CORRESP: A correspondence can be sent as a document with another submission type or can be sent as a separate submission.
Published on June 20, 2007
June
20,
2007
Via
Edgar
Division
of Corporation Finance
U.S.
Securities and Exchange Commission
CF/AD5
100
F
Street, NE
Washington,
D.C. 20549-3561
Attention: Michael
Fay, Branch Chief
RE: Southwest
Airlines Co.
Form
10-K: For the Year Ended December 31, 2006
File
Number: 001-07259
Dear
Mr.
Fay:
Form
10-K: For the Year Ended December 31, 2006
Item
7. Management’s Discussion and Analysis….page 16
Results
of Operations, page 18
1. We
note your discussion of operating expenses on a cost per available seat mile
basis and we understand its importance to the users of your financial
statements. It appears that certain of your costs may not be driven
solely by changes in available seat miles and, in such cases, supplemental
discussion and analysis of changes in absolute terms would also be
useful. For example, please quantify the increase in wages in
absolute dollars and quantify the amount related to the 2.9 percent increase
in
headcount. As another example, please quantify the increase in credit
card processing fees and quantify and discuss any other significant factors
that
led to the 16 percent increase in other operating expenses in absolute
dollars. Please revise as appropriate.
Response:
In
absolute dollars, Salaries, wages and benefits increased $270 million, of
which
$197 million was strictly wages. The $197 million increase in wages
represented a 10.1 percent increase compared to 2005, compared to the 8.8
percent increase in Available Seat Miles (ASMs). Of the $197 million
increase in wages, approximately 15 percent was related to the 2.9 percent
increase in headcount. As disclosed in our 10-K, the majority of the
increase in wages was related to an increase in wage rates.
In
absolute dollars, Other operating
expenses increased $122 million, of which $39 million related to credit card
processing fees. The $39 million increase in credit card processing
fees represented a 22.2 percent increase from 2005 compared to the Company’s
20.2 percent increase in Passenger revenues. In excess of 97 percent
of Passenger revenues are booked via customer credit cards, resulting in
a close
correlation between these two measures. The second and third largest
increases in Other operating expenses on an absolute dollar basis were in
Fuel
taxes ($18 million, or 14.0 percent, primarily due to a 15.0 percent increase
in
the unhedged cost of jet fuel per gallon and a 7.9 percent increase in gallons
consumed), and Personnel expenses ($16 million, or 11.9 percent, primarily
representing hotel and per diem costs for Pilots and Flight Attendants,
primarily due to a 6.2 percent increase in trips flown).
In
future filings, the Company will be
mindful of instances in which increases in operating expenses are due to
something other than changes in ASMs, and add disclosures as considered
appropriate.
1
Critical
Accounting Policies and Estimates, page 24
Financial
Derivative Instruments, page 26
2. Refer
to the second paragraph on page 26 under this heading. With regard to
the approximately $675 million in fuel derivative instruments that expired
in
2006, please tell us how you realized economic value upon their expiration
and
quantify the value realized. Also tell us how you accounted for these
expired derivatives.
Response:
The Company is using the term “expired” synonymously with the term “settled” in
this disclosure. In the context of the disclosure, the $675 million
in value referred to represents the actual cash proceeds the Company received
from third parties related to derivatives that expired (i.e., settled) during
2006, the majority of which ($634 million) was reflected as a reduction to
Fuel
and oil expense during 2006, when the hedged fuel impacted
earnings. The remainder of the settlement amounts, primarily
representing ineffectiveness of the hedges, would have been reflected in
earnings (Other gains or losses) in periods prior to 2006.
Any
of these financial derivative
instruments that qualified as such, would have been accounted for as cash
flow
hedges under SFAS 133 until the time that they expired or
settled. Any amounts remaining in Accumulated Other Comprehensive
Income related to these settled (i.e., expired) derivatives would have been
reclassified as a reduction to Fuel and oil expense during 2006, when the
hedged
fuel impacted earnings. For those instruments that the Company
determined did not qualify as cash flow hedges under SFAS 133, they would
have
been marked to market value each accounting period until they
expired/settled.
