Note 1 – Summary of Significant Accounting Policies

Description of Operations

SM Energy is an independent energy company engaged in the acquisition, exploration, development, and production of oil, gas, and NGLs in onshore North America, with a current focus on oil and liquids-rich resource plays.

Basis of Presentation

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries and have been prepared in accordance with GAAP and the instructions to Form 10-K and regulation S-X. Subsidiaries that the Company does not control are accounted for using the equity or cost methods as appropriate. Equity method investments are included in other noncurrent assets in the accompanying consolidated balance sheets (“accompanying balance sheets”). Intercompany accounts and transactions have been eliminated. In connection with the preparation of the consolidated financial statements, the Company evaluated subsequent events after the balance sheet date of December 31, 2012, through the filing date of this report.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of proved oil and gas reserves, assets and liabilities, 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. Actual results could differ from those estimates. Estimates of proved oil and gas reserve quantities provide the basis for the calculation of depletion, depreciation, and amortization (“DD&A”), impairment of proved properties, asset retirement obligations, and the Net Profits Interest Bonus Plan (“Net Profits Plan”) liability, each of which represents a significant component of the accompanying consolidated financial statements.

Cash and Cash Equivalents

The Company considers all liquid investments purchased with an initial maturity of three months or less to be cash equivalents. The carrying value of cash and cash equivalents approximates fair value due to the short-term nature of these instruments.

Restricted Cash

The Company’s restricted cash balance represents cash payments received from Mitsui that are contractually restricted to be used solely for development operations pursuant to the Company’s Acquisition and Development Agreement with Mitsui and accordingly are classified as non-current assets. Please refer to Note 12- Acquisition and Development Agreement and Carry and Earning Agreement for additional information.

Accounts Receivable

The Company’s accounts receivables consist mainly of receivables from oil, gas, and NGL purchasers and from joint interest owners on properties the Company operates. For receivables from joint interest owners, the Company typically has the ability to withhold future revenue disbursements to recover non-payment of joint interest billings. Generally, the Company’s oil and gas receivables are collected within two months, and the Company has had minimal bad debts.

Although diversified among many companies, collectability is dependent upon the financial wherewithal of each individual company and is influenced by the general economic conditions of the industry. Receivables are not collateralized. As of December 31, 2012, and 2011, the Company had no allowance for doubtful accounts recorded.

Concentration of Credit Risk and Major Customers

The Company is exposed to credit risk in the event of nonpayment by counterparties, a significant portion of which are concentrated in energy related industries. The creditworthiness of customers and other counterparties is subject to continuous review. During 2012, we had two major customers, Regency Gas Services LLC and Plains Marketing LP, which accounted for approximately 21 percent and 13 percent, respectively, of our total production revenue. During 2011 and 2010, we had one major customer, Regency Gas Services LLC, individually account for approximately 18 percent and 11 percent, respectively, of our total production revenue.

The Company currently uses 10 separate counterparties for its oil, gas, and NGL commodity derivatives, all of which are participating lenders in the Company’s credit facility. Two of our counterparties were downgraded during 2012, but all maintain investment grade ratings. Nine counterparties carry corporate credit ratings at or exceeding A- and Baa2 by Standard & Poor’s and Moody’s, respectively. The remaining counterparty fell to BBB- and Baa2, respectively. In response, the Company requires cash collateral to be posted when its portfolio of trades with that counterparty is in an overall asset position.

The Company has accounts in the following locations with a national bank: Denver, Colorado; Shreveport, Louisiana; Houston, Texas; Midland, Texas; and Billings, Montana. The Company has accounts with a local bank in Tulsa, Oklahoma. The Company’s policy is to invest in highly-rated instruments and to limit the amount of credit exposure at each individual institution.

Oil and Gas Producing Activities

The Company accounts for its oil and gas exploration and development costs using the successful efforts method. Geological and geophysical costs are expensed as incurred. Exploratory well costs are capitalized pending further evaluation of whether economically recoverable reserves have been found. If economically recoverable reserves are not found, exploratory well costs are expensed as dry holes. The application of the successful efforts method of accounting requires management’s judgment to determine the proper designation of wells as either development or exploratory, which will ultimately determine the proper accounting treatment of costs of dry holes. Once a well is drilled, the determination that economic proved reserves have been discovered may take considerable time and judgment. Exploratory dry hole costs are included in cash flows from investing activities as part of capital expenditures within the accompanying consolidated statements of cash flows (“accompanying statements of cash flows”). The costs of development wells are capitalized whether those wells are successful or unsuccessful.

