Chesapeake Energy 2010 Annual Report Download - page 103

The selection and application of accounting policies are an important process that changes as our
business changes and as accounting rules are developed. Accounting rules generally do not involve a
selection among alternatives, but involve an implementation and interpretation of existing rules and the use of
judgment to the specific set of circumstances existing in our business.
Hedging. Chesapeake uses commodity price and financial risk management instruments to mitigate our
exposure to price fluctuations in natural gas and oil and changes in interest rates and foreign exchange rates.
Recognized gains and losses on derivative contracts are reported as a component of the related transaction.
Results of natural gas and oil derivative contracts are reflected in natural gas and oil sales, and results of
interest rate and foreign exchange rate hedging contracts are reflected in interest expense. The changes in the
fair value of derivative instruments not qualifying for designation as either cash flow or fair value hedges that
occur prior to maturity are reported currently in the consolidated statement of operations as unrealized gains
(losses) within natural gas and oil sales or interest expense. Cash flows from derivative contracts are classified
in the same category within the statement of cash flows as the items being hedged, or on a basis consistent
with the nature of the instruments.
Accounting guidance for derivatives and hedging establishes accounting and reporting standards requiring
that derivative instruments (including certain derivative instruments embedded in other contracts) be recorded
at fair value and included in the consolidated balance sheet as assets or liabilities. The accounting for changes
in the fair value of a derivative instrument depends on the intended use of the derivative and the resulting
designation, which is established at the inception of a derivative. For derivative instruments designated as
natural gas and oil cash flow hedges, changes in fair value, to the extent the hedge is effective, are recognized
in other comprehensive income until the hedged item is recognized in earnings as natural gas and oil sales.
Any change in the fair value resulting from ineffectiveness is recognized immediately in natural gas and oil
sales. For derivative instruments designated as fair value hedges, changes in fair value, as well as the
offsetting changes in the estimated fair value of the hedged item attributable to the hedged risk, are recognized
currently in earnings as interest expense. Differences between the changes in the fair values of the hedged
item and the derivative instrument, if any, represent gains or losses on ineffectiveness and are reflected
currently in interest expense. Hedge effectiveness is measured at least quarterly based on the relative changes
in fair value between the derivative contract and the hedged item over time. Changes in fair value of contracts
that do not qualify as hedges or are not designated as hedges are also recognized currently in earnings as
interest expense. See Hedging Activities above and Item 7A. Quantitative and Qualitative Disclosures About
Market Risk for additional information regarding our hedging activities.
One of the primary factors that can have an impact on our results of operations is the method used to
value our derivatives. We have established the fair value of our derivative instruments utilizing established
index prices, volatility curves and discount factors. These estimates are compared to our counterparty values
for reasonableness. Derivative transactions are also subject to the risk that counterparties will be unable to
meet their obligations. Such non-performance risk is considered in the valuation of our derivative instruments,
but to date has not had a material impact on the values of our derivatives. The values we report in our financial
statements are as of a point in time and subsequently change as these estimates are revised to reflect actual
results, changes in market conditions and other factors.
Another factor that can impact our results of operations each period is our ability to estimate the level of
correlation between future changes in the fair value of the hedge instruments and the transactions being
hedged, both at inception and on an ongoing basis. This correlation is complicated since energy commodity
prices, the primary risk we hedge, have quality and location differences that can be difficult to hedge effectively.
The factors underlying our estimates of fair value and our assessment of correlation of our hedging derivatives
are impacted by actual results and changes in conditions that affect these factors, many of which are beyond
our control.
Due to the volatility of natural gas and oil prices and, to a lesser extent, interest rates and foreign
exchange rates, the company’s financial condition and results of operations can be significantly impacted by
changes in the market value of our derivative instruments. As of December 31, 2010, 2009 and 2008, the fair
value of our derivatives was a liability of $761 million, a liability of $63 million and an asset of $1.165 billion,
respectively.
Natural Gas and Oil Properties. The accounting for our business is subject to special accounting rules that
are unique to the natural gas and oil industry. There are two allowable methods of accounting for natural gas
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