measurement of the Company’s derivative option contracts is implied volatility. Holding other inputs constant, an increase (decrease) in implied volatility would result in a higher (lower) fair value measurement, respectively, for the Company’s derivative option contracts.


28

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


The following table presents a range of the unobservable inputs utilized in the fair value measurements of the Company’s fuel derivatives classified as Level 3 at March 31, 2018:

Quantitative information about Level 3 fair value measurements
 
 
Valuation technique
 
Unobservable input
 
Period (by year)
 
Range
Fuel derivatives
 
Option model
 
Implied volatility
 
Second quarter 2018
 
14-31%
 
 
 
 
 
 
Third quarter 2018
 
21-30%
 
 
 
 
 
 
Fourth quarter 2018
 
22-29%
 
 
 
 
 
 
2019
 
21-26%
 
 
 
 
 
 
2020
 
20-23%
 
 
 
 
 
 
2021
 
19-20%
 
 
 
 
 
 
2022
 
19%

The carrying amounts and estimated fair values of the Company’s long-term debt (including current maturities), as well as the applicable fair value hierarchy tier, at March 31, 2018, are presented in the table below. The fair values of the Company’s publicly held long-term debt 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 agreements as Level 2. Debt under six of the Company’s debt agreements is not publicly held. The Company has determined the estimated fair value of this debt to be Level 3, as certain inputs used to determine the fair value of these agreements are unobservable. The Company utilizes indicative pricing from counterparties and a discounted cash flow method to estimate the fair value of the Level 3 items.

(in millions)
 Carrying value
 
Estimated fair value
 
Fair value level hierarchy
French Credit Agreements due June 2018 - 2.54%
$
1

 
$
1

 
Level 3
2.75% Notes due 2019
298

 
298

 
Level 2
Term Loan Agreement payable through 2019 - 6.315%
55

 
55

 
Level 3
Term Loan Agreement payable through 2019 - 4.84%
15

 
15

 
Level 3
2.65% Notes due 2020
486

 
483

 
Level 2
Term Loan Agreement payable through 2020 - 5.223%
225

 
225

 
Level 3
737 Aircraft Notes payable through 2020
144

 
144

 
Level 3
2.75% Notes due 2022
300

 
295

 
Level 2
Pass Through Certificates due 2022 - 6.24%
273

 
293

 
Level 2
Term Loan Agreement payable through 2026 - 2.67%
215

 
215

 
Level 3
3.00% Notes due 2026
300

 
284

 
Level 2
3.45% Notes due 2027
300

 
292

 
Level 2
7.375% Debentures due 2027
126

 
151

 
Level 2


29

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


9. SUPPLEMENTAL FINANCIAL INFORMATION
(in millions)
March 31, 2018
 
December 31, 2017
Derivative contracts
$
175

 
$
136

Intangible assets, net
410

 
413

Capital lease receivable
72

 
76

Non-current prepaid maintenance
130

 
5

Other
172

 
156

Other assets
$
959

 
$
786


(in millions)
March 31, 2018
 
December 31, 2017
Accounts payable trade
$
189

 
$
186

Salaries payable
202

 
201

Taxes payable
282

 
203

Aircraft maintenance payable
51

 
38

Fuel payable
107

 
123

Other payables
412

 
569

Accounts payable
$
1,243

 
$
1,320


(in millions)
March 31, 2018
 
December 31, 2017
ProfitSharing and savings plans
$
132

 
$
579

Aircraft and other lease related obligations
39

 
40

Permanently grounded aircraft liability (a)
14

 
34

Vacation pay
372

 
365

Contract ratification bonuses
95

 
83

Health
95

 
100

Workers compensation
173

 
172

Property and income taxes
56

 
57

Other
158

 
270

Accrued liabilities
$
1,134

 
$
1,700


(in millions)
March 31, 2018
 
December 31, 2017
Postretirement obligation
$
282

 
$
275

Non-current lease-related obligations
75

 
85

Permanently grounded aircraft liability (a)
13

 
13

Other deferred compensation
241

 
237

Derivative contracts
24

 
21

Other
71

 
76

Other noncurrent liabilities
$
706

 
$
707


(a) These amounts represent the current and noncurrent portion of the Company's cease-use liability recorded as a result of the Company grounding its remaining leased Boeing 737-300 aircraft in 2017. The first quarter 2018 decrease was primarily related to contractual rent obligations paid.

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


30

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


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

10. SUBSEQUENT EVENT

On April 17, 2018, Southwest Airlines Flight 1380 ("Flight 1380") from New York-LaGuardia to Dallas Love Field suffered an uncontained failure of its port CFM56-7B engine, resulting in a Customer fatality, potential injuries to other Customers, and damage to the aircraft. While the cause of the failure is under investigation, the FAA has ordered inspections of all CFM56-7B engines in operation. On April 23, 2018, the Company announced that it was voluntarily going beyond the FAA requirement and performing ultrasonic inspections on all CFM engines in its fleet. The Company is cooperating with all federal, state, and local regulatory and investigatory agencies to determine the cause of this accident. The Company is unable to predict the full effects relating to this accident, which may include increased maintenance and replacement costs, increased litigation or regulatory costs, reduced revenues or reduced revenue growth, and harm to its brand.

31



Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations

Relevant comparative operating statistics for the three months ended March 31, 2018 and 2017 are included below. The Company provides these operating statistics because they are commonly used in the airline industry and, as such, allow readers to compare the Company’s performance against its results for the prior year period, as well as against the performance of the Company’s peers. Certain operating statistics for the three months ended March 31, 2017 have been recast as a result of the Company's January 1, 2018 adoption of Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (the "New Revenue Standard"), ASU No. 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (the "New Retirement Standard"), and ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities (the "New Hedging Standard"). See Note 2 to the unaudited Condensed Consolidated Financial Statements for further information on the changes associated with each ASU.
 
 
Three months ended March 31,
 
 
 
 
 
2018
 
2017
 
Change
Revenue passengers carried
 
31,332,137

 
29,538,790

 
6.1
 %
 
Enplaned passengers
 
37,543,100

 
35,578,350

 
5.5
 %
 
Revenue passenger miles (RPMs) (000s)(a)
 
30,439,493

 
29,340,658

 
3.7
 %
 
Available seat miles (ASMs) (000s)(b)
 
37,366,468

 
36,699,870

 
1.8
 %
 
Load factor(c)
 
81.5
%
 
79.9
%
 
1.6

pts
Average length of passenger haul (miles)
 
972

 
993

 
(2.1
)%
 
Average aircraft stage length (miles)
&#