ITEM 1A. RISK FACTORS RELATED TO THE COMPANY'S BUSINESS
JayHawk is subject to various risks and uncertainties in the course of its business. The following summarizes some, but not all, of the risks and uncertainties that may adversely affect its business, financial condition or results of operations.
Going Concern - As shown in the accompanying consolidated financial statements, the Company has incurred operating losses since inception. As of September 30, 2011, JayHawk Energy has limited financial resources with which to achieve its objectives and obtain profitability and positive cash flows. Achievement of the Company's objectives will be dependent upon its ability to obtain additional financing, to locate profitable oil and gas properties and generate revenue from the current and planned business operations, and control costs. The Company plans to fund future operations by joint venturing, obtaining additional financing from investors, and attaining additional commercial production. However, there is no assurance that JayHawk Energy will be able to achieve these objectives.
Commodity Price Risk: The Company's estimated proved reserves, revenue, operating cash flows, and operating margins are highly dependent on the prices of crude oil and natural gas. A substantial or extended decline in oil or natural gas prices would reduce its operating results and cash flows and could impact the rate of growth and carrying value of the Company's assets. Prices for liquid hydrocarbons and natural gas are very volatile. JayHawk Energy's revenues, operating results and ability to grow in the future are highly dependent on the prices it receives for its oil and natural gas. Many factors beyond the Company's control influence the price it receives for production. These include, but are not limited to, general economic conditions worldwide, political instability in other parts of the world, changes in weather patterns, price and availability of alternative sources of energy, and government regulation.
Technical Risk: The Company's exploration and development operations are subject to many risks which may affect its ability to profitably extract oil and natural gas reserves or achieve targeted returns. In addition, continued growth requires that the Company acquire and successfully develop additional oil and natural gas reserves.
JayHawk Energy's exploration and development activities will depend in part on the evaluation of data obtained through geophysical testing and geological analysis, as well as test drilling activity. The results of such studies and tests are subjective, and no assurances can be given that exploration and development activities based on positive analysis will produce oil or natural gas in commercial quantities or costs. As developmental and exploratory activities are performed, further data required for evaluation of its oil and natural gas interests will become available. The exploration and development activities that will be undertaken by the Company are subject to greater risks than those associated with the acquisition and ownership of producing properties. The drilling of development wells, although generally consisting of drilling to reservoirs believed to be productive, may result in dry holes or a failure to produce oil and natural gas in commercial quantities. Moreover, any drilling of exploratory wells is subject to significant risk of dry holes.
The Company's commercial success depends on its ability to find, acquire, develop and commercially produce oil and natural gas reserves. Without the continual addition of new reserves, any existing reserves and the production thereof will decline over time as such existing reserves are depleted. A future increase in the Company's reserves will depend not only on its ability to explore and develop any properties the Company may have from time to time, but also on its ability to select and acquire suitable producing properties or prospects. No assurance can be given that JayHawk Energy will be able to continue to locate satisfactory properties for acquisition or participation. Moreover, if such acquisitions or participations are identified, the Company may determine that current markets, terms of acquisition and participation or pricing conditions make such acquisitions or participations economically disadvantageous. There is no assurance that commercial quantities of oil and natural gas will be discovered or acquired by the Company.
Catastrophic Risk: The Company's oil and natural gas operations are subject to unforeseen operating hazards which may damage or destroy assets. Although the Company maintains a level of insurance coverage consistent with industry practices against property or casualty losses, unique circumstances to any particular event may make the coverage inadequate. Oil and natural gas exploration, development and production operations are subject to all the risks and hazards typically associated with such operations, including hazards such as fire, explosion, blowouts, sour gas releases and spills, each of which could result in substantial damage to oil and natural gas wells, production facilities, other property and the environment or in personal injury.
Competitive Risk: The petroleum industry is highly competitive and very capital intensive. If the Company is unable to successfully compete with the large number of oil and natural gas producers in its industry, it may not be able to achieve profitable operations. The Company encounters competition from numerous companies in each of its activities, including acquiring rights to explore for crude oil and natural gas. The Company's competitors include oil and natural gas companies that have substantially greater financial resources, staff and facilities than JayHawk Energy. JayHawk's ability to increase reserves in the future will depend not only on its ability to explore and develop its existing properties, but also on the ability to select and acquire suitable producing properties or prospects for exploratory drilling. Competitive factors in the distribution and marketing of oil and natural gas include price and methods and reliability of delivery. Competition may also be presented by alternate fuel sources.
Regulatory and Environment Risk: The Company is subject to various regulatory requirements, including environmental regulations, and may incur substantial costs to comply and remain in compliance with those requirements. Oil and gas operations are subject to environmental hazards such as oil spills, produced water spills, gas leaks and ruptures and discharges of substances or gases that could expose the Company to substantial liability. The Company's operations are also subject to numerous laws and regulations at the federal, state and local levels, including regulation relating to matters such as the exploration for and the development, production, marketing, pricing, transmission and storage of oil and natural gas, as well as environmental and safety matters. Failure to comply with applicable regulations could result in fines or penalties being owed to third parties or governmental entities, the payment of which could have a material adverse effect on the Company's financial condition or results of operations. The Company's operations are subject to significant laws and regulations, which may adversely affect its ability to conduct business or increase its costs.
Environmental legislation provides for, among other things, restrictions and prohibitions on spills, releases or emissions of various substances produced in association with oil and natural gas operations. The legislation also requires that wells and facility sites be operated, maintained, abandoned and reclaimed to the satisfaction of the applicable regulatory authorities. Compliance with such legislation can require significant expenditures and a breach may result in the imposition of fines and penalties.
The discharge of oil, natural gas or other pollutants into the air, soil or water may give rise to liabilities to governments and third parties and may require the Company to incur costs to remedy such discharge. No assurance can be given that environmental laws will not result in a curtailment of production or a material increase in the costs of production, development or exploration activities or otherwise adversely affect the Company's financial condition, results of operations or prospects. The Company could incur significant liability for damages, clean-up costs and/or penalties in the event of discharges into the environment, environmental damage caused by the Company or previous owners of the Company's property or non-compliance with environmental laws or regulations. In addition to actions brought by governmental agencies, the Company could face actions brought by private parties or citizens groups. Any of the foregoing could have a material adverse effect on the Company's financial results.
Market Risk: The marketability and price of oil and natural gas that may be acquired or discovered by the Company will be affected by numerous factors beyond JayHawk Energy's control. The Company's ability to market its natural gas may depend upon the ability to acquire space on pipelines that deliver natural gas to commercial markets. The Company may also be affected by deliverability uncertainties related to the proximity of its reserves to pipelines and processing facilities, by operational problems with such pipelines and facilities, and by government regulation relating to price, taxes, royalties, land tenure, allowable production, the export of oil and natural gas and by many other aspects of the oil and natural gas business.
Financial Risks: JayHawk Energy's business may be harmed if the Company is unable to retain interests in existing leases. All of the Company's properties are held under licenses, working interests in operating agreements and interest in oil and gas mineral leases, interests in oil and gas mineral leases, some of which expire within the next twelve months. If the Company fails to meet the specific requirements of each lease, especially future drilling and production requirements, the lease may be terminated or otherwise expire. The Company cannot be assured that it will be able to meet its obligations under each lease. The termination or expiration of its working interest relating to any lease would harm the Company's business, financial condition and results of operations.
Estimation Risks: Reserve estimates, like all estimates, are subject to numerous uncertainties and may be inaccurate. There are numerous uncertainties inherent in estimating quantities of oil or natural gas reserves and cash flows to be derived from, including many factors beyond the Company's control. The reserve and associated cash flow information set forth herein represents estimates only. In general, estimates of economically recoverable oil and natural gas reserves and the future net cash flows where therefrom are based upon a number of variable factors and assumptions, such as historical production from the properties, production rates, ultimate
reserve recovery, timing and amount of capital expenditures, marketability of oil and natural gas, royalty rates, the assumed effects of regulation by governmental agencies and future operating costs, all of which may vary from actual results. All such estimates are to some degree speculative, and classifications of reserves are only attempts to define the degree of speculation involved. For those reasons, estimates of the economically recoverable oil and natural gas reserves attributable to any particular group of properties, classification of such reserves based on risk of recovery and estimates of future net revenues expected wherefrom prepared by different engineers, or by the same engineers at different times, may vary. Actual production, revenues, taxes and development and operating expenditures with respect to the Company's reserves will vary from estimates thereof and such variations could be material.
Estimates of proved or unproved reserves that may be developed and produced in the future are often based upon volumetric calculations and upon analogy to similar types of reserves rather than actual production history. Estimates based on these methods are generally less reliable than those based on actual production history. Subsequent evaluation of the same reserves based upon production history and production practices will result in variations in the estimated reserves and such variations could be material.
Default Risks: Properties are held in the form of licenses, leases and working interests in operating agreements and leases. If the Company and/or a lease holder fail to meet the specific requirements of the lease, license or operating agreement the specific instrument may terminate or expire. There can be no assurance that any of the obligations required to maintain each license or lease will be met, although the Company exercises commercially reasonable efforts to do so. The termination or expiration of licenses or leases or the working interests relating to a license or lease may have a material adverse effect on the Company's results of operations and business.
Risk of Loss of Key Personnel: The Company's success depends in large measure on certain key personnel, including its President and Chief Executive Officer, and Chief Financial Officer. The loss of the services of such key personnel could have a material adverse effect on the Company. Although the Company is considering acquiring key person insurance, the Company does not currently have such insurance in effect for these key individuals. In addition, the competition for qualified personnel in the oil and natural gas industry is intense and there can be no assurance that the Company will be able to continue to attract and retain all personnel necessary for the development and operation of its business.
Title Deficiencies Risk: The existence of a material title deficiency can render a lease worthless and can result in a large expense to the Company's business. It is the Company's practice in acquiring oil and gas leases or undivided interests in oil and gas leases to forego the expense of retaining lawyers to examine the title to the oil or gas interest to be placed under lease or already placed under lease. Instead, we rely upon the judgment of oil and gas landmen who perform the field work in examining records in the appropriate governmental office before attempting to place under lease a specific oil or gas interest. This is customary practice in the oil and gas industry. However, we do not anticipate that we, or the person or company acting as operator of the wells located on the properties that we currently lease or may lease in the future, will obtain counsel to examine title to the lease until the well is about to be drilled. As a result, we may be unaware of deficiencies in the marketability of the title to the lease. Such deficiencies may render the lease worthless and impede upon the Company's ability to develop the property subject to the lease.
Risk Related to Debentures: The Company currently is indebted to five institutional investors in the form of convertible debentures. Should the debenture holders choose to exercise their rights to foreclose on the North Dakota properties, the Company's cash flow from operations could be reduced significantly to only those revenues derived from the Kansas natural gas operations. The Company is currently in default of provisions in the debenture agreements as discussed in Note 12 of the consolidated financial statements.
Risk related to disclosure controls: The Company's disclosure controls and procedures and internal control over financial reporting were not effective, which caused the Company's financial reporting to be unreliable and lead to incorrect financial information being disseminated to the public. The Company's management evaluated its disclosure controls and procedures as of September 30, 2011 and concluded that as of that date, the Company's disclosure controls and procedures were not effective. In addition, management evaluated the Company's internal control over financial reporting as of September 30, 2010 and concluded that that there were material weaknesses in the Company's internal control over financial reporting as of that date and that its internal control over financial reporting was not effective as of that date. A material weakness is a control deficiency, or combination of control deficiencies, such that there is a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected on a timely basis.
The Company has not yet remediated this material weakness and management believes that the Company's disclosure controls and procedures and internal control over financial reporting continue to be ineffective. Until these issues are corrected, the Company's ability to report financial results or other information required to be disclosed on a timely and accurate basis may be adversely affected and the Company's financial reporting may continue to be unreliable, which could result in additional incorrect financial information being disseminated to the public. Investors relying upon this incorrect information may make a misinformed investment decision.
Risks Related to the Company's Common Stock: Shares of the Company's common stock may continue to be subject to price volatility and illiquidity because the shares are thinly traded and may never become eligible for trading on a national securities
exchange. While the Company may at some point be able to meet the requirements necessary for its common stock to be listed on a national securities exchange, the Company cannot assure investors or potential investors that it will ever achieve a listing of its common stock. Initial listing is subject to a variety of requirements, including minimum asset values, minimum revenue, minimum trading price and minimum public “float” requirements. There are also continuing eligibility requirements for companies listed on public trading markets. If the Company is unable to satisfy the initial or continuing eligibility requirements of any such market, then its stock may not be listed or could be delisted. This could result in a lower trading price for the Company's common stock and may limit investors ability to sell their shares, any of which could result in losing some or all of their investment.
