Chesapeake Energy 2014 Annual Report Download - page 92

CHESAPEAKE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
84
Fair Value Measurements
Certain financial instruments are reported at fair value on our consolidated balance sheets. Under fair value
measurement accounting guidance, fair value is defined as the amount that would be received from the sale of an
asset or paid for the transfer of a liability in an orderly transaction between market participants, (i.e., an exit price). To
estimate an exit price, a three-level hierarchy is used. The fair value hierarchy prioritizes the inputs, which refer broadly
to assumptions market participants would use in pricing an asset or a liability, into three levels. Level 1 inputs are
unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 2
inputs are inputs other than quoted prices within Level 1 that are observable for the asset or liability, either directly or
indirectly. Level 3 inputs are unobservable inputs for the asset or liability and have the lowest priority.
The valuation techniques that may be used to measure fair value include a market approach, an income approach
and a cost approach. A market approach uses prices and other relevant information generated by market transactions
involving identical or comparable assets or liabilities. An income approach uses valuation techniques to convert future
amounts to a single present amount based on current market expectations, including present value techniques, option-
pricing models and the excess earnings method. The cost approach is based on the amount that currently would be
required to replace the service capacity of an asset (replacement cost).
The carrying values of financial instruments comprising cash and cash equivalents, restricted cash, accounts
payable and accounts receivable approximate fair values due to the short-term maturities of these instruments.
Derivatives
Derivative instruments are recorded on our consolidated balance sheets as derivative assets or derivative liabilities
at fair value, and changes in a derivative’s fair value are recognized currently in earnings unless specific hedge
accounting criteria are followed. For qualifying commodity derivative instruments designated as 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. Any change in fair value resulting from ineffectiveness is recognized immediately
in earnings. Locked-in gains and losses of settled cash flow hedges are recorded in accumulated other comprehensive
income and are transferred to earnings in the month of production. Changes in the fair value of interest rate derivative
instruments designated as fair value hedges are recorded on the consolidated balance sheets as assets or liabilities,
and the debt's carrying value amount is adjusted by the change in the fair value of the debt subsequent to the initiation
of the derivative. Differences between the changes in the fair values of the hedged item and the derivative instrument,
if any, represent hedge ineffectiveness and are recognized currently in earnings. Locked-in gains and losses related
to settled fair value hedges are amortized as an adjustment to interest expense over the remaining term of the related
senior notes. We have elected not to designate any of our qualifying commodity and interest rate derivatives as cash
flow or fair value hedges. Therefore, changes in fair value of these derivatives that occur prior to their maturity (i.e.,
temporary fluctuations in value) are recognized in our consolidated statements of operations within oil, natural gas and
NGL sales and interest expense, respectively.
Derivative instruments reflected as current in the consolidated balance sheets represent the estimated fair value
of derivatives scheduled to settle over the next twelve months based on market prices/rates as of the respective balance
sheet dates. Cash settlements of our derivative instruments are generally classified as operating cash flows unless
the derivatives are deemed to contain, for accounting purposes, a significant financing element at contract inception,
in which case these cash settlements are classified as financing cash flows in the accompanying consolidated statement
of cash flows. All of our derivative instruments are subject to master netting arrangements by contract type (i.e.,
commodity, interest rate and cross currency contracts) which provide for the offsetting of asset and liability positions
within each contract type, as well as related cash collateral if applicable, by counterparty. Therefore, we net the value
of our derivative instruments by contract type with the same counterparty in the accompanying consolidated balance
sheets.
We have established the fair value of our derivative instruments using established index prices, volatility curves
and discount factors. These estimates are compared to our counterparty values for reasonableness. 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. Derivative transactions are subject to the risk
that counterparties will be unable to meet their obligations. This 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. See Note 11
for further discussion of our derivative instruments.