Item 8. Financial Statements and Supplementary Data

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Item 8. Financial Statements and Supplementary Data

Southwest Airlines Co.

Consolidated Balance Sheet

(in millions, except share data)

December 31, 2016December 31, 2015
ASSETS
Current assets:
Cash and cash equivalents$1,680$1,583
Short-term investments1,6251,468
Accounts and other receivables546474
Inventories of parts and supplies, at cost337311
Prepaid expenses and other current assets310188
Total current assets4,4984,024
Property and equipment, at cost:
Flight equipment20,27519,462
Ground property and equipment3,7793,219
Deposits on flight equipment purchase contracts1,1901,089
Assets constructed for others1,220915
26,46424,685
Less allowance for depreciation and amortization9,4209,084
17,04415,601
Goodwill970970
Other assets774717
$23,286$21,312
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable$1,178$1,188
Accrued liabilities1,9852,591
Air traffic liability3,1152,990
Current maturities of long-term debt566637
Total current liabilities6,8447,406
Long-term debt less current maturities2,8212,541
Deferred income taxes3,3742,490
Construction obligation1,078757
Other noncurrent liabilities728760
Stockholders' equity:
Common stock, $1.00 par value: 2,000,000,000 shares authorized; 807,611,634 shares issued in 2016 and 2015808808
Capital in excess of par value1,4101,374
Retained earnings11,4189,409
Accumulated other comprehensive loss(323)(1,051)
Treasury stock, at cost: 192,450,855 and 160,010,017 shares in 2016 and 2015 respectively(4,872)(3,182)
Total stockholders' equity8,4417,358
$23,286$21,312

See accompanying notes.

Southwest Airlines Co.

Consolidated Statement of Income

(in millions, except per share amounts)

Year ended December 31,
201620152014
OPERATING REVENUES:
Passenger$18,594$18,299$17,658
Freight171179175
Special revenue adjustment—172—
Other1,6601,170772
Total operating revenues20,42519,82018,605
OPERATING EXPENSES:
Salaries, wages, and benefits6,7986,3835,434
Fuel and oil3,6473,6165,293
Maintenance materials and repairs1,0451,005978
Aircraft rentals229238295
Landing fees and other rentals1,2111,1661,111
Depreciation and amortization1,2211,015938
Acquisition and integration—39126
Other operating expenses2,5142,2422,205
Total operating expenses16,66515,70416,380
OPERATING INCOME3,7604,1162,225
OTHER EXPENSES (INCOME):
Interest expense122121130
Capitalized interest(47)(31)(23)
Interest income(24)(9)(7)
Other (gains) losses, net162556309
Total other expenses (income)213637409
INCOME BEFORE INCOME TAXES3,5473,4791,816
PROVISION FOR INCOME TAXES1,3031,298680
NET INCOME$2,244$2,181$1,136
NET INCOME PER SHARE, BASIC$3.58$3.30$1.65
NET INCOME PER SHARE, DILUTED$3.55$3.27$1.64
Cash dividends declared per common share$.3750$.2850$.2200

See accompanying notes.

Southwest Airlines Co.

Consolidated Statement of Comprehensive Income

(in millions)

Year ended December 31,
201620152014
NET INCOME$2,244$2,181$1,136
Unrealized gain (loss) on fuel derivative instruments, net of deferred taxes of $432, ($181), and ($430)735(308)(727)
Unrealized gain on interest rate derivative instruments, net of deferred taxes of $5, $6, and $5798
Unrealized loss on defined benefit plan items, net of deferred taxes of ($13), ($7), and ($8)(23)(12)(16)
Other, net of deferred taxes of $5, $-, and $-9(2)—
OTHER COMPREHENSIVE INCOME (LOSS)$728$(313)$(735)
COMPREHENSIVE INCOME$2,972$1,868$401

See accompanying notes.

Southwest Airlines Co.

Consolidated Statement of Stockholders' Equity

(in millions, except per share amounts)

Year ended December 31, 2016, 2015, and 2014
Common StockCapital in excess of par valueRetained earningsAccumulated other comprehensive income (loss)Treasury stockTotal
Balance at December 31, 2013$808$1,231$6,431$(3)(1,131)$7,336
Repurchase of common stock————(955)(955)
Issuance of common and treasury stock pursuant to Employee stock plans—40——60100
Net tax benefit (expense) of options exercised—23———23
Share-based compensation—21———21
Cash dividends, $.2200 per share——(151)——(151)
Comprehensive income——1,136(735)—401
Balance at December 31, 2014$808$1,315$7,416$(738)$(2,026)$6,775
Repurchase of common stock————(1,180)(1,180)
Issuance of common and treasury stock pursuant to Employee stock plans—6——2430
Net tax benefit (expense) of options exercised—24———24
Share-based compensation—29———29
Cash dividends, $.2850 per share——(188)——(188)
Comprehensive income——2,181(313)—1,868
Balance at December 31, 2015$808$1,374$9,409$(1,051)$(3,182)$7,358
Repurchase of common stock————(1,750)(1,750)
Issuance of common and treasury stock pursuant to Employee stock plans—8——1220
Conversion of 5.25% senior notes to common stock—(5)——4843
Share-based compensation—33———33
Cash dividends, $.3750 per share——(235)——(235)
Comprehensive income——2,244728—2,972
Balance at December 31, 2016$808$1,410$11,418$(323)$(4,872)$8,441

See accompanying notes.

Southwest Airlines Co.

Consolidated Statement of Cash Flows

(in millions)

Year ended December 31,
201620152014
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income$2,244$2,181$1,136
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization1,2211,015938
Loss on asset impairment21——
Unrealized/realized (gain) loss on fuel derivative instruments(200)113279
Deferred income taxes455(109)501
Changes in certain assets and liabilities:
Accounts and other receivables(50)(88)54
Other assets(119)103142
Accounts payable and accrued liabilities22696136
Air traffic liability12594326
Cash collateral received from (provided to) derivative counterparties535(570)(233)
Other, net(165)(462)(277)
Net cash provided by operating activities4,2933,2382,902
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures(2,038)(2,041)(1,748)
Assets constructed for others(109)(102)(80)
Purchases of short-term investments(2,388)(1,986)(3,080)
Proceeds from sales of short-term and other investments2,2632,2233,185
Other, net—(7)(4)
Net cash used in investing activities(2,272)(1,913)(1,727)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt515500300
Proceeds from Employee stock plans2946110
Reimbursement for assets constructed for others1072427
Proceeds from termination of interest rate derivative instrument—12—
Payments of long-term debt and capital lease obligations(523)(213)(561)
Payments of convertible debt(68)——
Payments of cash dividends(222)(180)(139)
Repayment of construction obligation(9)(10)(11)
Repurchase of common stock(1,750)(1,180)(955)
Other, net(3)(23)(19)
Net cash used in financing activities(1,924)(1,024)(1,248)
NET CHANGE IN CASH AND CASH EQUIVALENTS97301(73)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD1,5831,2821,355
CASH AND CASH EQUIVALENTS AT END OF PERIOD$1,680$1,583$1,282
CASH PAYMENTS FOR:
Interest, net of amount capitalized$100$105$128
Income taxes$902$1,440$155
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS:
Flight equipment acquired through the assumption of debt$20$—$—
Flight equipment under capital leases$307$193$153
Assets constructed for others$196$192$88

See accompanying notes.

Southwest Airlines Co.

Notes to Consolidated Financial Statements

  1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Southwest Airlines Co. (the “Company”) operates Southwest Airlines, a major domestic airline. The Consolidated Financial Statements include the accounts of the Company and its wholly owned subsidiaries, which include AirTran Holdings, LLC. The Company owns all of the outstanding equity of AirTran Holdings, Inc. (“AirTran Holdings”), the former parent company of AirTran Airways, Inc. (“AirTran Airways”). Throughout these Notes, the Company makes reference to AirTran, which is meant to be inclusive of AirTran Holdings, LLC, the successor to AirTran Holdings, and its subsidiaries, including among others, AirTran Airways. AirTran's final passenger service was on December 28, 2014. All integration costs were incurred in periods prior to 2016. The accompanying Consolidated Financial Statements include the results of operations and cash flows for all periods presented and all significant inter-entity balances and transactions have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.

Cash and Cash Equivalents

Cash in excess of that necessary for operating requirements is invested in short-term, highly liquid, income-producing investments. Investments with original maturities of three months or less when purchased are classified as cash and cash equivalents, which primarily consist of certificates of deposit, money market funds, and investment grade commercial paper issued by major corporations and financial institutions. Cash and cash equivalents are stated at cost, which approximates fair value.

As of December 31, 2016, $301 million in net cash collateral deposits were provided by the Company to its fuel hedge counterparties and no cash collateral deposits were held by or provided by the Company to its interest rate hedge counterparties. As of December 31, 2015, $835 million in cash collateral deposits were provided by the Company to its fuel hedge counterparties and no cash collateral deposits were held by or provided by the Company to its interest rate hedge counterparties. Cash collateral amounts provided or held associated with fuel and interest rate derivative instruments are not restricted in any way and earn interest income at an agreed upon rate that approximates the rates earned on short-term securities issued by the U.S. Government. Depending on the fair value of the Company’s fuel and interest rate derivative instruments, the amounts of collateral deposits held or provided at any point in time can fluctuate significantly. See Note 10 for further information on these collateral deposits and fuel derivative instruments.

Short-term and Noncurrent Investments

Short-term investments consist of investments with original maturities of greater than three months but less than twelve months when purchased. These are primarily short-term securities issued by the U.S. Government and certificates of deposit issued by domestic banks. All of these investments are classified as available-for-sale securities and are stated at fair value, which approximates cost. For all short-term investments, at each reset period or upon reinvestment, the Company accounts for the transaction as Proceeds from sales of short-term investments for the security relinquished, and Purchases of short-investments for the security purchased, in the accompanying Consolidated Statement of Cash Flows. Unrealized gains and losses, net of tax, if any, are recognized in Accumulated other comprehensive income (loss) (“AOCI”) in the accompanying Consolidated Balance Sheet. Realized net gains and losses on specific investments, if any, are reflected in Interest income in the accompanying Consolidated Statement of Income. Both unrealized and realized gains and/or losses associated with investments were immaterial for all years presented.

Noncurrent investments consist of investments with maturities of greater than twelve months. Noncurrent investments are included as a component of Other assets in the Consolidated Balance Sheet.

Accounts and Other Receivables

Accounts and other receivables are carried at cost. They primarily consist of amounts due from credit card companies associated with sales of tickets for future travel, and amounts due from business partners in the Company’s frequent flyer program. The allowance for doubtful accounts was immaterial at December 31, 2016 and 2015. In addition, the provision for doubtful accounts and write-offs for 2016, 2015, and 2014 were each immaterial.

Inventories

Inventories primarily consist of aircraft fuel, flight equipment expendable parts, materials, and supplies. All of these items are carried at average cost, less an allowance for obsolescence. These items are generally charged to expense when issued for use. The reserve for obsolescence was $57 million and $47 million at December 31, 2016, and 2015, respectively. In addition, the Company’s provision for obsolescence and write-offs for 2016, 2015, and 2014 were each immaterial.