The Company's common stock is subject to the “penny stock” rules of the Securities and Exchange Commission and the trading market in the Company's securities is limited, which makes transactions in JayHawk Energy's stock cumbersome and may reduce the value of an investment in its stock. The Securities and Exchange Commission (the “SEC”) has adopted Rule 3a51-1 which establishes the definition of a “penny stock,” for the purposes relevant to the Company, as any equity security that (i) has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share, or (ii) is not registered on a national securities exchange or listed on an automated quotation system sponsored by a national securities exchange. For any transaction involving a penny stock, unless exempt, Rule 15g-9 of the Securities and Exchange Act of 1934, as amended, requires:
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that a broker or dealer approve a person’s account for transactions in penny stocks; and
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the broker or dealer receives from the investor a written agreement to the transaction, setting forth the identity and quantity of the penny stock to be purchased.
In order to approve a person’s account for transactions in penny stocks, the broker or dealer must:
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obtain financial information and investment experience objectives of the person; and
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make a reasonable determination that the transactions in penny stocks are suitable for that person and the person has sufficient knowledge and experience in financial matters to be capable of evaluating the risks of transactions in penny stocks.
The broker or dealer must also deliver, prior to any transaction in a penny stock, a disclosure schedule prescribed by the SEC relating to the penny stock market, which, in highlight form:
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sets forth the basis on which the broker or dealer made the suitability determination; and
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attests that the broker or dealer received a signed, written agreement from the investor prior to the transaction.
Disclosure also has to be made about the risks of investing in penny stocks in both public offerings and in secondary trading, and about the commissions payable to the broker-dealer and the registered representatives, as well as current quotations for the securities, and the rights and remedies available to an investor in cases of fraud in penny stock transactions. Finally, monthly statements have to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks. Generally, brokers may be less willing to execute transactions in securities subject to the “penny stock” rules. This may make it more difficult for investors to dispose of the Company's common stock and cause a decline in the market value of its stock.
The market valuation of energy companies, such as JayHawk Energy, Inc., frequently fluctuate due to factors unrelated to the past or present operating performance of such companies. The Company's market valuation may fluctuate significantly in response to a number of factors, many of which are beyond its control, including:
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changes in securities analysts’ estimates of the Company's financial performance, although there are currently no analysts covering its stock;
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fluctuations in stock market prices and volumes, particularly among securities of energy companies;
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changes in market valuations of similar companies;
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announcements by the Company or its competitors of significant contracts, new technologies, acquisitions, commercial relationships, joint ventures or capital commitments;
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variations in the Company's quarterly or annual operating results;
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fluctuations in oil and natural gas prices; and
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additions or departures of key personnel.
Dividends: Investors should not look to dividends as a source of income. In the interest of reinvesting initial profits back into its business, the Company does not intend to pay cash dividends in the foreseeable future. Consequently, any economic return will initially be derived, if at all, from appreciation in the fair market value of the Company's stock, and not as a result of dividend payments.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
None
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report Form 10-K.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Market Information
The Company's common stock is quoted on the OTC Bulletin Board under the symbol "JYHW.OB". For the periods indicated, the following table sets forth the high and low bid prices per share of JayHawk’s common stock since inception of trading. These prices represent inter-dealer quotations without retail markup, markdown, or commission and may not necessarily represent actual transactions.
Holders
As of September 30, 2011, there were 93 stockholders of record who owned 58,236,245 shares of common stock. The number of record holders was determined from the records of the Company's transfer agent and does not include beneficial owners of common stock whose shares are held in the names of various security brokers, dealers, and registered clearing agencies. The transfer agent of the Company's common stock is Corporate Stock Transfer Company at 3200 Cherry Creek Drive South, Suite #340, Denver, Colorado, 80209.
Description of Securities
The authorized capital stock of the Company consists of 200,000,000 of the common stock, at $0.001 par value, and 10,000,000 shares of preferred stock, at $0.001 par value. The shares of preferred stock may be issued in one or more series. The designations, powers, rights, preferences, qualifications, restrictions, and limitations of each series of preferred stock shall be established from time to time by the Board of Directors in accordance with Colorado law.
Dividends
Holders of common and preferred stock are entitled to receive dividends as may be declared by the Board of Directors. The Board of Directors is not restricted from paying any dividends but is not obligated to declare a dividend. No dividends have ever been declared and it is not anticipated that dividends will ever be paid, but will be dependent upon the Company's financial condition, results of operations, capital requirements, and such other factors as the Board of Directors deem relevant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The Registrant is a “smaller reporting company” as defined Rule 10(f)(1) of Regulation S-K, and as such is not required to present the information required under this Item.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS
The following information should be read in conjunction with the consolidated financial statements and the notes thereto contained elsewhere in this report. All notes referred to in this Management Discussion and Analysis refer to the notes to the Consolidated Financial Statements presented in Item 8. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Information in this Item 7, "Management's Discussion and Analysis or Plan of Operation," and elsewhere in this 10-K that does not consist of historical facts, are "forward-looking statements."
Statements accompanied or qualified by, or containing words such as "may," "will," "should," "believes," "expects," "intends," "plans," "projects," "estimates," "predicts," "potential," "outlook," "forecast," "anticipates," "presume," and "assume" constitute forward-looking statements, and as such, are not a guarantee of future performance. The statements involve factors, risks and uncertainties including those discussed in the “Risk Factors” section contained elsewhere in this report, the impact or occurrence of
which can cause actual results to differ materially from the expected results described in such statements.
Investors should not place undue reliance on forward-looking statements as predictive of future results. The Company disclaims any obligation to update the forward-looking statements in this report.
Overview
This overview is presented in chronological order as to dates the respective transactions were completed. It should be read in conjunction with the "Notes to the Consolidated Financial Statements" presented in Item 8, specifically Note 13 relative to Common Stock, and Note 5 and Note 6 relative to Asset Impairments.
On June 21, 2007, the Company changed its name from Bella Trading Company, Inc. to JayHawk Energy, Inc. and shifted focus from the retail jewelry industry to the oil and gas business. The Company's new business plan was to acquire oil and gas properties for exploration and development with the intent to bring the projects to feasibility at which time it would either contract out the operations or joint venture the project to qualified interested parties. The Company implemented this plan on July 25, 2007 with the acquisition of certain oil, gas, and mineral leases to approximately 35,000 gross acres located in Bourbon County, Kansas (the “Uniontown project”). The assets were purchased for a total purchase price of $2.2 million.
On January 16, 2008, JayHawk purchased a 65% working interest in 5 producing oil wells located in the Williston Basin of North Dakota, along with the right to develop the oil, gas and mineral resources on 15,500 acres of leases in this same area. In consideration for these properties JayHawk paid JED Oil $3.5 million in cash. The cash used to complete this transaction was raised in a private placement offering of the Company's common stock.
On March 31, 2008, JayHawk closed a transaction, initiated with an agreement dated February 18, 2008, whereby JayHawk acquired a 16 mile pipeline, associated easements, oil, gas and mineral leases to approximately 6,500 gross acres, 34 gas wells, compressor, and other field equipment. In consideration for these assets JayHawk exchanged $1 million in cash and 1 million shares of its common stock.
On April 18, 2008, JayHawk entered into an agreement to acquire oil and natural gas rights to 1,336 gross acres and 14 completed but non-producing gas wells, in exchange for $300,000 in cash and 50,000 shares of the Company's common stock.
On June 30, 2008, the Company agreed to purchase oil, gas and mineral leases on 11,462 gross acres and 5 completed and cased gas wells, located in Crawford and Bourbon counties in Kansas. In consideration for these assets JayHawk paid $140,000 in cash and was obligated to issue 286,550 shares of its common stock as the leases were assigned at the rate of 25 shares per acre.
On July 22, 2008, the former purchaser of the Company's North Dakota crude oil production, SemCrude, L.P, filed a Chapter 11 bankruptcy proceeding in the United States Bankruptcy Court, District of Delaware. At the time of their filing JayHawk Energy, Inc., had not been paid for the crude oil they had taken from the Company's properties for the months of June and July 2008. As a consequence, the Company had an outstanding receivable exceeding $283,000 and offsetting allowance for doubtful accounts of $119,763 at September 30, 2009. The amount was subsequently paid.
During the 4th quarter of the year ending September 30, 2009 the Company completed a signed letter agreement with DK True Energy Development Limited ("DKTED”) which allows DKTED to earn up to an 85% working interest in JayHawk's Coal Bed Methane ("CBM") project in southeast Kansas (the Girard project). This interest can be earned by DKTED after paying the Company $500,000 and spending a minimum of $1,300,000 over a three year period. DKTED has the option to cap its participation and working interest at 42.5% after paying the Company $250,000 and spending $300,000 on workovers of existing wells during the first year, in what is described as the “Primary Program”. DKTED subsequently assigned its interests in the Girard project to WHL Energy Midcon, LLC. ("WHL"), in December 2009 who provided operational expertise and personnel on the Girard project.
In September 2009, the Company completed a full analysis of the Crosby North Dakota property in which JayHawk is the operator. At that time, there were five producing Ratcliffe formation oil wells with gross production of approximately 60 barrels of oil produced per day. Considering that large mineral interests held in the area by JayHawk and its joint venture partners, the area was considered a prime opportunity for exploitation of the reserves attributable to the reservoir as determined by management’s analysis of the Crosby pool and other analogue oil pools within the same depositional fairway of the Crosby pool. Many of these analogue pools had been successfully developed by other operators and had returned significant additional production and reserves associated with that drilling exploitation. Corroboration for the development of the pool was also given by the independent engineering assessment performed by McDaniel Associates of Calgary, Alberta, Canada who had been commissioned by JayHawk to perform an independent third party report for the Company’s year-end in both 2011 and 2010.
In March 2010, JayHawk commenced the drilling of the first of two vertical wells on the Crosby property located on the western side of the acreage position. These wells were inferred to be in the thick part of the reservoir and were offsetting some of the better producing wells in the pool. Both wells were ultimately drilled and tested oil in the Ratcliffe target formation and despite early encouraging results, both wells produced oil at marginal rates over a longer production period and were eventually shut in during September of 2010. Both wells are currently shut in pending further remedial action.
While the management and third party engineering assessments were both favorable in terms of the development potential of the Crosby pool, risk factors associated with any drilling of oil and gas resources are common. These risk factors are associated with changing parameters within the reservoir and include, but are not limited to; non-deposition of reservoir, reduced porosity and permeability of reservoir rock when present, structural changes to the reservoir which may preclude the trapping of hydrocarbons, drainage of existing reserves by other wells, mechanical problems while drilling which may prevent production, rising costs due to unforeseen circumstances which may result in wells becoming non-commercial, lower than anticipated production rates due to changes in reservoir quality which were un-anticipated, well bore damage by drilling which may prevent commercial production of hydrocarbons, catastrophic failure during drilling which may prevent the well from reaching its intended target or other unforeseen events which may mitigate the economic success of a drilling operation.
Management’s assessment of the economic viability of these two wells is pending further evaluation to determine whether pressure depletion and/or communication with the water leg in the formation directly below the zone occurred. Therefore, the Company has impaired both wells for the year ending September 30, 2011 pending further evaluation. Should either of the wells be ultimately determined to be non-commercial, the well may be converted to a water disposal well in order to reduce trucking and disposal costs associated with the existing producing wells. The Company would then also consider accepting disposal water from other producers in the area as an alternate revenue source in what had previously been a cost center.
In 2010, after WHL had fulfilled the $250,000 cash payment obligation and spent the $300,000 on workovers of the Girard project, the Company issued WHL an option to earn an additional 42.5 percent (total 85 percent) participation and working interest upon remitting to the Company an additional $250,000 within nine months of the granting of the option. During the year ended September 30, 2011, the option period expired unexercised and, per the terms of the agreement, WHL's total working interest earned was set at 35 percent. As such, the Company has reduced the cost basis of the Girard by $250,000 to offset the elimination of the corresponding investment from WHL that had previously been carried as "Investment by Joint Venture Partner" on JayHawk Energy's balance sheet. See Note 20, Subsequent Events, and Note 21, Commitments and Contingencies
The Company has not entered into commodity swap arrangements or hedging transactions, and although it has no current plans to do so, it may enter into commodity swap and/or hedging transactions in the future in conjunction with oil and gas production. The Company has no off-balance sheet arrangements.
The forecast for the period for which the Company's financial resources will be adequate to support its operations involves risks and uncertainties and actual results could fail as a result of a number of factors. The Company's future financial results continue to depend primarily on (1) the Company's ability to discover commercial quantities of oil and gas; (2) the market price for oil and gas; (3) the ability to continue to source and screen potential projects; and (4) the Company's ability to fully implement its exploration and development program with respect to these and other matters. The Company cannot assure that it will be successful in any of these activities or that the prices of oil and gas prevailing at the time of production will be at a level allowing for profitable production.