DD&A of capitalized costs related to proved oil and gas properties is calculated on a pool-by-pool basis using the units-of-production method based upon proved reserves. The computation of DD&A takes into consideration restoration, dismantlement, and abandonment costs as well as the anticipated proceeds from salvaging equipment. As of December 31, 2012, and 2011, the Company’s estimated salvage value was $64.4 million and $64.1 million, respectively.

Materials Inventory

The Company’s materials inventory is primarily comprised of tubular goods to be used in future drilling operations. Materials inventory is valued at the lower of cost or market and totaled $13.4 million and $16.5 million at December 31, 2012, and 2011, respectively. There were no materials inventory write-downs for the years ended December 31, 2012, 2011, or 2010.

Assets Held for Sale

Any properties held for sale as of the balance sheet date have been classified as assets held for sale and are separately presented on the accompanying balance sheets at the lower of net book value or fair value less the cost to sell. The asset retirement obligation liabilities related to such properties have been reclassified to asset retirement obligations associated with oil and gas properties held for sale in the accompanying balance sheets. For additional discussion on assets held for sale, please refer to Note 3 – Divestitures and Assets Held for Sale.

Other Property and Equipment

Other property and equipment such as facilities, office furniture and equipment, buildings, and computer hardware and software are recorded at cost. Costs of renewals and improvements that substantially extend the useful lives of the assets are capitalized. Maintenance and repair costs are expensed when incurred. Depreciation is calculated using either the straight-line method over the estimated useful lives of the assets, which range from three to thirty years, or the unit of output method where appropriate. When other property and equipment is sold or retired, the capitalized costs and related accumulated depreciation are removed from the accounts.

Intangible Assets

As of December 31, 2012, and 2011, the Company had $10.8 million and $7.1 million, respectively, of intangible assets consisting of acquired water rights, which are included as other noncurrent assets in the accompanying balance sheets. All indefinite lived intangible assets are evaluated for impairment if such indicators arise and at least annually.

Cash Settlement Balancing

The Company uses the sales method of accounting for gas revenue whereby sales revenue is recognized on all gas sold to purchasers, regardless of whether the sales are proportionate to the Company’s ownership in the property. An asset or liability is recognized to the extent that there is an imbalance in excess of the remaining gas reserves on the underlying properties. As of December 31, 2012, and 2011, the Company has recorded a receivable of $1.7 million and $1.9 million, respectively, and a liability of $1.3 million and $1.1 million, respectively, which is included as other noncurrent assets and other noncurrent liabilities in the accompanying balance sheets.

Derivative Financial Instruments

The Company seeks to manage or reduce commodity price risk on production by entering into derivative contracts. The Company seeks to minimize its basis risk and indexes its oil derivative contracts to NYMEX prices, its NGL derivative contracts to OPIS prices, and the majority of its gas derivative contracts to various regional index prices associated with pipelines in proximity to the Company’s areas of gas production. For additional discussion on derivatives, please see Note 10 – Derivative Financial Instruments.

Net Profits Plan

The Company records the estimated fair value of expected future payments made under the Net Profits Plan as a noncurrent liability in the accompanying balance sheets. The underlying assumptions used in the calculation of the estimated liability include estimates of production, proved reserves, recurring and workover lease operating expense, transportation, production and ad valorem tax rates, present value discount factors, pricing assumptions, and overall market conditions. The estimates used in calculating the long-term liability are adjusted from period-to-period based on the most current information attributable to the underlying assumptions. Changes in the estimated liability of future payments associated with the Net Profits Plan are recorded as increases or decreases to expense in the current period as a separate line item in the accompanying consolidated statements of operations (“accompanying statements of operations”), as these changes are considered changes in estimates.

The distribution amounts due to participants and payable in each period under the Net Profits Plan as cash compensation related to periodic operations are recognized as compensation expense and are included within general and administrative expense and exploration expense in the accompanying statements of operations. The corresponding current liability is included in accounts payable and accrued expenses in the accompanying balance sheets. This treatment provides for a consistent matching of cash expense with net cash flows from the oil and gas properties in each respective pool of the Net Profits Plan. For additional discussion, please refer to the heading Net Profits Plan in Note 7 – Compensation Plans and Note 11 – Fair Value Measurements.

