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Question: Southwest Airlines Co. is a major airline

Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q.
Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?

Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?

Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?

Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?
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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. /
Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?

Southwest Airlines Co. is a major airline that operates in the United States. Refer to the following information from Southwest Airlines’ 2015 3rd quarter 10-Q. 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 represent 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 time frames, 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 time frames 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. 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. For the three months ended September 30, 2015, the Company had fuel derivative instruments that settled. Although a portion of these instruments finished “out of the money” and did not result in a payment to or from the counterparty at settlement, the instruments in place could have represented an “economic” hedge for up to 43 percent of its fuel consumption if prices had increased to significantly higher levels. During third quarter 2015, the Company reduced its hedge position related to future periods. This reduction in the Company’s hedge position primarily was accomplished through entering into offsetting derivatives that will also settle in the same periods as the economic hedge derivative. Prior to third quarter 2015, the Company had paid $39 million to counterparties to purchase offsetting derivatives that also settled during third quarter 2015. These transactions are reflected in the total economic fuel hedge settlement losses of $245 million recognized in Fuel and oil expense during third quarter 2015. The Company also paid $294 million to counterparties during third quarter 2015 to purchase offsetting derivatives that will settle in fourth quarter 2015 and first half 2016. Therefore, as of September 30, 2015, the Company no longer had an “economic” hedge in place for its remaining 2015 estimated fuel consumption. However, in periods prior to third quarter, the Company did have fourth quarter 2015 hedges in place that were subsequently offset. / Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?
Required: 1. Refer to the statements of comprehensive income for the 9 months ended September 30, 2015, and September 2014, respectively. What is the main reason that 2015 net income is higher than 2014 net income? 2. Refer to Note 3. Why might an “economic” hedge not receive hedge accounting treatment? 3. Refer to Note 3. Why do you think Southwest chose to go without fuel hedges in the fourth quarter of 2015? 4. Refer to Note 4. Other comprehensive income includes after-tax losses on fuel contracts of $164 million. Does this indicate that these are the extent of the new losses occurring in 2015? 5. How would have Fuel and oil expense have changed in 2015 if Southwest had not used cash flow hedges? 6. Refer to Note 5. What does the note tell you about the timing of payments regarding derivative contracts?





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December 31, September 30, 2015 2014 ASSETS Current assets: Cash and cash equivalents Short-term investments $ 1,740 1,356 $ 1,282 1,706 Accounts and other receivables 465 365 Inventories of parts and supplies, at cost 308 342 Deferred income taxes 465 477 Prepaid expenses and other current assets 239 232 4,404 (сontinued) Total current assets 4,573 Condensed Consolidated Balance Sheet (In millions) September 30, 2015 December 31, 2014 Property and equipment, at cost: Flight equipment Ground property and equipment Deposits on flight equipment purchase contracts Assets constructed for others 19,244 18,473 3,066 2,853 692 566 823 621 23,825 8,896 22,513 8,221 Less allowance for de preciation and amortiz ation 14,929 14,292 Goodwill 970 970 Other assets 687 534 $21,159 $20,200 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: $ 1,203 1,565 $ 1,235 Accounts payable Accrued liabilities Air traffic liability Current maturities of long-term debt 2,049 3,513 2,897 287 258 Total current liabilities 7,084 Long-term debt less current maturities Deferred income taxes 2,381 3,111 5,923 2,434 3,259 Construction obligation 684 554 Other noncurrent liabilities 931 1,255 Stockholders' EQUITY: Сommon stock 808 808 1,315 1,330 Capital in excess of par value Retained earnings Accumulated other comprehensive loss Treasury stock, at cost Total stockholders' equity 8,922 7,416 (903) (3,189) (738) (2,026) 6,968 6,775 $21,159 $20,200 Condensed Consolidated Statement of Comprehensive Income (in millions, except per share amounts) Three months ended Nine months ended September 30, September 30, 2015 2014 2015 2014 OPERATING REVENUES: $13,249 Passenger Freight Special revenue adjustment Other $4,716 $4,564 45 $13,746 44 134 128 172 172 - - 386 191 791 600 Total operating revenues 5,318 4,800 14,843 13,977 OPERATING EXPENSES: Salaries, wages, and benefits 1,699 1,363 4,725 2,818 4,044 Fuel and oil 936 1,386 4,125 Maintenance materials and repairs 259 248 729 734 Aircraft rentals 60 71 179 227 Landing fees and other rentals Depreciation and amortization 303 289 887 849 258 238 751 687 (continued) Condensed Consolidated Statement of Comprehensive Income (in millions, except per share amounts) Three months ended September 30, Nine months ended September 30, 2015 2014 2015 2014 Acquisition and integration Other operating expenses Total operating expenses 6 23 32 78 572 568 1,632 11,753 1,628 12,372 4,093 4,186 OPERATING INCOME 1,225 614 3,090 1,605 OTHER EXPENSES (INCOME): Interest expense Capitalized interest 31 (9) (2) 31 92 97 (6) (2) (18) (5) (23) Interest income (5) 394 Other (gains) losses, net Total other expenses (income) 272 66 16 292 89 458 90 INCOME BEFORE INCOME TAXES 933 525 1,515 2,632 987 PROVISION FOR INCOME TAXES 349 196 569 $ 329 $ 0.48 $ 584 $ 0.89 $ 0.88 $ 345 $ 1,645 $ 2.47 $ 2.45 $ 1,480 NET INCOME $ 946 $ 1.37 NET INCOME PER SHARE, BASIC NET INCOME PER SHARE, DILUTED $ 0.48 2$ 1.36 COMPREHENSIVE INCOME $ 126 857 WEIGHTED AVERAGE SHARES OUTSTANDING 690 699 Basic 655 663 683 665 Diluted 691 673 Cash dividends declared per common share $.075 $.060 $ 210 .160 Notes to Condensed Consolidated Financial Statements 4. COMPREHENSIVE INCOME Nine months ended September 30, (in millions) 2015 2014 $ 946 $1,645 (164) NET INCOME Unrealized loss on fuel derivative instruments, (101) net of deferred taxes of ($97) and ($60) Unrealized gain on interest rate derivative instruments, net of deferred taxes of $2 and $4 Other, net of deferred taxes of ($1) and $4 Total other comprehensive loss 3 (4) $ (165) $1,480 4 $ (89) $ 857 COMPREHENSIVE INCOME Accumulated other Defined Fuel Interest benefit plan Deferred | (in millions) comprehensive income (loss) derivatives rate derivatives items Other tax Balance at December 31, 2014 $(1,177) $(45) $41 $8 $ 435 $(738) (340) Changes in fair value Reclassification to earnings Balance at September 30, 2015 (525) (10) 200 264 15 (104) 175 $ (1,438) $(40) $ 531 $(903) Nine months ended September 30, 2015 (in millions) Affected line item in the unaudited Condensed Consolidated Amounts reclassified Statement of AOCI components from AOCI Comprehensive Income Unrealized loss on fuel derivative instruments $264 Fuel and oil expense Less: Tax Expense 98 $166 Net of tax Unrealized loss on interest rate derivative instruments $ 15 Interest expense Less: Tax Expense 6. $ 9 Net of tax Total reclassifications for the period $175 Net of tax

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