Results of Operations
For the years ending September 30, 2011 and 2010 we report gross revenues of $363,122 and $684,708, respectively, from the sales of oil and natural gas. Details of these two revenue components follow:
Oil Revenues: As commented on in Note 2 to the Consolidated Financial Statements for the period ended September 30, 2011, the Company recognizes revenues only to the extent of its net working interest, which is the remainder after deduction of the outside working and royalty interests and the deduction of severance and production taxes.
For the years ended September 30, 2011 and 2010 JayHawk sold a gross 9,518 Bbls and 19,282 Bbls respectively. Gross working interest in the revenues generated from the five North Dakota oil wells were $333,375 and $612,607 respectively. Gross receipts reconciled to JayHawk net working interest, or revenue recognized is reflected in the following table:
The decrease in gross revenues evidenced here is attributable to the inability of the Company to access its production fields for much of fiscal year 2011 as a result of inclement weather and associated flooding which resulted in road restrictions. Without access to storage tanks, the Company was unable to distribute production to wholesalers for much of the year ending September 30, 2011. For the year ending September 30, 2011 the average price the Company received for a barrel of oil was $74.18. During the comparable period ending September 30, 2010 the average price received per barrel was $63.13. While the price per barrel strengthened in fiscal year 2011, the Company was unable to capitalize on higher oil prices as a result of the transportation issues previously disclosed.
The Company has subsequently returned to production four of five wells in North Dakota during November 2011. The remaining well remains inaccessible due to slowly receding flood waters. Management anticipates the remaining well to become accessible sometime in early 2012 barring unforeseen weather consequences but can provide no assurance to an exact date given the unpredictable nature of weather patterns in North Dakota.
Gas Revenues: During the first quarter ending December 31, 2009, the Company entered into an agreement whereby initially 42.5 percent of the gas revenues generated from the Girard properties were assigned to a joint venture partner in exchange for $250,000. Net gas revenues accruing to the Company for the year ending September 30, 2011 and 2010 are reported net of the Company's joint venture partner's interest. Under the previous agreement, the joint venture partner was responsible for 100% of the operating expenses and retained a 42.5% percent of the gas revenue generated. During the year ended September 30, 2011, the joint venture partner chose not to exercise their option, which will subsequently cause natural gas revenues to be reported on a gross basis and the previous joint venture partner being recognized as a 35% working interest partner responsible for only their pro-rata share of operating expenses.
Revenues derived from gas sales for the years ending September 30, 2011 and 2010 were $29,847 and $72,101. Average monthly prices received for each thousand cubic feet (mcf) of gas sold during the period end September 30, 2011 have remained volatile, ranging from a high of $5.15, received for the sale of June 2011 production, to a low of $3.08 received for October 2010 production. The average price received for the 12 month period ending September 31, 2011 was $3.85 per mcf. The average price received for the 12 month period ending September 30, 2010 was $4.13 per mcf. The Company’s gas revenue was adversely impacted in late June/July 0f 2011 as a result of acts of vandalism to the pipeline which has since been repaired.
Exploration Expenses: There were no exploration expenses incurred during the years ending September 30, 2011 or 2010.
Production Expenses: Production expenses are comprised of field labor, maintenance, chemicals, fuel, and salt water disposal, less amounts charged other working interests in the particular wells. These expenses associated with the Company’s North Dakota oil operations decreased from $286,464 for the year ending September 30, 2010 to $148,750 for the year ending September 30, 2011. Decrease in production expenses are a result of inability to produce and re-sell oil during extended periods of inclement weather and flooding in North Dakota for the year ended September 30, 2011, coupled with ongoing efforts to reduce operating expenses . The Kansas gas operations saw production expenses increase slightly from $26,060 to $28,411 between the same periods. This is a result of maintenance and repair expense associated with acts of vandalism to the pipeline in late June/early July 2011.
Depreciation, depletion, amortization, abandonment and asset impairment expense: The aggregate of these expenses for the years ending September 30. 2011 and 2010 are detailed below.
As discussed generally in Note 2, and specifically in Note 5, of "Notes to the Consolidated Financial Statements," JayHawk periodically reviews and assesses its unproved properties to determine if they have been impaired. During the year ending September 30, 2008, management made a review of the portfolio of leases acquired in the Uniontown transaction of July 2007, and decided, based on geology and proximity to the pipeline owned by JayHawk Energy, Inc's subsidiary, to allow approximately half of the original Uniontown leases acquired, to expire. Further, given the Company's inability at that time to fund development of any acreage, the Company has provided a valuation for potential loss equal to two-thirds, 67%, of the original cost of this leased acreage. Accordingly, this amount is included in operating expenses. During the year ended September 30, 2011, management's evaluation of the Uniontown project indicated the capital required to develop the property exceeded the Company's ability to fund the project, and any capital raised would be better served being deployed on other opportunities. Therefore, the remainder of the leases in Uniontown expired without renewal. Consequently, the Company charged off remaining balance of $1,020,479 on the Uniontown project at September 30, 2011.
General and Administrative Expenses: General and administrative expenses have been decreased 36% to $826,273 for the year ending September 2011 from $1,292,351 for the comparable period ended September 30, 2010. The Company implemented cost-cutting measures to counteract reduced oil revenue resulting from flooding in North Dakota. The CEO reduced and deferred taking salary for the final six months of the fiscal year as well as taking on the role of Company President in April. The Company eliminated the investor relations firm previously engaged resulting in an ongoing annual savings of $48,000. Management expects to continue under this structure at least through the early part of 2012.
Included in Salaries, Wages and Compensation is the recognition of a non-cash Stock Option expense in the amount of $200,560 for the year ended September 30, 2010 awarded to certain directors, officers and employees of the Company as part of the 2009 Stock Option Incentive Plan compared to $213,144 recognized in the year ended September 30, 2011.
Other Income and Expense: Detail of the aggregate of this classification is disclosed in the following table:
Interest expense increased $5,607 during the year ended September 30, 2011 compared to the year ended September 30, 2010. The Company incurred additional debt of $500,000 in the form of convertible debentures in October 2010, bringing the face value of issued convertible debt to $1,997,000. At the comparable date in October 2009, the Company carried approximately $800,000 in debt instruments. Consequently, interest expense increased. While offset by conversions to the debentures throughout the course of the year, the corresponding debt for the majority of fiscal year 2011 exceeded that of 2010. The debentures balance at September 30, 2011 of $1,279,000, coupled with subsequent conversions of debt should further decrease interest expense in the forthcoming fiscal year,
notwithstanding additional debt yet to be incurred. Additionally, interest expense is reported net of interest income, of which there was a minimal amount reported in the current year as a result of no excess cash availability for investment.
As discussed in Note 19 of the consolidated financial statements, the Company has restated its financial statements for the quarters in the period ended September 30, 2010 , the fiscal year ended September 30, 2010, and the subsequent quarters ending during the fiscal year ending September 30, 2011 as a result of derivative accounting related to convertible debentures with "down-round" provisions. Consequently, the Company has recognized gain (loss) directly attributed to the recording of the associated derivative liabilities and the recurring revaluation of the derivatives to the extent detail in the table above. Also, the Company has recorded an adjustment to property as a result of leases that were incorrectly amortized in prior years. The adjustments and quarterly restatements are detail in Section 9B- Other Information. The restatement of the September 30, 2010 financial statements are in Note 19 of the consolidated financial statements.
The Company will continue to recognize gains (losses) on the fair value of derivative based on quarterly revaluation of the warrant and conversion option derivatives. The extent of these gain (losses) is unpredictable due to the volatility of the Company's share price, the unknown future value of the Company's shares and the length of term still remaining on the warrants and debentures at any particular revaluation event (end of quarter, conversion of debenture, etc.). The change in value will be charged to operations.
Liquidity and Capital Resources: At September 30, 2011 and 2010, the balances of the Company's cash and cash equivalents were $52,912 and $56,280, respectively. The Company's accounts receivable totaled $78,855 and $225,415, respectively. Subsequent to year-end, in October 2011, the Company received $71,235 from the current purchasers of its crude oil and gas production, representing proceeds of September sales, included in accounts receivable at September 30, 2011.
The Company's working capital deficit (current liabilities less current assets) was $2,209,359 at September 30, 2011. At September 30, 2010, the Company's working capital deficit was $2,703,952. The decrease in liabilities at September 30, 2011 is attributable to improved expense control and strengthening cash flow from resumption of oil production, coupled with no exploration expenditures during the fiscal year.
As discussed in Note 12 of the Consolidated Financial Statements, the Company secured financing in the form of convertible debentures in October 2010 in the amount of $500,000. The proceeds were used for working capital and payment of outstanding vendor payables related to the drilling of the Jenks and Knudsen wells.
To fully carry out the Company's business plans the Company needs to raise a substantial amount of additional capital, or obtain industry joint venture financing, which we are currently seeking. The Company can give no assurance that it will be able to raise such capital. The Company has limited financial resources until such time that it is able to generate such additional financing or cash flow from operations. The Company's ability to establish profitability and positive cash flow is dependent upon its ability to exploit its mineral holdings, generate revenue from its planned business operations and control exploration cost. Should the Company be unable to raise adequate capital or to meet the other above objectives, it is likely that the Company would have to substantially curtail its business activity, and that the Company's investors would incur substantial losses of their investment.
The accompanying Consolidated Financial Statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As reflected in the accompanying Consolidated Financial Statements JayHawk Energy is an independent oil and gas company with a limited operating history and losses since inception. These factors, among others, may indicate that the Company will be unable to continue as a going concern for reasonable period of time.
The Consolidated Financial Statements do not include any adjustments relating to the recoverability and classification of assets and liabilities that might be necessary should the Company be unable to continue as a going concern. The Company's continuation as a going concern is dependent upon its ability to obtain additional operating capital, and ultimately, to attain profitability. The Company intend to acquire additional operating capital through equity offerings to fund its business plan. There is no assurance that the Company will be successful in raising additional funds.
Cash Flows: Net cash provided by operations decreased primarily due to significantly less cash being received for the Company’s crude oil sales associated with inability to deliver oil to market. In the year ending at September 30, 2010, cash provided by operating activities exceeded cash used by operating activities by $214,903. In the year ending at September 30, 2011, cash used in operating activities exceeded cash provided by operating activities by $527,840, primarily as a result of ongoing efforts to pay down liabilities incurred in prior years associated with drilling and exploration which have yet to yield any operating revenue.
During the year ending September 30, 2011, investment activities provided the Company with $185,521 as compared to $1,632,842 used during the comparable period ending September 30, 2010. Due to constraints on cash flow as a result of decreased oil revenue from weather-related causes, the Company did not grow its lease position nor did it increase capital equipment spending during the
year ended September 30, 2011 compared to the prior year. The Company did purchase leases in Divide County in January 2011 for $48,445 but those properties remain unproved and undeveloped. During the year ended September 30, 2010, the Company did actively grow its capital equipment assets by drilling two wells which subsequently have been impaired due to lack of production.
The Cash flows provided from financing activities were $338,951 and $1,468,561 for the years ended September 30, 2011 and 2010, respectively.
Commitments: At September 30, 2011 the Company has no commitments to make any capital expenditures. Any potential future capital expenditures will be dependent on concluding adequate and successful financing arrangements.
The Company was obligated under its original office lease agreement, expiring July 1, 2011, to make payments of $1,500 per month. Management was successful in extending this agreement through December 1, 2011 whereby the Company entered into a new lease agreement in Coeur d'Alene, Idaho for $2,500 per month. The term of the lease is four years and contains no escalation clauses.
ITEM 7A.
ITEM 7A. QUANTITATIVE and QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Registrant has no investments in any market risk sensitive instruments either held for trading purposes or entered into for other than trading purposes.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
Consolidated Financial Statements
September 30, 2011 and 2010
JAYHAWK ENERGY, INC. AND SUBSIDIARY
Contents
Page
FINANCIAL STATEMENTS:
Report of Registered Public Accounting Firms
20-21
Consolidated balance sheets
Consolidated statements of operations
Consolidated statements of changes in stockholders' equity
Consolidated statements of cash flows
Notes to consolidated financial statements
26-46
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
JayHawk Energy, Inc.