The
Company will clarify these
disclosures in future filings.
3. Refer
to the fourth paragraph on page 26 under this heading. Please
disclose the specific items for which estimates have differed materially
from
actual results, and how these differences affected the hedging relationships,
related accounting and your financial results. For example, relate
how such differences bear on the determination of your estimate of forward
jet
fuel prices and fair values of related fuel derivative instruments, measuring
the effectiveness of hedging instruments and determining hedges that are
discontinued and thereby not eligible for hedge accounting. Further,
relate how such differences impact the historic and prospective correlation
between your estimates of forward jet fuel prices and commodity future prices
such that commodity future prices continue to qualify as relevant hedging
relationships upon which to assess effectiveness of your fuel
derivatives. Provide us with a copy of your intended revised
disclosure.
Response:
The
specific area in which estimates have differed materially from actual results
is
primarily in the amount of dollar ineffectiveness and mark to market gains
and
losses recorded as a result of our hedging program. Based on the
Company’s historical analysis of the commodities we have used in our hedging
program, our expectation was that we would have minimal ineffectiveness from
our
hedges and all of these commodities would continue to qualify for hedge
accounting.
Our cash flow hedges of jet fuel purchases must hedge the risk of changes
in the
cash flows related to all changes in the purchase price of jet fuel reflecting
its actual geographic location in accordance with paragraph 29(h) of Statement
133. Because there are not readily available jet fuel forward
or option contracts, we, and others in our industry that utilize hedging,
must
use substitute, or “proxy” commodity derivatives that we believe at the outset
will be highly effective at hedging jet fuel price risk, and we must measure
the
ineffectiveness caused by the unavailability of a jet fuel-specific derivative
as well as any ineffectiveness due to geographic location
differences. We must also continuously assess whether these
inherent sources of ineffectiveness (commodity basis differences and geographic
basis differences) ever increase to the point that we believe an individual
hedge is no longer “highly effective.” We utilize a rigorous
and consistently applied assessment methodology based on regression analysis
(discussed further in our response to Comment 4) to distinguish between (a)
highly effective hedges that may have a greater amount of hedge ineffectiveness
to record and (b) hedges that are deemed overall to no longer be “highly
effective” and therefore should lose hedge accounting.
Just as there are not readily available jet fuel derivatives, there is not
an
observable forward market for jet fuel. Accordingly, forward
jet fuel prices must be modeled and estimated for purposes of measuring hedge
effectiveness. The fourth paragraph of page 26 of our disclosure was
attempting to describe the necessity of having to estimate forward jet fuel
prices, and the resultant consequence once the forward period has expired
and
jet fuel is actually purchased on the spot market and the spot price is
known. The Company continually looks for better and
more accurate methodologies in forecasting future cash flows relating to
its jet
fuel hedging program, which are used in the measurement of effectiveness
for the
Company’s fuel hedges, as discussed in our response to Comment 5
below. Also, as discussed in our response to Comment 4 below, on a
quarterly basis, the Company evaluates whether derivative instruments utilizing
products such as crude oil, heating oil, and unleaded gasoline meet the
qualifications for hedge accounting under SFAS 133. This evaluation
includes a retrospective and prospective effectiveness analysis using regression
techniques to determine if such products would be highly effective in offsetting
forecasted cash flow transactions for the purchase of jet fuel.