Asset Retirement Obligations

The Company recognizes an estimated liability for future costs associated with the abandonment of its oil and gas properties. A liability for the fair value of an asset retirement obligation and corresponding increase to the carrying value of the related long-lived asset are recorded at the time a well is completed or acquired. The increase in carrying value is included in proved oil and gas properties in the accompanying balance sheets. The Company depletes the amount added to proved oil and gas property costs and recognizes expense in connection with the accretion of the discounted liability over the remaining estimated economic lives of the respective oil and gas properties. For additional discussion, please refer to Note 9 – Asset Retirement Obligations.

Revenue Recognition

The Company derives revenue primarily from the sale of produced oil, gas, and NGLs. The Company reports revenue as the gross amount received before taking into account production taxes and transportation costs, which are reported separately as expenses and are included in oil, gas, and NGL production expense in the accompanying statements of operations. Revenue is recorded in the month the Company’s production is delivered to the purchaser, but payment is generally received between 30 and 90 days after the date of production. No revenue is recognized unless it is determined that title to the product has transferred to the purchaser. At the end of each month, the Company estimates the amount of production delivered to the purchaser and the price the Company will receive. The Company uses its knowledge of its properties, their historical performance, NYMEX, OPIS, and local spot market prices, quality and transportation differentials, and other factors as the basis for these estimates.

Impairment of Proved and Unproved Properties

Proved oil and gas property costs are evaluated for impairment and reduced to fair value, which is based on expected future discounted cash flows, when there is an indication that the carrying costs may not be recoverable. Expected future cash flows are calculated on all developed proved reserves and risk adjusted proved undeveloped, probable, and possible reserves using a discount rate and price forecasts selected by the Company’s management. The discount rate is a rate that management believes is representative of current market conditions. The prices for oil and gas are forecasted based on NYMEX strip pricing, adjusted for basis differentials, for the first five years, after which a flat terminal price is used for each commodity stream. The prices for NGLs are forecasted using OPIS pricing, adjusted for basis differentials, for as long as the market is actively trading, after which a flat terminal price is used. Future operating costs are also adjusted as deemed appropriate for these estimates. An impairment is recorded on unproved property when the Company determines that either the property will not be developed or the carrying value is not realizable.

The Company recorded $208.9 million, $219.0 million, and $6.1 million, of proved property impairments for the years ended December 31, 2012, 2011, and 2010, respectively. The impairments in 2012 were a result of the Company’s write-down of Wolfberry assets in its Permian region due to negative engineering revisions and the Company’s Haynesville shale assets as a result of low natural gas prices. The impairments in 2011 were related to the Company’s James Lime, Cotton Valley, and Haynesville shale assets as a result of significantly lower natural gas prices at the end of 2011.

For the years ended December 31, 2012, 2011, and 2010, the Company recorded expense related to the abandonment and impairment of unproved properties of $16.3 million, $7.4 million, and $2.0 million, respectively. The Company’s abandonment and impairment of unproved properties in 2012 related to acreage that the Company no longer intends to develop in the Rocky Mountain region.

Sales of Proved and Unproved Properties

The partial sale of proved properties within an existing field is accounted for as normal retirement and no gain or loss on divestiture activity is recognized as long as the treatment does not significantly affect the units-of-production depletion rate. The sale of a partial interest in an individual proved property is accounted for as a recovery of cost. A gain or loss on divestiture activity is recognized in the accompanying statements of operations for all other sales of proved properties.

The partial sale of unproved property is accounted for as a recovery of cost when substantial uncertainty exists as to the ultimate recovery of the cost applicable to the interest retained. A gain on divestiture activity is recognized to the extent that the sales price exceeds the carrying amount of the unproved property. A gain or loss on divestiture activity is recognized in the accompanying statements of operations for all other sales of unproved property. For additional discussion, please refer to Note 3 – Divestitures and Assets Held for Sale.

Stock-Based Compensation

At December 31, 2012, the Company had stock-based employee compensation plans that included RSUs, PSUs, restricted stock awards, and stock options issued to employees and non-employee directors, as more fully described in Note 7 - Compensation Plans. The Company records expense associated with the fair value of stock-based compensation in accordance with authoritative accounting guidance, which is based on the estimated fair value of these awards determined at the time of grant.

Income Taxes

The Company accounts for deferred income taxes whereby deferred tax assets and liabilities are recognized based on the tax effects of temporary differences between the carrying amounts on the financial statements and the tax basis of assets and liabilities, as measured using current enacted tax rates. These differences will result in taxable income or deductions in future years when the reported amounts of the assets or liabilities are recorded or settled, respectively. The Company records deferred tax assets and associated valuation allowances, when appropriate, to reflect amounts more likely than not to be realized based upon Company analysis.

