Consolidated Financial Statements of ARSENAL ENERGY INC. Years ended December 31, 2011 and 2010
MANAGEMENT S REPORT Management, in accordance with International Financial Reporting Standards ( IFRS ) as issued by the International Accounting Standards Board, has prepared the accompanying consolidated financial statements of Arsenal Energy Inc. (the Company ). Financial and operating information presented throughout this report is consistent with that shown in the consolidated financial statements. Management is responsible for the integrity of the financial information. Internal control systems are designed and maintained to provide reasonable assurance that assets are safeguarded from loss or unauthorized use and to produce reliable accounting records for financial reporting purposes. KPMG LLP was appointed by the Company s shareholders to conduct an audit of the consolidated financial statements so as to express an opinion on the consolidated financial statements. Their examination included such tests and procedures, as they considered necessary, to provide reasonable assurance that the financial statements are presented fairly in accordance with IFRS. The Board of Directors is responsible for ensuring that management fulfills its responsibilities for financial reporting and internal control. The Board exercises this responsibility through the Audit Committee, with assistance from the Reserve Committee regarding the annual evaluation of our petroleum and natural gas reserves. The Audit Committee meets regularly with management and the independent auditors to ensure that management s responsibilities are properly discharged, to review the consolidated financial statements and recommend that the consolidated financial statements be presented to the Board of Directors for approval. The Audit Committee also considers the independence of the external auditors and reviews their fees. The external auditors have access to the Audit Committee without the presence of management. signed Tony van Winkoop President and Chief Executive Officer signed J. Paul Lawrence Vice President Finance and Chief Financial Officer March 21, 2012
Independent Auditors Report To the Shareholders of Arsenal Energy Inc. We have audited the accompanying consolidated financial statements of Arsenal Energy Inc., which comprise the consolidated statements of financial position as at December 31, 2011, December 31, 2010 and January 1, 2010, the consolidated statements of loss, comprehensive loss, changes in shareholders equity and cash flows for the years ended December 31, 2011 and December 31, 2010, and notes, comprising a summary of significant accounting policies and other explanatory information. Management s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on our judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, we consider internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the consolidated financial position of Arsenal Energy Inc. as at December 31, 2011, December 31, 2010 and January 1, 2010, and its consolidated financial performance and its consolidated cash flows for the years ended December 31, 2011 and December 31, 2010 in accordance with International Financial Reporting Standards. Singed KPMG LLP Chartered Accountants Calgary, Canada March 21, 2012
Arsenal Energy Inc. Consolidated Statements of Financial Position December 31, December 31, January 1, 2011 2010 2010 (note 22) (note 22) Assets Current assets: Cash and cash equivalents $ 625,541 $ 1,448,009 $ 1,325,915 Accounts receivable (note 14) 11,677,448 8,099,902 6,470,045 Inventory 482,136 - - Prepaid expenses and deposits 978,354 398,009 532,808 Risk management contracts (note 14) - - 126,749 13,763,479 9,945,920 8,455,517 Reclamation deposit 152,550 149,190 157,650 Exploration and evaluation assets (note 8) 9,100,169 6,394,505 - Property, plant and equipment (notes 9) 146,194,342 74,331,026 77,989,725 Deferred taxes (notes 16) 1,775,276 1,775,276 1,775,276 $ 170,985,816 $92,595,917 $88,378,168 Liabilities Current liabilities Accounts payable and accrued liabilities $ 17,452,738 $17,320,820 $14,778,189 Bank loan (note 11) - 11,412,875 22,290,000 Risk management contracts (note 14) 2,291,080 993,344-19,743,818 29,727,039 37,068,189 Bank loan (note 11) 52,062,272 - - Flow through share premium - 792,968 346,492 Risk management contracts (note 14) 1,484,526 427,169 123,371 Deferred taxes (notes 16) 5,496,305 1,473,676 - Decommissioning obligations (note 12) 37,325,946 19,667,331 21,182,129 116,112,867 52,088,183 58,720,181 Shareholders Equity Common shares (note 13(a)) 136,859,986 122,609,238 106,471,683 Contributed surplus 9,986,602 7,374,054 6,170,547 Accumulated other comprehensive loss (152,863) (199,996) - Deficit (91,820,776) (89,275,562) (82,984,243) 54,872,949 40,507,734 29,657,987 $ 170,985,816 $92,595,917 $88,378,168 Segmented information (note 19) Commitments and contingencies (note 20) The notes are an integral part of these consolidated financial statements. Approved on behalf of the Board of Directors: signed William Hews Director signed R. Neil MacKay Director
Arsenal Energy Inc. Consolidated Statements of Loss 2011 2010 (note 22) Revenue Oil and gas $ 58,465,937 $ 43,665,720 Royalties (11,777,485) (7,826,810) 46,688,452 35,838,910 Realized gain on risk management contracts (note 14(a)) 3,356,993 1,788,624 Unrealized loss on risk management contracts (note 14(a)) (2,355,109) (1,423,891) 47,690,336 36,203,643 Expenses Operating and transportation 15,826,747 15,284,387 General and administrative 3,971,847 3,566,617 Exploration and evaluation (note 8) 5,663,250 2,250,984 Property, plant and equipment impairment (note 10) 5,500,000 5,948,300 Depletion and depreciation 12,893,856 12,843,385 Share-based compensation 1,405,166 1,050,827 Gain on sale of property (note 9) (31,141) (1,282,406) 45,229,725 39,662,094 Income (loss) from operations 2,460,611 (3,458,451) Financial items Interest and other financing charges (note 18) 933,990 1,019,755 Accretion (note 12 and18) 708,499 756,042 Transaction costs (note 18) 613,611 - Foreign exchange gain (334,489) (13,828) 1,921,611 1,761,969 Income (loss) before income tax 539,000 (5,220,420) Deferred tax expense (note 16) (3,084,214) (1,070,899) Net loss for the year $ (2,545,214) $ (6,291,319) Loss per share (note 13 (c)) Basic and diluted $ (0.02) $ (0.05) Consolidated Statements of Comprehensive Loss 2011 2010 Net loss for the year $ (2,545,214) $ (6,291,319) Translation gain (loss) on foreign operations 47,133 (199,996) Comprehensive loss $ (2,498,081) $ (6,491,315) The notes are an integral part of these consolidated financial statements.
Arsenal Energy Inc. Consolidated Statements of Changes in Shareholders Equity Number of Shares Share capital Contributed surplus Accumulated other comprehensive loss Deficit Total Shareholders equity Balance January 1, 2011 (note 22) 140,812,472 $122,609,238 $7,374,054 $(199,996) $(89,275,562) $40,507,734 Net loss for the year - - - - (2.545,214) (2.545,214) Issue of shares (note 13 (a)) 22,158,500 21,050,575 - - - 21,050,575 Share issue costs (note 13 (a)) - (1,694,307) - - - (1,694,307) Share-based compensation expensed - - 1,405,165 - - 1,405,165 Share-based compensation capitalized - - 297,480 - - 297,480 Transfer of share-based compensation on exercise of options (note 13 (a)) - 469,834 (469,834) - - - Issued on exercise of options (note 13 (a)) 1,342,833 560,807 - - - 560,807 Repurchase of shares (note 13 (a)) (7,031,544) (6,136,161) 1,379,737 - - (4,756,424) Translation gain on foreign operations - - - 47,133-47,133 Balance December 31, 2011 157,282,261 $136,859,986 $9,986,602 $(152,863) $(91,820,776) $54,872,949 Number of Shares Share capital Contributed surplus Accumulated other comprehensive loss Deficit Total Shareholders equity Balance January 1, 2010 (note 22) 120,461,890 $106,471,683 $6,170,547 $ - $(82,984,243) $29,657,987 Net loss for the year - - - - (6,291,319) (6,291,319) Issue of shares (note 13 (a)) 21,583,000 18,315,650 - - - 18,315,650 Share issue costs (note 13 (a)) - (1,161,279) - - - (1,161,279) Share-based compensation expensed - - 1,050,827 - - 1,050,827 Share-based compensation capitalized - - 211,130 - - 211,130 Transfer of share-based compensation on exercise of options (note 13 (a)) - 65,318 (65,318) - - - Issued on exercise of options (note 13 (a)) 171,500 79,150 - - - 79,150 Repurchase of shares (note 13 (a)) (1,403,918) (1,161,284) 6,868 - - (1,154,416) Translation loss on foreign operations - - - (199,996) - (199,996) Balance December 31, 2010 140,812,472 $122,609,238 $7,374,054 $(199,996) $(89,275,562) $40,507,734 The notes are an integral part of these consolidated financial statements.