Beginning in 2005, energy markets (including jet fuel “proxies” such as crude
oil, heating oil, and unleaded gasoline, and also jet fuel itself) began
experiencing more variability, and as a result, the Company began to experience
more ineffectiveness from its hedges that were based on these jet fuel
“proxies”, and even lost hedge accounting entirely for all of the jet fuel
hedges that were based on unleaded gasoline during 2006. These
events, combined with the variability in energy markets for crude oil and
certain refined products (including jet fuel), also resulted in the significant
fluctuation in fair value of the Company’s portfolio of derivatives, which led
the Company to experience significant fluctuations in earnings related to
these
derivative instruments. As it relates to the impact this variability
has on our forward jet fuel prices, we estimate the forward jet fuel prices
utilizing a mathematical formula based on the data points from actual market
prices of similar commodities (heating oil, crude oil and unleaded
gas). To the extent unexpected changes occur in market prices, our
estimates of the forward jet fuel curve are updated to reflect such
changes. This results in the timely reflection of this variability in
our estimates of the forward jet fuel prices and hence, in our measurement
of
ineffectiveness.
The next eight paragraphs represent our proposed revised disclosure to be
included in future filings, and also include modifications in response to
other
comments received (for your convenience, additions or changes to our previous
disclosure are noted by underline):
2
The
Company utilizes financial derivative instruments primarily to manage its
risk
associated with changing jet fuel prices, and accounts for them under Statement
of Financial Accounting Standards No. 133, “Accounting for Derivative
Instruments and Hedging Activities”, as amended (SFAS 133). See
“Qualitative and Quantitative Disclosures about Market Risk” for more
information on these risk management activities and see Note 10 to the
Consolidated Financial Statements for more information on SFAS 133, the
Company’s fuel hedging program, and financial derivative
instruments.
SFAS
133
requires that all derivatives be reflected at market (fair value) and
recorded on the Consolidated Balance Sheet. At December 31, 2006, the
Company was a party to over 480 financial derivative instruments, related
to its
fuel hedging program, for year 2007 and beyond. The fair value of the
Company’s fuel hedging financial derivative instruments recorded on the
Company’s Consolidated Balance Sheet as of December 31, 2006, was $999 million,
compared to $1.7 billion at December 31, 2005. The large decrease in
fair value primarily was due to the decrease in energy prices in the second
half
of 2006, as well as the expiration (i.e., settlement) of approximately
$675 million in fuel derivative instruments that related to 2006, net of
new
derivative instruments the Company added for future years. Of the
remaining $999 million in fair value of fuel hedging financial derivative
instruments at December 31, 2006, approximately $369 million is expected
to
settle, or expire during 2007. Changes in the fair values of
these instruments can vary dramatically, as was evident during both 2005
and
2006, based on changes in the underlying commodity prices. Market
price changes can be driven by factors such as supply and demand, inventory
levels, weather events, refinery capacity, political agendas, and general
economic conditions, among other items. The financial derivative
instruments utilized by the Company primarily are a combination of collars,
purchased call options, and fixed price swap agreements. The Company
does not purchase or hold any derivative instruments for trading
purposes.
The
Company enters into financial derivative instruments with third party
institutions in “over-the-counter” markets. Since the majority of the
Company’s financial derivative instruments are not traded on a market exchange,
the Company estimates their fair values. Depending on the type of
instrument, the values are determined by the use of present value methods
or
standard option value models with assumptions about commodity prices based
on
those observed in underlying markets. Also, since there is not a
reliable forward market for jet fuel, the Company must estimate the future
prices of jet fuel in order to measure the effectiveness of the hedging
instruments in offsetting changes to those prices, as required by SFAS
133. Forward jet fuel prices are estimated through the observation of
similar commodity futures prices (such as crude oil, heating oil, and unleaded
gasoline) and adjusted based on variations of those like commodities to the
Company’s ultimate expected price to be paid for jet fuel at the specific
locations in which the Company hedges.
