Earnings Quality Report: Chesapeake Energy Corp. (NYSE: CHK)

Accruals are estimates by company management of non-cash expenses, assets and liabilities that are recognized before they are paid. They are calculated as net operating cash flow less net income.

The analysis of accruals can help signal possible earnings management of reported net income and EPS results. For example, ‘Over-Accrued’ can signal under reported net income and/or the building of balance sheet reserve accounts, while ‘Under-Accrued’ can signal inflated Net Income results and/or release of balance sheet reserves to aid reported earnings.

The annual trend suggests that CHK-US’s accruals to revenue ratio has increased 4.0 percentage points from last year’s low but is still below its four-year average accruals to revenue ratio of 66.6%. While its accruals to revenue ratio increased to 39.7% from 35.7% (in 2010), its peer median decreased during this period to 37.9% from 40.2%. Relative to peers, accruals to revenue ratio rose 6.3 percentage points (and ended higher than its peer median).

On a quarterly basis, CHK-US’s accruals to revenue ratio is its highest over the last five quarters and compares to a low of -11.8% in 2012-06-30. The increase in its accruals to revenue ratio to 95.7% from -11.8% was also accompanied by an increase in its peer median during this period to 65.2% from 18.4%. Relative to peers, accruals to revenue ratio rose 60.7 percentage points (and ended higher than its peer median).

CHK-US reported relatively weak net income margins for the last twelve months (-4.5% vs. peer median of 10.4%). However, the company booked a level of accruals that is around peer median (44.3% vs. peer median of 40.6%) for the same period, suggesting that its reported net income is supported by a reasonable level of accruals.

CHK-US’s accruals over the last twelve months are positive suggesting a buildup of reserves. However, this level of accruals is also around the peer median and suggests the company is recording a proper level of reserves compared to its peers.

We assess the impact of various categories on the cash flow of the company by performing a variance

analysis. For each category, this variance analysis measures the movement between the current and previous periods, normalized for the size of the company (e.g. days outstanding or percentage of revenues). This normalization eliminates any movement attributable to period-by-period growth and helps isolate the impact of any accounting policy changes the company might have made in recording the values in each category.

The chart on the right shows the impact of the top accounting categories on Chesapeake Energy Corp.’s cash flow for the current quarter. We consider both positive and negative impacts on the cash flow since the categories could have either decreased or increased the reported net income.

The table below details the impact of the major accounting categories on Chesapeake Energy Corp.’s net operating cash flow for the current quarter. While we have identified the major accrual categories, and conduct several tests on this standardized set, it should be noted that companies can sometimes have a non-standard accrual item that has a higher impact on the difference between net operating cash flow and net income.

For further reference, we provide an extended analysis of the quality of accounting for each accrual category and the company’s results. We judge these results by comparing (i) against the company’s previous accounting policy — to ascertain if the policy has changed or (ii) against the peer group — to check if the company is being more aggressive or conservative than the peers or (iii) the appropriateness of the change and its implication. Log-in for this portion of our report.

Chesapeake Energy Corp. explores, develops and produces oil and natural gas properties. Its principal activities include discovering and developing unconventional natural gas and oil fields onshore in the U.S. The company has also vertically integrated its operations and owns substantial marketing, midstream and oilfield services businesses directly and indirectly through its subsidiaries Chesapeake Energy Marketing, Inc., Chesapeake Midstream Development LP, Chesapeake Oilfield Services LLC, and Chesapeake Midstream Partners LP. Chesapeake Energy operates its business though the following segments: Exploration and Production; Natural Gas and Oil Marketing; Gathering and Compression; and Oilfield Services. The Exploration and Production segment is responsible for finding and producing natural gas and oil. The Marketing, Gathering and Compression segment is responsible for marketing, gathering and compression of natural gas and oil primarily from Chesapeake-operated wells. The Oilfield Services segment is responsible for contract drilling, oilfield trucking, oilfield rental, pressure pumping and other oilfield services operations for both Chesapeake-operated wells and wells operated by third parties. The company was founded by Aubrey K. McClendon and Tom L. Ward on May 18, 1989 and is headquartered in Oklahoma City, OK.

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