Arsenal Energy Inc. Consolidated Statements of Cash Flows Year ended December 31 2011 2010 (note 22) Operating Activities: Net loss for the period $ (2,545,214) $ (6,291,319) Items not affecting cash: Non-cash general and administrative expense - 63,375 Unrealized loss on risk management contracts 2,355,109 1,423,891 Depletion and depreciation Accretion 12,893,856 708,499 12,843,385 756,042 Transaction costs (note 7) 613,611 - Deferred tax expense 3,084,214 1,070,899 Property, plant and equipment impairment 5,500,000 5,948,300 Share-based compensation 1,405,166 1,050,828 Unrealized foreign exchange (gain) loss Gain on sale of property and equipment (373,458) (31,141) 38,511 (1,282,406) Exploration and evaluation expense 4,108,120 587,947 Decommissioning obligations settled (note 12) (819,283) (1,083,838) 26,899,479 15,125,615 Net change in non-cash working capital (note 17) (1,598,245) (4,042,961) Net cash from operating activities 25,301,234 11,082,654 Financing Activities: Bank loan advances (repayments) 40,564,619 (10,603,715) Issue of shares for cash 21,050,575 19,598,550 Issue of shares on exercise of stock options 560,807 79,150 Repurchase of shares (4,756,424) (1,154,417) Share issue costs (1,694,304) (1,518,404) Net change in non-cash working capital items (note 17) (126,304) 56,839 Net cash from financing activities 55,598,969 6,458,003 Investing Activities: Property, plant and equipment (31,107,154) (14,927,652) Exploration and evaluation expenditures Property acquisition Transaction costs (9,363,845) (38,574,702) (613,611) (11,028,488) (2,259,529) - Disposition of property, plant and equipment 621,914 5,919,077 Net change in non-cash working capital items (note 17) (2,575,600) 5,033,695 Net cash (used in) investing activities (81,612,998) (17,262,897) Foreign exchange loss on cash held in foreign currency (109,673) (155,666) Change in cash and cash equivalents during the year (822,468) 122,094 Cash and cash equivalents, beginning of year 1,448,009 1,325,915 Cash and cash equivalents, end of year $ 625,541 $ 1,448,009 The notes are an integral part of these consolidated financial statements.
1. Reporting entity: Arsenal Energy Inc. ( Arsenal or the Company ) is an oil and gas exploration, development and production Company based in Calgary, Alberta, Canada. The Company conducts its operations in the Western Canadian Sedimentary basin and Williston basin in Canada and the United States. The consolidated financial statements of the Company as at and for the years ended December 31, 2011 and 2010 comprise the Company and its wholly owned subsidiaries, Arsenal Energy USA Ltd. and Arsenal Energy Holdings; which were incorporated in the USA and Canada respectively. Arsenal s principle place of business is located at Suite 1900, 639 5 th Avenue SW, Calgary Alberta, Canada, T2P 0M9. 2. Basis of preparation: (a) Statement of compliance: These financial statements have been prepared in accordance with International Financial Reporting Standards IFRS ) as issued by the International Accounting Standards Board. A summary of the significant accounting policies and method of computation is presented in note 3 to the financial statements. These policies have been retrospectively and consistently applied except where specific exemptions permitted an alternative treatment on transition to IFRS in accordance with IFRS 1 First-time adoption of International Financial Reporting Standards ( IFRS-1 ). An explanation of how the transition to IFRS has affected the reported financial position, financial performance and cash flows of the Company is provided in note 22 and includes reconciliations of equity and net loss for comparative periods from former Canadian GAAP ( previous GAAP ) to IFRS. The consolidated financial statements were authorized for issue by the Board of Directors on March 21, 2012. (b) Basis of measurement: The consolidated financial statements have been prepared on the historical cost basis except for the derivative financial instruments which are measured at fair value. The methods used to measure fair value are discussed in notes 5 and 14. (c) Functional and presentation currency: These consolidated financial statements are presented in Canadian dollars, which is the parent company s functional currency. It s subsidiary Arsenal Energy USA Ltd. has a U.S. dollar functional currency. (d) Use of estimates and judgments: The preparation of financial statements in conformity with IFRS requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the reported amounts regarding assets, liabilities, revenue, and expenses. Actual results may differ from estimated amounts as future confirming events occur. Reserve estimates including production profiles, future development costs, and discount rates are a critical part of many of the estimated amounts and calculations contained in the financial statements. These estimates are verified by third party professional engineers, who work with information provided by the Company to establish reserve determinations. These determinations are updated at least on an annual basis.
2. Basis of preparation (continued): Significant areas of estimation, uncertainty and critical judgments in applying accounting policies that have the most significant effect on the amount recognized in the consolidated financial statements include: Impairment testing estimates of reserves, future commodity prices, future costs, production profiles, discount rates, market value of land. Depletion and depreciation - oil and natural gas reserves, including future prices, costs and reserve base to use on calculation of depletion. Decommissioning obligations estimates relating to amounts, likelihood, timing, inflation and discount rates. Share-based compensation forfeiture rates and volatility. Risk management contracts expected future oil and natural gas prices and expected volatility in these prices. Deferred tax estimates of reversal of temporary differences, tax rates substantively enacted, and likelihood of assets being realized. 3. Significant accounting policies: The accounting policies set out below have been applied consistently to all periods presented in these consolidated financial statements, and have been applied consistently by the Company and its subsidiaries. Certain comparative amounts have been reclassified to conform with the current year s presentation. (a) Basis of consolidation: (i) (ii) (iii) Subsidiaries are entities controlled by the Company. Control exists when the Company has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. In assessing control, potential voting rights that currently are exercisable are taken into account. The financial statements of subsidiaries are included in the consolidated financial statements from the date that control commences until the date that control ceases. Jointly controlled operations and jointly controlled assets: Many of the Company s oil and natural gas activities involve jointly controlled assets. The consolidated financial statements include the Company s share of these jointly controlled assets and a proportionate share of the relevant revenue and related costs. Transactions eliminated on consolidation: Intercompany balances and transactions, and any unrealized income and expenses arising from intercompany transactions, are eliminated in preparing the consolidated financial statements. (b) Foreign currency: (i) (ii) Transactions in foreign currencies are generally translated to Canadian dollars at the average exchange rate for the period. Monetary assets and liabilities denominated in foreign currencies are translated to Canadian dollars at the period end exchange rate. Foreign currency differences arising on translation are recognized in net income in the period in which they arise. Assets and liabilities of Arsenal s U.S. operations are translated into Canadian dollars at period end exchange rates while revenues and expenses are translated using average rates for the period. Gains and losses from the translation are deferred and included in accumulated other comprehensive income ( AOCI ).
