Chesapeake Energy 2010 Annual Report Download - page 104

and oil business activities: the successful efforts method and the full-cost method. Chesapeake follows the full-
cost method of accounting under which all costs associated with property acquisition, exploration and
development activities are capitalized. We also capitalize internal costs that can be directly identified with our
acquisition, exploration and development activities and do not include any costs related to production, general
corporate overhead or similar activities.
Under the successful efforts method, geological and geophysical costs and costs of carrying and retaining
undeveloped properties are charged to expense as incurred. Costs of drilling exploratory wells that do not
result in proved reserves are charged to expense. Depreciation, depletion, amortization and impairment of
natural gas and oil properties are generally calculated on a well by well or lease or field basis versus the
aggregated “full-cost” pool basis. Additionally, gain or loss is generally recognized on all sales of natural gas
and oil properties under the successful efforts method. As a result, our financial statements will differ from
companies that apply the successful efforts method since we will generally reflect a higher level of capitalized
costs as well as a higher natural gas and oil depreciation, depletion and amortization rate, and we will not have
exploration expenses that successful efforts companies frequently have.
Under the full-cost method, capitalized costs are amortized on a composite unit-of-production method
based on proved natural gas and oil reserves. If we maintain the same level of production year over year, the
depreciation, depletion and amortization expense may be significantly different if our estimate of remaining
reserves or future development costs changes significantly. Proceeds from the sale of properties are
accounted for as reductions of capitalized costs unless such sales involve a significant change in proved
reserves and significantly alter the relationship between costs and proved reserves, in which case a gain or
loss is recognized. The costs of unproved properties are excluded from amortization until the properties are
evaluated. We review all of our unevaluated properties quarterly to determine whether or not and to what
extent proved reserves have been assigned to the properties, and otherwise if impairment has occurred.
Unevaluated properties are grouped by major producing area where individual property costs are not significant
and are assessed individually when individual costs are significant.
We review the carrying value of our natural gas and oil properties under the full-cost accounting rules of
the Securities and Exchange Commission on a quarterly basis. This quarterly review is referred to as a ceiling
test. Under the ceiling test, capitalized costs, less accumulated amortization and related deferred income taxes,
may not exceed an amount equal to the sum of the present value of estimated future net revenues (adjusted
for cash flow hedges) less estimated future expenditures to be incurred in developing and producing the proved
reserves, less any related income tax effects. For 2010 and 2009, in calculating estimated future net revenues,
current prices are calculated as the unweighted arithmetic average of natural gas and oil prices on the first day
of each month within the 12-month period ended. Costs used are those as of the end of the appropriate
quarterly period. For 2008, current prices and costs used are those as of the end of the appropriate quarterly
period. Such prices are utilized except where different prices are fixed and determinable from applicable
contracts for the remaining term of those contracts, including the effects of derivatives qualifying as cash flow
hedges.
Two primary factors impacting this test are reserve levels and natural gas and oil prices, and their
associated impact on the present value of estimated future net revenues. Revisions to estimates of natural gas
and oil reserves and/or an increase or decrease in prices can have a material impact on the present value of
estimated future net revenues. Any excess of the net book value, less deferred income taxes, is generally
written off as an expense.
Income Taxes. As part of the process of preparing the consolidated financial statements, we are required
to estimate the federal and state income taxes in each of the jurisdictions in which Chesapeake operates. This
process involves estimating the actual current tax exposure together with assessing temporary differences
resulting from differing treatment of items, such as derivative instruments, depreciation, depletion and
amortization, and certain accrued liabilities for tax and accounting purposes. These differences and our net
operating loss carryforwards result in deferred tax assets and liabilities, which are included in our consolidated
balance sheet. We must then assess, using all available positive and negative evidence, the likelihood that the
deferred tax assets will be recovered from future taxable income. If we believe that recovery is not likely, we
must establish a valuation allowance. Generally, to the extent Chesapeake establishes a valuation allowance
or increases or decreases this allowance in a period, we must include an expense or reduction of expense
within the tax provision in the consolidated statement of operations.
58