Fair
values for financial derivative instruments and forward jet fuel prices are
both
estimated prior to the time that the financial derivative instruments settle,
and the time that jet fuel is purchased and consumed,
respectively. However, once settlement of the financial derivative
instruments occurs and the hedged jet fuel is purchased and consumed, all
values
and prices are known and are recognized in the financial
statements. In recent years, because of increased volatility in
energy markets, the Company’s estimates of the presumed effectiveness of its
hedges made at the time the hedges were initially designated have materially
differed from actual results, resulting in increased volatility in the Company’s
periodic financial results. For example, historical data had been
utilized in qualifying unleaded gasoline for SFAS 133 hedge accounting under
the
presumption that derivatives of such commodity would result in effective
hedges,
as defined. This historical data is updated every quarterly reporting
period to ascertain whether SFAS 133 hedge accounting is allowed for every
commodity the Company uses in its hedging program. During 2006, based
on these updates, the Company in fact lost SFAS 133 hedge accounting for
all
unleaded gasoline derivative instruments, and thus has marked all such
derivatives to market value in each subsequent quarterly period since that
time,
with all changes in value reflected as a component of Other gains/losses
in the
Consolidated Statement of Income. Although commodities such as crude
oil and heating oil have continued to qualify for hedge accounting in most
cases, there have been instances in which the Company has also lost hedge
accounting in specific geographic locations for these commodities. In
these instances, the Company has also marked such derivatives to market
value. Although the Company’s prospective assessment utilized to
ensure that crude oil and heating oil in most cases still qualify for SFAS
133
hedge accounting in specific locations where the Company hedges, there are
no
assurances that these commodities will continue to qualify in the future,
as
future price changes in these refined products may not be consistent with
historical price changes. If recent volatility in these commodity
markets continues for an extended period of time or worsens in the near future,
the Company could lose hedge accounting altogether for all crude oil and
heating
oil derivatives, which would create further volatility in the Company’s
financial results.
3
Estimating
the fair value of these fuel derivative instruments and forward prices for
jet
fuel will also result in changes in their values from period to period and
thus
determine how they are accounted for under SFAS 133. To the extent
that the change in the estimated fair value of a fuel derivative instrument
differs from the change in the estimated price of the associated jet fuel
to be
purchased, both on a cumulative and a period-to-period basis, ineffectiveness
of
the fuel hedge can result, as defined by SFAS 133. This could result
in the immediate recording of noncash charges or income, representing the
change
in the fair value of the derivative, even though the derivative instrument
may
not expire/settle until a future period. Likewise, if a
derivative contract ceases to qualify for hedge accounting, the changes in
the
fair value of the derivative instrument is recorded every period to “Other gains
and losses” in the income statement in the period of the change.
Ineffectiveness
is inherent in hedging jet fuel with derivative positions based in other
crude
oil related commodities, especially given the magnitude of the current fair
market value of the Company’s fuel derivatives and the recent volatility in the
prices of refined products. Due to the volatility in markets for
crude oil and related products, the Company is unable to predict the amount
of
ineffectiveness each period, including the loss of hedge accounting, which
could
be determined on a derivative by derivative basis or in the aggregate for a
specific commodity. This may result, and has resulted, in
increased volatility in the Company’s financial statements. The
significant increase in the amount of hedge ineffectiveness and unrealized
gains
and losses on the change in value of derivative contracts settling in future
periods recorded during recent periods has been due to a number of
factors. These factors include: the significant fluctuation in energy
prices, the number of derivative positions the Company holds, significant
weather events that have affected refinery capacity and the production of
refined products, and the volatility of the different types of products the
Company uses for protection. The number of instances in which the
Company has discontinued hedge accounting for specific hedges and for specific
refined products, such as unleaded gasoline, has increased recently, primarily
due to these reasons. In these cases, the Company has determined that
the hedges will not regain effectiveness in the time period remaining until
settlement and therefore must discontinue special hedge accounting, as defined
by SFAS 133. When this happens, any changes in fair value of the
derivative instruments are marked to market through earnings in the period
of
change. As the fair value of the Company’s hedge positions can
fluctuate significantly in amount from period to period, it is more probable
that there will be continued variability recorded in the income statement
and
that the amount of hedge ineffectiveness and unrealized gains or losses recorded
in future periods will be material. This is primarily due to the fact
that small differences in the correlation of crude oil related products are
leveraged over large dollar volumes.