3. Significant accounting policies (continued): (c) Financial instruments: (i) (ii) Non-derivative financial instruments: Non-derivative financial instruments comprise account receivable, cash and cash equivalents, bank loans, and accounts payables and accrued liabilities. Non-derivative financial instruments are recognized initially at fair value plus, for instruments not at fair value through profit or loss, any directly attributable transaction costs. Subsequent to initial recognition non-derivative financial instruments are measured as described below. Cash and cash equivalents comprise cash on hand, term deposits held with banks, other short-term highly liquid investments with original maturities of three months or less. Financial assets at fair value through profit or loss: An instrument is classified at fair value through profit or loss if it is held for trading or is designated as such upon initial recognition. Financial instruments are designated at fair value through profit or loss if the Company manages such investments and makes purchase and sale decisions based on their fair value in accordance with the Company s risk management or investment strategy. Upon initial recognition attributable transaction costs are recognized in profit or loss when incurred. Financial instruments are measured at fair value and changes therein are recognized in profit or loss. Other: Other non-derivative financial instruments, such as cash and cash equivalents, accounts receivable, bank loans, accounts payables and accrued liabilities, are measured at amortized cost using the effective interest method, less any impairment losses. Derivative financial instruments: The Company has entered into certain financial derivative contracts in order to manage the exposure to market risks from fluctuations in commodity prices. These instruments are not used for trading or speculative purposes. The Company has not designated its financial derivative contracts as effective accounting hedges, and thus not applied hedge accounting, even though the Company considers all commodity contracts to be economic hedges. As a result, all financial derivative contracts are classified as fair value through profit or loss and are recorded on the balance sheet at fair value. Transaction costs are recognized in profit or loss when incurred. The Company accounts for any forward physical delivery sales contracts, which are entered into and continue to be held for the purpose of receipt or delivery of nonfinancial items in accordance with its expected purchase, sale or usage requirements as executory contracts. As such, these contracts are not considered to be derivative financial instruments and are not recorded at fair value on the balance sheet. Settlements on these physical sales contracts are recognized in oil and natural gas revenue. Embedded derivatives are separated from the host contract and are accounted for separately if the economic characteristics and risks of the host contract and the embedded derivative are not closely related, a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative, and the combined instrument is not measured at fair value through profit or loss. Changes in the fair value of separable embedded derivatives are recognized immediately in profit or loss.
3. Significant accounting policies (continued): (iii) Share capital: Common shares are classified as equity. Incremental costs directly attributable to the issue of common shares and share options are recognized as a deduction from equity, net of any deferred taxes. (d) Property, plant and equipment and intangible exploration assets: (i) (ii) Recognition and measurement: Exploration and evaluation expenditures: Pre-license costs, dry holes, seismic and lease rentals are recognized in the statement of operations as incurred. Exploration and evaluation costs are capitalized as exploration and evaluation assets according to the expenditure. Exploration and evaluation assets are assessed for impairment if (i) sufficient data exists to determine technical feasibility and commercial viability, and (ii) facts and circumstances suggest that the carrying amount exceeds the recoverable amount. For purposes of impairment testing, exploration and evaluation assets are allocated to cash-generating units. The technical feasibility and commercial viability is considered to be determinable when proved and or probable reserves are determined to exist. A review is carried out, at least annually, to ascertain whether proved and or probable reserves have been discovered. Upon determination of proved and or probable reserves, exploration and evaluation assets attributable to those reserves are first tested for impairment and then reclassified from exploration and evaluation assets to a separate category within tangible assets referred to as property, plant and equipment. Development and production costs: Items of property, plant and equipment, which include oil and gas development and production assets, are measured at cost less accumulated depletion and depreciation and accumulated impairment. Development and production assets are grouped into Cash Generating Units ( CGU s ) for impairment testing. The Company allocated its historical property, plant and equipment at January 1, 2010, the date of transition to IFRS, to the CGU s, based on a proration using December 31, 2009 externally determined proved and probable reserve volumes underlying each of the CGU s. When significant parts of an item of property, plant and equipment, including oil and natural gas interests, have different useful lives, they are accounted for as separate items (major components). Gains and losses on disposal of an item of property, plant and equipment, including oil and natural gas interests, are determined by comparing the proceeds from disposal with the carrying amount of property, plant and equipment and are recognized in profit or loss. Subsequent costs: Costs incurred subsequent to the determination of technical feasibility and commercial viability and the costs of replacing parts of property, plant and equipment are recognized as oil and natural gas interests only when they increase the future economic benefits embodied in the specific asset to which they relate. All other expenditures are recognized in profit or loss as incurred. Such capitalized oil and natural gas interests generally represent costs incurred in developing proved and/or probable reserves and bringing in or enhancing production from such reserves, and are accumulated on a field or geotechnical area basis. The carrying amount of any replaced or sold component is