We have audited the accompanying consolidated balance sheet of JayHawk Energy, Inc. (“the Company”) as of September 30, 2011, and the related consolidated statement of operations, stockholders’ equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of JayHawk Energy, Inc. as of September 30, 2011, and the results of its consolidated operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company has incurred substantial losses, has negative working capital and has an accumulated deficit. These factors raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
DeCoria, Maichel & Teague, PS
Spokane, Washington
February 13, 2012
I
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
NOTE 1 - ORGANIZATION AND DESCRIPTION OF BUSINESS
JayHawk Energy, Inc. (the Company or JayHawk) and its wholly owned subsidiary, is engaged in the acquisition, exploration, development, production and sale of natural gas, crude oil and natural gas liquids primarily from conventional reservoirs within North America. The Company incorporated in Colorado on April 5, 2004 as Bella Trading Company, Inc. During the third quarter ending June 30, 2007, the Company changed management and entered the oil and gas business, and ceased all activity in retail jewelry. On June 21, 2007, the Company changed its name to JayHawk Energy, Inc. Since then, the Company has devoted its efforts principally to the raising of capital, organizational infrastructure development, the acquisition of oil and gas properties and exploration activities. To date, the Company has acquired three properties, the Uniontown in Kansas, the Crosby in North Dakota, and Girard in Kansas. The Company also formed a wholly owned subsidiary to transport natural gas in Kansas called JayHawk Gas Transportation Corporation.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
This summary of significant accounting policies is presented to assist in understanding the financial statements. These consolidated financial statements as of and for the years ended September 30, 2011 and 2010 are prepared using the accrual basis of accounting in accordance with generally accepted accounting principles in the United States of America ("US GAAP") and have been consistently applied in the preparation of the Consolidated Financial Statements.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary JayHawk Gas Transportation Company after elimination of the intercompany accounts and transactions.
Going Concern
As shown in the accompanying consolidated financial statements, the Company has incurred operating losses since inception. As of September 30, 2011, the Company has limited financial resources with which to achieve the objectives and obtain profitability and positive cash flows. As shown in the accompanying balance sheets and statements of operations, the Company has an accumulated deficit of $18,414,890 and a net loss of $4,341,393 for the year ended September 30, 2011, and as of that date the Company's current liabilities exceeded its current assets by $2,209,359. Achievement of the Company's objectives will be dependent upon the ability to obtain additional financing, to locate profitable energy properties and generate revenue from current and planned business operations, and control costs. The Company plans to fund its future operations by joint venturing, obtaining additional financing from investors, and attaining additional commercial production. However, there is no assurance that the Company will be able to achieve these objectives, therefore substantial doubt about its ability to continue as a going concern exists. The financial statements do not include adjustments relating to the recoverability of recorded assets nor the implications of associated bankruptcy costs should the Company be unable to continue as a going concern.
Fair Value of Financial Instruments
The Company's financial instruments include cash and cash equivalent, restricted cash, accounts receivable, investments, and accounts payable. The carrying value of notes payable and convertible debentures approximate fair value based on the contractual terms of those instruments.
Joint Venture Operations
In instances where the Company’s oil and gas activities are conducted jointly with others, the Company’s accounts reflect only its proportionate interest in such activities.
Use of Estimates
The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses during the respective reporting periods. Significant areas requiring the use of management assumptions and estimates relate to asset impairments, proved and unproved properties, asset retirement obligations, stock-based compensation, income taxes and derivatives. Actual results may differ from these
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
estimates and assumptions which could have a material effect on the Company's reported financial position and results of operations.
Income or Loss Per Common Share
Basic earnings per share ("EPS") is computed as net income (loss) available to common stockholders divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants, and other convertible securities.
The dilutive effect of convertible and outstanding securities as of September 30, 2011 and 2010, would be as follows:
At September 30, 2011 and 2010, the effect of the Company's outstanding options and common stock equivalents would have been anti-dilutive.
Revenue and Cost Recognition
The Company uses the sales method of accounting for oil and gas revenues. Under this method, revenues are recognized based on the actual volumes of gas and oil sold to purchasers. The volume sold may differ from the volumes the Company may be entitled to, based on the Company's individual interest in the property. Periodically, imbalances between production and nomination volumes can occur for various reasons. In cases where imbalances have occurred, a production imbalance receivable or liability will be recorded when determined. Costs associated with production are expensed in the period in which they are incurred.
Cash Equivalents
The Company considers all highly liquid debt instruments purchased with maturity of three months or less to be cash equivalents.
Trade Accounts Receivable
Trade acccounts receivable are carried at original invoice amount less an estimate for doubtful accounts. Management determines the allowance by regularly evaluating individual customer receivables and considering a customer's financial condition, credit history and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded as income when received.
Concentrations
All of the Company’s direct operating revenues originate from oil production from its property in Crosby, North Dakota or from natural gas production from its property in Girard, Kansas. Each revenue stream is sold to a single customer through month to month contracts. While this creates a customer concentration, there are alternate buyers of the production in the event the sole customer is unable or unwilling to purchase.
Property, Plant and Equipment
Acquisition costs associated with the acquisition of leases are capitalized when incurred. These consist of costs incurred in obtaining a mineral interest or right in the property, such as a lease, concession, license, production sharing agreement, or other type of agreement granting such rights. In addition, options to lease, brokers' fees, recording fees, legal costs, and other similar costs related to activities in acquiring property interests are capitalized.
The Company follows the successful effort method of accounting for oil and gas property as promulgated in Accounting Standards Codification (ASC) Topic 932, "Extractive Activities - Oil and Gas". Under this method of accounting, acquisition costs for proved and unproved properties are capitalized when incurred. Exploration costs, including geological and geophysical costs, the costs of carrying and retaining unproved properties and exploratory dry hole drilling costs, are expensed. Development costs, including the costs to drill and equip development wells, and successful exploratory drilling costs to locate proved reserves are capitalized. Exploratory drilling costs are capitalized when incurred pending the determination of whether a well has found proved reserves. A determination of whether a well has
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
found proved reserves is made shortly after drilling is completed. The determination is based on a process that relies on interpretations of available geologic, geophysics and engineering data. If a well is determined to be successful, the capitalized drilling costs will be reclassified as part of the cost of the well. If a well is determined to be unsuccessful, the capitalized drilling costs will be charged to expense in the period the determination is made. If an exploratory well requires a major capital expenditure before production can begin, the cost of drilling the exploratory well will continue to be carried as an asset pending determination of whether proved reserves have been found only as long as: i) the well has found a sufficient quantity of reserves to justify its completion as a producing well if the required capital expenditure is made and ii) drilling of the additional exploratory wells is under way or firmly planned for the near future. If drilling in the area is not under way or firmly planned, or if the well has not found a commercially producible quantity of reserves, the exploratory well is assumed to be impaired and its costs are charged to expense.
In the absence of a determination as to whether the reserves that have been found can be classified as proved, the costs of drilling such an exploratory well is not carried as an asset for more than one year following completion of drilling. If, after that year has passed, a determination that proved reserves exist cannot be made, the well is assumed to be impaired, and its capitalized costs, net of salvage value are charged to expense. Its costs can, however, continue to be capitalized if sufficient quantities of reserves are discovered in the well to justify its completion as a producing well and sufficient progress is made in assessing the reserves and the well's economic and operating feasibility.
The Company calculates depletion, depreciation and amortization (DD&A) of capitalized cost of proved oil properties on a field-by-field basis using the units-of-production method based upon proved reserves. In computing DD&A the Company will take into consideration restoration, dismantlement and abandonment cost and the anticipated proceeds from equipment salvage. When applicable, the Company will apply the provisions of ASC Topic 410, "Accounting for Asset Retirement Obligations", ("ASC 410") which provides guidance on accounting for dismantlement and abandonment cost (see Note 10).
Support equipment and other property, plant and equipment related to oil and gas production are depreciated on a straight-line basis over their estimated useful lives which range from 5 to 35 years. Property, plant and equipment unrelated to oil and gas producing activities is recorded at cost and depreciated on a straight-line basis over the estimated useful lives of the assets, which range from 3 to 25 years.
The Company recognizes a gain or loss on sales or retirement of property, plant and equipment and includes the gain or loss in the results of operations.
Impairment of Long-Lived Assets
The Company performs separate impairment tests for proved and unproved properties.
Proved properties - The Company evaluates its proved properties for impairment when circumstances or events occur that may impact the fair value of the assets. The fair value of property is primarily evaluated based upon the present value of expected revenues directly associated with those assets. An impairment loss would be recognized if the carrying amount of a capitalized asset is not recoverable and exceeds its fair value.
Unproved properties - Unproved properties are assessed periodically to determine whether they have been impaired. A property may be considered impaired as the expiration of a lease term approaches and the Company has not begun drilling on the property or nearby properties and the possibility of partial or total impairment of the property increases. If the property is found to be impaired, an impairment allowance is provided and a loss is charged to operations. However, if the property is surrendered or the lease expires without identifying proved reserves, the cost of the property is charged against the impairment allowance already to the extent impairment has been recognized. Any remaining cost is charged to operations.
Sales of Producing and Non-producing Property
The Company accounts for the sale of a partial interest in a proved property as normal retirement. The Company accounts for the sale of a partial interest in an unproved property as a recovery of cost when substantial uncertainty exists as to recovery of the cost applicable to the interest retained. The Company recognizes a gain or loss for all other sales of non-producing properties and include the gain or loss in the results of operations.
Fair Value Measures
ASC Topic 820 "Fair Value Measurements and Disclosures" ("ASC 820") requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 establishes a fair value hierarchy based on the level of
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. ASC 820 prioritizes the inputs into three levels that may be used to measure fair value:
Level 1: Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.
Level 2: Level 2 applies to assets or liabilities for which there are inputs other than quoted prices that are observable for the asset or liability such as quote prices for similar assets or liabilities in active markets; quoted prices for identical assets in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.
Level 3: Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.
Derivative Instruments
The Company has financing arrangements that consist of freestanding derivative instruments or are hybrid instruments that contained embedded derivative features. In accordance with accounting principles generally accepted in the United States (“GAAP”), derivative instruments and hybrid instruments are recognized as either assets or liabilities in the Company’s balance sheet and are measured at fair value with gains or losses recognized in earnings depending on the nature of the derivative or hybrid instruments. Embedded derivatives that are not clearly and closely related to the host contract are bifurcated and recognized at fair value with changes in fair value recognized as either a gain or loss in earnings if they can be reliably measured. When the fair value of embedded derivative features cannot be reliably measured, the Company measures and reports the entire hybrid instrument at fair value with changes in fair value recognized as either a gain or loss in earnings. The Company determines the fair value of derivative instruments and hybrid instruments based on available market data using a Black Scholes model, giving consideration to all of the rights and obligations of each instrument and precluding the use of “blockage” discounts or premiums in determining the fair value of a large block of financial instruments. Fair value under these conditions does not necessarily represent fair value determined using valuation standards that give consideration to blockage discounts and other factors that may be considered by market participants in establishing fair value.
Asset Retirement Obligation
The Company recognizes the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. The carrying value of a property associated with the capitalization of an asset retirement cost is included in proved oil and gas property in the balance sheets. The future cash outflows for oil and gas properties associated with settling the asset retirement obligations is accrued in the balance sheets. The asset retirement obligation consists of costs related to the plugging of wells and removal of facilities and equipment on its oil and gas properties (see Note 9).
Income Tax and Accounting for Uncertainty
Income taxes are determined using the liability method in accordance with ASC Topic 740 "Income Taxes" ("ASC 740"). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. In addition, a valuation allowance is established to reduce any deferred tax asset for which it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.
ASC 740 recognizes that the ultimate deductibility of positions taken or expected to be taken on tax returns is often uncertain. It provides guidance on when tax positions claimed by an entity can be recognized and guidance on the dollar amount at which those positions are recorded. In order to recognize the benefits associated with a tax position taken the entity must conclude that the ultimate allowability of the deduction is more likely than not. If the ultimate allowability of the tax position exceeds 50% (more likely than not), the benefit associated with the position is recognized at the largest dollar amount that has more than a 50% likelihood of being realized upon ultimate settlement. Differences between tax positions taken in a tax return and recognized in accordance with the guidance will generally result in (1) an increase in income taxes currently payable or a reduction in an income tax refund receivable or (2) an increase in a deferred tax liability or a decrease in a deferred tax asset, or both (1) and (2).
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Stock Options Granted to Employees and Non-Employees
The Company follows financial accounting standards that require the measurement of the value of employee services received in exchange for an award of an equity instrument based on the grant-date fair value of the award. Non-employee stock-based compensation is granted at the Board of Director’s discretion to award select consultants for exceptional performance. Prior to issuance of the awards, the Company is not under any obligation to issue the stock options. Subsequent to the award, the recipient is not obligated to perform any services. Therefore, the fair value of these options is expensed on the grant date, which is also the measurement date.
