Summary of Significant Accounting Policies

12 Months Ended

Mar. 31, 2012

Notes to Financial Statements

Summary of Significant Accounting Policies

1. Summary of Significant Accounting Policies

Organization and Nature of Operations.  Earthstone Energy, Inc. was originally organized in July 1969 as Basic Earth Science Systems, Inc. and changed its name in 2011 to Earthstone Energy, Inc.  The Company is principally engaged in the acquisition, exploration, development, and production of crude oil and natural gas properties, primarily operating in the North Dakota and Montana portions of the Williston basin and south Texas.

Principles of Consolidation.  The consolidated financial statements include the accounts of Earthstone Energy, Inc. and its wholly-owned subsidiary.  All significant intercompany accounts and transactions have been eliminated.  The Company does not have any unconsolidated special purpose entities.

At the directive of the Securities and Exchange Commission to use “plain English” in public filings, the Company will use such terms as “we,” “our,” “us” or “the Company” in place of Earthstone Energy, Inc. and its wholly-owned subsidiary.  When such terms are used in this manner throughout this document, they are in reference only to the corporation, Earthstone Energy, Inc. and its subsidiaries, and are not used in reference to the Board of Directors, corporate officers, management, or any individual employee or group of employees.

Basis of Presentation.  The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP").

Oil and Gas Sales.  We derive revenue primarily from the sale of produced natural gas and crude oil.  Revenues from production on properties in which the Company shares an economic interest with other owners are recognized on the basis of the Company's interest.  Revenues are reported on a gross basis for the amounts received before taking into account production taxes and transportation costs, which are reported as separate expenses.  Revenue is recorded and receivables are accrued using the sales method, which occurs in the month production is delivered to the purchaser, at which time ownership of the oil is transferred to the purchaser.  Payment is generally received between 30 and 90 days after the date of production.  Estimates of the amount of production delivered to purchasers and the prices at which it was delivered are necessary at year end.  Management’s knowledge of the Company’s properties, their historical performance, the anticipated effect of weather conditions during the month of production, NYMEX and local spot market prices, and other factors are the basis for these estimates.  Variances between estimates and the actual amounts received are recorded when payment is received, or when better information is available.

Oil and Gas Reserves. Oil and gas reserves represent theoretical, estimated quantities of crude oil and natural gas which geological and engineering data estimate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.  There are numerous uncertainties inherent in estimating oil and gas reserves and their values, including many factors beyond the Company’s control.  Accordingly, reserve estimates are different from the future quantities of oil and gas that are ultimately recovered and the corresponding lifting costs associated with the recovery of these reserves.

Oil and Gas Property.  The Company uses the full cost method of accounting for costs related to its oil and gas property.  Accordingly, all costs associated with the acquisition, exploration and development of oil and gas reserves (including the costs of unsuccessful efforts) are capitalized.  These costs include land acquisition costs, geological and geophysical expense, carrying charges on non-producing properties, costs of drilling, and overhead charges directly related to acquisition and exploration activities.

Under the full cost method, no gain or loss is recognized upon the sale or abandonment of oil and gas property unless non-recognition of such gain or loss would significantly alter the relationship between capitalized costs and proved oil and gas reserves.

Capitalized costs are subject to a ceiling test, as prescribed by Securities and Exchange Commission (“SEC”) regulations, that limits such pooled costs to the aggregate of the present value of future net cash flows attributable to proved oil and gas reserves, less future cash outflows associated with the asset retirement obligation that have been accrued plus the lower of cost or estimated fair value of unproved properties not being amortized less any associated tax effects.  Prices are held constant for the productive life of each well.  If the full cost pool of capitalized oil and gas property costs exceeds the ceiling, the excess is reflected as a non-cash charge to earnings.  The write-down is permanent and not reversible in future periods, even though higher oil and gas prices in the future may subsequently and significantly increase the ceiling amount.  As of the balance sheet date, capitalized costs did not exceed the ceiling test limit.