Property and Equipment

Property and equipment is stated at cost. Capital expenditures includes payments made for aircraft, other flight equipment, purchase deposits related to future aircraft deliveries, and ground and other property and equipment. Depreciation is provided by the straight-line method to estimated residual values over periods generally ranging from 23 to 25 years for flight equipment, 5 to 30 years for ground property and equipment, and 25 to 30 years, or the expected term of the Company's lease if shorter, for Assets constructed for others, once the asset is placed in service. Residual values estimated for aircraft generally range from 2 to 20 percent, for ground property and equipment generally range from 0 to 10 percent, and for Assets constructed for others range from 17 to 25 percent. Property under capital leases and related obligations are initially recorded at an amount equal to the present value of future minimum lease payments computed on the basis of the Company’s incremental borrowing rate or, when known, the interest rate implicit in the lease. Amortization of property under capital leases is on a straight-line basis over the lease term and is included in Depreciation and amortization expense. Leasehold improvements generally are amortized on a straight-line basis over the shorter of the estimated useful life of the improvement or the remaining term of the lease. Assets constructed for others primarily consists of airport improvement projects, once placed into service, in which the Company is considered the accounting owner of the facilities. See Note 4 for further information.

During first quarter 2016, the Company made the decision to further simplify its operations and accelerate the retirement of its less-efficient Classic fleet to no later than third quarter 2017, versus the original scheduled retirement of this fleet that had extended out to 2021. This change in retirement dates is considered a change in estimate and has been accounted for on a prospective basis as of the dates the decisions were finalized. Therefore, the Company has recorded and will record accelerated depreciation expense over the remainder of the useful lives for each Classic aircraft and related parts. See Note 7 for further information regarding the Company's aircraft fleet.

The impacts on expense and earnings from this change in assumption for the year ended December 31, 2016 are as follows:

(in millions, except per share amounts)Year ended December 31, 2016
Depreciation and amortization expense$123
Net income *$(66)
Net income per basic share$(0.11)
Net income per diluted share$(0.10)
  • net of profitsharing benefit

The estimated impact to Depreciation and amortization expense from this change in assumption for 2017 is an approximate increase of $21 million.

The Company evaluates its long-lived assets used in operations for impairment when events and circumstances indicate that the undiscounted cash flows to be generated by that asset are less than the carrying amounts of the asset and may not be recoverable. Factors that would indicate potential impairment include, but are not limited to, significant decreases in the market value of the long-lived asset(s), a significant change in the long-lived asset’s physical condition, and operating or cash flow losses associated with the use of the long-lived asset. If an asset is deemed to be impaired, an impairment loss is recorded for the excess of the asset book value in relation to its estimated fair value.

Aircraft and Engine Maintenance

The cost of scheduled inspections and repairs and routine maintenance costs for all aircraft and engines are charged to Maintenance materials and repairs expense as incurred. The Company also has “power-by-the-hour” agreements related to certain of its aircraft engines with external service providers. Under these agreements, which the Company has determined effectively transfer the risk and create an obligation associated with the maintenance on such engines to the counterparty, expense is recorded commensurate with each hour flown on an engine. In situations where the payments to the counterparty do not sufficiently match the level of services received during the period, expense is recorded on a straight-line basis over the term of the agreement based on the Company's best estimate of expected future aircraft utilization. For its engine maintenance contracts that do not transfer risk to the service provider, the Company records expense on a time and materials basis when an engine repair event takes place. Modifications that significantly enhance the operating performance or extend the useful lives of aircraft or engines are capitalized and amortized over the remaining life of the asset.

Goodwill and Intangible Assets

The Company applies a fair value based impairment test to the carrying value of goodwill and indefinite-lived intangible assets annually on October 1st, or more frequently if certain events or circumstances indicate that an impairment loss may have been incurred. The Company assesses the value of goodwill and indefinite-lived assets under either a qualitative or quantitative approach. Under a qualitative approach, the Company considers various market factors, including applicable key assumptions listed below. These factors are analyzed to determine if events and circumstances could reasonably have affected the fair value of goodwill and indefinite-lived intangible assets. If the Company determines that it is more likely than not that an indefinite-lived intangible asset is impaired, the quantitative approach is used to assess the asset’s implied fair value and the amount of the impairment. Under a quantitative approach, the implied fair value of the Company's identifiable assets and liabilities is calculated based on key assumptions. If the Company assets' carrying value exceeds the fair value calculated using the quantitative approach, an impairment charge is recorded for the difference in fair value and carrying value.

The following table is a summary of the Company’s intangible assets, which are included as a component of Other assets in the Company's Consolidated Balance Sheet, as of December 31, 2016 and 2015:

Year ended December 31, 2016Year ended December 31, 2015
(in millions)Weighted-average useful life (in years)Gross carrying amountAccumulated amortizationGross carrying amountAccumulated Amortization
Customer relationships/marketing agreements9$38$32$38$30
Trademarks/trade names636363634
Owned domestic slots (a)Indefinite295—303n/a
Leased domestic slots (a)———173
Gate leasehold rights (b)151805518043
Total13$549$123$574$110

(a) The Company recorded a $21 million impairment associated with owned and leased slots at Newark Liberty International Airport as a result of the FAA announcement, in April 2016, that this airport was being changed to a Level 2 schedule-facilitated airport from its previous designation as Level 3.

(b) Intangible assets primarily consist of acquired leasehold rights to certain airport owned gates, takeoff and landing slots (a “slot” is the right of an air carrier, pursuant to regulations of the FAA, to operate a takeoff or landing at a specific time at certain airports) at certain domestic slot-controlled airports, and certain intangible assets acquired.

The aggregate amortization expense for 2016, 2015, and 2014 was $17 million, $19 million, and $13 million, respectively. Estimated aggregate amortization expense for the five succeeding years and thereafter is as follows: 2017 – $13 million, 2018 – $13 million, 2019 – $13 million, 2020 – $12 million, 2021 – $12 million, and thereafter – $68 million.

Revenue Recognition

Tickets sold are initially deferred as Air traffic liability. Passenger revenue is recognized when transportation is provided. Air traffic liability primarily represents tickets sold for future travel dates and funds that are past flight date and remain unused. The majority of the Company’s tickets sold are nonrefundable. Refundable tickets that are sold but not flown on the travel date can be reused for another flight, up to a year from the date of sale, or refunded. A small percentage of tickets (or partial tickets) expire unused. The Company estimates the amount of tickets that expire unused and recognizes such amounts in Passenger revenue using the redemption method based on the scheduled flight date. Southwest has a No Show policy that applies to certain nonrefundable fares that are not canceled or changed by a Customer at least ten minutes prior to a flight's scheduled departure. Based on the Company's revenue recognition policy, revenue is recorded at the flight date for a Customer who does not change his/her itinerary and loses his/her funds. Amounts collected from passengers for ancillary service fees are generally recognized as Other revenue when the service is provided, which is typically the flight date.

The Company's policy is to record revenue for the estimated spoilage of tickets (including partial tickets) once the flight date has passed, under the redemption method. Initial spoilage estimates are routinely adjusted and ultimately finalized once the tickets expire, which is typically twelve months after the original purchase date. Spoilage estimates are based on the Customers' historical travel behavior as well as assumptions about the Customers' future travel behavior. Assumptions used to generate spoilage estimates can be impacted by several factors including, but not limited to: fare increases, fare sales, changes to the Company's ticketing policies, changes to the Company’s refund, exchange and unused funds policies, and economic factors.

The Company is also required to collect certain taxes and fees from Customers on behalf of government agencies and remit these back to the applicable governmental entity on a periodic basis. These taxes and fees include foreign and U.S. federal transportation taxes, federal security charges, and airport passenger facility charges. These items are collected from Customers at the time they purchase their tickets, but are not included in Passenger revenue. The Company records a liability upon collection from the Customer and relieves the liability when payments are remitted to the applicable governmental agency.

Frequent Flyer Program

The Company records a liability for the estimated incremental cost of providing free travel under its frequent flyer program for all amounts earned from flight activity that are expected to be redeemed for future travel. The estimated incremental cost includes direct passenger costs such as fuel, food, and other operational costs, but does not include any contribution to fixed overhead costs or profit.

Southwest also sells frequent flyer points and related services to companies participating in its frequent flyer program. Historically, until July 1, 2015, funds received from the sale of points associated with these agreements were accounted for under the residual method. Under this method, the Company estimated the portion of the amounts received from the sale of frequent flyer points that related to free travel and these amounts were deferred and recognized as Passenger revenue when the ultimate free travel awards were flown. Effective July 1, 2015, the Company entered into an amended co-branded credit card agreement ("Agreement") with Chase Bank USA, N.A. (“Chase”), through which the Company sells loyalty points and other items to Chase. This material modification triggered an accounting change under ASU 2009-13, which was recorded on a prospective basis. The impact of the accounting change is that the Company estimated the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the deliverables (travel points to be awarded; use of the Southwest Airlines’ brand and access to Rapid Reward Member lists; advertising elements; and the Company’s resource team). The Company records passenger revenue related to air transportation and certificates for discounted companion travel when the transportation is delivered. The other elements are recognized as Other - net revenue when earned.

The Company followed the transition approach of ASU 2009-13, which required that the Company adjust the existing deferred revenue balance, classified within Air traffic liability, to reflect the value, on a relative selling price basis, of any undelivered element remaining at the date of contract modification. The relative selling price of the undelivered element (air transportation) was lower than the rate at which it had been deferred under the residual method, and the Company recorded a one-time, non-cash adjustment to decrease frequent flyer deferred revenue and increase revenue through the recording of a Special revenue adjustment of $172 million in 2015. The estimated impacts on revenue and earnings associated with the Agreement and this change in accounting principle recognized subsequent to the effective date of July 1, 2015, are as follows:

(in millions, except per share amounts)Year ended December 31, 2016Year ended December 31, 2015
Passenger revenue$(250)$(89)
Special revenue adjustment—172
Other revenue794344
Operating revenues$544$427
Net income$293$227
Net income per basic share$0.47$0.34
Net income per diluted share$0.46$0.34

For all points sold to business partners that are expected to expire unused, the Company recognizes spoilage in accordance with the redemption method. The Company’s consolidated liability associated with the sale of frequent flyer points, was approximately $1.4 billion and $1.3 billion as of December 31, 2016, and 2015, respectively, which is classified within Air traffic liability. During fourth quarter 2014, the Company obtained sufficient historical behavioral data to develop a predictive statistical model to analyze the amount of spoilage expected for points sold to business partners, which indicated an increase in the expected spoilage rate. This change in estimate was recorded on a prospective basis, as of October 1, 2014. The impacts on revenue and earnings were as follows:

(in millions, except per share amounts)Year ended December 31, 2015Year ended December 31, 2014
Passenger revenue$115$55
Net income$61$29
Net income per basic share$0.09$0.04
Net income per diluted share$0.09$0.04

The Company continues to evaluate annually in October, but these analyses have not resulted in a material adjustment.

Advertising

Advertising costs are charged to expense as incurred. Advertising and promotions expense for the years ended December 31, 2016, 2015, and 2014 was $232 million, $218 million, and $207 million, respectively, and is included as a component of Other operating expense in the accompanying Consolidated Statement of Income.

Share-based Employee Compensation

The Company has share-based compensation plans covering certain Employees, including a plan that also covers the Company’s Board of Directors. The Company accounts for share-based compensation based on its grant date fair value. See Note 9 for further information.

Financial Derivative Instruments

The Company accounts for financial derivative instruments at fair value and applies hedge accounting rules where appropriate. The Company utilizes various derivative instruments, including jet fuel, crude oil, unleaded gasoline, and heating oil-based derivatives, to attempt to reduce the risk of its exposure to jet fuel price increases. These instruments consist primarily of purchased call options, collar structures, call spreads, put spreads, and fixed price swap agreements, and upon proper qualification are accounted for as cash-flow hedges. The Company also has interest rate swap agreements to convert a portion of its fixed-rate debt to floating rates and has swap agreements that convert certain floating-rate debt to a fixed-rate. These interest rate hedges are appropriately designated as either fair value hedges or as cash flow hedges.

