NOTE A—ORGANIZATION AND ACCOUNTING POLICIES

Nature of Operations

Warren Resources, Inc. (the "Company" or "Warren"), was originally formed on June 12, 1990 for the purpose of acquiring and developing oil and gas properties. The Company is incorporated under the laws of the state of Maryland. The Company's properties are located in California, Wyoming, New Mexico, North Dakota and Texas.

Principles of Consolidation

The consolidated financial statements include accounts of the Company, its wholly-owned subsidiaries, Warren Development Corp., Warren Drilling Corp., Warren Management Corp., Warren Resources of California, Inc., Warren Energy Services LLC and Warren E&P, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation.

Oil and Gas Properties

The Company accounts for its oil and gas activities using the full cost method. As prescribed by full cost accounting rules, all costs associated with property acquisition, exploration and development activities are capitalized. Exploration and development costs include dry hole costs, geological and geophysical costs, direct overhead related to exploration and development activities and other costs incurred for the purpose of finding oil and gas reserves. Salaries and benefits paid to employees directly involved in the exploration and development of oil and gas properties as well as other internal costs that can be specifically identified with acquisition, exploration and development activities are also capitalized. Proceeds received from disposals are credited against accumulated cost except when the sale represents a significant disposal of reserves, in which case a gain or loss is recognized. The sum of net capitalized costs and estimated future development and dismantlement costs are depleted on the equivalent unit-of-production method, based on proved oil and gas reserves as determined by independent petroleum engineers.

In accordance with full cost accounting rules, the Company is subject to a limitation on capitalized costs. The capitalized cost of oil and gas properties, net of accumulated depreciation, depletion and amortization, may not exceed the estimated future net cash flows from proved oil and gas reserves discounted at 10 percent, plus the cost of unproved properties excluded from amortization, as adjusted for related tax effects. If capitalized costs exceed this limit (the "ceiling limitation"), the excess must be charged to expense. There was no impairment charge in 2012, 2011 or 2010.

The costs of certain unevaluated oil and gas properties and exploratory wells being drilled are not included in the costs subject to amortization. The Company assesses costs not being amortized for possible impairments or reductions in value and if impairments or a reduction in value has occurred, the portion of the carrying cost in excess of the current value is transferred to costs subject to amortization.

Revenue Recognition

Oil and gas sales result from undivided interests held by the Company in various oil and gas properties. Sales of natural gas and oil produced are recognized when delivered to, or picked up, by the purchaser. For 2012, the largest purchasers and marketers for the Company's production primarily included Phillips 66 (formerly ConocoPhillips, Inc.) and Anadarko Energy Services, which accounted for 55% and 38%, respectively, of total oil and natural gas sold in 2012. For 2011, the largest purchasers and marketers for the Company's production primarily included ConocoPhillips and Anadarko Energy Services, which accounted for 52% and 38%, respectively, of total oil and natural gas sold in 2011. For 2010, the largest purchasers and marketers for the Company's production primarily included ConocoPhillips and Anadarko Energy Services, which accounted for 55% and 33%, respectively, of total oil and natural gas sold in 2010.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturities of three months or less when acquired to be cash equivalents. The Company maintains its cash and cash equivalents in bank deposit accounts that may exceed federally insured limits. At December 31, 2012, the Company had the majority of its cash and cash equivalents with one financial institution. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk on cash and cash equivalents.

Accounts Receivable

Accounts receivable include trade receivables from joint interest owners and oil and gas purchasers. Credit is extended based on evaluation of a customer's financial condition and, generally, collateral is not required. Accounts receivable under joint operating agreements generally have a right of offset against future oil and gas revenues if a producing well is completed. Accounts receivable are due within 30 days and are stated at amounts due from customers net of an allowance for doubtful accounts when the Company believes collection is doubtful. Accounts outstanding longer than the contractual payment terms are considered past due. The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the Company's previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off specific accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. As of December 31, 2012 and 2011, the Company has an allowance of $13,000 for doubtful accounts.

Investments

The Company classifies its investment in debt securities into two categories: trading securities and available-for-sale securities. Trading securities, classified as current assets, are recorded at fair value with net unrealized gains or losses included in the determination of net earnings. Available-for- sale securities are recorded at fair value, with net unrealized gains and losses excluded from net earnings and reported as other comprehensive income (loss). Available-for-sale securities represent the market value of zero coupon Treasury Bonds collateralizing convertible debentures and are classified as current or non-current based on the classification of the related debentures. Realized gains and losses are determined on the basis of specific identification of the securities.