SFAS
133
is a complex accounting standard with stringent requirements, including the
documentation of a Company hedging strategy, statistical analysis to qualify
a
commodity for hedge accounting both on a historical and a prospective basis,
and
strict contemporaneous documentation that is required at the time each hedge
is
designated by the Company. As required by SFAS 133, the Company
assesses the effectiveness of each of its individual hedges on a quarterly
basis. The Company also examines the effectiveness of its entire
hedging program on a quarterly basis utilizing statistical
analysis. This analysis involves utilizing regression and other
statistical analyses that compare changes in the price of jet fuel to changes
in
the prices of the commodities used for hedging purposes.
The
Company continually looks for better and more accurate methodologies in
forecasting future cash flows relating to its jet fuel hedging
program. These estimates are an important component used in the
measurement of effectiveness for the Company’s fuel hedges, as required by SFAS
133. During first quarter 2006, the Company did revise its method for
forecasting these future cash flows. Prior to 2006, the Company had
estimated future cash flows using actual market forward prices of a
single like commodity and adjusting for historical differences from the
Company’s actual jet fuel purchase prices. The Company implemented
an improved model for forecasting forward jet fuel prices during 2006, due
to
the fact that different types of commodities are statistically better predictors
of forward jet fuel prices, depending on specific geographic locations in
which
the Company hedges. In accordance with SFAS 133, the Company then
adjusts for certain items, such as transportation costs, that are stated
in fuel
purchasing contracts with its vendors, in order to estimate the actual price
paid for jet fuel associated with each hedge. This improved
methodology for estimating future cash flows (i.e., jet fuel prices) was
applied
prospectively, in accordance with the Company’s interpretation of SFAS
133. The Company did not, however, change its method for either
assessing or measuring hedge ineffectiveness.As a result of this new
method for forecasting future jet fuel prices, the Company believes its
hedges are more likely to be effective over the long-term.
4
4. Refer
to the first full paragraph on page 27. In view of the volatility in
markets for crude oil and related products and your inability to predict
the
amount of ineffectiveness each period for fuel derivatives, please clarify
for
us and in your disclosure why such derivatives qualify for hedge
accounting. In other words, explain to us and in your disclosure the
basis for your expectation that the hedging relationship will continue to
be
highly effective in achieving offsetting cash flows in light of the recent
associated volatility. In particular, explain to us and in your
disclosure why use of derivatives associated with specific refined products,
such as unleaded gasoline, continue to be qualified hedging relationships
for
you (as indicated in the third paragraph on page 26 under “Financial Derivative
Instruments”) when you disclosed in this paragraph that there has been a recent
increase in the number of instances in which hedge accounting has been
discontinued in regard to unleaded gasoline hedges.
Response:
In
determining whether the financial derivative instruments the Company holds
continue to qualify for hedge accounting on a prospective basis, the Company
has
historically, and currently, utilizes regression analysis of actual historical
prices updated each quarterly reporting period. Our regression
analysis is completed on a rolling basis, such that the oldest data points
are
replaced with the most recent data points each period. Therefore, our
regression analysis reflects the increased volatility of energy markets over
the
past few years. Based on this assessment, the Company did lose hedge
accounting entirely for all unleaded gasoline derivative instruments during
2006
(the Company was attempting to convey this fact in the first full paragraph
on
page 27, but will clarify better in future filings as noted in the above
intended revised disclosure). Whether or not hedge accounting is lost
is dependent on the particular derivative product, the particular geography,
and
the particular time horizon. Each hedge is assessed separately on its own
merits under SFAS 133, and some hedges continued to achieve hedge accounting
(although, perhaps with more hedge ineffectiveness) while other hedges have
not.