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 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. Forward jet fuel prices are estimated through utilization of a statistical-based regression equation with data from market forward prices of like commodities. This equation is then adjusted for certain items, such as transportation costs, that are stated in the Company’s fuel purchasing contracts with its vendors.

For the effective portion of settled fuel hedges, the Company records the associated gains or losses as a component of Fuel and oil expense in the Consolidated Statement of Income. For amounts representing ineffectiveness, as defined, or changes in fair value of derivative instruments for which hedge accounting is not applied, the Company records any gains or losses as a component of Other (gains) losses, net, in the Consolidated Statement of Income. Amounts that are paid or received in connection 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. All cash flows associated with purchasing and selling derivatives are classified as operating cash flows in the Consolidated Statement of Cash Flows, within Changes in certain assets and liabilities. See Note 10 for further information on hedge accounting and financial derivative instruments.

The Company classifies its cash collateral provided to or held from counterparties in a “net” presentation on the Consolidated Balance Sheet against the fair value of the derivative positions with those counterparties. See Note 10 for further information.

Software Capitalization

The Company capitalizes certain internal and external costs related to the acquisition and development of internal use software during the application development stages of projects. The Company amortizes these costs using the straight-line method over the estimated useful life of the software, which is typically five to fifteen years. Costs incurred during the preliminary project or the post-implementation/operation stages of the project are expensed as incurred. Capitalized computer software, included as a component of Ground property and equipment in the accompanying Consolidated Balance Sheet, net of accumulated depreciation, was $544 million and $378 million at December 31, 2016, and 2015, respectively. Computer software depreciation expense was $111 million, $106 million, and $122 million for the years ended December 31, 2016, 2015, and 2014, respectively, and is included as a component of Depreciation and amortization expense in the accompanying Consolidated Statement of Income. The Company evaluates internal use software for impairment on a quarterly basis; if it is determined the value of an asset was not recoverable or it qualifies for impairment, a charge would be recorded to write down the software to the lower of its carrying value or fair value. The Company had no significant impairments during 2016, 2015, or 2014.

Income Taxes

The Company accounts for deferred income taxes utilizing an asset and liability method, whereby deferred tax assets and liabilities are recognized based on the tax effect of temporary differences between the financial statements and the tax basis of assets and liabilities, as measured by current enacted tax rates. The Company also evaluates the need for a valuation allowance to reduce deferred tax assets to estimated recoverable amounts. See "Basis of Presentation" for further information on current presentation of deferred income taxes.

The Company’s policy for recording interest and penalties associated with uncertain tax positions is to record such items as a component of income before income taxes. Penalties are recorded in Other (gains) losses, net, and interest paid or received is recorded in Interest expense or Interest income, respectively, in the Consolidated Statement of Income. Amounts recorded for penalties and interest related to uncertain tax positions were immaterial for all years presented. See Note 14 for further information.

Concentration Risk

Approximately 83 percent of the Company’s full-time equivalent Employees are unionized and are covered by collective-bargaining agreements. A small percentage of the Company's unionized Employees, including its Mechanics, Material Specialists, and Facilities Maintenance Technicians, are in discussions on labor agreements. These Employee groups represent approximately five percent of the Company’s full-time equivalent Employees as of December 31, 2016.

The Company attempts to minimize its concentration risk with regards to its cash, cash equivalents, and its investment portfolio. This is accomplished by diversifying and limiting amounts among different counterparties, the type of investment, and the amount invested in any individual security or money market fund.

To manage risk associated with financial derivative instruments held, the Company selects and will periodically review counterparties based on credit ratings, limits its exposure to a single counterparty, and monitors the market position of the program and its relative market position with each counterparty. The Company also has agreements with counterparties containing early termination rights and/or bilateral collateral provisions whereby security is required if market risk exposure exceeds a specified threshold amount or credit ratings fall below certain levels. Collateral deposits provided to or held from counterparties serve to decrease, but not totally eliminate, the credit risk associated with the Company’s hedging program. See Note 10 for further information.

As of December 31, 2016, the Company operated an all-Boeing fleet, all of which are variations of the Boeing 737. If the Company were unable to acquire additional aircraft or associated aircraft parts from Boeing, or Boeing were unable or unwilling to make timely deliveries of aircraft or to provide adequate support for its products, the Company’s operations would be materially adversely impacted. In addition, the Company would be materially adversely impacted in the event of a mechanical or regulatory issue associated with the Boeing 737 aircraft type, whether as a result of downtime for part or all of the Company’s fleet, increased maintenance costs, or because of a negative perception by the flying public. The Company is also dependent on sole suppliers for aircraft engines and certain other aircraft parts and would, therefore, also be materially adversely impacted in the event of the unavailability of, or a mechanical or regulatory issue associated with, engines and other parts.

The Company has historically entered into agreements with some of its co-brand, payment, and loyalty partners that contain exclusivity aspects which place certain confidential restrictions on the Company from entering into certain arrangements with other payment and loyalty partners. These arrangements generally extend for the terms of the agreements, none of which currently extend beyond May 2022. The Company believes the financial benefits generated by the exclusivity aspects of these arrangements outweigh the risks involved with such agreements.

  1. NEW ACCOUNTING PRONOUNCEMENTS AND ACCOUNTING CHANGES

On August 26, 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-15, Statement of Cash Flows. The standard is intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, with early adoption permitted. The Company is evaluating the new guidance, but does not expect it to have a significant impact on its financial statement presentation or results.

On June 16, 2016, the FASB issued ASU No. 2016-13, Accounting for Credit Losses. The new standard requires the use of an “expected loss” model on certain types of financial instruments. The standard also amends the impairment model for available-for-sale debt securities and requires estimated credit losses to be recorded as allowances instead of reductions to amortized cost of the securities. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2019, with early adoption permitted. The Company is evaluating the new guidance, but does not expect it to have a significant impact on its financial statement presentation or results.

On March 30, 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting. The standard is part of the FASB effort to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements. This ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. Early adoption is permitted in any interim or annual period, with any adjustments reflected as of the beginning of the fiscal year of adoption. The Company early adopted this standard during the three months ended June 30, 2016, with an effective date as of January 1, 2016. The prospective method of adoption of this standard resulted in the recognition of $7 million of excess tax benefits to the Company's income tax provision for the year ended December 31, 2016.

On February 25, 2016, the FASB issued ASU No. 2016-02, Leases. The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. The Company believes the most significant impact of this ASU on its accounting will be the presentation of operating leases with durations greater than twelve months, with certain exceptions, on the balance sheet. A portion of the Company's aircraft fleet is on operating lease, and it has contractual lease agreements associated with the majority of space from which it operates at the airports it serves. See Note 7 for more information on the Company's lease arrangements. The Company has formed a project team to evaluate and implement the standard and plans to provide additional information about its expected financial impact at a future date.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. Following the FASB's finalization of a one year deferral of this standard, the ASU is now effective for fiscal years, and interim periods within

those years, beginning on or after December 15, 2017, with early adoption permitted for fiscal years, and interim periods within those years, beginning on or after December 15, 2016. The Company has formed a project team to evaluate and implement the standard, and currently believes the most significant impact of this ASU on its accounting will be the elimination of the incremental cost method for frequent flyer accounting, which will require the Company to re-value its liabilities associated with Customer flight points with a relative fair value approach, resulting in a significant increase in the liabilities. The Company's liabilities associated with these flight points was $63 million at December 31, 2016, and the Company currently estimates that applying a relative fair value would increase the liabilities by approximately twenty times that value. The adoption of the new standard is also expected to result in different income statement classification for certain types of revenues, such as ancillary revenues, which are currently classified as Other revenues. The Company currently anticipates utilizing 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 provide additional information at a future date.

  1. NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share (in millions except per share amounts):

Year ended December 31,
201620152014
NUMERATOR:
Net income$2,244$2,181$1,136
Incremental income effect of interest on 5.25% convertible notes (a)244
Net income after assumed conversion$2,246$2,185$1,140
DENOMINATOR:
Weighted-average shares outstanding, basic627661687
Dilutive effect of Employee stock options and restricted stock units123
Dilutive effect of 5.25% convertible notes (a)566
Adjusted weighted-average shares outstanding, diluted633669696
NET INCOME PER SHARE:
Basic$3.58$3.30$1.65
Diluted$3.55$3.27$1.64

(a) See Note 6 for further information related to the convertible notes.

  1. COMMITMENTS AND CONTINGENCIES

Commitments

The Company has contractual obligations and commitments primarily with regard to future purchases of aircraft, repayment of debt (see Note 6), and lease arrangements (see Note 7). During the year ended December 31, 2016, the Company purchased 38 new 737-800 aircraft from Boeing and acquired 23 used 737-700 aircraft from third parties under capital leases. In addition, the Company retired from service 42 of its older aircraft (31 737-300 and 11 737-500). As of December 31, 2016, the Company had firm deliveries and options for Boeing 737-700, 737-800, 737-7, and 737-8 aircraft as follows:

The Boeing Company
-800 Firm Orders-800 Options-7 Firm Orders-8 Firm Orders-8 OptionsAdditional -700sTotal
201739——14—1467
2018219—13—447
2019——15—5—20
2020——14—8—22
2021——11318—32
2022———1519—34
2023———3423—57
2024———4123—64
2025———4036—76
2026————36—36
2027————23—23
609(a)30170(b)19118(c)478

(a) Includes two -800 options exercised in January 2017.

(b) The Company has flexibility to substitute 737-7 in lieu of 737-8 firm orders beginning in 2019.

(c) To be acquired in leases from various third parties.

The Company's capital commitments associated with the firm orders and additional aircraft in the above aircraft table are as follows: $1.1 billion in 2017, $893 million in 2018, $614 million in 2019, $821 million in 2020, $952 million in 2021, and $5.1 billion thereafter.

Fort Lauderdale-Hollywood International Airport

In December 2013, the Company entered into an agreement with Broward County, Florida, which owns and operates Fort Lauderdale-Hollywood International Airport, to oversee and manage the design and construction of the airport's Terminal 1 Modernization Project. Pursuant to an addendum entered into during 2016, the cost of the project is not to exceed $333 million. In addition to significant improvements to the existing Terminal 1, the project includes the design and construction of a new five-gate Concourse A with an international processing facility. Funding for the project has come directly from Broward County aviation sources, but flows through the Company in its capacity as manager of the project. Major construction on the project began during third quarter 2015 and is estimated to be substantially completed by mid-2017. The Company has determined that due to its agreed upon role in overseeing and managing the project, it is considered the owner of the project for accounting purposes. As such, during construction the Company records expenditures as Assets constructed for others in the Consolidated Balance Sheet, along with a corresponding outflow within Assets constructed for others in the Consolidated Statement of Cash Flows, and an increase to Construction obligation (with a corresponding cash inflow from Financing activities in the Consolidated Statement of Cash Flows) as reimbursements are received from Broward County. As of December 31, 2016, the Company had recorded construction costs related to the project of $132 million.

Houston William P. Hobby Airport

The Company entered into a Memorandum of Agreement (“MOA”) with the City of Houston (“City”), effective June 2012, to expand the existing Houston Hobby airport facility. As provided in the MOA, the Company and the City entered into an Airport Use and Lease Agreement (“Lease”) to control the execution of this expansion and the financial terms thereof. Per the MOA and Lease, this project provided a new five-gate international terminal with international passenger processing facilities, expansion of the security checkpoint, and upgrades to the Southwest Airlines ticket counter area. Construction was effectively completed in October 2015, at which time the Company began operating from the new facility. The project's final cost was approximately $150 million, of which $22 million was considered proprietary and thus not classified as Assets constructed for others. The Company provided the funding for, as well as

management over, the project. In return, the capital cost portion of the rent the Company pays for the international facility is waived from the initial occupancy until the expiration of the Lease. However, the City has the option at any time during the term of the Lease to reimburse the Company's investment at the then-unamortized cost of the facility. This purchase would trigger payment of the previously waived capital cost component of rents owed the City. Additionally, a small portion of the project qualified for rental credits that have been utilized against a portion of the Company’s 2016 lease payments at the airport.

