Exercise B6-1: Derivatives, Hedge Accounting and Financial Statements
Southwest Airlines gained a lot of notoriety in the mid-2000s because was the only major air carrier to turn a profit. Southwest was quick to attribute this success to its efficient operations, bare-bones pricing and well-organized service structure. Another widely publicized aspect of Southwest’s performance was its use of derivatives to hedge market risk in an important operating input: jet fuel. In this exercise, we will explore the effect of these derivatives on Southwest Airlines’ financial position and reported performance for the years ended December 31, 2018.
To complete this exercise, please download from the Canvas class page the supplemental handout “SWA - 2018 - financial statements and notes for B06.pdf.”
Required:
1. What is the measurement attribute used to record SWA’s fuel derivatives in its balance sheet? What commodities does SWA use to hedge fuel and oil expense? Identify the asset accounts in which the derivatives are recorded and the amounts recorded for derivatives in each of those accounts.
2. For the two years ended December 31, 2018, calculate the common-size proportion of fuel and oil expenses (i.e., fuel and oil expenses divided by “total operating revenues”). For each of these years, calculate the amount of fuel and oil expense that omits the effect of Southwest’s jet-fuel hedging. Using these unhedged amounts, recalculate the common-size proportion of fuel and oil expenses during the two years ended December 31, 2018. Evaluate Southwest’s fuel and oil hedging strategy.
3. During 2018, what percentage of fuel consumption was hedged? At December 31, 2018, what proportion of 2019 fuel consumption does SWA have fuel derivatives in place? Assuming constant fuel requirements across 2019-2022, what percentage of each year’s fuel requirements are hedged at December 31, 2018? What total dollar amount of future fuel and oil expense increase or decrease do we expect at December 31, 2018?
4. Assess the effect of derivatives transactions on SWA’s “Net cash provided by operating activities” for the three years ended December 31, 2018.