Offering Costs

Costs incurred in connection with the issuance of debt are capitalized and amortized over the term of the related debt using the effective interest rate method. The Company has $1.5 million and $1.5 million, net of accumulated amortization of $584 thousand and $377 thousand, included in other assets at December 31, 2012 and 2011, respectively. Costs associated with the issuance of preferred and common stock are reflected as a reduction of proceeds. Preferred stock is accreted to its liquidation value over seven years from the date of issuance.

Income Taxes

Deferred income taxes are recognized for the tax consequences in future years of differences between the tax basis of assets and liabilities and their financial reporting amounts based on enacted tax laws and statutory rates applicable to the period in which the differences are expected to affect taxable income. Valuation allowances are established when, in management's opinion, it is more likely than not that a portion or all of the deferred tax assets will not be realized. The Company's policy is to classify accrued penalties and interest related to unrecognized tax benefits in the Company's income tax provision. The Company routinely assesses potential uncertain tax positions and, if required, establishes accruals for such amounts. Only tax positions that meet the more-likely-than-not recognition threshold are recorded.

Use of Estimates

In preparing financial statements, accounting principles generally accepted in the United States of America require management to make estimates and assumptions in determining the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. In addition, significant estimates are used in determining year end proved oil and gas reserves. Actual results could differ from those estimates. The estimate of the Company's oil and natural gas reserves, which is used to compute depreciation, depletion, amortization and impairment of oil and gas properties, is the most significant of the estimates and assumptions that affect reported results.

Gas Imbalances

The Company follows the sales method of accounting for gas imbalances. A liability is recorded when the Company's excess takes of natural gas volumes exceed its estimated remaining recoverable reserves. No receivables are recorded for those wells where the Company has taken less than its ownership share of gas production. The Company has no significant gas imbalances.

Stock Based Compensation

The Company uses the Black-Scholes option-pricing formula and the Monte Carlo Simulation method to estimate the fair value of stock based compensation expense at the grant date related to stock options and restricted stock issued. This expense is then recognized using the straight-line method over the vesting period. For the years ended December 31, 2012, 2011 and 2010, the Company recognized approximately $2.6 million, $1.5 million and $2.4 million in compensation expense, respectively, related to stock option plans and restricted stock. Both the Black-Scholes and the Monte Carlo Simulation method require numerous assumptions, including volatility, service periods and cancellations in their calculations.

The fair value of each grant is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted-average assumptions used for grants in 2012, 2011 and 2010, respectively: No expected dividends, weighted average volatility of 72%, 75%, and 78%, risk-free interest rates of 0.43%, 1.26%, and 1.60% and expected lives of 3.5 years for incentive options issued in 2012, 2011 and 2010. The volatility assumptions were calculated based on the performance of our stock prices for the year. The weighted average fair values of the options issued in 2012, 2011 and 2010 were $1.41, $2.04, and $1.33, respectively.

Accounting for Long-Lived Assets

The Company reviews property and equipment for impairment whenever indicators of impairment are present to determine if the carrying amounts exceed the estimated future net cash flows to be realized. Impairment losses are recognized based on the estimated fair value of the asset.

Derivative financial instruments

The Company has entered into several crude oil and natural gas hedges in order to minimize any effect of a downturn in oil and gas prices and protect profitability. These derivative financial instruments are carried on the balance sheet at fair value. If a derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If a derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive income ("OCI") and are recognized in the statement of operations when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. The Company has elected not to designate its derivatives as fair value or cash flow hedges (Note I). Gains and losses resulting from changes in the fair value of the non-designated hedges are recognized in earnings.

Property and Equipment

Property and equipment are stated at cost and are depreciated using the straight-line method over the estimated useful lives of the assets, ranging from three through 25 years, except for land which is not depreciated. Property and equipment consisted of the following at December 31:

	2012		2011

	(in thousands)
Drilling rig	$	18,318	$	16,627
Equipment		1,542		1,543
Automobiles and trucks		876		662
Furniture and fixtures		461		422
Land and buildings		905		872
Office equipment		1,786		1,424

		23,888		21,550
Less accumulated depreciation and amortization		5,947		4,624

	$	17,941	$	16,926

Earnings (Loss) Per Common Share

Basic earnings (loss) per common share is computed by dividing the net earnings (loss) applicable to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share is based on the assumption that stock options and warrants are converted into common shares using the treasury stock method and convertible debentures and preferred stock are converted using the if-converted method. Conversion or exercise is not assumed if the results are antidilutive.