Earnings per Share

Basic net income (loss) per common share is calculated by dividing net income or loss available to common stockholders by the basic weighted-average common shares outstanding for the respective period. The earnings per share calculations reflect the impact of any repurchases of shares of common stock made by the Company.

Diluted net income or loss per common share is calculated by dividing adjusted net income or loss by the diluted weighted-average common shares outstanding, which includes the effect of potentially dilutive securities. Potentially dilutive securities for this calculation consist of in-the-money outstanding stock options, unvested RSUs, contingent PSUs, and shares into which the 3.50% Senior Convertible Notes were convertible. When there is a loss from continuing operations, as was the case for the year ended December 31, 2012, all potentially dilutive shares are anti-dilutive and are consequently excluded from the calculation of earnings per share.

PSUs represent the right to receive, upon settlement of the PSUs after the completion of the three-year performance period, a number of shares of the Company’s common stock that may range from zero to two times the number of PSUs granted on the award date. The number of potentially dilutive shares related to PSUs is based on the number of shares, if any, which would be issuable at the end of the respective reporting period, assuming that date was the end of the contingency period applicable to such PSUs. For additional discussion on PSUs, please refer to Note 7 – Compensation Plans under the heading Performance Share Units Under the Equity Incentive Compensation Plan.

The Company called for redemption of its 3.50% Senior Convertible Notes on April 2, 2012, after which the majority of the holders of the outstanding 3.50% Senior Convertible Notes elected to convert their notes. The Company issued 864,106 common shares upon conversion, and these shares were included in the calculation of basic weighted-average common shares outstanding for the year ended December 31, 2012. Please refer to Note 5 - Long-term Debt for additional discussion. Prior to calling the 3.50% Senior Convertible Notes for redemption, the Company’s notes had a net-share settlement right giving the Company the option to irrevocably elect, by notice to the trustee under the indenture for the notes, to settle the Company’s obligation, in the event that holders of the notes elected to convert all or a portion of their notes, by delivering cash in an amount equal to each $1,000 principal amount of notes surrendered for conversion and, if applicable, at the Company’s option, shares of common stock or cash, or any combination of common stock and cash, for the amount of conversion value in excess of the principal amount. Prior to the settlement of the Company’s 3.50% Senior Convertible Notes, potentially dilutive shares associated with the conversion feature were accounted for using the treasury stock method when shares of the Company’s common stock traded at an average closing price that exceeded the $54.42 conversion price. Shares of the Company’s common stock traded at an average closing price exceeding the conversion price and were included on an adjusted weighted basis for the portion of the year ended December 31, 2012, for which they were outstanding. Shares of the Company’s common stock traded at an average closing price exceeding the $54.42 conversion price for the twelve-month period ended December 31, 2011, making the 3.50% Senior Convertible Notes dilutive for that period. Shares of the Company's common stock did not trade at an average closing price exceeding the $54.42 conversion price for the year ended December 31, 2010. Therefore, the 3.50% Senior Convertible Notes were not dilutive and did not impact the diluted earnings per share calculation for the year ended December 31, 2010.

The treasury stock method is used to measure the dilutive impact of in-the-money stock options, unvested RSUs, contingent PSUs, and 3.50% Senior Convertible Notes.

The following table details the weighted-average dilutive and anti-dilutive securities related to stock options, RSUs, PSUs, and the 3.50% Senior Convertible Notes for the years presented:



	For the Years Ended December 31,
	2012	2011	2010
	(in thousands)
Dilutive	—	3,809	1,720
Anti-dilutive	2,102	—	—

The following table sets forth the calculations of basic and diluted earnings per share:



	For the Years Ended December 31,
	2012			2011		2010
	(in thousands, except per share amounts)
Net income (loss)	$	(54,249	)	$	215,416	$	196,837
Basic weighted-average common shares outstanding	65,138			63,755		62,969
Add: dilutive effect of stock options, unvested RSUs, and contingent PSUs	—			2,592		1,720
Add: dilutive effect of 3.50% Senior Convertible Notes	—			1,217		—
Diluted weighted-average common shares outstanding	65,138			67,564		64,689
Basic net income (loss) per common share	$	(0.83	)	$	3.38	$	3.13
Diluted net income (loss) per common share	$	(0.83	)	$	3.19	$	3.04

Comprehensive Income (Loss)

Comprehensive income (loss) is used to refer to net income (loss) plus other comprehensive income (loss). Other comprehensive income (loss) is comprised of revenues, expenses, gains, and losses that under GAAP are reported as separate components of stockholders’ equity instead of net income (loss). Comprehensive income (loss) is presented net of income taxes in the accompanying consolidated statements of comprehensive income (loss).