3. Significant accounting policies (continued): (iii) derecognized. The costs of the periodic servicing of property, plant and equipment are recognized in profit or loss as incurred. Depletion and depreciation: The net carrying value of development or production assets is depleted using the unit of production method by reference to the ratio of production in the period to the related proved and probable reserves, taking into account estimated future development and decommissioning costs necessary to bring those reserves into production. Future development and decommissioning costs are estimated taking into account the level of development required to produce the reserves. These estimates are reviewed by independent reserve engineers at least annually. Proved and probable reserves are estimated using independent reserve engineer reports, in accordance with Canadian Securities Regulation National Instrument 51-101, and represent the estimated quantities of crude oil, natural gas and natural gas liquids which geological, geophysical and engineering data demonstrate with a specified degree of certainty to be recoverable in future years from known reservoirs and which are considered commercially producible. For depletion purposes, relative volumes of petroleum and natural gas production and reserves are converted at the energy equivalent conversion rate of six thousand cubic feet of natural gas to one barrel of crude oil. The estimated useful lives for certain production assets for the current and comparative years are as follows: Pipeline facilities Turnaround and work over costs Unit of production Expensed as incurred For other assets, depreciation is recognized in profit or loss on a straight-line basis over the estimated useful lives of each part of an item of property, plant and equipment. Leased assets are depreciated over the shorter of the lease term and their useful lives unless it is reasonably certain that the Company will obtain ownership by the end of the lease term. Land is not depreciated. The estimated useful lives for other assets for the current and comparative years are as follows: Office equipment 5 years Depreciation methods, useful lives and residual values are reviewed at each reporting date. (e) Leased assets: Leases where the Company assumes substantially all the risks and rewards of ownership are classified as finance leases. Upon initial recognition the leased asset is measured at an amount equal to the lower of its fair value and the present value of the minimum lease payments. Subsequent to initial recognition, the asset is accounted for in accordance with the accounting policy applicable to that asset.
3. Significant accounting policies (continued): Minimum lease payments made under finance leases are apportioned between the finance expenses and the reduction of the outstanding liability. The finance expenses are allocated to each year during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Other leases are operating leases, which are not recognized on the Company s statement of financial position. Payments made under operating leases are recognized in profit or loss on a straight-line basis over the term of the lease. Lease incentives received are recognized as an integral part of the total lease expense, over the term of the lease. (f) Business combinations: The acquisition method of accounting is used to account for acquisitions of subsidiaries and assets that meet the definition of a business under IFRS. The cost of an acquisition is measured as the fair value of the assets given, equity instruments issued and liabilities incurred or assumed at the date of exchange. The recognized amount of identifiable assets acquired and liabilities and contingent liabilities assumed in a business combination are measured mostly at fair value at the acquisition date. The excess of the cost of acquisition over the recognized amount of identifiable assets, liabilities and contingent liabilities acquired is recorded as goodwill. If the cost of acquisition is less than the recognized amount of the net assets of the subsidiary acquired, the difference is recognized immediately in the income statement. (g) Inventory: Crude oil inventory consists of amounts produced and in storage tanks or in transit, and is recorded at the lower of the average cost of production and estimated net realizable value. Net realizable value is the estimated selling price in the normal course of business less applicable selling expenses. (h) Impairment: (i) (ii) Financial assets: A financial asset is assessed at each reporting date to determine whether there is any objective evidence that it is impaired. A financial asset is considered to be impaired if objective evidence indicates that one or more events have had a negative effect on the estimated future cash flows of that asset. An impairment loss in respect of a financial asset measured at its net book value is calculated as the difference between its carrying amount and the present value of the estimated future cash flows discounted at the effective interest rate. Individually significant financial assets are tested for impairment on an individual basis. The remaining financial assets are assessed collectively in groups that share similar credit risk characteristics. All impairment losses are recognized in profit or loss. An impairment loss is reversed if the reversal can be related objectively to an event occurring after the impairment loss was recognized. For financial assets measured at amortized cost the reversal is recognized in profit or loss. Non-financial assets: The carrying amounts of the Company s non-financial assets net of decommissioning obligations, other than E&E assets and deferred tax assets, are reviewed at each reporting date to determine whether there is any indication of impairment. If any such