For the years ended March 31, 2012 and 2011, the oil and natural gas prices used to calculate the full cost ceiling limitation are the 12 month average prices, calculated as the unweighted arithmetic average price of oil and gas on the first day of each month for each of the 12 months prior to the last day of the reporting period (unless prices are defined by contractual arrangements) and net cash flows are discounted at 10 percent.

Unproved properties are excluded from the ceiling test.  Instead, these property costs are periodically reviewed for impairment by reviewing the status of the activity on those properties and surrounding properties either held by us or other parties.

Capitalized costs of oil and gas property, excluding those pertaining to unproved properties, are depleted on a composite units-of-production method based on estimated proved reserves.  For depletion purposes, the volume of reserves and production is converted into a common unit of measure at the energy equivalent conversion rate of six thousand cubic feet of natural gas to one barrel of crude oil.  Investments in unproved properties and major development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs.  If the results of an assessment indicate that the properties are impaired, the amount of the impairment is added to the capitalized costs to be amortized.

Oil and Gas Production Costs.  Costs incurred to operate and maintain wells and related equipment and facilities are expensed as incurred.  Production costs (also referred to as lifting costs) include the costs of labor to operate the wells and related equipment and facilities, repairs and maintenance, materials, supplies, and fuel consumed and supplies utilized in operating the wells and related equipment and facilities, property taxes and insurance applicable to proved properties and wells and related equipment and facilities, and severance taxes.

Asset Retirement Obligation.  The Company's activities are subject to various laws and regulations, including legal and contractual obligation to plug, reclaim, remediate, or otherwise restore oil and gas property at the time such asset ceases to be productive.  An asset retirement obligation ("ARO") is initially measured at fair value and recorded as a liability with a corresponding asset when incurred if a reasonable estimate of fair value can be made.  This is typically when a well is completed or an asset is placed in service.  When the ARO is initially recorded, the Company capitalizes the cost by increasing the carrying value of the full cost pool.  Over time, the liability increases for the change in its present value (and accretion expense is recorded), while the capitalized cost decreases by way of depletion of the full cost pool.  Estimates are reviewed quarterly and adjusted in the period in which new information results in a change of estimate.

Income Tax.  Income taxes are computed using the asset and liability method.  Accordingly, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities, their respective tax bases as well as the effect of net operating losses, tax credits and tax credit carry-forwards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the year in which the differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in income tax rates is recognized in the results of operations in the period that includes the enactment date.

No significant uncertain tax positions were identified as of any date on or before March 31, 2012.  The Company’s policy is to recognize interest and penalties related to uncertain tax benefits in income tax expense.  As of March 31, 2012, the Company has not recognized any interest or penalties related to uncertain tax benefits.  For further information, see Note 8 below.

Earnings Per Share.  Basic and diluted earnings per share are computed by dividing net income by the weighted average number of common shares outstanding for the period, after giving effect to the 1-for-10 reverse stock split effective December 31, 2010.  As of the balance sheet date, no dilutive securities were outstanding.

Cash and Cash Equivalents.  All highly liquid investments with original maturities of ninety days or less are considered to be cash equivalents.  During the period and at the balance sheet date, balances of cash and cash equivalents exceeded the federally insured limit.

Fair Value Measurements.  Financial instruments and nonfinancial assets and liabilities, whether measured on a recurring or non-recurring basis, are recorded at fair value.  A fair value hierarchy, established by the Financial Accounting Standards Board, prioritizes the inputs used to measure fair value.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).

The Company’s financial instruments consist of cash and cash equivalents, trade receivables, trade payables and accrued liabilities, all of which are considered to be representative of their fair market value, due to the short-term and highly liquid nature of these instruments.

As discussed in Note 5, the Company incurred asset retirement obligations of $133,000 and $49,000 during the years ended March 31, 2012 and 2011, respectively, the value of which was determined using unobservable pricing inputs (or Level 3 inputs).  The Company uses the income valuation technique to estimate the fair value of the obligation using several assumptions and judgments about the ultimate settlement amounts, inflation factors, credit adjusted discount rates, and timing of settlement.

Hedging Activities.  We had no hedging activities in the years ended March 31, 2012 and 2011.  Hedging strategies, or absence of hedging, may vary or change due to change of circumstances, unforeseen opportunities, inability to fund margin requirements, lending institution requirements and other events which we are not able to anticipate.