The Company estimates the fair value of employee stock option awards on the date of grant using a Black-Scholes valuation model which requires management to make certain assumptions regarding: (i) the expected volatility in the market price of the Company's common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees are expected to hold the award prior to exercised (referred to as the expected holding period). The expected volatility under this valuation model is based on the current and historical implied volatilities of the Company's common stock. The dividend yield is based on the approved annual dividend rate in effect and current market price of the underlying common stock at the time of grant. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for bonds with maturities ranging from one month to five years. The expected holding period of the awards granted is estimated using the historical exercise behavior of employees. In addition, the Company estimates the expected impact of forfeited awards and recognize stock-based compensation cost only for those awards expected to vest. The Company utilizes historical experience to estimate projected forfeitures. If actual forfeitures are materially different from estimates, stock-based compensation expense could be significantly different from what we have recorded in the current period. The cumulative effect on current and prior periods of a change in the estimated forfeiture rate is recognized as compensation cost in the period of the revision.
Stock Granted to Employees and Non-Employees in Lieu of Cash Payments
The Company periodically issues shares of its common stock in lieu of cash payments to certain consultants, vendors and employees. The Company follows financial accounting standards that require the measurement of the value of services received in exchange for an award of an equity instrument based on the grant-date fair value of the award.
Reclassifications
Certain reclassifications have been made to the 2010 financial statements in order to conform to the 2011 presentation. These reclassifications have no effect on net loss, total assets or accumulated deficit as restated except as otherwise described in Note 19 (Correction Of An Error In Previously Issued Financial Statements).
Accounting Changes and Error Corrections
Changes in accounting principle are reported through retrospective application of the new accounting principle to all prior periods. Errors in the financial statements of a prior period discovered subsequent to their issuance are reported as a prior-period adjustment restating the prior period. As described in Note 19, financial information included for the year ended September 30, 2010 has been restated.
New Accounting Pronouncements
The FASB issued an ASU to amend existing oil and gas reserve accounting and disclosure guidance to align its requirements with the SEC's revised rules. The significant revisions involve revised definitions of oil and gas producing activities, changing the pricing used to estimate reserves at period end to a twelve month arithmetic average of the first day of the month prices and additional disclosure requirements. In contract to the SEC rule, the FASB does not permit the disclosure of probable and possible reserves in the supplemental oil and gas information in the notes to the financial statements. The amendments are effective for annual reporting periods ending on or after December 31, 2009.
In June 2011, the Financial Accounting Standards Board issued Accounting Standards Update No. 2011-05, "Presentation of Comprehensive Income" ("ASU 2011-05"). This standard will require entities to present net income and other comprehensive income in either a single continuous statement or in two separate, but consecutive, statements of net income and other comprehensive income. The option to present items of other comprehensive income in the statement of changes in equity is eliminated. The new requirements are generally effective for public entities in fiscal years (including interim periods) beginning after December 15, 2011. Management does not believe ASU 2011-05 will have a material effect on the Company's consolidated financial statements.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
From time to time, new accounting guidance is issued by the FASB that the Company adopts as of the specified effective date. If not discussed, management believe that the impact of recently issued standards, which are not yet effective, will not have a material impact on its financial statements upon adoption.
NOTE 3 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying values of cash and cash equivalents, trade accounts receivables, accounts payable and accrued liabilities approximate fair value due to their limited time to maturity or ability to immediately convert them to cash in the normal course. The carrying values of convertible debentures is net of a discount and does not reflect fair value of similar instruments. The approximate fair value of the convertible debentures based upon the number of shares into which the debentures are convertible is $850,000 using the current market price per share of stock at September 30, 2011.
The table below sets forth the Company's financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2011 and September 30, 2010, respectively, and the fair value calculation input hierarchy that the Company has determined has applied to each asset and liability category.
NOTE 4 - TRADE ACCOUNTS RECEIVABLE
At September 30, 2011, trade accounts receivable represents those amounts the Company is owed for its oil and gas production delivered during the month of September 2011 and amounts due from other working interests for their respective percentages of joint operating costs and drilling costs. Management has determined the allowance for doubtful accounts by evaluating individual customer receivables and considering a customer's financial condition, credit history and current economic conditions. As of September 30, 2011 and 2010 there is no allowance recognized for bad debt.
Proceeds for the September 2011 deliveries, valued at $70,664, were subsequently received in October 2011. Amounts receivable for September natural gas deliveries, $571 were also received in October 2011.
Proceeds for the August and September 2010 deliveries, valued at $193,297, were subsequently received in October 2010. Amounts receivable for September natural gas deliveries, $6,533 were also received in October 2010. Specifically, trade accounts receivable are detailed as follows:
NOTE 5 - UNPROVED PROPERTIES AND IMPAIRMENT
The total of the Company's investment in unproved properties at September 30, 2011 and 2010, consists of the following capitalized costs respectively:
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Abandonment of Uniontown: In 2008, management made a review of the portfolio of leases acquired in the Uniontown transaction of July 2007 and decided, based on geology and proximity to the Company's pipeline, to permit only approximately one-third of the original leases acquired and allow the remainder to expire without renewal. Given the Company's inability at that time to fund development of any acreage, justification existed at the time to abandon those properties. The abandonment was estimated at two-thirds, 67 percent, of the original investment. Further evaluation by management during the year ended September 30, 2011 indicated the capital required to develop the Uniontown Project exceeded the Company's ability to fund the project and any capital raised would be better served being deployed on other opportunities. Thus, the remainder of the leases expired without renewal and the Company recognized an additional abandonment loss of $1,020,479 on the Uniontown project for the year ended September 30, 2011.
NOTE 6 - PROVED PROPERTIES AND IMPAIRMENT
Net capitalized costs are comprised of the following; detailed by property:
During the year ended September 30, 2011, the Company impaired certain previously capitalized non-saleable assets of $1,301,422 at the Crosby, North Dakota property.
For the years ended September 30, 2011 and 2010, respectively, the Company performed an analysis to determine whether the carrying amounts in its financial statements exceeded the net present value of the reserve estimates for the Crosby, North Dakota property. Management determined that the net values reflected in the financial statements did not exceed the net discounted present value of the reserves estimated by the independent reserve engineer.
Based upon estimates provided by independent reserve engineers, management has determined an impairment exists on the Crosby property. The impairment write-down was recognized at $280,963 for the year ended September 30, 2011 and $811,339 for the year ending September 30, 2010.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
NOTE 7 - OTHER LONG-TERM ASSETS
Other assets consists of various deposits and reclamation bonds. Detail is disclosed in the following table:
NOTE 8 - DERIVATIVE LIABILITIES
As discussed in Notec 12, the Company entered into three separate issuances of convertible debentures, dated December 14, 2009, April 23, 2010 and October 20, 2010, which contained provisions allowing holders of the debentures to convert outstanding debt to shares of the Company's common stock. The debentures contain ‘down-round’ provisions which call for the debt conversion and warrant exercise prices to be reduced based on future issues of debt or equity with more favorable provisions. Management has determined that these provisions cause the conversion options and warrants to require derivative liability accounting. As such, management has valued them at fair value at the date of issuance and bifurcated from the host instruments.
The debentures are convertible at any time after the original issue date into a number of shares of the Company’s common stock, determined by dividing the amount to be converted by a conversion price at September 30, 2011, of $0.12 per share or an aggregate of 10,658,333 shares. Additionally common share purchase warrants were issued, expiring 42 months from the original issue date and permit the holders two exercisable options. The warrants were exercisable by purchase of the Company’s common stock for cash, or alternatively, in a cashless exercise, the number of shares being determined in accordance with a predetermined formula based on the Company’s then current stock price.
Conversion option derivative
For the years ended September 30, 2011 and 2010, the fair value of conversion options was estimated at the date of grant using the Black-Scholes option pricing model using the following weighted average assumptions and the associated revaluation range of assumptions on designated event dates over the past two years:
December 14, 2009
April 23, 2010
October 20, 2010
Revaluation Ranges
Risk-free interest rate
0.87%
1.10%
0.40%
0.04% to 1.60%
Expected dividend
yield
-
-
-
-
Expected term
2 years
1.64 years
2 years
.21 years to 3 years
Expected volatility
169.0%
196.6%
173.8%
120.1% to 184%
Per unit fair value of conversion option derivative liability
$0.60
$0.65
$0.14
$0.02 to $0.90
Number of conversion units valued
3,000,000
2,000,000
2,777,778
--
Valuation of conversion option derivative on date of issue
$1,800,000
$1,300,000
$388,889
--
Below is detail of the conversion option liability balance at September 30, 2011 and September 30, 2010.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Warrant derivative
For 2011 and 2010, the fair value of warrants was estimated at the date of grant using the Black-Scholes option pricing model using the following weighted average assumptions and the associated revaluation range of assumptions on designated event dates over the past two years:
December 14, 2009
April 23, 2010
October 20, 2010
Revaluation Ranges
Risk-free interest rate
1.70%
1.68%
0.59%
0.25% to 1.70%
Expected dividend
yield
-
--
--
Expected term
3.5 years
3 years
3 years
3 to 3.5 years
Expected volatility
165.4%
166.2%
159.6%
136.6% to 172.8%
Per unit fair value of warrant derivative
$0.63
$0.66
$0.16
$0.06 to $1.44
Number of warrants valued
3,166,000
2,000,000
2,833,113
166,000 to 3,166,000
Valuation of warrant derivative
$2,564,460
$1,320,000
$453,298
--
Below is detail of the warrant derivative balance at September 30, 2011 and September 30, 2010.
NOTE 9 - NOTES PAYABLE DUE IN LESS THAN ONE YEAR
On July 30, 2008 JayHawk signed a convertible promissory note in the amount of $800,000 for cash received of an equal amount. The original note provided for interest to be paid at the maturity date of July 30, 2009, computed at a rate of 12 percent per annum. The note and accrued interest was convertible into share of common stock at $1.75 per share. On July 30, 2009, the note was amended to extend the maturity date to July 30, 2010. Under the amended agreement, interest continued to be accrued and the holder continued the right to convert the outstanding principal balance and unpaid accrued interest to shares of the Company's common stock, at the conversion price of $1.75.
On February 25, 2010 the $800,000 principal of the note payable and currently accrued interest was converted to 1.6 million shares of the Company’s common stock. An expense is recognized when convertible debt is converted to equity securities of the debtor to the extent that the fair value of the securities and other consideration transferred exceeds the fair value of securities issuable pursuant to the original conversion terms. Management made an assessment of the modified terms of conversion and determined that the fair value of the 1.6 million shares on the date of issuance was $2,112,000 and exceeded the value of shares issuable pursuant to the amended agreement of $645,022, by $1,469,078. This amount was charged to debt conversion expense and is included in Gain (loss) on extinguishment and
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
conversion of debt on the Consolidated Statement of Operations. As of September 30, 2011 and 2010, the Company has satisfied all financial obligations on this note.
On September 1, 2010 the Company entered into a short-term promissory note with a vendor for its balance of accounts payable. The initial principal balance of $272,373 was due and payable in six (6) equal payments of $46,729 including interest at a rate of 12% per annum. The balance as of September 30, 2010 was $227,914. As of September 30, 2011, the Company has satisfied all financial obligations on this note.
On March 10, 2011 the Company entered into a short-term promissory note with a vendor for its balance of accounts payable. The principal balance of $146,905 was due and payable in five (5) equal payments of $29,768 beginning on March 15, 2011 including interest at a rate of 5.25% per annum. As of September 30, 2011, the Company has satisfied all financial obligations on this note.
On April 28, 2011 the Company entered into a short-term promissory note with a vendor for its balance of accounts payable. The principal balance of $107,230 was due and payable in four (4) equal payments of $21,446 beginning on April 28, 2011 including interest at a rate of 5.25% per annum. As of September 30, 2011, the Company has satisfied all financial obligations on this note.
NOTE 10 - ASSET RETIREMENT OBLIGATIONS
The Company has identified asset retirement obligations at the Girard, Kansas and Crosby, North Dakota operating sites. These retirement obligations are determined based on the estimated cost to comply with abandonment regulations established by the Kansas Corporation Commission and the State of North Dakota. The Company's engineers have estimated the cost, in today's dollars, to comply with these regulations. These estimates have been projected out to the anticipated retirement date 12 to 18 years in the future, at an assumed inflation rate of 1.5 percent. The anticipated future cost of remediation efforts in North Dakota, and Kansas, are $204,685, and $281,547, respectively. These amounts were discounted back at an assumed interest rate of 10 percent, to arrive at a net present value of the obligation. The amount of the annual increase in the obligation is charged to "accretion expense" and for the years ended September 30, 2011 and 2010, was computed to be $15,493 and $14,084, respectively.