As a result of its significant involvement in the Houston Hobby project, the Company determined that it is the owner of the facility for accounting purposes. As such, during construction, the Company recorded expenditures as Assets constructed for others in the Consolidated Balance Sheet, along with a corresponding outflow within Assets constructed for others, in the Consolidated Statement of Cash Flows.

Los Angeles International Airport

In March 2013, the Company executed a lease agreement with Los Angeles World Airports (“LAWA”), which owns and operates Los Angeles International Airport ("LAX"). Under the lease agreement, which was amended in June 2014, the Company is overseeing and managing the design, development, financing, construction, and commissioning of the airport's Terminal 1 Modernization Project (the “Project”) at a cost not to exceed $526 million. The Project is being funded primarily using the Regional Airports Improvement Corporation ("RAIC"), which is a quasi-governmental special purpose entity that acts as a conduit borrower under a syndicated credit facility provided by a group of lenders. Loans made under the credit facility are being used to fund the development of the Project, and the outstanding loans will be repaid with the proceeds of LAWA’s payments to purchase completed Project phases. The Company has guaranteed the obligations of the RAIC under the credit facility. Construction on the Project began during 2014 and is estimated to be completed during 2018. The Company has determined that due to its agreed upon role in overseeing and managing the Project, it is considered the owner of the Project for accounting purposes. LAWA will reimburse the Company (through the RAIC credit facility) for the non-proprietary renovations, while proprietary renovations will not be reimbursed. As a result, the $344 million of costs incurred as of December 31, 2016, to fund the Project are included within Assets constructed for others and all amounts that have been or will be reimbursed will be included within Construction obligation on the accompanying Consolidated Balance Sheet.

Dallas Love Field

During 2008, the City of Dallas approved the Love Field Modernization Program (“LFMP”), a project to reconstruct Dallas Love Field with modern, convenient air travel facilities. Pursuant to a Program Development Agreement with the City of Dallas and the Love Field Airport Modernization Corporation (or “LFAMC,” a Texas non-profit “local government corporation” established by the City of Dallas to act on the City of Dallas' behalf to facilitate the development of the LFMP), the Company managed this project. Major construction was effectively completed by December 31, 2014. This project consisted of the complete replacement of gate facilities with a new 20-gate facility, including infrastructure, systems and equipment, aircraft parking apron, fueling system, roadways and terminal curbside, baggage handling systems, passenger loading bridges and support systems, and other supporting infrastructure.

Although the City of Dallas received commitments from various sources that are helping to fund portions of the LFMP project, including the FAA, the Transportation Security Administration, and the City of Dallas' Aviation Fund, the majority of the funds used were from the issuance of bonds. The Company guaranteed principal and interest payments on $456 million of such bonds issued by the LFAMC. As of December 31, 2016, $432 million of principal remained outstanding.

In conjunction with the Company's significant presence at Dallas Love Field, the Company agreed to manage the majority of the LFMP project. Based on the pertinent factors in place at the time the agreement was made, the Company utilized the accounting guidance provided for lessees involved in asset construction. As of December 31, 2016, the Company had recorded LFMP construction costs of $538 million within Assets constructed for others and had recorded a liability of $522 million within Construction obligation in its Consolidated Balance Sheet. Upon completion of

different phases of the LFMP project, the Company has placed the associated assets in service and has begun depreciating the assets over their estimated useful lives. In addition, upon the effective completion of construction, the Company noted the project assets did not meet the qualifications for sale and leaseback accounting due to the Company's continuing involvement with the facility, as defined; therefore, for financial reporting purposes, these assets will remain on the Company's books until the bonds issued by the City of Dallas are repaid. The corresponding LFMP liabilities are being reduced primarily through the Company's airport rental payments to the City of Dallas as the construction costs of this project are passed through to the Company via recurring airport rates and charges. A portion of these payments are reflected as Repayment of construction obligation in the Consolidated Statement of Cash Flows. The imputed interest rate associated with Construction obligation was nominal for 2015 and 2016.

During 2015, the City of Dallas issued additional bonds for the construction of a new parking garage at Dallas Love Field. The Company has not guaranteed the principal or interest payments on these bonds, but remains the accounting owner of this project. As of December 31, 2016, the Company recorded LFMP parking construction expenditures of $80 million with Assets constructed for others with a corresponding increase to Construction obligation on the accompanying Consolidated Balance Sheet.

Contingencies

The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the Internal Revenue Service ("IRS"). The Company's management does not expect that the outcome of any of its currently ongoing legal proceedings or the outcome of any adjustments presented by the IRS, individually or collectively, will have a material adverse effect on the Company's financial condition, results of operations, or cash flow.

  1. SUPPLEMENTAL FINANCIAL INFORMATION
(in millions)December 31, 2016December 31, 2015
Derivative contracts$120$9
Intangible assets, net426464
Capital lease receivable9094
Other138150
Other assets$774$717
(in millions)December 31, 2016December 31, 2015
Accounts payable trade$138$178
Salaries payable200173
Taxes payable184179
Aircraft maintenance payable26168
Fuel payable9548
Other payable535442
Accounts payable$1,178$1,188
(in millions)December 31, 2016December 31, 2015
Profitsharing and savings plans$645$655
Aircraft and other lease related obligations5574
Vacation pay355309
Union bonuses188(a)329
Health9686
Derivative contracts158643
Workers compensation183187
Property and income taxes6862
Other237246
Accrued liabilities$1,985$2,591

(a) The decrease was due to collective-bargaining agreements reached with multiple workgroups during 2016 resulting in the payout of previously accrued bonuses. The remaining liability includes estimated bonuses that would be paid to union members upon ratification of collective-bargaining agreements for the various union contract groups that were in ongoing negotiations at December 31, 2016, coupled with the accrual of bonuses related to the collective-bargaining agreement reached with the Company's Flight Attendants that were paid in January 2017. The liability excludes certain immaterial benefit costs that are included as a component of Accounts payable. The amount accrued related to ongoing negotiations with various union contract groups is subject to change based on subsequent negotiations, and any changes would be recorded on a prospective basis.

(in millions)December 31, 2016December 31, 2015
Postretirement obligation$256$201
Non-current lease-related obligations125165
Other deferred compensation204179
Deferred gains from sale and leaseback of aircraft3043
Derivative contracts3574
Other7898
Other noncurrent liabilities$728$760

Other Operating Expenses

Other operating expenses consist of distribution costs, advertising expenses, personnel expenses, professional fees, and other operating costs, none of which individually exceed 10 percent of Operating expenses.

  1. LONG-TERM DEBT
(in millions)December 31, 2016December 31, 2015
5.25% Convertible Senior Notes due November 2016$—$111
5.75% Notes due December 2016—307
5.125% Notes due 2017301309
French Credit Agreements due 2018 - 2.23%1425
Fixed-rate 737 Aircraft Notes payable through 2018 - 7.03%817
2.75% Notes due 2019301303
Term Loan Agreement payable through 2019 - 6.315%106143
Term Loan Agreement payable through 2019 - 4.84%2836
2.65% Notes due 2020492494
Term Loan Agreement payable through 2020 - 5.223%284329
737 Aircraft Notes payable through 2020206257
Term Loan Agreements payable through 2021 - 7.94%20—
Pass Through Certificates due 2022 - 6.24%324340
Term Loan Agreement payable through 2026 - 2.36%215—
3.00% Notes due 2026300—
7.375% Debentures due 2027130132
Capital leases681395
$3,410$3,198
Less current maturities566637
Less debt discount and issuance costs2320
$2,821$2,541

AirTran Long-Term Debt

AirTran Holdings is party to aircraft purchase financing facilities, and as of December 31, 2016, 18 Boeing 737 aircraft remained that were financed under floating-rate facilities. Each note is secured by a first mortgage on the aircraft to which it relates. The notes bear interest at a floating rate per annum equal to a margin plus the three or six-month LIBOR in effect at the commencement of each semi-annual or three-month period, as applicable. As of December 31, 2016, the weighted average interest rate was 2.40 percent. Principal and interest under the notes are payable semi-annually or every three months as applicable. As of December 31, 2016, the remaining debt outstanding may be prepaid without penalty under all aircraft loans provided under such facilities. The remaining notes mature in years 2017 to 2020. As discussed further in Note 10, a portion of the above floating-rate debt has been effectively converted to a fixed rate via interest rate swap agreements which expire as the underlying notes mature.

As of December 31, 2016, two Boeing 737 aircraft were financed under a fixed-rate facility. Each note is secured by a first mortgage on the aircraft to which it relates. As of December 31, 2016, the weighted average interest rate was 7.03 percent. Payments of principal and interest under the notes are due semi-annually. The remaining notes mature in years 2017 to 2018.

In October 2009, AirTran Holdings completed a public offering of $115 million of convertible senior notes due November 1, 2016. Such notes bore interest at 5.25 percent payable semi-annually, in arrears, on May 1 and November 1. As a result of the acquisition and subsequent dividends declared by the Company, the convertible senior notes were convertible into AirTran conversion units of 168.6576 per $1,000 in principal amount of such notes. Based on the terms of the merger agreement, the holders of these notes could receive shares of the Company’s common stock at a conversion rate of 54.5143 shares and $615.16 in cash per $1,000 in principal amount of such notes. During 2016, all the bonds matured, the majority of which had been converted prior to the maturity date, with approximately 6 million shares issued and cash paid of approximately $68 million.

Other Company Long-Term Debt

During November 2016, the Company issued $300 million senior unsecured notes due 2026. The notes bear interest at 3.00 percent. Interest is payable semi-annually in arrears on May 15 and November 15, beginning in 2017.

During October 2016, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $215 million, to be secured by mortgages on seven of the Company's 737-800 aircraft. The Company has borrowed the full $215 million and secured this loan with the requisite seven aircraft mortgages. The loan matures on October 31, 2026, and is repayable via semi-annual installments of principal that begin April 30, 2018. The loan bears interest at the LIBO Rate (as defined in the term loan agreement) plus 1.10 percent, which equates to an initial rate of 2.36 percent, and interest is payable semi-annually in installments that begin April 30, 2017.

During third quarter 2016, the Company entered into term loan agreements to purchase the equity interest in four aircraft that were previously classified as operating leases, for a total of $20 million. As of December 31, 2016, the weighted average interest rate for the four term loan agreements was 7.94 percent. Payments of principal and interest under the loans are due semi-annually. The loans mature in years 2018 to 2021.

During November 2015, the Company issued $500 million senior unsecured notes due 2020. The notes bear interest at 2.65 percent, payable semi-annually in arrears on May 5 and November 5. Concurrently, the Company entered into a fixed-to-floating interest rate swap to convert the interest on these unsecured notes to a floating rate until their maturity. See Note 10 for further information on the interest-rate swap agreement.

During November 2014, the Company issued $300 million senior unsecured notes due 2019. The notes bear interest at 2.75 percent, payable semi-annually in arrears on May 6 and November 6. Concurrently, the Company entered into a fixed-to-floating interest rate swap to convert the interest on these unsecured notes to a floating rate until their maturity. See Note 10 for further information on the interest-rate swap agreement.

On July 1, 2009, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $124 million, to be secured by mortgages on five of the Company’s 737-700 aircraft. The Company has borrowed the full $124 million and secured this loan with the requisite five aircraft mortgages. The loan matures on July 1, 2019, and is repayable semi-annually in installments of principal that began January 1, 2010. The loan bears interest at a fixed rate of 4.84 percent, and interest is payable semi-annually, which payments began on January 1, 2010. In September 2015, the Company prepaid $24 million on the loan agreement, which in turn released one of the encumbered aircraft. As such, the remaining four aircraft related to this transaction are still encumbered as of December 31, 2016.