We have applied our hedge assessment methodology consistently in all
occasions.
We
have also incorporated our proposed
revised disclosure for future filings for this item in our response to above
Comment #3.
5. Refer
to the third full paragraph on page 27. Please tell us and disclose
how the revised methodology in forecasting future cash flows is expected
to
result in more effective hedges, what brought about this change in methodology,
and how adjustments for certain items made in the equation (for example,
transportation costs) are relevant in assessing the effectiveness of the
hedging
relationship. Further, explain to us and disclose the accounting
treatment (and related amounts) applied to all fuel derivative instruments
affected by the revised methodology upon adoption of the revised
methodology. Paragraph 62 of FAS 133 specifies that when an improved
methodology is applied prospectively, the existing hedging relationship must
be
discontinued and the relationship designated anew using the improved
method. Also refer to paragraphs 30.b and 31 to 33 of FAS 133 for
further guidance.
Response:
Because there is not a reliable long-term forward market for jet fuel prices,
the Company continuously challenges its assumptions and looks for better
ways to
estimate these prices so
that we can more accurately estimate expected future cash flows of our hedged
transaction (the purchase of jet fuel). Our disclosure describes an
improved methodology for more accurately modeling forward jet fuel prices;
so
that there is less of an “adjustment” when these estimated forward prices are
replaced by actual jet fuel prices upon completion of the hedge. This
“adjustment” can and has resulted in hedge ineffectiveness, but can more
accurately be represented as modeling risk. Beginning in 2006, the
Company determined, through statistical analysis, that jet fuel prices are
in
fact influenced by a number of different commodities, depending on the specific
geographic location in which the hedge is designated. For example, in
one geographical location, jet fuel prices may better correlate with heating
oil
prices, but in another location, they may better correlate with crude oil
prices
or unleaded gasoline prices. As another example, we improved our
ability to model the transportation element of a forward jet fuel price by
discontinuing our estimating practice of applying average historical
differentials and instead now add transportation and other related charges
that
are specific to exact fuel contracts from which the Company is purchasing
fuel. This improvement resulted in a more subjective model that
requires more effort and more precision, but it decreases the amount of
adjustment that is present when our modeled forward jet fuel price is replaced
by an actual jet fuel price upon completion of the hedge. Holding all
other factors constant, the Company believes this improvement increases the
likelihood that we will record less hedge ineffectiveness over the long
term.
5
We did not change our method of assessing hedge effectiveness, and so concluded
paragraph 62 of SFAS 133 is not applicable to our situation. As
described above, we did improve our modeling of forward jet fuel prices which
are unobservable, so that in turn allows us to reduce the modeling risk that
may
have been present in our measurements of hedge ineffectiveness performed
in
accordance with paragraph 30. Assessing hedge effectiveness and
measuring hedge ineffectiveness are separate concepts under Statement
133. The Company continues to assess hedge effectiveness, both
prospectively and retrospectively, utilizing regression analysis, and continues
to measure hedge effectiveness retrospectively utilizing the dollar offset
method, specifically Method 2 (Hypothetical Derivative Method) under SFAS
133
Implementation Issue G7. We will clarify these concepts in future
filings.
We
have also incorporated our proposed
revised disclosure for future filings for this item in our response to above
Comment #3.
Item
8. Financial Statements and Supplementary Data, page
32
Consolidated
Balance Sheet, page 32
6. Please
disclose the amount of the allowance for doubtful accounts associated with
accounts and other receivables, and to the extent material, include “Schedule
II” in regard to such allowance pursuant to Rule 5-04(c) of Regulation
S-X.
Response:
As of December 31, 2006, the Company’s allowance for doubtful accounts
associated with accounts and other receivables was $2 million. Since
this amount is immaterial, the Company believes that the disclosure of such
amount and inclusion of “Schedule II” is not warranted. We will
consider making a disclosure of the amount in future periods in the Notes
to the
financial statements.