The following table summarizes the change in the asset retirement obligation since the beginning of the fiscal year ending September 30, 2010:
NOTE 11 - INVESTMENT BY JOINT VENTURE PARTNER
During 2008, the Company completed a signed letter agreement with DK True Energy Development Limited ("DKTED”) which allowed DKTED to earn up to an 85% working interest in the Company's Girard project in southeast Kansas. The agreement permitted DKTED to earn an initial participation and working interest of 42.5 percent after paying the Company $250,000 and spending $300,000 on workovers of existing wells during the first year. DKTED subsequently assigned its interest in the Girard project to WHL Energy Midcon, LLC. ("WHL"), in December 2009. At that time, the Company recognized receipt of $250,000 as a long-term liability called "Investment by Joint Venture Partner".
In 2010, after WHL had paid the $250,000 cash payment obligation and spent the $300,000 on workovers, the Company issued WHL an option to earn an additional 42.5 percent (total 85 percent) participation and working interest upon remitting to the Company an additional $250,000 within nine months of the granting of the option. During the current year, the option period expired unexercised and, per the terms of the agreement, WHL's total working interest earned was set at 35 percent. In accordance with ASC 932-360, the sale of the 35 percent partial interest in an unproved property for the initial payment amount of $250,000 has been treated as a recovery of cost of the property.
NOTE 12 - CONVERTIBLE DEBENTURES
During the year ended September 30, 2010, the Company issued, pursuant to a securities purchase agreement, 10% convertible debentures with a face value of $1,500,000. The first tranche of the total financing, with a face value of $900,000, was issued during the first quarter
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
ended December 31, 2009. In April 2010, additional debentures with a face value of $600,000 were issued. All of the debentures have a two year maturity and were issued with attached common stock purchase warrants. The effective interest rate on the debentures is 10% per annum. The debentures are secured by all assets of the Company except those specifically excluded in the agreement which include all Kansas properties and related assets.
The debentures are convertible at any time after the original issue date into a number of shares of the Company’s common stock, determined by dividing the amount to be converted by an initial conversion price of $0.30 per share. Additionally, attached common share purchase warrants expire 42 months from the original issue date and permit the holders two exercise options. The warrants were exercisable by purchase of the Company’s common stock for cash at an initial exercise price of $0.45, or alternatively, with respect to the warrants issued in conjunction with the initial $900,000 tranche, in a cashless exercise, the number of shares being determined in accordance with a predetermined formula based on the Company’s then current stock price. Subsequent to the initial issue date, the initial conversion price of $0.30 per share was amended to $0.18 per share and then $0.12 based on of provisions in the agreements related to equity issuances and issuance of additional convertible debentures described hereafter during the year ended September 30, 2011. All of the warrants containing cashless exercise provision were fully exercised during the year ended September 30, 2010.
During the year ended September 30, 2010, the holders of the debentures and the common stock purchase warrants associated with the first $900,000 issuance, exercised all 3,000,000 warrants to acquire 2,111,388 shares of the Company’s common stock in two separate cashless exercises on January 6 and January 27, 2010. Warrants attached to the debentures issued in April 2010 total 2,000,000, do not contain a cashless exercise provision, and remain to be exercised at the election of the debenture holders.
During the year ended September 30, 2011, the Company entered into a Securities Purchase Agreement with certain institutional investors to purchase $500,000 of Secured Convertible Debentures. The debentures provide for interest to be paid quarterly, at the rate of 10% per annum, and are due two years from the issuance date. The debentures are secured by all assets of the Company except those specifically excluded in the agreement which include all Kansas properties and related assets.
The debentures are convertible at any time after the original issue date into a number of shares of the registrant’s common stock, determined by dividing the amount to be converted by an initial conversion price of $0.18 per share. In addition to the debentures the purchasers were issued an aggregate of 2,833,113 common share purchase warrants, each having a term of 42 months, expiring April of 2014, and giving the purchasers the right to purchase the Company’s common shares at an initial exercise price of $0.18 per share. Subsequent to the initial issue date, the initial conversion price of $0.18 per share was amended to $0.12 per share based on provisions in the agreements related to equity issuances and issuance of additional convertible debentures described hereafter during the year ended September 30, 2011
Based upon the fair values as of the original agreement dates of the December 2009 and April 2010 debentures, $1,500,000 was allocated to the common stock purchase warrants and the conversion features resulting in a discount on the debt. Giving effect to the amortization of the discount, and the conversion of $658,000 and $3,000 in principal conversion for the years ended September 30, 2011 and 2010, $118,625 and $982,564 of the discount remains to be amortized at September 30, 2011 and 2010, respectively. The discount will continue to be amortized over the remaining life of the underlying convertible debentures.
Based upon the fair values as of the original agreement dates of the October 2010 debentures, $500,000 was allocated to the common stock purchase warrants and the conversion features resulting in a discount on the debt. Giving effect to the amortization of the discount and the conversion of $60,000 in principal conversion, $198,000 of the discount remains to be amortized as of September 30, 2011. The discount will continue to be amortized over the remaining life of the underlying convertible debentures.
The 10% interest payable quarterly as per provisions in the debentures may be paid in shares of common stock at the Company's option according to a predetermined formula. For the years ended September 30, 2011 and 2010, 1,238,751 and 134,443 common shares were issued, respectively, for interest payable under the debentures. Interest expense of $192,036 and $50,083 has been included in ‘Interest and financing costs’ in the consolidated statements of operations for the years ended September 30, 2011 and 2010, respectively. Interest accrued is included on the Consolidated Balance Sheets in "Other payables, interest and taxes accrued" of $33,362 and $37,500 at September 30, 2011 and 2010, respectively.
The debentures all contain ‘down-round’ provisions which call for the debt conversion and warrant exercise prices to be reduced based on future issues of debt or equity with more favorable provisions. Management has determined that these provisions cause the conversion options and warrants to require derivative liability accounting. As such, management has valued at fair value at the date of issuance and bifurcated from the host instruments. See Note 8.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
In all three of these debt issuances, the fair value of the derivative liabilities at the date of issuance exceeded the amount of the debt. The excess of the fair value of the derivative liabilities issued over the debt amount has been recorded to the statement of operations during the years ended September 30, 2011 and 2010, as follows:
In all three cases, the entire face amount of the debt issued has been allocated to discount, and is being amortized over the respective term of the debt.
During the fiscal years ended September 30, 2011 and 2010, holders of the debt elected to convert $718,000 and $3,000 face amount of the debt into 4,898,614 and 10,000 shares of common stock, respectively, according to the terms of the agreements. See Note 13.
Giving effect to monthly amortization of the debt discounts and the conversion of debt into shares of common stock, during the years ended September 30, 2011 and 2010, $825,257 and $517,436, respectively, of debt discount amortization has been posted to the statement of operations. The remaining discounts will continue to be amortized to the statement of operations over the remaining life of the underlying convertible debentures.
As of September 30, 2011, the Company is in default of the terms of the convertible debentures as a result of certain provisions of the agreement. The December 2009 and April 2010 debentures maturity date of December 14, 2011 has lapsed, causing the default provisions on all debentures including the October 2010 debentures for a total balance of $1,279,000 as of September 30, 2011. Management has reclassified the outstanding balance of all debentures, including the October 2010 debentures to current liabilities as of September 30, 2011.
Note 13 - COMMON STOCK
Fiscal Year End September 30, 2011
October 1, 2010 - The Company issued 124,999 shares of common stock in lieu of paying interest with cash, to holders of 10% convertible debentures described in Note 12. The interest totaled $37,500 and was converted to shares at a price of $0.30 per common share.
April 13, 2011 - The Company closed on a private placement offering in the amount of $321,000 (the “Offering”). Under the terms of this Offering, the Company issued 2,675,000 shares of its common stock at $0.12 per share. No warrants are associated with this Offering. The Company's Chief Executive Officer, purchased $144,000 or 44.9% of the Offering.
April 13, 2011 - The Company issued 649,564 shares of common stock in lieu of paying interest with cash, to holders of 10% convertible debentures described in Note 12. The interest totaled $77,948 and was converted to shares at a price of $0.12 per common share.
May 6, 2011 - The Company issued 120,422 shares of common stock were issued to a member of the Board of Directors in lieu of cash payment for services provided. The shares were valued at $0.1246 per share; with the fair value of the aggregate issuance approximating the value of the services rendered of $15,000.
June 30, 2011 - The Company issued 323,132 shares of common stock to the Board of Directors in lieu of cash payment for services provided. These shares were valued at $.1246; with the fair value of the aggregate issuance approximating the value of the services provided of $49,710.
July 8, 2011 - The Company issued 404,637 shares of common stock in lieu of paying interest with cash, to holders of 10% convertible debentures described in Note 12. The interest totaled $38,251 and was converted to shares at a price of $0.0945 per common share.
Per the terms of the debentures, holders have the option to receive shares issues in lieu of cash for accrued interest through the date of
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
conversion. The table below details common shares issued for conversion of debentures and accrued interest during the year ended September 30, 2011:
(1) Includes 59,551 shares of common stock issued as accrued interest on date of conversion at a 5-day variable weight average per share. 4,898,614 common shares issued strictly for conversion of debentures at stated price per share.
Fiscal Year End September 30, 2010
October 2, 2009 - The Company issued 30,000 shares of common stock to one vendor for services rendered. These shares were valued at $0.38 per share or $11,400. The fair value of the aggregate issuance approximated the value of the services rendered.
October 30, 2009 - The Company issued 30,000 shares of common stock to one vendor for services rendered. These shares were valued at $0.28 per share or $8,400. The fair value of the aggregate issuance approximated the value of the services rendered
November 16, 2009 - As discussed in Note 9, the Company issued 544,000 shares of common stock to fulfill the stock issuance obligation recognized on July 30, 2009. This obligation was recognized as the result of amending the original $800,000 short-term convertible promissory note, signed in July 2008. The original note had a one-year maturity, maturing July 30, 2009, and provided for interest to be paid upon maturity, computed at a rate of 12 percent per annum. The amendment extended the maturity date to July 30, 2010. Accrued interest to the date of the amendment was $96,000. This along with a 5 percent extension fee of $40,000 was converted to shares of the Company’s restricted common stock, at the rate of $0.25 per share. The total amount of $136,000 was reflected as a stock issuance obligation as at September 30, 2009.
January 6 and 27, 2010 - Holders of the debentures and the common stock purchase warrants, more fully described in Note 12, exercised their rights under those warrants to acquire 2,111,387 shares of the Company’s common stock in two separate cashless exercises. As a result, the Company issued 1,398,065 shares, and 713,322 shares, in each of the respective transactions.
February 25, 2010 - As discussed in Note 9, the Company issued 1,600,000 shares of common stock for the conversion of the $800,000 convertible note payable reflected at September 30, 2009, and the accrued interest through February 25, 2010 of $55,143 at $0.53 per share.
April 01, 2010 - The Company issued 21,666 shares of common stock in lieu of paying interest, to one investor in the 10% convertible debentures, with cash. The interest totaled $16,250 and was converted to shares at a price of $0.75 per common share.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
May 04, 2010 - The Company issued 11,000 shares of common stock in lieu of paying cash for the rental of field equipment. The value of the services was determined to be equivalent to the value of the shares issued at the closing stock price of that day, $0.47 per share, or $5,170.
June 28, 2010 - The Company issued 10,000 shares of common stock in conversion of $3,000 of principal to one of the holder’s of the 10% convertible debentures, in agreement with the terms thereof referenced above in Note 12,
July 20, 2010 - The Company issued the holders of the debentures 112,777 shares of the Company’s common stock in lieu of interest due and payable, totaling $33,833 as of July 01, 2010. These were valued at $0.30 per share.
NOTE 14 - STOCK BASED COMPENSATION
The Company’s board of directors approved a stock option plan on August 11, 2009. The purpose of the Plan is to provide employees and consultants of the Corporation and its Subsidiaries with an increased incentive to make significant and extraordinary contributions to the long-term performance and growth of the Corporation and its Subsidiaries, to join the interests of employees and consultants with the interests of the shareholders of the Corporation, and to facilitate attracting and retaining employees and consultants of exceptional ability. The total number of shares available for grant under the terms of the Plan is 4,000,000. The stock option price is the market price of the share at the date of issuance, but may be changed by the Board of Directors or designee from time to time. The stock options are non-transferable and expire not more than five (5) years from the date of the granting.
The Company recognizes compensation expense straight-line over the vesting term. Historically, the Company has issued new shares to satisfy exercises of stock options and the Company expects to issue new shares to satisfy any future exercises of stock options.