3. Significant accounting policies (continued): indication exists, then the asset s recoverable amount is estimated. E&E assets are assessed for impairment when they are reclassified to property, plant and equipment, as oil and natural gas interests, and also if facts and circumstances suggest that the carrying amount exceeds the recoverable amount. For the purpose of impairment testing, assets are grouped together into the smallest group of assets that generates cash inflows from continuing use that are largely independent of the cash inflows of other assets or groups of assets. The recoverable amount of an asset or a CGU is the greater of its value in use and its fair value less costs to sell. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. Value in use is generally computed by reference to the present value of the future cash flows expected to be derived from production of proved and probable reserves. Management does not expect a significant difference between value in use and fair value less cost to sell E&E assets are allocated to related CGU s when they are assessed for impairment, both at the time of any triggering facts and circumstances as well as upon their eventual reclassification to property, plant and equipment. An impairment loss is recognized if the carrying amount of an asset or its CGU net of decommissioning obligations exceeds its estimated recoverable amount. Impairment losses are recognized in profit or loss. An impairment loss in respect of property, plant and equipment and E&E assets recognized in prior years are assessed at each reporting date for any indications that the loss has decreased or no longer exists. An impairment loss is reversed if there has been a change in the estimates used to determine the recoverable amount. An impairment loss is reversed only to the extent that the asset s carrying amount does not exceed the carrying amount that would have been determined, net of depletion and depreciation or amortization, if no impairment loss had been recognized. (i) Share based payments: The grant date fair value of equity settled options granted to employees is recognized as compensation expense with a corresponding increase in contributed surplus over the vesting period. A forfeiture rate is estimated on the grant date and is adjusted to reflect the actual number of options that vest. (j) Provisions: A provision is recognized if, as a result of a past event, the Company has a present legal or constructive obligation that can be estimated reliably, and it is probable that an outflow of economic benefits will be required to settle the obligation. Provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability. Provisions are not recognized for future operating losses. Decommissioning obligations: The Company s activities give rise to dismantling, decommissioning and site disturbance remediation activities. Provision is made for the estimated cost of site restoration and capitalized in the relevant asset category. Decommissioning obligations are measured at the present value of the expected expenditures required to settle the present obligation at the balance sheet date. Subsequent to the initial measurement, the obligation is adjusted at the end of each period to
3. Significant accounting policies (continued): reflect the passage of time and changes in the estimated future cash flows and discount rate underlying the obligation. The increase in the provision due to the passage of time is recognized as finance expense whereas increases/decreases due to changes in the estimated future cash flows and discount rate are capitalized. Actual costs incurred upon settlement of the decommissioning obligations are charged against the provision to the extent the provision was established. (k) Revenue: Revenue from the sale of oil and natural gas is recorded when the significant risks and rewards of ownership of the product is transferred to the buyer which is usually when legal title passes to the external party. This is generally at the time the product enters the pipeline. Royalty income is recognized as it accrues in accordance with the terms of the overriding royalty agreements. (l) Finance income and expenses: Finance expense comprises interest expense on borrowings, accretion of the discount on provisions and transaction costs. Borrowing costs incurred for the construction of qualifying assets are capitalized during the period of time that is required to complete and prepare the assets for their intended use or sale. All other borrowing costs are recognized in profit or loss using the effective interest method. Finance income is recognized as it accrues in profit or loss, using the effective interest method. (m) Income tax: Income tax expense comprises current and deferred tax. Deferred tax expense is recognized in profit or loss except to the extent that it relates to items recognized directly in equity, in which case it is recognized in equity. Current tax is the expected tax payable on the taxable income for the year, using tax rates enacted or substantively enacted at the reporting date, and any adjustment to tax payable in respect of previous years. Deferred tax is recognized using the balance sheet method, providing for temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax is not recognized on the initial recognition of assets or liabilities in a transaction that is not a business combination. Deferred tax is measured at the tax rates that are expected to be applied to temporary differences when they reverse, based on the laws that have been enacted or substantively enacted by the reporting date. Deferred tax assets and liabilities are offset if there is a legally enforceable right to offset, and they relate to income taxes levied by the same tax authority on the same taxable entity, or on different tax entities, but they intend to settle current tax liabilities and assets on a net basis or their tax assets and liabilities will be realized simultaneously. A deferred tax asset is recognized to the extent that it is probable that future taxable profits will be available against which the temporary difference can be utilized. Deferred tax assets are reviewed at each reporting date and are reduced to the extent that it is no longer probable that the related tax benefit will be realized. (n) Per share amounts: Basic earnings per share is calculated by dividing the profit or loss attributable to common shareholders of the Company by the weighted average number of common shares
