Chesapeake Energy 2012 Annual Report Download - page 77

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Application of Critical Accounting Policies
Readers of this report and users of the information contained in it should be aware that certain events may impact
our financial results based on the accounting policies in place. The four policies we consider to be the most significant
are discussed below. The Company's management has discussed each critical accounting policy with the Audit
Committee of the Company's Board of Directors.
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.
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 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 those of 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 SEC's full cost accounting rules 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 natural gas and oil cash flow hedges) less estimated future
expenditures to be incurred in developing and producing the proved reserves, less any related income tax effects. 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 prior to the ending date of the quarterly
period. 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 designated 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. See
Natural Gas and Oil Properties in Note 1 of the notes to our consolidated financial statements included in Item 8 of
this report for further information on the full cost method of accounting.