Notes
to Consolidated Financial Statements, page 36
Note
1. Summary of Significant Accounting Policies, page
36
Frequent
Flyer Program, page 37
7. Please
tell us and disclose whether you accrue for the incremental cost of free
travel
awards as the awards are being earned or after the awards are fully
earned. In addition, as awards are no longer restricted by “black
out” dates, tell us your consideration of deferring revenue associated with the
future benefit of the award rather than accruing the associated incremental
cost.
Response:
The Company accrues for the incremental cost of a free travel award at such
time
that it has been fully earned by the Customer. We will make this
clarification in future filings.
With
regards to the Company’s program
change in 2006 to eliminate “Black out” dates, as disclosed in Part 1, Item 1,
under “Frequent Flyer Awards”, the Company concurrently implemented seat
restrictions on all flights to limit the number of awards that can be flown
per
flight. Prior to this time, there were no seat restrictions on
flights, but the Company did enforce a limited number of “Black out”
dates. The net result of making these changes concurrently during
2006 resulted in the number of seats available for award tickets being
restricted at least as much as they were before the change, despite the
elimination of “Black out” dates. Although the Company periodically
reviews our accounting for our frequent flyer program, in this case we did
not
believe changing our accounting to a deferred revenue model was
warranted. Since there are no applicable Generally Accepted
Accounting Principles that pertain to this subject, we have followed the
guidance contained within the current draft of the revised AICPA Airline
Audit
Guide, and have determined we do not have circumstances in which a significant
number of paying passengers are displaced by award travel, and the value
of an
award is insignificant compared to the purchases necessary to earn the
award.
6
8. With
respect to the sale of frequent flyer miles, please tell us and disclose
the
portion of those funds that are deferred and recognized as passenger revenue
and
the portion that are not associated with future travel and how you determine
such portions. Please clarify for us and in your disclosure what the
portion not associated with future travel is associated with, in what period
you
earn this portion, what specifically you do to earn it, and when the earnings
process is complete. Please also explain to us your basis under GAAP for
not
associating the full amount of sold miles with future
travel.
Response:
The Company has a marketing agreement that, in addition to providing a travel
component associated with the frequent flyer credits, provides other benefits
that are not related to travel. These non-travel items include access
to our frequent flyer program population for marketing/solicitation purposes,
use of the Company’s logo on co-branded credit cards, and other trademarks,
designs, images, etc. of Southwest for use in marketing materials (herein
referred to as the “marketing component”). Since the Company has been
unable to objectively determine a value for the marketing component, we have
utilized the residual value method as described in EITF 00-21, to determine
the
fair value of the undelivered element (i.e., the travel component) and associate
the remainder of the revenue with the marketing component.
As
of December 31, 2006, the portion of
the proceeds received from the sale of frequent flyer credits in this marketing
agreement related to travel was approximately 80 percent of the proceeds
received from the sale of the credit. This was determined by analysis
of fares in markets where award tickets have been flown, and is updated each
reporting period. This is the portion that is deferred and recognized
in Passenger revenue at the time the associated travel takes
place. The remaining 20 percent is recognized in Other revenue on a
monthly basis, as marketing services are provided (i.e., the earnings process
is
complete).
We
will make these clarifications in
future filings.
Financial
Derivative Instruments, page 38
9. Please
revise to disclose the income statement classification of the various results
of
your hedging activities (for example, effectiveness classified as an offset
to
fuel and oil expense, ineffectiveness classified as other expense (income),
etc.).