On April 29, 2009, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $332 million, to be secured by mortgages on 14 of the Company’s 737-700 aircraft. The Company borrowed the full $332 million and secured the loan with the requisite 14 aircraft mortgages. The loan matures on May 6, 2019, and is being repaid via quarterly installments of principal that began August 6, 2009. The loan bears interest at the LIBO Rate (as defined in the term loan agreement) plus 3.30 percent, and interest is payable quarterly, which payments began on August 6, 2009. Pursuant to the terms of the term loan agreement, the Company entered into an interest rate swap agreement to convert the variable rate on the term loan to a fixed 6.315 percent until maturity.

On May 6, 2008, the Company entered into a term loan agreement providing for loans to the Company aggregating up to $600 million, to be secured by first-lien mortgages on 21 of the Company’s 737-700 aircraft. On May 9, 2008, the Company borrowed the full $600 million and secured these loans with the requisite 21 aircraft mortgages. The loans mature on May 9, 2020, and are repayable quarterly in installments of principal, with the first payment made on August 9, 2008. The loans bear interest at the LIBO Rate (as defined in the term loan agreement) plus 0.95 percent, and interest is payable quarterly. Pursuant to the terms of the term loan agreement, the Company entered into an interest rate swap agreement to convert the variable rate on the term loan to a fixed 5.223 percent until maturity.

On October 3, 2007, grantor trusts established by the Company issued $500 million Pass Through Certificates consisting of $412 million 6.15 percent Series A certificates and $88 million 6.65 percent Series B certificates. A separate trust was established for each class of certificates. The trusts used the proceeds from the sale of certificates to acquire equipment notes in the same amounts, which were issued by the Company on a full recourse basis. Payments on the equipment notes held in each trust will be passed through to the holders of certificates of such trust. The equipment notes were issued for each of 16 Boeing 737-700 aircraft owned by the Company and are secured by a mortgage on each aircraft. Interest on the equipment notes held for the certificates is payable semi-annually, with the first payment made on February 1, 2008. Also beginning February 1, 2008, principal payments on the equipment notes held for both series of certificates are due semi-annually until the balance of the certificates mature on August 1, 2022. Prior to their issuance, the Company also entered into swap agreements to hedge the variability in interest rates on the Pass Through Certificates. The swap agreements were accounted for as cash flow hedges, and resulted in a payment by the Company of $20 million upon issuance of the Pass Through Certificates. The effective portion of the hedge is being amortized to interest expense concurrent with the amortization of the debt and is reflected in the above table as a reduction in the debt balance. The ineffectiveness of the hedge transaction was immaterial.

During December 2006, the Company issued $300 million senior unsecured notes due December 15, 2016. The notes bore interest at 5.75 percent. During fourth quarter 2009, the Company entered into a fixed-to-floating interest rate swap to convert the interest on these unsecured notes to a floating rate; however, the interest rate swap was terminated in 2015. The notes matured and were redeemed in full on December 15, 2016, utilizing available cash on hand.

During February 2005, the Company issued $300 million senior unsecured notes due 2017. The notes bear interest at 5.125 percent, payable semi-annually in arrears, with the first payment made on September 1, 2005.

In fourth quarter 2004, the Company entered into four identical 13-year floating-rate financing arrangements, whereby it borrowed a total of $112 million from French banking partnerships. Although the interest rates on the borrowings float, the Company estimated at inception that, considering the full effect of the “net present value benefits” included in the transactions, the effective economic yield over the 13-year term of the loans will be approximately LIBOR minus 45 basis points. Principal and interest are payable semi-annually on June 30 and December 31 for each of the loans, and the Company may terminate the arrangements in any year on either of those dates, under certain conditions. The Company pledged four aircraft as collateral for the transactions.

On February 28, 1997, the Company issued $100 million of senior unsecured 7.375 percent debentures due March 1, 2027. Interest is payable semi-annually on March 1 and September 1. The debentures may be redeemed, at the option of the Company, in whole at any time or in part from time to time, at a redemption price equal to the greater of the principal amount of the debentures plus accrued interest at the date of redemption or the sum of the present values of the remaining scheduled payments of principal and interest thereon, discounted to the date of redemption at the comparable treasury rate plus 20 basis points, plus accrued interest at the date of redemption. In January 2007, the Company entered into an interest rate swap agreement to convert this fixed-rate debt to a floating rate; however, the interest rate swap was terminated in December 2012.

The Company is required to provide standby letters of credit to support certain obligations that arise in the ordinary course of business. Although the letters of credit are an off-balance sheet item, the majority of the obligations to which they relate are reflected as liabilities in the Consolidated Balance Sheet. Outstanding letters of credit totaled $179 million at December 31, 2016.

The net book value of the assets pledged as collateral for the Company’s secured borrowings, primarily aircraft and engines, was $2.8 billion at December 31, 2016. In addition, the Company has pledged a total of up to 82 of its Boeing 737-700 and 30 of its Boeing 737-800 aircraft at a net book value of $2.7 billion, in the case that it has obligations related to its fuel derivative instruments with counterparties that exceed certain thresholds. See Note 10 for further information on these collateral arrangements.

As of December 31, 2016, aggregate annual principal maturities of debt and capital leases (not including amounts associated with interest rate swap agreements, interest on capital leases, amortization of capital lease incentives, and

amortization of purchase accounting adjustments) for the five-year period ending December 31, 2021, and thereafter, were $555 million in 2017, $323 million in 2018, $573 million in 2019, $797 million in 2020, $148 million in 2021, and $926 million thereafter.

  1. LEASES

The Company's fleet included 51 aircraft on capital lease as of December 31, 2016, compared with 28 aircraft on capital lease, including one B717, as of December 31, 2015. Amounts applicable to these aircraft that are included in property and equipment were:

(in millions)20162015
Flight equipment$923$435
Less: accumulated amortization8229
$841$406

Total rental expense for operating leases, both aircraft and other, charged to operations in 2016, 2015, and 2014 was $932 million, $909 million, and $931 million, respectively. The majority of the Company’s terminal operations space, as well as 83 aircraft, were under operating leases at December 31, 2016. For aircraft operating leases and for terminal operations leases, expense is recorded on a straight-line basis and included in Aircraft rentals and in Landing fees and other rentals, respectively, in the Consolidated Statement of Income. Future minimum lease payments under capital leases and noncancelable operating leases and rentals to be received under subleases with initial or remaining terms in excess of one year at December 31, 2016, were:

(in millions)Capital leasesOperating leases (b)SubleasesLFMP facility lease*Operating leases, net
2017$80$671$(103)$24$592
201880562(102)25485
201978491(97)25419
202078377(78)26325
202174232(41)26217
Thereafter353715(26)6081,297
Total minimum lease payments$743$3,048$(447)$734$3,335
Less amount representing interest128
Present value of minimum lease payments (a)615
Less current portion58
Long-term portion$557
* See Note 4 for further details

(a) Excludes lease incentive obligation of $66 million.

(b) Includes a portion of the Company's Construction obligation that has not yet been placed into service as of December 31, 2016. See Note 4 for further information.

The aircraft leases generally can be renewed for one to five years at rates based on fair market value at the end of the lease term. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, generally limited to a stated percentage of the lessor’s defined cost of the aircraft.

On July 9, 2012, the Company signed an agreement with Delta Air Lines, Inc. and Boeing Capital Corp. to lease or sublease all 88 of AirTran's B717s to Delta at agreed-upon lease rates. The first converted B717 was delivered to Delta in September 2013, and as of December 31, 2016, the Company had delivered all B717s to Delta. A total of 76 of the B717s are on operating lease, ten are owned, and two are on capital lease.

The Company paid the majority of the costs to convert the aircraft to the Delta livery and perform certain maintenance checks prior to the delivery of each aircraft. The agreement to pay these conversion and maintenance costs is a “lease incentive” under applicable accounting guidance. The sublease terms for the 76 B717s on operating lease and the two B717s on capital lease coincide with the Company's remaining lease terms for these aircraft from the original lessor, which range from approximately two to seven years. The leasing of the ten B717s that are owned by the Company is subject to certain conditions, and the lease terms are for up to six years, after which Delta will have the option to purchase the aircraft at the then-prevailing market value. The ten owned B717s are accounted for as sales type leases, the two B717s classified by the Company as capital leases are accounted for as direct financing leases, and the remaining 76 subleases are accounted for as operating leases with Delta. There are no contingent payments and no significant residual value conditions associated with the transaction.

The accounting for this transaction was based on the guidance provided for lease transactions. The Company recorded an initial charge of approximately $137 million during third quarter 2012, representing the remaining estimated cost, at the scheduled date of delivery of each B717 to Delta (including the conversion, maintenance, and other contractual costs to be incurred), of the Company's lease of the 76 B717s that are accounted for as operating leases, net of the future sublease income from Delta and the remaining unfavorable aircraft lease liability established as of the acquisition date. During 2014, the Company recorded an additional $22 million in expense for its revised estimate of conversion costs for these B717s, and an additional $9 million associated with the extension of time between when the Company removed the aircraft from revenue service, on December 28, 2014, and when they entered the conversion process. The charges recorded by the Company for this transaction were included as a component of Acquisition and integration costs in the Company's Consolidated Statement of Income and were included as a component of Other, net in Cash flows from operating activities in the Company's Consolidated Statement of Cash Flows, and the corresponding liability for this transaction, which was not material as of December 31, 2016 or 2015, is included as a component of Current liabilities and Other noncurrent liabilities in the Company's Consolidated Balance Sheet.

  1. COMMON STOCK

The Company has one class of capital stock, its common stock. Holders of shares of common stock are entitled to receive dividends when and if declared by the Board of Directors and are entitled to one vote per share on all matters submitted to a vote of the Shareholders. At December 31, 2016, the Company had 60 million shares of common stock reserved for issuance pursuant to Employee equity plans (of which 31 million shares had not been granted) through various share-based compensation arrangements. See Note 9 to the Consolidated Financial Statements for information regarding the Company's equity plans.

  1. STOCK PLANS

Share-based Compensation

The Company accounts for share-based compensation utilizing fair value, which is determined on the date of grant for all instruments. The Consolidated Statement of Income for the years ended December 31, 2016, 2015, and 2014, reflects share-based compensation expense of $33 million, $29 million, and $21 million, respectively. The total tax benefit recognized in earnings from share-based compensation arrangements for the years ended December 31, 2016, 2015, and 2014, was not material. As of December 31, 2016, there was $36 million of total unrecognized compensation cost related to share-based compensation arrangements, which is expected to be recognized over a weighted-average period of 1.7 years. The Company expects substantially all unvested awards to vest.

Restricted Stock Units and Stock Grants

Under the Company’s Amended and Restated 2007 Equity Incentive Plan (“2007 Equity Plan”), it granted restricted stock units (“RSUs”) and performance-based restricted stock units (“PBRSUs”) to certain Employees during 2014, 2015, and 2016. Outstanding RSUs vest over three years, subject generally to the individual’s continued employment or service. The PBRSUs granted in May 2014, January 2015, and January 2016 are subject to the Company’s performance with respect to a three-year simple average of Return on Invested Capital, before taxes and excluding special items ("ROIC"), for the defined performance period and the individual’s continued employment or service. The number of PBRSUs vesting on the vesting date will be interpolated based on the Company's ROIC performance

and ranges from zero PBRSUs to 200 percent of granted PBRSUs. Forfeiture rates are estimated at the time of grant based on historical actuals for similar grants, and are trued-up to actuals over the vesting period. The Company recognizes all expense on a straight-line basis over the vesting period, with any changes in expense due to the number of PBRSUs expected to vest being modified on a prospective basis.

