The Southwest Airlines Blog tries to explain accounting rules and how how a $120 million quarterly loss is really a profit.

Which leads us back to the original question: “Did we make a profit, or not?”

The short answer is: yes, we made a profit running our airline in the third quarter. Thanks to strong revenues, relatively low costs, gains from hedges that actually settled this quarter, and lots of Employee elbow grease, we actually did pretty great (all things considered). We even beat Wall Street’s expectations!

The long answer is… well, long. There are these things called Generally Accepted Accounting Principles (GAAP) which govern how companies report their financial results. The intent of GAAP is to help standardize and simplify financial reports. In practice, however, GAAP can get really complicated – like, tax code complicated.

Case in point: fuel hedge accounting rules. As you may know, we hedge fuel. This is a great way for us to help control and predict costs. The thing is, GAAP requires us to report certain future-date hedges differently than others, which can result in a “paper gain” or “paper loss” on our books, above and beyond what we actually earned flying Customers and cargo. Why “paper” gains or losses? Because no cash is actually gained or lost in the period when we record them—after all, they’re future hedges. We just have to calculate and record them in a very specific way to comply with GAAP rules.

‘Mark to market’ accounting rules have gotten a lot of bad press in the current financial meltdown (a bit too much bad press in my view, we want to know what an asset is really worth ideally — but not hide our head in the sand and pretend assets are worth more than they are).

But here I think Southwest does a bit of a disservice to GAAP.

(1) Southwest’s earnings from operations number mentions that it includes fuel hedge gains on contracts that closed during the quarter. But if you include the upside of hedging, is it really fair to exclude fuel hedge investments that appear to be under water?

(2) The value of the hedge investment fell, because while Southwest has been brilliant over the years in protecting itself against increasing fuel costs it unsurprisingly didn’t guess the downward trajectory of fuel prices and spent real money and took on hedges that are now under water. Those are *real losses* whether the contracts have closed during the quarter or not.

Japanese banks got themselves in real trouble in the 90s with accounting rules that let them keep junk assets on their books and not report losses, and as long as they didn’t sell the assets they didn’t record the losses. (Japanese accounting rules permitted valuing strips and zeros equally, banks would sell the higher value piece at a paper profit and hold the lower value piece and not record a loss until it was sold, which more or less meant never.) It would be unwise to revert that sort of practice.

Now, if Southwest wants to say “The performance of our airline business made X dollars. Our fuel hedging was kinda a disaster last quarter, and it lost Y. So overall we lost Z. But our airline is great, our people are great, and if we can avoid big mistakes like betting wrong on fuel our future looks bright! And hey, at least we didn’t blow it like United did….” then that would be more than fair.

Southwest lost money for the quarter, even though their airline itself was pretty well run. Ironically they lost money because fuel got less expensive. The world’s a strange place. But own it, buster!