UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

Southwest Airlines Co.

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"large accelerated filer,” “accelerated" "accelerated filer,” “smaller" "smaller reporting company,”" and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Southwest Airlines Co.

Condensed Consolidated Balance Sheet

(in millions)

See accompanying notes.

Southwest Airlines Co.

Condensed Consolidated Statement of Comprehensive Income

See accompanying notes.

Southwest Airlines Co.

Condensed Consolidated Statement of Cash Flows

See accompanying notes.

Southwest Airlines Co.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1.    BASIS OF PRESENTATION

Southwest Airlines Co. (the “Company”"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”("GAAP") for complete financial statements. The unaudited Condensed Consolidated Financial Statements for the interim periods ended June 30, 2017March 31, 2018 and 20162017 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 operatingOperating income and netNet 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, and the requirements related to hedge accounting, 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 and six months ended June 30, 2017March 31, 2018, are not necessarily indicative of the results that may be expected for future quarters or for the year ended December 31, 20172018. 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, 2016.2017.

On March 10, 2017,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

On August 28, 2017, the FASB issued ASU No. 2017-12, Targeted Improvements to Accounting Standards Update ("ASU"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.Cost (the "New Retirement Standard"). The standardNew 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 employeeEmployee 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. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted in first fiscal quarters only. TheAs required by the New Retirement Standard, the Company does not expectadopted this to have a material impact on Operating income and expects this to have no impact on Net income. The Company will adopt this guidance retrospectively as of January 1, 2018.

On February 25, 2016, the FASB issued ASU No. 2016-02, Leases.Leases (the "New Lease Standard"). The standardNew Lease Standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The guidanceNew 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

leased aircraft under operating leases.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 this ASUthe New Lease Standard to impact any of its existing debt covenants.

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

The Company anticipates utilizingis evaluating the modified retrospectiverecently affirmed proposal which provided an optional transition approach to adopt the standard, which requires applicationmethod for adoption of the newNew Lease Standard, which would allow entities to continue to apply the legacy guidance for allin ASC 840, including its disclosure requirements, in the comparative periods presented with an option to use certain practical expedients.in the year of adoption. The Company currently plans to adopt the standard as ofNew Lease Standard on January 1, 2018, pending successful implementation of a third–party lease accounting software. The Company is continuing to evaluate the new guidance both internally2019, and through its participation in an industry-working group, and planswill continue to provide additional information at aupdates to its plans in future date.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. FollowingThe 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 FASB's finalizationconsideration the Company expects to receive in exchange for satisfaction of a one year deferral of this standard, the ASU is now effectivethose performance obligations, or standalone selling price. The New Revenue Standard also requires new, expanded disclosures regarding revenue recognition. See Note 5 for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted for fiscal years, and interim periods within those years, beginning after December 15, 2016.further information. The Company has formed a project teamadopted 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 evaluatebe comparative with current period results in the accompanying unaudited Condensed Consolidated Statements of Comprehensive Income and work to implementCash Flows. The amounts in the standard, and currently believes theaccompanying unaudited Condensed Consolidated Balance Sheet as of December 31, 2017, have also been recast.

The most significant impact of this ASU on itsthe New Revenue Standard relates to the accounting will befor the elimination ofCompany’s loyalty program. The New Revenue Standard eliminated the incremental cost method for frequent flyerloyalty program accounting, which will requirewas previously allowed in prior accounting guidance. The Company is now required to account for the Company to re-value its liabilities associated with Customer flightliability for points withearned using a relative fair value approach, resulting in a significant increase in the liabilities. approach.

The Company's liabilities associated with these flight points were $62 million at June 30, 2017, and the Company currently estimates that applying a relative fair value would increase the liabilities by approximately 20 to 25 times that value, depending on various assumptions made at the time of measurement. The adoption of the new standard isNew Revenue Standard also expected to resultresulted in different income statement classification for certain types of revenues such as(primarily ancillary revenues,revenues) which are currentlywere previously classified as Other revenues. However, based onrevenues, but under the Company's full year 2016 results, the estimated impact of this ASU would not have had a material impact on OperatingNew Revenue Standard are included in Passenger revenues, and would not have impacted any of its existing debt covenants. The Company currently anticipates utilizingcertain expenses, which were previously classified as Other operating expenses, but under the full retrospective method of adoption allowed by the standard, in order to provide for comparative results in all periods presented, and plans to adopt the standard as of January 1, 2018. The Company is continuing to evaluate the new guidance both internally and through its participation in an industry working group, and plans to continue to provide relevant and material information prior to adoption. The Company is in the process of completing its analysis of information necessary to restate prior period results, however it does not believe thereNew Revenue Standard are any remaining significant implementation topics associated with the anticipated adoption of this ASU that have not yet been addressed.offset against Passenger revenues.

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”("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 three and six months ended June 30, 2017March 31, 2018, the Company had fuel derivative instruments in place for up to 6084 percent and 63 percent, respectively, of its fuel consumption. As of June 30, 2017,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 6276 percent of its remaining 20172018 estimated fuel consumption, depending on where market prices settle. The following table provides information about the Company’s volume of fuel hedging for the years 2017 through 2020 on an economic basis considering current market prices:

(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.

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:

(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.

In addition, the Company had the following amounts associated with fuel derivative instruments and hedging activities in its unaudited Condensed Consolidated Balance Sheet:

 

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

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 liability 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:

(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 5.9.

(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 5.9.

*Net of tax

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during the three months ended June 30,March 31, 2018 and 2017 and 2016 of $34 million and $48 million, respectively, and the six months ended June 30, 2017 and 2016 of $68 million and $83$34 million, respectively. These amounts are excluded from the Company’s measurement of effectivenessrecognized through changes in fair value within AOCI for relateddesignated hedges, and are includedultimately recorded as a component of Other (gains) losses, net,Fuel and oil in the unaudited Condensed Consolidated Statement of Comprehensive Income.Income during the period the contracts settle.

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”"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 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 June 30, 2017,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. For example, at June 30, 2017, the Company had chosen to provide all of its collateral in the form of cash postings, although it could have chosen to provide aircraft and/or letters of credit for a significant portion of its collateral posted.

The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of June 30, 2017,March 31, 2018, at which such postings are triggered:

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 and six months ended June 30,March 31, 20172018 and 20162017 were as follows:

5.    SUPPLEMENTAL FINANCIAL INFORMATIONREVENUE