	Year ended December 31,

	2012		2011		2010
Weighted average shares outstanding—basic		71,376,046		70,830,855		70,382,517
Incremental shares issuable from dilutive stock options		720,626		1,216,633		1,046,593

Weighted average shares outstanding—diluted		72,096,672		72,047,488		71,429,110

Potential common shares relating to options, warrants, preferred stock, restricted stock and convertible debentures excluded from the computations of diluted earnings (loss) per share because they are antidilutive are as follows:

	Year ended December 31,

	2012		2011		2010
Employee stock options		575,750		918,416		2,208,666
Convertible debentures		32,720		47,170		47,170
Preferred stock		5,352		5,352		5,352
Restricted Stock		1,606,460		615,731		28,373

Preferred stock is convertible from the date of issuance until redemption at 100% of the redemption price amount into common stock of the Company at a conversion rate between 1 to 1 and 1 to 0.5 (Note D).

At December 31, 2012, the Convertible Debentures may be converted until maturity at 100% of principal amount into common stock of the Company at a price of $50.00. At December 31, 2011 and 2010, the Convertible Debentures may be converted until maturity at 100% of principal amount into common stock of the Company at prices ranging from $35.00 to $50.00 (Note C).

Asset Retirement Obligations

The estimated fair value of the future costs associated with dismantlement, abandonment and restoration of oil and gas properties is recorded generally upon acquisition or completion of a well. The net estimated costs are discounted to present values using a risk adjusted rate over the estimated economic life of the oil and gas properties. Such costs are capitalized as part of the related asset. The asset is depleted on the units-of-production method. The associated liability is classified in other long-term liabilities, net of current portion, in the accompanying Consolidated Balance Sheets. The liability is periodically adjusted to reflect (1) new liabilities incurred, (2) liabilities settled during the period, (3) accretion expense, and (4) revisions to estimated future cash flow requirements. The accretion expense is recorded as a component of depreciation, depletion and amortization. The Company has cash held in escrow with a fair market value of $3.2 million that is legally restricted for potential plugging and abandonment liability in the Wilmington field which is recorded in other assets in the Consolidated Balance Sheets. A reconciliation of the Company's asset retirement obligations is as follows:

	December 31,

	2012			2011
	(in thousands)
Balance at beginning of year	$	15,507		$	10,217
Liabilities incurred in current year		261			113
Obligations on properties acquired		3,499			—
Liabilities settled in current year		(1,287	)		(965	)
Accretion expense		1,525			995
Revisions in estimated cash flows		5,731			5,147

Carrying amount	$	25,236		$	15,507

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board ("FASB") issued ASU 2011-05, "Comprehensive Income: Presentation of Comprehensive Income," ("ASU 2011-05") which amended ASC 220, "Presentation of Comprehensive Income." In accordance with the new guidance, an entity will no longer be permitted to present comprehensive income in its consolidated statements of stockholders' equity. Instead, entities will be required to present components of comprehensive income in either one continuous financial statement with two sections, net income and comprehensive income, or in two separate but consecutive statements. The guidance, which must be applied retroactively, was effective for the Company beginning January 1, 2012. The adoption of ASU 2011-05 did not have a material effect on the Company's consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs," to develop common requirements for valuation and disclosure of fair value measurements in accordance with U.S. GAAP and International Financial Reporting Standards. This ASU became effective for fiscal years and interim periods within those years beginning after December 15, 2011. The adoption of ASU 2011-04 did not have a material effect on the Company's consolidated financial statements.

In December 2011, the FASB issued ASU No. 2011-11, "Disclosures about Offsetting Assets and Liabilities," to improve reporting and transparency of offsetting (netting) assets and liabilities and the related affects on the financial statements. This ASU is effective for fiscal years and interim periods within those years beginning on or after January 1, 2013. We do not expect the adoption of this ASU will have a material effect on the Company's consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02, "Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income," ("ASU 2013-02"). ASU 2013-02 finalizes the requirements of ASU 2011-05 that ASU 2011-12 deferred, clarifying how to report the effect of significant reclassifications out of accumulated other comprehensive income. ASU 2013-02 is to be applied prospectively. We do not anticipate that the adoption of this ASU will have a material effect on the Company's consolidated financial statements.