During the year ended September 30, 2010, the Company granted 2,790,000 stock options to employees, contractors, board members and consultants exercisable at a price of $0.20 per share which expire September 2015.
At September 30, 2011, the Company had 2,040,000 options granted and outstanding.
The following table reflects the summary of stock options outstanding at September 30, 2011 and changes during the year ended September 30, 2011:
The fair value of the stock options granted was estimated using the Black-Scholes option-pricing model and is amortized over the vesting period of the underlying options. The underlying assumptions used to calculate the fair value are as follows:
A summary of the status of the Company’s nonvested stock options outstanding at September 30, 2011 is presented as follows:
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
As of September 30, 2011, there was $25,669 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 1.1 years.
NOTE 15 - BROKER AND SHARE PURCHASE WARRANTS
In conjunction with the issuance of the $1,500,000 convertible debentures described in Note 12, 166,000 warrants were issued for services provided in execution of the debentures. As discussed in Note 8, the share purchase and broker warrants are treated as derivatives. The warrants were valued at $104,580 using the Black-Scholes option pricing model with the following assumptions: risk free interest rate of 1.70%, volatility of 165.4%, exercise price of $0..45, current market price of $0.63 per share and an expected life of 3.5 years. The warrants expire June 14, 2013.
In conjunction with the issuance of the $500,000 convertible debentures on or about October 26, 2010, described in Note 12, 55,335 warrants were issued for services provided in execution of the debentures. The warrants were valued at $8,854 using the Black-Scholes option pricing model with the following assumptions: risk free interest rate of 0.59%, volatility of 159.6%, exercise price of $0.18, current market price of $0.16 per share and an expected life of 3.5 years. The warrants expire April 26, 2014.
The fair value of the broker warrants were expensed as financing costs.
A summary of the Company's share purchase and broker warrants outstanding at September 30, 2011 is presented as follows:
(1) Provisions allow for a reduction in exercise price based on equity issuances subsequent to warrant issuance. See Notes 7 and 12.
NOTE 16 - RELATED PARTY TRANSACTIONS
On July 1, 2008, the Company subleased office space for $1,500 per month from Marlin Property Management, LLC an entity owned by the spouse of the Company's President, CEO and member of the board of directors. On December 1, 2011, the Company subsequently entered into a four year lease with Marlin Property Management, LLC for $2,500 for office space at an alternate location in Coeur d'Alene, Idaho, at market rate on terms acceptable to the Company.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
NOTE 17 - SUPPLEMENTAL CASH FLOW AND OTHER DISCLOSURES
NOTE 18 - INCOME TAX
The Company did not recognize an income tax benefit or expense for the fiscal years ended September 30, 2011 and 2010.
The deferred tax assets were calculated based on an expected future combined tax rate of 40% consisting of maximum statutory federal tax rate of 35% and state taxes calculated at the rate of 5%, which is net of the expected federal income tax benefit.
The components of the Company’s net deferred tax assets are as follows:
As management of the Company cannot determine that it is more likely than not the Company will realize the benefit of the net deferred tax asset, a valuation allowance equal to 100% of the net deferred tax asset has been recorded at September 30, 2011 and 2010.
The Company has approximately $7.5 million of federal and state net operating loss carryforwards that expire through 2025 and 2028 that may be used to offset future taxable income.
Based on the net loss for the year ended September 30, 2011 and 2010, of $4,341,393 and $8,576,582, respectively, the income tax benefit shown in the financial statements for the years ended September 30, 2011 and 2010 differs from the statutory rate as follows:
The Company has concluded that the guidance regarding accounting for uncertainty in income taxes had no significant impact on the results of operations or financial position as of September 30, 2011 or 2010. Therefore, the Company does not have an accrual for
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
uncertain tax positions as of September 30, 2011 or 2010. As a result, tabular reconciliation of beginning and ending balances would not be meaningful. If interest and penalties were to be assessed, the Company would charge interest expense and penalties to other operating expense. It is not anticipated that unrecognized tax benefits would significantly increase or decrease within 12 months of the reporting date. Fiscal years 2008 through 2011 remain subject to examination by state and federal tax authorities.
NOTE 19 - CORRECTION OF ERROR IN PREVIOUSLY ISSUED FINANCIAL STATEMENTS
Management has determined that certain errors were contained in the Company's financial statements for the year ended September 30, 2010.
The errors were related to an incorrect application of conversion option derivative and warrant derivative accounting related to convertible debentures entered into by the Company on or about December 14, 2009, April 23, 2010 and October 18, 2010 (Note 12). As discussed in Note 2, embedded derivatives that are not clearly and closely related to the host contract are bifurcated and recognized at fair value with changes in fair value recognized as either a gain or loss in earnings if they can be reliably measured.
Management has also assessed undeveloped properties in both North Dakota and Kansas and determined restatement of financial statements is appropriate for the quarters ended June 30, 2011 and prior. The Uniontown, Kansas project was acquired for $2,200,000 in 2007, and consisted of mineral leases covering approximately 35,000 acres in Bourbon County, KS. During 2008, it was determined that the Company only actually permitted approximately one-third of the leases it had acquired initially, and therefore recognized an impairment for the remaining two-thirds of the original cost ($1,474,000). Throughout 2007 and 2008, the Company paid approximately $295,000 to renew these leases, each for a term of three years. The payments represented acquisition costs, and since the property was not yet in production the leases should not have been subject to amortization but is instead subjected to an annual impairment test, and consequently, the asset was understated by the accumulated amortization for the prior year ended September 30, 2010 of $256,486, amortization expense is overstated by the amount taken that year of $93,752.
The adjustments required to appropriately record these adjustments are material to the previously filed financial statements, thus management is restating these financial statements. The accompanying financial statements have been restated to reflect the corrections. As discussed in Note 1, certain reclassifications have been made for comparative purposes.
The effects of the Company's previously issued 2010 audited financial statements are summarized as follows:
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Balance sheet
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Statement of Operation
NOTE 20 - SUBSEQUENT EVENTS
On October 4, 2011, the Company issued 472,604 shares of common stock in lieu of paying interest with cash, to holders of 10% convertible debentures described in Note 12. The interest totaled $33,362 and was issued at the 5-day variable weighted-average price (VWAP) of $0.0706 per share.
On December 1, 2011, the Company entered into a four year lease with Marlin Property Management for $2,500 for office space at an alternate location in Coeur d'Alene, Idaho, at market rate on terms acceptable to the Company.
NOTE 21 - COMMITMENTS AND CONTINGENCIES
There is no pending litigation or proceeding involving any director or officer of the Company for which indemnification is being sought.
On July 1, 2008, the Company leased office space for a period of three years for a fixed monthly rental of $1,500. On December 1, 2011, the Company leased office space for a period of four years for fixed monthly rental of $2,500. Accordingly, the Company's commitment to make these lease payments for each successive year is $30,000.
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
The Company is obligated to pay royalties to holders of oil and natural gas interests in both North Dakota and Kansas operations. The Company also is obligated to pay working interest holders a pro-rata portion of revenue in oil operations net of shared operating expenses. The amounts are based on monthly oil and natural gas sales and are charged monthly net of to oil and gas revenue and recognized as "Due to royalty and working interest holders" on the Company's balance sheet.
NOTE 22 - SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION (Unaudited)
In January 2010, the FASB issued an ASU to amend existing oil and gas reserve accounting and disclosure guidance to align its requirements with the SEC's revised rules discussed in Note 1. The significant revisions involved revised definitions of oil and gas producing activities, changing the pricing used to estimate reserves the period end to a twelve month arithmetic average of the first day of the month prices and additional disclosure requirements. In contrast to the SEC rule, the FASB does not permit the disclosure of probable and possible reserves in the supplemental oil and gas information in the notes to the financial statements. The amendments are effective for annual reporting periods ending on or after December 31, 2009. Application of the revised rules is prospective and companies are not required to change prior period presentation to conform to the amendments. Application of the amended guidance has only resulted in changes to the prices used to determine proved reserves at December 31, 2009. The new guidelines have expanded the definition of proved undeveloped reserves that can be recorded from an economic producer did not impact or prove undeveloped reserves.
The Company follows the guidelines prescribed in ASC 932 for computing a standardized measure of future cash net cash flows and changes therein relating to estimated proved reserves. Future cash inflows and future production and development costs are determined by applying prices and costs, including transportation, quality and basis differentials to the year-end estimated quantities of oil and gas to be produced in the future. The resulting net cash flows are reduced to present value amounts by applying a ten percent annual discount factor. Future operating costs are determined based on estimates of expenditures to be incurred in producing the proved oil and gas reserves in place at the end of the period using year-end costs and assuming continuation of existing conditions, plus Company overhead incurred. Future development costs are determined based on estimates of capital expenditures to be incurred in developing proved oil and gas reserves.
The assumptions used to compute the standardized measure are those prescribed by the FASB and the SEC. The assumptions do not necessarily reflect the Company's expectations of actual revenues to be derived from these reserves, no their present value. The limitations inherent in the reserve quantity estimation process, as discussed previously, are equally applicable to the standardized measure computations since these reserve quantity estimates are the basis for the valuation process. The Company emphasizes that reserve estimates are inherently imprecise and that estimate of new discoveries and undeveloped locations are more imprecise than estimates of establishing proved producing oil and gas properties.
Proved oil reserve quantities at September 30, 2011 and 2010, and the related future net cash flows are based on the estimates prepared by independent petroleum engineers. The following reserve quantity and future net cash flow information for 2011 and 2010 was prepared by McDaniel & Associates Consultants, Ltd and are consistent with internal estimates. The Company provided McDaniel & Associates with engineering, geological and geophysical data, actual production histories and other information necessary for the reserve determination. The reserve estimates were prepared based on economic and operating conditions existing at September 30, 2011 and 2010.
All of the Company's oil and gas reserves are within the continental United States in the states of North Dakota and Kansas. Based on the evaluation described in the preceding paragraph, presented below (in barrels) is a summary of changes to the Company's net interest in proved developed and proved undeveloped reserves for the years ending September 30, 2011 and 2010:
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Oil reserves
Based on the evaluation described in the preceding paragraph, presented below (in barrels) is a summary of changes to the Company’s net interest in proved undeveloped and proved developed producing and non-producing reserves for the years ending September 30, 2011 and 2010:
Capitalized Costs Relating to Oil and Gas Producing Activities
Evaluated and unevaluated capitalized costs related to the Company's oil and natural gas producing activities are summarized as follow in $ thousands:
The Company will continue to evaluate its unevaluated properties; however, the timing of the ultimate evaluation and disposition of the properties has not been determined.
Costs Incurred in Oil and Gas Producing Activities (in $ thousands)
Costs incurred in oil and natural gas property acquisitions, exploration and development are summarized as follows, in $ thousands:
Standardized Measure of Discounted Future Net Cash Flow
The standardized measure of discounted future net cash flows relating to the Company's ownership interests in proved developed oil reserves for the years ended December 31, 2011 and 2010 are as follows:
JAYHAWK ENERGY, INC. AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
Results of Operations for Oil and Gas Producing Activities
The results of operations shown below exclude non-oil and gas producing activities, corporate overhead items, interest expense and other incomes expense, gains and losses. Therefore, these results are on a different basis than results of operations reported upon in the consolidated statement of operations.
All operations were conducted in the United States. The Company produces crude oil in North Dakota and natural gas in southeast Kansas. Because of limited funding, exploration activities were not conducted in the years ended September 30, 2011 and 2010.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The Company was notified on October 31, 2011 that the audit practice of BehlerMick PS, the Company's independent registered public accounting firm ("BehlerMick"), was no longer practicing public accounting and ceased operations. As of November 1, 2011 BehlerMick resigned as the independent registered public accounting firm of the Company and upon recommendation of the Audit Committee of the Company's Board of Directors, the Company accepted BehlerMick's resignation on November 4, 2011.
BehlerMick performed audits of the Company's financial statements for the years ended September 30, 2010, and September 30, 2009. BehlerMick's reports did not did not contain an adverse opinion or a disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope, or accounting principles, except that such report on JayHawk Energy's consolidated financial statements contained an explanatory paragraph with respect to uncertainty as to the Company’s ability to continue as a going concern.
During the two years ended September 30, 2010, and September 30, 2009, there were no disagreements with BehlerMick on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements if not resolved to BehlerMick's satisfaction would have caused them to make reference to the subject matter of the disagreement in connection with their report. For the year ended September 30, 2010, and through November 4, 2011, there were no “reportable events” as that term is described in Item 304(a)(1)(v) of Regulation S-K.
On November 11, 2011, and with the approval of the Company's Board of Directors, the Company engaged DeCoria Maichel and Teague, P.S. ("DMT") as the Company's independent registered public accounting firm.