Aggregated information regarding the Company’s RSUs and PBRSUs is summarized below:

All Restricted Stock Units
Units (000)Wtd. Average Fair Value (per share)
Outstanding December 31, 2013, Unvested2,584$11.38
Granted834(a)24.93
Vested(1,239)11.05
Surrendered(102)13.18
Outstanding December 31, 20142,07716.92
Granted561(b)45.80
Vested(1,095)13.33
Surrendered(58)25.49
Outstanding December 31, 20151,48530.17
Granted675(c)37.29
Vested(665)23.29
Surrendered(56)36.29
Outstanding December 31, 2016, Unvested1,439$36.52

(a) Includes 198 thousand PBRSUs

(b) Includes 183 thousand PBRSUs

(c) Includes 247 thousand PBRSUs

In addition, the Company granted approximately 27 thousand shares of unrestricted stock at a weighted average grant price of $42.90 in 2016, approximately 28 thousand shares at a weighted average grant price of $41.27 in 2015, and approximately 36 thousand shares at a weighted average grant price of $24.91 in 2014, to members of its Board of Directors.

A remaining balance of up to 22 million shares of the Company’s common stock may be issued pursuant to grants under the 2007 Equity Plan.

Employee Stock Purchase Plan

Under the amended 1991 Employee Stock Purchase Plan ("ESPP"), which has been approved by Shareholders, the Company is authorized to issue up to a remaining balance of 9 million shares of the Company’s common stock to Employees of the Company. These shares may be issued at a price equal to 90 percent of the market value at the end of each monthly purchase period. Common stock purchases are paid for through periodic payroll deductions. For the years ended December 31, 2016, 2015, and 2014, participants under the plan purchased 622 thousand shares, 597 thousand shares, and 792 thousand shares at average prices of $36.57, $36.40, and $23.17, respectively. The weighted-average fair value of each purchase right under the ESPP granted for the years ended December 31, 2016, 2015, and 2014, which is equal to the ten percent discount from the market value of the Common Stock at the end of each monthly purchase period, was $4.06, $4.04, and $2.68, respectively.

Taxes

A portion of the Company’s granted options qualify as incentive stock options for income tax purposes. As such, a tax benefit is not recorded at the time the compensation cost related to the options is recorded for book purposes due to the fact that an incentive stock option does not ordinarily result in a tax benefit unless there is a disqualifying disposition.

Grants of non-qualified stock options and RSUs result in the creation of a deferred tax asset, which is a temporary difference, until the time that the option is exercised or the RSU vests. With the issuance of ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, all excess tax benefits and tax deficiencies are recorded through the income statement. Due to the treatment of incentive stock options, non-qualified stock options, and RSUs for tax purposes, the Company’s effective tax rate from year to year is subject to variability.

  1. 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 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”) 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.

For the purpose of evaluating its net cash spend for jet fuel and for forecasting its future estimated jet fuel expense, 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 2016, the Company had fuel derivative instruments in place for up to 46 percent of its fuel consumption. As of December 31, 2016, the Company also had fuel derivative instruments in place to provide coverage for up to 63 percent of its 2017 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 2019 on an “economic” basis considering current market prices:

Fuel hedged as of
December 31, 2016Derivative underlying commodity type as of
Period (by year)(gallons in millions) (a)December 31, 2016
20171,281WTI crude and Brent crude oil
20181,185Brent crude oil
2019305Brent crude oil

(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.

Upon proper qualification, the Company accounts for its fuel derivative instruments as cash flow hedges. Generally, utilizing hedge accounting, all periodic changes in fair value of the derivatives designated as hedges that are considered to be effective are recorded in Accumulated other comprehensive income (loss) ("AOCI") until the underlying jet fuel is consumed. See Note 12. The Company’s results are subject to the possibility that periodic changes will not be effective, as defined, or that the derivatives will no longer qualify for hedge accounting. Ineffectiveness results when the change in the fair value of the derivative instrument exceeds the change in the value of the Company’s expected future cash outlay to purchase and consume jet fuel. To the extent that the periodic changes in the fair value of the derivatives are ineffective, the ineffective portion is recorded to Other (gains) losses, net, in the Consolidated Statement of Income. Likewise, if a hedge ceases to qualify for hedge accounting, any change in the fair value of derivative instruments since the last reporting period is recorded to Other (gains) losses, net, in the Consolidated Statement of Income in the period of the change; however, any amounts previously recorded to AOCI would remain there until such time as the original forecasted transaction occurs, at which time these amounts would be reclassified to Fuel and oil expense. When the Company has sold derivative positions in order to effectively “close” or offset a derivative already held as part of its fuel derivative instrument portfolio, any subsequent changes in fair value of those positions are marked to market through earnings. Likewise, any changes in fair value of those positions that were offset by entering into the sold positions and were de-designated as hedges are concurrently marked to market through earnings. However, any changes in value related to hedges that were deferred as part of AOCI while designated as a hedge would remain until the originally forecasted transaction occurs. In a situation where it becomes probable that a fuel hedged forecasted transaction will not occur, any gains and/or losses that have been recorded to AOCI would be required to be immediately reclassified into earnings. The Company did not have any such situations occur during 2014, 2015, or 2016.

Ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related commodities. 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 results. Factors that have and may continue to lead to ineffectiveness and unrealized gains and losses on derivative contracts include: significant fluctuation in energy prices, the number of derivative positions the Company holds, significant weather events affecting refinery capacity and the production of refined products, and the volatility of the different types of products the Company uses in hedging. However, even though derivatives may not qualify for hedge accounting, the Company continues to hold the instruments as management believes derivative instruments continue to afford the Company the opportunity to stabilize jet fuel costs.

Accounting pronouncements pertaining to derivative instruments and hedging are complex 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. The Company also examines the effectiveness of each individual hedge and 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.

All cash flows associated with purchasing and selling fuel derivatives are classified as Other operating cash flows in the Consolidated Statement of Cash Flows. The following table presents the location of all assets and liabilities associated with the Company’s hedging instruments within the Consolidated Balance Sheet:

Asset derivativesLiability derivatives
Balance SheetFair value atFair value atFair value atFair value at
(in millions)location12/31/201612/31/201512/31/201612/31/2015
Derivatives designated as hedges*
Fuel derivative contracts (gross)Prepaid expenses and other current assets$7$2$44$—
Fuel derivative contracts (gross)Other assets1262——
Fuel derivative contracts (gross)Accrued liabilities4107412526
Fuel derivative contracts (gross)Other noncurrent liabilities—55—658
Interest rate derivative contractsOther assets—2——
Interest rate derivative contractsOther noncurrent liabilities——3549
Total derivatives designated as hedges$137$168$491$1,233
Derivatives not designated as hedges*
Fuel derivative contracts (gross)Prepaid expenses and other current assets$54$39$—$26
Fuel derivative contracts (gross)Other assets52552—
Fuel derivative contracts (gross)Accrued liabilities2011,3952621,854
Fuel derivative contracts (gross)Other noncurrent liabilities—330—352
Total derivatives not designated as hedges$307$1,769$314$2,232
Total derivatives$444$1,937$805$3,465
  • 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 also had the following amounts associated with fuel derivative instruments and hedging activities in its Consolidated Balance Sheet:

Balance SheetDecember 31,December 31,
(in millions)location20162015
Cash collateral deposits held from counterparties for fuel contracts - currentOffset against Prepaid expenses and other current assets$4$—
Cash collateral deposits held from counterparties for fuel contracts - noncurrentOffset against Other assets6—
Cash collateral deposits provided to counterparties for fuel contracts - currentOffset against Accrued liabilities311235
Cash collateral deposits provided to counterparties for fuel contracts- noncurrentOffset against Other noncurrent liabilities—600
Due to third parties for fuel contractsAccounts payable7546

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 for derivatives and hedging. The types of derivative instruments the Company has determined are subject to netting requirements in the accompanying 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 provided to counterparties, the Company nets such amounts against the fair value of the Company's derivative portfolio by each counterparty. The Company has elected to utilize netting for both its fuel derivative instruments and interest rate swap agreements and also classifies such amounts as either current or noncurrent, based on the net fair value position with each of the Company's counterparties in the Consolidated Balance Sheet.

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 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 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:

Offsetting of derivative assets
(in millions)
(i)(ii)(iii) = (i) + (ii)(i)(ii)(iii) = (i) + (ii)
December 31, 2016December 31, 2015
DescriptionBalance Sheet locationGross amounts of recognized assetsGross amounts offset in the Balance SheetNet amounts of assets presented in the Balance SheetGross amounts of recognized assetsGross amounts offset in the Balance SheetNet amounts of assets presented in the Balance Sheet
Fuel derivative contractsPrepaid expenses and other current assets$61$(48)$13$41$(26)$15
Fuel derivative contractsOther assets$178$(58)$120(a)$7$—$7(a)
Fuel derivative contractsAccrued liabilities$516$(516)$—(a)$1,737$(1,737)$—(a)
Fuel derivative contractsOther noncurrent liabilities$—$—$—(a)$985$(985)$—(a)
Interest rate derivative contractsOther assets$—$—$—(a)$2$—$2(a)

(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the Consolidated Balance Sheet in Note 5.

(i)(ii)(iii) = (i) + (ii)(i)(ii)(iii) = (i) + (ii)
December 31, 2016December 31, 2015
DescriptionBalance Sheet locationGross amounts of recognized liabilitiesGross amounts offset in the Balance SheetNet amounts of liabilities presented in the Balance SheetGross amounts of recognized liabilitiesGross amounts offset in the Balance SheetNet amounts of liabilities presented in the Balance Sheet
Fuel derivative contractsPrepaid expenses and other current assets$48$(48)$—$26$(26)$—
Fuel derivative contractsOther assets$58$(58)$—(a)$—$—$—(a)
Fuel derivative contractsAccrued liabilities$674$(516)$158(a)$2,380$(1,737)$643(a)
Fuel derivative contractsOther noncurrent liabilities$—$—$—(a)$1,010$(985)$25(a)
Interest rate derivative contractsOther noncurrent liabilities$35$—$35(a)$49$—$49(a)

(a) The net amounts of derivative assets and liabilities are reconciled to the individual line item amounts presented in the Consolidated Balance Sheet in Note 5.

The following tables present the impact of derivative instruments and their location within the Consolidated Statement of Income for the year ended December 31, 2016 and 2015:

Derivatives in cash flow hedging relationships
(Gain) loss recognized in AOCI on derivatives (effective portion)(Gain) loss reclassified from AOCI into income (effective portion)(a)(Gain) loss recognized in income on derivatives (ineffective portion)(b)
Year endedYear endedYear ended
December 31,December 31,December 31,
(in millions)201620152016201520162015
Fuel derivative contracts$(122)*$546*$613*$238*$(11)$(9)
Interest rate derivatives2*4*9*13*(3)(4)
Total$(120)$550$622$251$(14)$(13)

*Net of tax

(a) Amounts related to fuel derivative contracts and interest rate derivatives are included in Fuel and oil and Interest expense, respectively.

(b) Amounts are included in Other (gains) losses, net.

Derivatives not in cash flow hedging relationships
(Gain) loss
recognized in income on
derivatives
Year endedLocation of (gain) loss
December 31,recognized in income
(in millions)20162015on derivatives
Fuel derivative contracts$14$444Other (gains) losses, net
Interest rate derivatives(2)—Interest Expense
Total$12$444

The Company also recorded expense associated with premiums paid for fuel derivative contracts that settled/expired during 2016, 2015, and 2014 of $153 million, $124 million, and $62 million, respectively. These amounts are excluded from the Company’s measurement of effectiveness for related hedges and are included as a component of Other (gains) losses, net, in the Consolidated Statement of Income.