3. Significant accounting policies (continued): outstanding during the period. Diluted earnings per share is determined by adjusting the profit or loss attributable to common shareholders and the weighted average number of common shares outstanding for the effects of dilutive instruments such as options granted to employees. The calculation assumes that the proceeds on exercise of options are used to repurchase shares at the current market price. (o) Flow-through shares: The resource expenditure deductions for income tax purposes related to exploration and development activities funded by flow-through share arrangements are renounced to investors in accordance with tax legislation. On issuance the premium received on the flowthrough shares, being the difference in price over a common share with no tax attributes is recognized on the statement of financial position. As expenditures are incurred the deferred tax liability associated with the renounced tax deductions are recognized through profit and loss along with a pro-rata portion of the deferred premium. 4. Future accounting policies: The Company has reviewed the following new and revised accounting pronouncements that have been issued but are not yet effective and determined that the following may have an impact on the Company s financial statements: (a) IFRS-9 Financial Instruments: As of January 1, 2015, the Company will be required to adopt IFRS-9 Financial Instruments, which is the result of the first phase of the IASB project to replace IAS -39 Financial Instruments: Recognition and Measurement. The new standard replaces the current multiple classification and measurement models for financial assets and liabilities with a single model that has two classification categories: amortized cost and fair value. Portions of the standard remain in development and the full impact of the standard on the Company s financial statements will not be known until the project is complete. (b) In May, 2011, the IASB released the following new standards which are effective for fiscal years beginning January 1, 2013 with earlier adoption permitted. (i) (ii) (iii) (iv) IFRS-10 Consolidated Financial Statements, supersedes IAS -27 Consolidation and Separate Financial Statements and SIC -12 Consolidation Special Purpose Entities. This standard provides a single model to be applied in control analysis for all investees including special purpose entities. IFRS-11 Joint Arrangements, divides joint arrangements into two types, joint operations and joint ventures, each with their own accounting model. All joint arrangements are required to be reassessed on transition to IFRS 11 to determine their type to apply the appropriate accounting. IFRS-12 Disclosures of Interests in Other Entities, combines in a single standard the disclosure requirements for subsidiaries, associates and joint arrangements as well as unconsolidated structured entities. IFRS-13 Fair Value Measurement, defines fair value, establishes a framework for measuring fair value and sets out disclosure requirements for fair value measurements. This standard defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company is currently assessing the expected impact, if any, that the adoption of these standards will have on its financial statements.
5. Determination of fair values: A number of the Company s accounting policies and disclosures require the determination of fair value, for both financial and non-financial assets and liabilities. Fair values have been determined for measurement and/or disclosure purposes based on the following methods. When applicable, further information about the assumptions made in determining fair values is disclosed in the notes specific to that asset or liability. (i) Property, plant and equipment and exploration and evaluation assets: The fair value of property, plant and equipment recognized in a business combination, is based on fair values. The fair value of property, plant and equipment is the estimated amount for which property, plant and equipment could be exchanged on the acquisition date between a willing buyer and a willing seller in an arm s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion. The fair value of oil and natural gas interests (included in property, plant and equipment) and exploration and evaluation assets is estimated with reference to the discounted cash flows expected to be derived from oil and natural gas production based on externally prepared reserve reports. The risk-adjusted discount rate is specific to the asset with reference to general market conditions. (ii) Cash and cash equivalents, accounts receivables, bank loans and accounts payables: The fair value of cash and cash equivalents, accounts receivables, bank loans and accounts payable is estimated as the present value of future cash flows, discounted at the market rate of interest at the reporting date. At December 31, 2011 and December 31, 2010, the fair value of these balances approximated their carrying value due to their short term to maturity. Bank loans bear a floating rate of interest therefore carrying value approximates fair value. (iii) Derivatives: The fair value of forward contracts and swaps is determined by discounting the difference between the contracted prices and published forward price curves as at the statement of inancial position date, using the remaining contracted oil and natural gas volumes and a riskfree interest rate (based on published government rates). The fair value of options and costless collars is based on option models that use published information with respect to volatility, prices and interest rates. (iv) Stock options: The fair value of employee stock options is measured using a Black Scholes option pricing model. Measurement inputs include share price on measurement date, exercise price of the instrument, expected volatility (based on weighted average historic volatility adjusted for changes expected due to publicly available information), weighted average expected life of the instruments (based on historical experience and general option holder behavior), expected dividends and the risk-free interest rate (based on government bonds). 