Financial Report for Southwest Airlines

Financial Report for Southwest Airlines

Hedging the price of oil through options contracts including the purchase of call options, defining collar structures and developing swap agreements that are fixed priced in scope are all financial strategies airline companies are using to minimize cost exposure to oil (Carter, Rogers, Simkins, 54). Of American-based airlines, Southwest continues to be a leader in the domestic market in the use of these strategies (Wood, 42). Hedging can alleviate the negative effects of lower prices, less passenger traffic and higher operating expenses as well. In past years, Southwest Airlines used this strategy successfully to stay solvent and attain the distinction of being the only American-based airline to not file bankruptcy (Wood, 42).

From the 2009 Annual Report for Southwest Airlines, the following note explains the reclassification of fuel prices and excise taxes. "The company reclassified fuel prices and excise taxes for the years 2005 through 2007 from "Other operating expenses" to "Fuel and oil expense" in order to conform to the presentation for 2008 and 2009. Average fuel cost per gallon figures, as well as the percent of operating expenses, have also been recalculated based on the reclassified information." The reasons for this is the re-classification of expenses is the fact that for the first time in years, Southwest Airlines had a loss with regard to fuel hedging. By assigning this cost to the "Fuel operating expenses" category the company can now have a clearer reporting of the costs, gains or losses from fuel hedging more accurately over time. In another area of the annual report the point is made that fuel derivative contracts were reduced significantly during their latest fiscal year from $246M in 2008 to $32M in 2009. The difference was a loss on fuel derivates and hedging due to lower passenger traffic levels and lower demand for supply chain and value-added services for Southwest with the business customers it serves.

Accounting Framework

The reclassification of this expense from an aggregated category to a specific one, Fuel and oil expense, reflects a shift in how hedging will be done in the future within Southwest. Hedging was treated as a pre-emptive financial strategy within the air carrier, often managed completely off the Income Statement and included in accrued or long-term liabilities (Carter, Rogers, Simkins, 54). Given the market-to-market impact of fuel contracts being negative ($73M in 2009 per the annual report) and the ineffectiveness of fuel hedges settling in future periods of -$97M the net effect on the company's profitability will be a -$54M reduction in asset valuation. This is compared to a $92M valuation in 2008. This significant shift in the valuation of hedging contracts led to the redefinition of the expense category as well.