Support Equipment.  Support equipment (including such items as vehicles, well servicing equipment, and office furniture and equipment) is stated at the lower of cost or market.  Depreciation of support equipment is computed using primarily the straight-line method over periods ranging from five to seven years.

Inventory.  Inventory, consisting primarily of tubular goods and oil field equipment to be used in future drilling operations or repair operations, is stated at the lower of cost or market, cost being determined by the FIFO method.  See also Notes 2 and 3 below.

Commitments.  The Company is committed to $8,750 per month plus maintenance fees on a 6,200 square foot office space located in downtown Denver, Colorado.  The lease term ends on May 31, 2013.  The Company does not have any off-balance sheet financing transactions, arrangements or obligations.

Major Customers and Operating Region.  The Company operates exclusively within the United States of America.  All of the Company's assets are employed in and all of its revenues are derived from the oil and gas industry.  Individual purchasers of 10% or more of the Company's oil and gas production revenue from operated wells for the years ended March 31, 2012 and 2011, were as follows:

	2012			2011
Valero Energy Company		20	%		19	%
Plains Marketing LP		11	%		4	%
Total		31	%		23	%

For the years ended March 31, 2012 and 2011, approximately 57% and 52%, respectively, of Earthstone’s oil and gas revenue was from non-operated properties where the Company has no direct contact with the actual purchaser.  On these properties, Earthstone’s portion of the product was marketed by the 21 different companies who operate these wells.  These 21 companies may, unbeknownst to us, market to one or more of the same purchasers to whom we sell directly.  Therefore, we are unable to ascertain the total extent of combined purchaser concentration.  To the extent of our knowledge, in the event of the bankruptcy of any one of these purchasers, it has been estimated that the reduction in annual revenue would be less than 10%.  It is not expected that the loss of any one of these purchasers would cause a material adverse impact on the Company’s results from operations, as alternative markets for oil and gas production are readily available.

Bad Debt Expense.  A charge is recognized in general and administrative expenses and an allowance is established against specific receivable balances from joint interest owners in instances where working interest owners dispute amounts billed for their proportionate share in the cost of wells which the Company operates.  As individual disputes are resolved, either the expense is reversed in the period of the resolution or the receivable is written down.

Share-Based Compensation.  The Company recognizes all equity-based compensation as share-based compensation expense, included in general and administrative expenses, based on the fair value of the compensation measured at the grant date.  The expense is recognized over the vesting period of the grant.  See Note 7 below for information.

Use of Estimates.  The preparation of financial statements in conformity with U.S. GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  These estimates and assumptions concern matters that are inherently uncertain.  Estimates and assumptions are revised periodically and the effects of revisions are reflected in the financial statements in the period it is determined to be necessary.  Actual results could differ from those estimates.

Reclassifications. Certain prior year amounts were reclassified to conform to current presentation.  Such reclassifications had no effect on the prior year net income, accumulated deficit, net assets or total shareholders' equity.

Recent Accounting Pronouncements

In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities.  This ASU requires the Company to disclose both net and gross information about assets and liabilities that have been offset, if any, and the related arrangements.  The disclosures under this new guidance are required to be provided retrospectively for all comparative periods presented.  The Company is required to implement this guidance effective for the first quarter of fiscal 2014 and does not expect the adoption of ASU 2011-11 to have a material impact on its consolidated financial statements.

Various other accounting pronouncements have been recently issued, most of which represented technical corrections to the accounting literature or were applicable to specific industries, and are not expected to have a material effect on our financial position, results of operations, or cash flows.

Subsequent Events

On June 1, 2012, we received a commitment for a line of credit in an amount up to $4,000,000 with The Bank of Oklahoma.  The Company expects to finalize in the ensuing weeks.  This line of credit will enable the Company to take advantage of opportunities that may arise in the future.

For the year ended March 31, 2012, there were no other subsequent events to recognize or disclose in the consolidated financial statements which would either impact the results reflected in this report or the Company’s results going forward.