The fair values of the derivative instruments, depending on the type of instrument, were determined by the use of present value methods or option value models with assumptions about commodity prices based on those observed in underlying markets or provided by third parties. Included in the Company’s cumulative net unrealized losses from fuel hedges as of December 31, 2016, recorded in AOCI, were approximately $302 million in unrealized losses, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to December 31, 2016.

Interest Rate Swaps

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. Several of the Company's interest rate swap agreements qualify for the “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, including AirTran Holdings', interest rate swap agreements for all periods presented was not material.

The fair values of the interest rate swap agreements, which are adjusted regularly, have been aggregated by counterparty for classification in the Consolidated Balance Sheet. Agreements totaling a net liability of $35 million are fair value hedges, cash flow hedges, and interest rate derivatives not utilizing hedge accounting, are classified as a component of Other noncurrent liabilities. The corresponding adjustment related to the net liability associated with the Company’s cash flow hedges is to AOCI, fair value hedges is to the carrying value of the long-term debt, and interest rate derivatives not utilizing hedge accounting is to Interest expense. See Note 12.

The Company has fixed-to-floating interest rate swap agreements in place associated with its $500 million 2.65 percent Notes due 2020 and its $300 million 2.75 percent Notes due 2019 that are accounted for as fair value hedges. As a result of the fixed-to-floating interest rate swap agreements in place, the average floating rate recognized during 2016 was approximately 2.03 percent on the $500 million Note, and approximately 1.85 percent on the $300 million Note, based on actual and forward rates as of December 31, 2016.

The Company has floating-to-fixed interest rate swap agreements associated with its $600 million floating-rate term loan agreement due 2020 and its $332 million term loan agreement due 2019 that are accounted for as cash flow hedges. These interest rate hedges have fixed the interest rate on the $600 million floating-rate term loan agreement at 5.223 percent until maturity, and for the $332 million term loan agreement at 6.315 percent until maturity.

There are also a number of interest rate swap agreements, which convert a portion of AirTran Holdings' floating-rate debt to a fixed-rate basis for the remaining life of the debt, thus reducing the impact of interest rate changes on future interest expense and cash flows. Under these agreements, which expire between 2017 and 2020, it pays fixed rates between 4.35 percent and 6.435 percent and receives either three-month or six-month LIBOR on the notional values. The notional amount of outstanding debt related to interest rate swaps as of December 31, 2016, was $166 million. These interest rate swap arrangements were designated as cash flow hedges as of the acquisition date, and subsequently de-designated during fourth quarter 2016 as the Company no longer believes these hedges will be highly effective in offsetting future cash flows. The mark-to-market impact associated with these hedges for all periods presented was not material.

Credit Risk and Collateral

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 December 31, 2016, 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 whenever the net fair value of derivatives associated with those counterparties exceeds specific thresholds. The following table provides the fair values of fuel derivatives, amounts posted as collateral, and applicable collateral posting threshold amounts as of December 31, 2016, at which such postings are triggered:

Counterparty (CP)
(in millions)ABCDEFOther(a)Total
Fair value of fuel derivatives$(298)$(78)$36$(5)$3$12$4$(326)
Cash collateral held from (by) CP(279)(33)———11—(301)
Aircraft collateral pledged to CP————————
Letters of credit (LC)————————
Option to substitute LC for aircraft(200) to (600)(h)(100) to (500)(d)N/A(150) to (550)(d)(150) to (550)(d)N/A
Option to substitute LC for cashN/A>(500)(e)(225) to (275)(e)(75) to (150) or >(550)(e)(125) to (150) or >(550)(e)(g)
If credit rating is investment grade, fair value of fuel derivative level at which:
Cash is provided to CP(50) to (200) or >(600)(50) to (100) or >(500)>(125)(75) to (150) or >(550)(125) to (150) or >(550)>(100)
Cash is received from CP>50(c)>150(c)>175(c)>250(c)>75(c)>0(c)
Aircraft or cash can be pledged to CP as collateral(200) to (600)(f)(100) to (500)(d)N/A(150) to (550)(d)(150) to (550)(d)N/A
If credit rating is non-investment grade, fair value of fuel derivative level at which:
Cash is provided to CP(0) to (200) or >(600)(0) to (100) or >(500)(b)(0) to (150) or >(550)(0) to (150) or >(550)(b)
Cash is received from CP(b)(b)(b)(b)(b)(b)
Aircraft or cash can be pledged to CP as collateral(200) to (600)(100) to (500)N/A(150) to (550)(150) to (550)N/A

(a) Individual counterparties with fair value of fuel derivatives <$3 million.

(b) Cash collateral is provided at 100 percent of fair value of fuel derivative contracts.

(c) Thresholds may vary based on changes in credit ratings within investment grade.

(d) The Company has the option of providing cash, letters of credit, or pledging aircraft as collateral.

(e) The Company has the option of providing cash or letters of credit as collateral.

(f) The Company has the option of providing cash or pledging aircraft as collateral.

(g) The Company has the option to substitute letters of credit for 100 percent of cash collateral requirement.

(h) The Company has the option of providing letters of credit in addition to aircraft collateral if the appraised value of the aircraft does not meet the collateral requirement.

  1. FAIR VALUE MEASUREMENTS

Accounting standards pertaining to fair value measurements establish a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

As of December 31, 2016, the Company held certain items that are required to be measured at fair value on a recurring basis. These included cash equivalents, short-term investments (primarily treasury bills and certificates of deposit), interest rate derivative contracts, fuel derivative contracts, and available-for-sale securities. The majority of the Company’s short-term investments consist of instruments classified as Level 1. However, the Company has certificates of deposit, commercial paper, and Eurodollar time deposits that are classified as Level 2, due to the fact that the fair value for these instruments is determined utilizing observable inputs in non-active markets. Other available-for-sale securities primarily consist of investments associated with the Company’s excess benefit plan.

The Company’s fuel and interest rate derivative instruments consist of over-the-counter contracts, which are not traded on a public exchange. Fuel derivative instruments include swaps, as well as different types of option contracts, whereas interest rate derivatives consist solely of swap agreements. See Note 10 for further information on the Company’s derivative instruments and hedging activities. The fair values of swap contracts are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized these swap contracts as Level 2. The Company’s Treasury Department, which reports to the Chief Financial Officer, determines the value of option contracts utilizing an option pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are provided by financial institutions that trade these contracts. The option pricing model used by the Company is an industry standard model for valuing options and is the same model used by the broker/dealer community (i.e., the Company’s counterparties). The inputs to this option pricing model are the option strike price, underlying price, risk free rate of interest, time to expiration, and volatility. Because certain inputs used to determine the fair value of option contracts are unobservable (principally implied volatility), the Company has categorized these option contracts as Level 3. Volatility information is obtained from external sources, but is analyzed by the Company for reasonableness and compared to similar information received from other external sources. The fair value of option contracts considers both the intrinsic value and any remaining time value associated with those derivatives that have not yet settled. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. To validate the reasonableness of the Company’s option pricing model, on a monthly basis, the Company compares its option valuations to third party valuations. If any significant differences were to be noted, they would be researched in order to determine the reason. However, historically, no significant differences have been noted. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.

Included in Other available-for-sale securities are the Company's investments associated with its deferred compensation plans, which consist of mutual funds that are publicly traded and for which market prices are readily available. These plans are non-qualified deferred compensation plans designed to hold contributions in excess of limits established by the Internal Revenue Code of 1986, as amended. The distribution timing and payment amounts under these plans are

made based on the participant's distribution election and plan balance. Assets related to the funded portions of the deferred compensation plans are held in a rabbi trust, and the Company remains liable to these participants for the unfunded portion of the plans. The Company records changes in the fair value of the assets in the Company's earnings.

The following tables present the Company’s assets and liabilities that are measured at fair value on a recurring basis at December 31, 2016, and December 31, 2015:

Fair value measurements at reporting date using:
Quoted prices in active markets for identical assetsSignificant other observable inputsSignificant unobservable inputs
DescriptionDecember 31, 2016(Level 1)(Level 2)(Level 3)
Assets(in millions)
Cash equivalents
Cash equivalents (a)$1,344$1,344$—$—
Commercial paper325—325—
Certificates of deposit11—11—
Short-term investments:
Treasury bills1,3451,345——
Certificates of deposit280—280—
Fuel derivatives:
Swap contracts (c)42—42—
Option contracts (b)239——239
Option contracts (c)163——163
Other available-for-sale securities8383——
Total assets$3,832$2,772$658$402
Liabilities
Fuel derivatives:
Swap contracts (c)$(110)$—$(110)$—
Option contracts (b)(96)——(96)
Option contracts (c)(564)——(564)
Interest rate derivatives (see Note 10)(35)—(35)—
Total liabilities$(805)$—$(145)$(660)

(a) Cash equivalents are primarily composed of money market investments.

(b) In the Consolidated Balance Sheet amounts are presented as a net asset. See Note 10.

(c) In the Consolidated Balance Sheet amounts are presented as a net liability. See Note 10.

Fair value measurements at reporting date using:
Quoted prices in active markets for identical assetsSignificant other observable inputsSignificant unobservable inputs
DescriptionDecember 31, 2015(Level 1)(Level 2)(Level 3)
Assets(in millions)
Cash equivalents
Cash equivalents (a)$1,337$1,337$—$—
Commercial paper200—200—
Certificates of deposit13—13—
Eurodollar Time Deposits33—33—
Short-term investments:
Treasury bills1,2481,248——
Certificates of deposit220—220—
Interest rate derivatives (see Note 10)2—2—
Fuel derivatives:
Swap contracts (b)38—38—
Swap contracts (c)931—931—
Option contracts (b)10——10
Option contracts (c)956——956
Other available-for-sale securities9366—27
Total assets$5,081$2,651$1,437$993
Liabilities
Fuel derivatives:
Swap contracts (c)$(774)$—$(774)$—
Option contracts (b)(26)——(26)
Option contracts (c)(2,616)——(2,616)
Interest rate derivatives (see Note 10)(49)—(49)—
Total liabilities$(3,465)$—$(823)$(2,642)

(a) Cash equivalents are primarily composed of money market investments.

(b) In the Consolidated Balance Sheet amounts are presented as a net asset. See Note 10.

(c) In the Consolidated Balance Sheet amounts are presented as a net liability. See Note 10.

The Company had no transfers of assets or liabilities between any of the above levels during the years ended December 31, 2016 or 2015. The Company did not have any assets or liabilities measured at fair value on a nonrecurring basis as of December 31, 2016 or 2015. The following tables present the Company’s activity for items measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for 2016 and 2015:

Fair value measurements using significant unobservable inputs (Level 3)
FuelOther
(in millions)derivativessecuritiesTotal
Balance at December 31, 2015$(1,676)$27$(1,649)
Total gains (losses) (realized or unrealized)
Included in earnings175(2)173
Included in other comprehensive income2018209
Purchases221(a)—221
Sales(61)(a)(33)(94)
Settlements882—882
Balance at December 31, 2016$(258)$—$(258)
The amount of total gains for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at December 31, 2016$93$—$93

(a) The purchase and sale of fuel derivatives are recorded gross based on the structure of the derivative instrument and

whether a contract with multiple derivatives is purchased as a single instrument or separate instruments.