Response:
We
will revise Note 1 in future filings to add the following paragraph under
“Financial Derivative Instruments”:
For
the effective portion of settled
hedges, as defined in SFAS 133, the Company records the associated gains
or
losses as a component of Fuel and oil expense in the Consolidated Statement
of
Income. Dollar amounts representing ineffectiveness, as defined, or
any changes in fair value of derivative instruments for which hedge accounting
is not applied, the Company records associated gains or losses as a component
of
Other (gains) losses, net, in the Consolidated Statement of
Income. Amounts that are paid or received associated with the
purchase or sale of financial derivative instruments (i.e., premium costs
of
option contracts) are classified as a component of Other (gains) losses,
net, in
the Consolidated Statement of Income in the period in which the instrument
settles or expires. See Note 10
for further information on SFAS 133 and financial derivative
instruments.
Note
10. Derivative and Financial Instruments, page
44
Fuel
Contracts, page 44
10. Please
tell us and disclose how you classify the cash flows associated with purchasing
and selling derivative positions.
Response:
Although not all fuel derivatives purchased and sold qualify for special
hedge
accounting under SFAS 133, the Company believes they are all considered good
“economic” hedges and does not buy and sell derivatives for trading
purposes. As such, all cash flows associated with purchasing and
selling derivatives (selling a derivative is extremely rare) are classified
as
operating cash flows either as a component of changes in Other current assets
or
Other, net, depending on whether the derivative will settle within twelve
months
or beyond twelve months. We will specifically state this fact in
future filings.
7
11. Please
clarify for us and in your disclosure the accounting applied to amounts in
accumulated other comprehensive income in regard to hedges for which hedge
accounting has been discontinued. Refer to paragraphs 32 and 33 of
FAS 133.
Response:
For any dollar amounts that exist within Accumulated other comprehensive
income
at the time a hedge is discontinued, the Company continues to classify such
amounts within Accumulated other comprehensive income until the time that
the
original forecasted cash flow transaction occurs, in accordance with paragraphs
32 and 33 of SFAS 133. We will make this clarification in future
filings.
12. Pursuant
to paragraph 45.b(4) of FAS 133, please tell us and disclose the amount of
gains
and losses reclassified into earnings as a result of the discontinuance of
cash
flow hedges because it is probable that the original forecasted transactions
will not occur by the end of the originally specified time period or within
the
additional time period discussed in paragraph 33 of FAS
133.
Response:
Since the Company originally adopted SFAS 133 in 2001, we have not had a
situation in which it became probable that an originally forecasted transaction
would not occur, resulting in the immediate reclassification of amounts held
in
Accumulated other comprehensive income into earnings. In future
filings we will specify whether such situations have occurred and make
appropriate disclosures.
13. Please
consider including a table in this footnote to more clearly present the
components of fuel and oil expense (for example, fuel and oil expense, net
gains/losses from effective hedges, etc.) and of the derivative-related
components of other expense (income) (for example, net gains/losses from
ineffective derivatives, premiums for contracts, etc.). We believe
inclusion of such a table would greatly improve the clarity of the impact
of
such items on your financial statements.
Response:
We
agree with the staff’s recommendation and will include a table in future filings
in order to better present the information that is now presented in a text
format.
****
In
connection with our above responses to the Staff’s comments, the Company
acknowledges that:
|
·
|
The
Company is responsible for the adequacy and accuracy of the disclosures
in
the filings;
|
|
·
|
Staff
comments or changes to disclosure in response to Staff comments
do not
foreclose the Commission from taking any action with respect to
the
filings; and
|
|
·
|
The
Company may not assert Staff comments as a defense in any proceeding
initiated by the Commission or any person under the federal securities
laws of the United States.
|
Thank
you
for your assistance. If you have any questions, please do not
hesitate to contact me at (214) 792-4459.
|
|
Sincerely, |
|
/s/
Laura Wright
|
|
|
Laura
Wright
|
|
|
Chief
Financial Officer
|
8
Copy
to:
Doug Jones (Division of Corporation Finance)
William
H. Cunningham, Ph.D. (Chairman,
Audit Committee)
Gary
C. Kelly
Tammy
Romo
Deborah
Ackerman
James
Bradow (Ernst & Young
LLP)
9