The changes in the balances of components comprising other comprehensive income (loss) are presented in the following table:



	Change in Derivative Instrument Fair Value			Derivative Reclassification to Earnings			Pension Liability Adjustments
	(in thousands)
For the year ended December 31, 2010
Before tax income (loss)	$	26,904		$	10,608		$	(1,570	)
Tax benefit (expense)	(10,093		)	(3,967		)	590
Income (loss), net of tax	$	16,811		$	6,641		$	(980	)
For the year ended December 31, 2011
Before tax income (loss)	$	—		$	20,707		$	(2,779	)
Tax benefit (expense)	—			(7,710		)	984
Income (loss), net of tax	$	—		$	12,997		$	(1,795	)
For the year ended December 31, 2012
Before tax (loss)	$	—		$	(3,865	)	$	(3,909	)
Tax benefit	—			1,601			1,439
(Loss), net of tax	$	—		$	(2,264	)	$	(2,470	)

Fair Value of Financial Instruments

The Company’s financial instruments including cash and cash equivalents, accounts receivable, and accounts payable are carried at cost, which approximates fair value due to the short-term maturity of these instruments. The recorded value of the Company’s credit facility approximates its fair value as it bears interest at a floating rate that approximates a current market rate. The Company had $340.0 million of outstanding loans under its credit facility as of December 31, 2012. The Company had no borrowings outstanding under its credit facility as of December 31, 2011. The Company’s 3.50% Senior Convertible Notes, 2019 Notes, 2021 Notes, and 2023 Notes, are recorded at cost, and the fair values are disclosed in Note 11 - Fair Value Measurements. The Company has derivative financial instruments that are recorded at fair value. Considerable judgment is required to develop estimates of fair value. The estimates provided are not necessarily indicative of the amounts the Company would realize upon the sale or refinancing of such instruments.

Industry Segment and Geographic Information

The Company operates exclusively in the exploration and production segment of the oil and gas industry and all of the Company’s operations are conducted entirely in the United States. The Company reports as a single industry segment. The Company’s gas marketing function provides mostly internal services and acts as the first purchaser of natural gas and natural gas liquids produced by the Company in certain cases. The Company considers its marketing function as ancillary to its oil and gas producing activities. The amount of income these operations generate from marketing gas produced by third parties is not material to the Company’s results of operations, and segmentation of such activity would not provide a better understanding of the Company’s performance. However, gross revenue and expense related to marketing activities for gas produced by third parties are presented in the marketed gas system revenue and marketed gas system expense line items in the accompanying statements of operations.

Off-Balance Sheet Arrangements

The Company has not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. The Company has not been involved in any unconsolidated SPE transactions.

The Company evaluates its transactions to determine if any variable interest entities exist. If it is determined that SM Energy is the primary beneficiary of a variable interest entity, that entity is consolidated into SM Energy.

Recently Issued Accounting Standards

On January 1, 2012, the Company adopted new fair value measurement authoritative accounting guidance issued by the FASB, that clarifies the application of fair value measurement and disclosure requirements and changes particular principles and requirements for measuring fair value. For each class of assets and liabilities not measured at fair value in the Company’s financial statements but for which fair value is disclosed, this guidance requires the Company to disclose the nature, characteristics, and risks of the asset or liability and the level of the fair value hierarchy within which the fair value measurement is categorized. Please refer to Note 11 - Fair Value Measurements in which the changes to the Company’s financial statements resulting from the new authoritative guidance are presented.

On January 1, 2012, the Company adopted new authoritative accounting guidance issued by the FASB stating an entity that reports items of other comprehensive income has the option to present the components of comprehensive income in either one continuous financial statement or two consecutive financial statements, including reclassification adjustments. The adoption of this statement did not have a material impact on the Company. The Company has elected to present a separate statement of comprehensive income, including the individual components, titled Consolidated Statements of Comprehensive Income (Loss), as part of these financial statements. Additionally, the Company has elected to present the reclassification adjustments under the heading Comprehensive Income (Loss), above.

On September 30, 2012, the Company elected to early adopt new authoritative accounting guidance issued by the FASB, which provided that an entity that tests indefinite-lived intangible assets for impairment has the option to assess qualitative factors to determine whether it is more likely than not that an asset is impaired as a basis for determining whether a quantitative test is necessary. The adoption of this statement did not have a material impact on the Company’s financial statements.

There are no new significant accounting standards applicable to the Company that have been issued but not yet adopted by the Company as of December 31, 2012.