Fair value measurements using significant unobservable inputs (Level 3)
FuelOther
(in millions)derivativessecuritiesTotal
Balance at December 31, 2014$(1,091)$32$(1,059)
Total losses (realized or unrealized)
Included in earnings(646)(1)(647)
Included in other comprehensive income(858)—(858)
Purchases750(a)—750
Sales(196)(a)(4)(200)
Settlements365—365
Balance at December 31, 2015$(1,676)$27$(1,649)
The amount of total losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at December 31, 2015$(428)$—$(428)

(a) The purchase and sale of fuel derivatives are recorded gross based on the structure of the derivative instrument and

whether a contract with multiple derivatives is purchased as a single instrument or separate instruments.

The significant unobservable input used in the fair value measurement of the Company’s derivative option contracts is implied volatility. Holding other inputs constant, a significant increase (decrease) in implied volatility would result in a significantly higher (lower) fair value measurement, respectively, for the Company’s derivative option contracts.

The following table presents a range of the unobservable inputs utilized in the fair value measurements of the Company’s fuel derivatives classified as Level 3 at December 31, 2016:

Quantitative information about Level 3 fair value measurements
Valuation techniqueUnobservable inputPeriod (by year)Range
Fuel derivativesOption modelImplied volatility201716-36%
201820-31%
201918-24%

The carrying amounts and estimated fair values of the Company’s long-term debt (including current maturities), as well as the applicable fair value hierarchy tier, at December 31, 2016, are presented in the table below. The fair values of the Company’s publicly held long-term debt are determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets; therefore, the Company has categorized these agreements as Level 2. Eight of the Company’s debt agreements are not publicly held. The Company has determined the estimated fair value of this debt to be Level 3, as certain inputs used to determine the fair value of these agreements are unobservable. The Company utilizes indicative pricing from counterparties and a discounted cash flow method to estimate the fair value of the Level 3 items.

(in millions)Carrying valueEstimated fair valueFair value level hierarchy
5.125% Notes due 2017$301$303Level 2
French Credit Agreements due 2018 - 2.23%1414Level 3
Fixed-rate 737 Aircraft Notes payable through 2018 - 7.03%88Level 3
2.75% Notes due 2019301306Level 2
Term Loan Agreement payable through 2019 - 6.315%106107Level 3
Term Loan Agreement payable through 2019 - 4.84%2829Level 3
2.65% Notes due 2020492493Level 2
Term Loan Agreement payable through 2020 - 5.223%284284Level 3
737 Aircraft Notes payable through 2020206204Level 3
Term Loan Agreements payable through 2021 - 7.94%2022Level 3
Pass Through Certificates due 2022 - 6.24%324362Level 2
Term Loan Agreement payable through 2026 - 2.36%215215Level 3
3.00% Notes due 2026300284Level 2
7.375% Debentures due 2027130156Level 2
  1. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

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. A rollforward of the amounts included in AOCI, net of taxes, is shown below for 2016 and 2015:

(in millions)Fuel derivativesInterest rate derivativesDefined benefit plan itemsOtherDeferred tax impactAccumulated other comprehensive income (loss)
Balance at December 31, 2014$(1,177)$(45)$41$8$435$(738)
Changes in fair value(867)(5)(19)(2)329(564)
Reclassification to earnings37820——(147)251
Balance at December 31, 2015$(1,666)$(30)$22$6$617$(1,051)
Changes in fair value194(3)(36)14(63)106
Reclassification to earnings97315——(366)622
Balance at December 31, 2016$(499)$(18)$(14)$20$188$(323)

The following table illustrates the significant amounts reclassified out of each component of AOCI for the year ended December 31, 2016:

Year ended December 31, 2016
(in millions)Amounts reclassified from AOCIAffected line item in the Consolidated Statement of Comprehensive Income
AOCI components
Unrealized loss on fuel derivative instruments$973Fuel and oil expense
360Less: Tax expense
$613Net of tax
Unrealized loss on interest rate derivative instruments$15Interest expense
6Less: Tax expense
$9Net of tax
Total reclassifications for the period$622Net of tax
  1. EMPLOYEE RETIREMENT PLANS

Defined Contribution Plans

Southwest has defined contribution plans covering substantially all of its Employees. Contributions under all defined contribution plans are primarily based on Employee compensation and performance of the Company. The Company sponsors Employee savings plans under section 401(k) of the Internal Revenue Code of 1986, as amended, which include Company matching contributions. In addition, the Southwest Airlines Co. ProfitSharing Plan (ProfitSharing Plan) is a defined contribution plan to which the Company may contribute a percentage of its eligible pre-tax profits, as defined, on an annual basis. No Employee contributions to the ProfitSharing Plan are allowed.

Amounts associated with the Company's defined contribution plans expensed in 2016, 2015, and 2014, reflected as a component of Salaries, wages, and benefits, were $937 million, $945 million, and $644 million, respectively.

Postretirement Benefit Plans

The Company provides postretirement benefits to qualified retirees in the form of medical and dental coverage. Employees must meet minimum levels of service and age requirements as set forth by the Company, or as specified in collective-bargaining agreements with specific workgroups. Employees meeting these requirements, as defined, may use accrued unused sick time to pay for medical and dental premiums from the age of retirement until age 65.

The following table shows the change in the accumulated postretirement benefit obligation (APBO) for the years ended December 31, 2016 and 2015:

(in millions)20162015
APBO at beginning of period$201$169
Service cost1311
Interest cost97
Benefits paid(6)(6)
Actuarial loss3820
Plan amendments1—
APBO at end of period$256$201

All plans are unfunded, and benefits are paid as they become due. Estimated future benefit payments expected to be paid are $7 million in 2017, $8 million in 2018, $9 million in 2019, $10 million in 2020, $12 million in 2021, and $90 million for the next five years thereafter.

The funded status (the difference between the fair value of plan assets and the projected benefit obligations) of the Company’s consolidated benefit plans are recognized in the Consolidated Balance Sheet, with a corresponding adjustment to AOCI. The following table reconciles the funded status of the plans to the accrued postretirement benefit cost recognized in Other non-current liabilities on the Company’s Consolidated Balance Sheet at December 31, 2016 and 2015.

(in millions)20162015
Funded status$(256)$(201)
Unrecognized net actuarial (gain)/loss7(31)
Unrecognized prior service cost79
Accumulated other comprehensive income (loss)(14)22
Cost recognized on Consolidated Balance Sheet$(256)$(201)

The consolidated periodic postretirement benefit cost for the years ended December 31, 2016, 2015, and 2014, included the following:

(in millions)201620152014
Service cost$13$11$10
Interest cost977
Amortization of prior service cost333
Recognized actuarial gain—(3)(4)
Settlements——(1)
Net periodic postretirement benefit cost$25$18$15

Unrecognized prior service cost is expensed using a straight-line amortization of the cost over the average future service of Employees expected to receive benefits under the plans. Actuarial gains are amortized utilizing the minimum amortization method. The following actuarial assumptions were used to account for the Company’s postretirement benefit plans at December 31, 2016, 2015, and 2014:

201620152014
Weighted-average discount rate4.25%4.50%4.10%
Assumed healthcare cost trend rate (1)7.08%7.08%6.88%
(1)The assumed healthcare cost trend rate is assumed to remain at 7.08% for 2017, then decline gradually to 5.19% by 2027 and remain level thereafter.

The assumed healthcare cost trend rates have a significant effect on the amounts reported for the consolidated postretirement plans. A one percent change in all healthcare cost trend rates used in measuring the APBO at December 31, 2016, would have the following effects:

(in millions)1% increase1% decrease
Increase (decrease) in total service and interest costs$4$(3)
Increase (decrease) in the APBO$36$(31)

The selection of a discount rate is made annually and is selected by the Company based upon comparison of the expected future cash flows associated with the Company’s future payments under its consolidated postretirement obligations to a yield curve created using high quality bonds that closely match those expected future cash flows. This rate decreased during 2016 due to market conditions. The assumed healthcare trend rate is also reviewed at least annually and is determined based upon both historical experience with the Company’s healthcare benefits paid and expectations of how those trends may or may not change in future years.

  1. INCOME TAXES

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The components of deferred tax assets and liabilities at December 31, 2016 and 2015, are as follows:

(in millions)20162015
DEFERRED TAX LIABILITIES:
Accelerated depreciation$4,726$4,429
Other13462
Total deferred tax liabilities4,8604,491
DEFERRED TAX ASSETS:
Fuel derivative instruments233750
Construction obligation402289
Accrued employee benefits451541
Other400421
Total deferred tax assets1,4862,001
Net deferred tax liability$3,374$2,490

The provision for income taxes is composed of the following:

(in millions)201620152014
CURRENT:
Federal$778$1,292$203
State6911429
Total current8471,406232
DEFERRED:
Federal426(97)421
State30(11)27
Total deferred456(108)448
$1,303$1,298$680

The effective tax rate on income before income taxes differed from the federal income tax statutory rate for the following reasons:

(in millions)201620152014
Tax at statutory U.S. tax rates$1,241$1,218$636
State income taxes, net of federal benefit646637
Other, net(2)147
Total income tax provision$1,303$1,298$680

The only periods subject to examination for the Company’s federal tax return are the 2015 and 2016 tax years.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Southwest Airlines Co.

We have audited the accompanying consolidated balance sheet of Southwest Airlines Co. as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southwest Airlines Co. at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016 in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the consolidated financial statements, the Company has changed its method of accounting for its co-brand credit card agreement and applied the amendments to the FASB Accounting Standard Codification resulting from Accounting Standards Update No. 2009-13, Multiple Deliverable Revenue Arrangements, effective July 1, 2015.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Southwest Airlines Co.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated February 7, 2017 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Dallas, Texas

February 7, 2017

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Southwest Airlines Co.

We have audited Southwest Airlines Co.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (the COSO criteria). Southwest Airlines Co.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying “Management’s Annual Report on Internal Control Over Financial Reporting.” Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Southwest Airlines Co. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Southwest Airlines Co. as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016 and our report dated February 7, 2017 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Dallas, Texas

February 7, 2017

QUARTERLY FINANCIAL DATA

(unaudited)

Three months ended
(in millions except per share amounts)March 31June 30Sept. 30Dec. 31
2016
Operating revenues (a)$4,826$5,384$5,139$5,076
Operating income9441,276695846
Income before income taxes8161,304618809
Net income (b)513820388522
Net income per share, basic (a)(b)0.801.300.630.85
Net income per share, diluted (a)(b)0.791.280.620.84
March 31June 30Sept. 30Dec. 31
2015
Operating revenues (a)$4,414$5,111$5,318$4,977
Operating income7801,0851,2251,026
Income before income taxes723977933847
Net income453608584536
Net income per share, basic (a)0.670.910.890.83
Net income per share, diluted (a)0.660.900.880.82

(a) Includes the impact of the Agreement with Chase and the resulting required change in accounting methodology. The impact of this change during third quarter and fourth quarter 2015 resulted in increases to Operating revenue of approximately $303 million and $124 million, respectively, and increased Basic and Diluted net income per share by approximately $.24 in third quarter 2015 and by approximately $.10 in fourth quarter 2015. The impact of this change resulted in an increase to Operating revenue during first quarter 2016 of approximately $115 million and increased Basic and Diluted net income per share by approximately $.10 and $.09, respectively. The impact of this change resulted in an increase to Operating revenue during second quarter 2016 of approximately $137 million, and increased Basic and Diluted net income per share by approximately $.12 and $.11, respectively. See Note 1 for further detail.

(b) During second quarter 2016, the Company early adopted ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, with an effective date as of January 1, 2016. The prospective method of adoption of this standard resulted in the recognition of $2 million of excess tax benefits to the Company's income tax provision for the six months ended June 30, 2016, but which were related to first quarter 2016. For this presentation and in future periods in which first quarter 2016 results are reported, these amounts are reflected in the appropriate period. The adoption had no impact to net income per share amounts. See Note 2 for further information.

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