6. Related party transactions: An officer of the Company is a partner in a law firm that provides legal services to the Company. During the year, the Company incurred a total of $175,706 (2010 - $ 262,265) for legal fees and disbursements. As at December 31, 2011, accounts payable include $25,000 (December 31, 2010 - $35,000) relating to these payments. 7. Business acquisition: On November 15, 2011, the Company acquired certain producing properties in Western Canada for total cash consideration $39.3 million. The acquisition has been accounted for using the acquisition method with the results of the operations included in the Company s financial and
7. Business acquisition (continued): operating results commencing November 15, 2011. The Company incurred $613,611 of transaction costs related to the acquisition. The following table presents the allocation of the purchase price based on estimated fair values: Identifiable assets acquired and liabilities assumed: Property, plant and equipment $ 56,764,698 Prepaid expenses 675,574 Trade receivables 400,000 Inventory 202,344 Decommissioning obligations (18,703,225) Total $ 39,339,391 The value attributed to the property, plant and equipment acquired was determined in reference to an engineering report prepared by the Company s third party reserve evaluators using proved plus probable reserves discounted at a rate of 12-15%. Accounts receivable are recognized at the contractual amount and are expected to be collected. The following table presents the estimated impact on the following as if the acquisition had occurred on January 1, 2011 instead of the actual closing of November 15, 2011: 2011 Oil and natural gas revenue $82,800,000 Net income for the year 7,900,000 Per share - basic and diluted $ 0.05 Since the closing date of November 15, 2011, approximately $3.8 million of revenue and $1.5 million of income have been included in comprehensive loss 8. Exploration and evaluation assets: Cost or deemed cost Total Balance at January 1, 2010 $ - Additions 11,028,488 Transfer to property, plant and equipment (4,046,054) Transfer to exploration and evaluation expenses (587,929) Balance at December 31, 2010 6,394,505 Additions 9,363,845 Transfer to property, plant and equipment (2,913,440) Transfer to exploration and evaluation expenses (3,744,741) Balance at December 31, 2011 $ 9,100,169 For the year ended December, 2011, $1,555,130 (2010 - $1,663,037) of seismic costs were recorded directly to exploration and evaluation expense in the consolidated statement of loss.
9. Property, plant and equipment: Cost or deemed cost Total Balance at January 1, 2010 (after transitional impairment) $ 77,989,725 Additions 14,947,866 Property acquisitions 2,259,529 Transfer from exploration and evaluation assets 4,046,054 Divestitures (7,969,065) Change in decommissioning obligations 1,109,054 Decommissioning obligations acquired and incurred 685,313 Capitalized share-based compensation 211,130 Changes in translati
9. Property, plant and equipment (continued): During 2011, the Company disposed of certain non-core properties for proceeds of $621,914 December 31, 2010 - $5,919,077), this resulted in a gain of $31,141 (December 31, 2010 gain of $1,282,406). 10. Impairment loss: As at December 31, 2011, as a result of depressed gas prices and downward revisions of oil reserves, the Company tested certain natural gas and oil CGU s for impairment. The recoverable amount was determined using value in use, net of decommissioning expenditures, based on discounted cash flows of proved plus probable reserves as estimated by the Company s third party reserve evaluators using forecast prices and costs and discount rates of between 10% and 20%. In determining the appropriate discount rate the Company considered the acquisition metrics of recent transactions completed with assets similar to those in the specific CGU s. The following estimates were used in determining whether an impairment to the carrying value of the CGU s existed at December 31, 2011. Benchmark reference price forecast 2012 2013 2014 2015 2016 2017 2018 2019 WTI ($US/bbl) 100.00 102.00 104.05 106.10 108.25 110.40 112.60 114.85 Edmonton Par ($CDN/bbl) 98.00 100.00 102.00 104.00 106.10 108.20 110.35 112.55 Bow River Hardisty ($CDN/bbl) 81.20 81.10 80.00 82.00 84.10 86.20 88.35 90.55 AECO-C ($CDN/mcf) 3.50 4.10 4.70 5.15 5.55 6.00 6.40 6.90 Edmonton Butanes ($CDN/bbl) 83.30 85.00 86.70 88.40 90.20 91.95 93.80 95.65 Edmonton Pentanes 102.90 105.00 107.10 109.20 111.40 113.60 115.85 118.20 ($CDN/bbl) Exchange rate ($CDN/$US) 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 After 2019 the price forecast escalates at 2% per year to the end of the reserve life and the exchange rate remains constant at 1.00. During 2011 it was determined that the net book value of certain CGU s exceeded the recoverable amount and an impairment of $5.5 million was recognized. A one per cent increase in the assumed discount rate would result in an additional impairment of $1.2 million while a ten percent decrease to the forward commodity price estimate would result in an additional impairment of $3.8 million. As at December 31, 2010, as a result of depressed gas prices and downward revisions of oil reserves, the Company tested certain natural gas and oil CGU s for impairment. The recoverable amount was determined using value in use, based on discounted cash flows of proved plus probable reserves as estimated by the Company s third party reserve evaluators using forecast prices and costs and discount rates of between 12% and 14%. In determining the appropriate discount rate the Company considered the acquisition metrics of recent transactions completed with assets similar to those in the specific CGU s.