During the year ended September 30, 2010, and through November 11, 2011 (the date DMT was appointed), the Company did not consult DMT with respect to the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Company’s Consolidated Financial Statements, or any other matters or reportable events as defined in Item 304(a)(2)(i) and (ii) of Regulation S-K.
Management has determined that certain errors were contained in the Company's financial statements for the quarters within the year ended September 30, 2011 and the year ended September 30, 2010. Disclosures are provided in Note 19 to the Company's financial statements, and management does not intend on filing quarterly financial statements amendments.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
In connection with the preparation of this annual report on Form 10-K, an evaluation was carried out by JayHawk’s management, with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)) as of September 30, 2011. Disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures.
Based on that evaluation, JayHawk’s management concluded, as of the end of the period covered by this report, that the Company’s disclosure controls and procedures were not effective in recording, processing, summarizing, and reporting information required to be disclosed, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of JayHawk Energy, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process, under the supervision of the Chief Executive Officer and the Chief Financial Officer, designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with United States generally accepted accounting principles (GAAP). Internal control over financial reporting includes those policies and procedures that:
·
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the Company’s assets;
·
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the Board of Directors; and
·
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of September 30, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). As a result of this assessment, management identified a material weakness in internal control over financial reporting.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
The material weakness identified is described below.
Communication failures between individuals executing transactions and individuals accounting for transactions led to the identification of certain required disclosures to the financial statements. Additionally, due to insufficient staffing, it was not possible to ensure appropriate segregation of duties between incompatible functions, and formalized monitoring procedures have not been established or implemented.
Management has determined that certain errors were contained in the Company's financial statements for the quarters within the years ended September 30, 2011 and 2010, and the year ended September 30, 2010. As described in Note 19 to the Consolidated Financial Statements and Item 9B
ITEM 9B - OTHER INFORMATION
As discussed in Note 19 of the Company's Notes to the Consolidated Financial Statements and pursuant to the January 27, 2012 8K/A filed disclosing restatement of a material misstatement resulting from i) derivative accounting of warrants and convertible debt and ii) accounting for unproved and undeveloped property leases.
The effect of the Company's previously issued 2010 quarterly financial statements are summarized as follows:
Balance sheets (Unaudited)
Statements of Operations (Unaudited)
The effect of the Company’s previously issued 2011 quarterly financial statements is summarized as follows:
Balance sheets (Unaudited)
Statements of Operations (Unaudited)
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS.
DIRECTORS AND EXECUTIVE OFFICERS
Name
Age
Position
Lindsay E. Gorrill
Chief Executive Officer, President and Director
Kelly J. Stopher
Chief Financial Officer
Matthew J. Wayrynen
Chairman of the Board and of Compensation Committee
Jeffrey W. Bright
Director, Chairman of Nominating Committee
Tyrone Docherty
Director, Chairman of Audit Committee
Directors are elected to serve until the next annual meeting of stockholders and until their successors are elected and qualified. Directors are compensated at the rates of $8,000 per year. The Chairmen of the Audit Committee is compensated an additional $4,000 per year. Each other committee chairman is compensated an additional $2,000 per year. Officers are elected by the Board of Directors and serve until their successors are appointed by the Board of Directors. Biographical resumes of each officer and director are set forth below.
Lindsay E. Gorrill - CEO, President and Director
Mr. Lindsay Gorrill is a C.A. and has university degrees in Finance and Marketing. Mr. Gorrill has a background in acquisitions, company building, financial markets and world exposure. Mr. Gorrill has served as Chief Executive Officer, Chief Financial Officer and as a member of the Company's Board of Directors since July 2007. Mr. Gorrill has also, in the past, served as the Company's Chief Financial Officer and also President (an office he currently holds as well). He has also served as President and Treasurer of Star Gold Corp., a company quoted on the OTC Bulletin Board since February 2008. Mr. Gorrill has also served as a member of the board of directors of Yaterra Ventures Corp, a company quoted on the OTC Bulletin Board since August 2008. He has served as President, Chief Operating Officer and as a member of the board of directors of Berkley Resources Inc., a company listed on the TSX Venture Exchange, since July 2004. Additionally, since April 2009, Mr. Gorrill has served as President, Chief Executive Officer and Chief Financial Officer of Canada Fluorspar Inc., a company listed on the TSX Venture Exchange. He has also been a member of the board of directors of Deer Horn Metals, Inc., a TSX Venture Exchange listed company since September 2009.
Kelly J. Stopher - CFO
Mr. Kelly Stopher was appointed Chief Financial Officer of the Company on September 28, 2010. Mr. Stopher’s has developed strategies to implement financial management systems, internal control policies and procedures, and financial reporting and modeling for small-cap companies From March, 20010 through September, 2010, Mr. Stopher worked for Allied Security. Mr. Stopher worked as business relationship manager for Wells Fargo Bank, Spokane, WA, from April 2006 through August 2009. From September 2004 through January 2006, he acted as CFO for Weldon Barber, Spokane, WA. From October 2003 through September 2004, he was a sales associate for Kiemle & Hagood Company, in Spokane, WA. And from January 2001 through March 2003 he worked as an account executive for Aston Business Solutions in Boise, ID specializing in enterprise accounting software systems. Prior that Mr. Stopher worked as CFO for Lee Read Jewelers in Boise, ID and spent 5 years in public accounting with Langlow Tolles & Company in Tacoma, WA. Mr. Stopher also serves as Chief Financial Officer for Star Gold Corp., a company quoted on the OTC Bulletin Board, and was appointed to that position in October 2010. Mr. Stopher holds a bachelors degree from Washington State University in Business Administration - Accounting.
Matthew J. Wayrynen - Director
Mr. Wayrynen was appointed to the Board of Directors on April 30, 2008. Mr. Wayrynen is a citizen of Canada. He also serves as a director of Deer Horn Metals, Inc. (since 2009), as a director of Avino Silver & Gold Mines, Ltd. (since 2004), as a director and President of American Uranium Corporation (since 2010) and as a director, President and CEO of Berkley Resources, Inc. (since 2003). Mr. Wayrynen also serves as Director, President and CEO of Encore Renaissance Resource Corp. Prior to these positions Mr. Wayrynen was a broker with Golden Capital Securities, located in Vancouver, British Columbia. Mr. Wayrynen is not an officer or director of any other U.S. reporting company.
Tyrone Docherty - Director
Mr. Docherty was appointed to the Board of Directors on July 10, 2008. Mr. Docherty is a citizen of Canada and is presently the CEO and a director of Deer Horn Metals, Inc. Prior to this position he was president and CEO of Quinto Mining Corporation from June 1997 to June 2008. Mr. Docherty is not an officer or director of any other U.S. reporting company.
Jeffrey W. Bright - Director
Mr. Bright was appointed to the Board of Directors on April 30, 2008. Mr. Bright is a citizen of Canada. Mr. Bright has worked as an attorney since 2003, currently employed with Miller Thomson LLP of Calgary, Alberta, Canada. Mr. Bright was previously legal counsel for Agrium Inc., located in Calgary Alberta, Canada. He is a member of the Association of International Petroleum Negotiators, and the Canadian and American Bar Associations. Mr. Bright is not an officer or director of any other U.S. reporting entity.
COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) requires the Company's directors and executive officers, and persons who own more than ten percent of a registered class of the Company's equity securities, to file with the Commission initial reports of ownership and reports of changes in ownership of the Company's Common Stock and other equity securities of the Company. Officers, directors and greater than ten percent shareholders are required by the Commission's regulations to furnish the Company with copies of all Section 16(a) forms they filed.
The Company have been provided with copies of all forms (3, 4 and 5) filed by officers, directors, or ten percent shareholders within three days of such filings. Based on the review of such forms that the Company received, or written representations from reporting persons that no Forms 5s were required for such persons, the Company believe that, during all prior fiscal periods, all Section 16(a) filing requirements have been satisfied on a timely basis for members of the Board of Directors and Executive Officers.
Code of Ethics
The Company's Board of Directors has adopted a Code of Business Conduct and Ethics Compliance Program and an Insider Trading Policy providing guidelines with respect to transactions in Company securities and is applicable to all directors, officers, employees and consultants who receive or have accesses to material non-public Company information.
Corporate Governance
Audit Committee
On June 30, 2008 JayHawk established an audit committee of its Board of Directors, appointed Mr. Don Siemens as its Chairman, and adopted a "Code of Ethics" to promote honest and ethical conduct, proper disclosure of financial information and compliance with applicable laws, rules and regulations by all of the Company's employees and members of the board of directors. Mr. Tyrone Docherty has served as Chairman of the Audit Committee since June 15, 2009. Jeff W. Bright also serves on the Audit Committee.
Compensation Committee
Mathew J. Wayrynen has served as Chairman of the Compensation Committee since August 27, 2008. Lindsay Gorrill and Tyrone Docherty also serve on the Compensation Committee.
Nominating Committee
Jeff W. Bright was appointed Chairman of the Nominating Committee. On August 27, 2008, Lindsay Gorrill and Matthew Wayrynen also serve as members of the Nominating Committee.
Reserves Committee
Lindsay Gorrill has served as the Chairman of the Reserves Committee since April 29, 2011. Jeff W. Bright also serves on the Reserves Committee.
Compensation Committee Interlocks and Insider Participation
Mathew J. Wayrynen has served as the Chairman of the Compensation Committee since August 27, 2008. Lindsay Gorrill and Tyrone Docherty also serve as members of the compensation committee.
None of the Company's directors or executive officers serves as a member of the board of directors or compensation committee of any other entity that has one or more of its executive officers serving as a member of JayHawk Energy Inc.'s board of directors.
Director Compensation
The table below sets forth, for the last fiscal year, the compensation earned by the Company's non-employee directors:
Name
Fees Earned or Paid in Cash
($)
Stock
Awards
($)
Option
Awards
($)
Non-Equity
Incentive Plan Compensation
($)
Nonqualified
Deferred
Compensation
Earnings
($)
All Other
Compensation
($)
Total
-
Matthew Wayrynen
11,250
-
15,730
-
-
-
$26,980
Tyrone Docherty
5,750
-
15,730
-
-
-
$21,480
Jeffrey Bright
4,500
-
11,798
-
-
-
$16,298
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Each individual's total compensation consisted of cash paid as salary and recognition of options vested during the year ended September 30, 2011. The following amounts were paid to the respective individuals.
Name and
Principal Position
Year
Salary
($)
Bonus
($)
Stock
Awards
($)
Option
Awards
($)
Non-equity Incentive Plan Compensation
($)
Nonqualified
Deferred
Compensation
Earnings
($)
All Other
Compensation
($)
Total
Lindsay Gorrill, President/CEO
40,000
-
-
86,516
-
-
-
$126,516
Kelly Stopher, CFO
78,000
-
-
12,584
-
-
-
$90,584
The amounts in the Option Awards column reflect the dollar amount recognized and expensed for financial statement reporting purposes for the years ended September 30, 2011, in accordance with ASC Topic 718 of awards of stock options and thus do not represent aggregate fair value of grants. The Company used the Black-Scholes option price calculation to value the options granted in 2010 and using the following assumptions: risk-free rate of 0.06% and 5.35%; volatility of 0.99; actual term and exercise price of options granted. See Note 14 - Stock Based Compensation in the Notes to the Consolidated Financial Statements for additional details on option issuances.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The following table sets forth certain information regarding beneficial ownership of the Company's common stock as of September 30, 2011:
· by each person who is known by us to beneficially own more than 5% of the Company's common stock;
· by each of the Company's officers and directors; and
· by all of the Company's officers and directors as a group.
(1) Beneficial Ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities. Shares of common stock subject to options or warrants currently exercisable or convertible, or exercisable or convertible within 60 days of September 30, 2011 are deemed outstanding for computing the percentage of the person holding such option or warrant but are not deemed outstanding for computing the percentage of any other person.
(2) Percentage based on 58,236,245 shares of common stock outstanding as of September 30, 2011
Outstanding Equity awards at fiscal year ended September 30, 2011
Name, Title
Number of Securities Underlying Unexercised Options
(#)
Exercisable
Number of Securities Underlying Unexercised Options
(#)
Unexercisable
Equity Incentive Plan
Number of Securities
Underlying Unexercised Unearned
Options
(#)
Option Exercise Price
($)
Option
Expiration
Date
Lindsay Gorrill, President/CEO
1,100,000
-
-
$0.20
9/2/2015
Kelly Stopher, CFO
80,000
160,000
-
$0.20
9/28/2015
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
As discussed in Note 13 - Common Stock in the Notes to the Consolidated Financial Statements, on April 13, 2011, the Company closed on a private placement offering in the amount of $321,000 (the “Offering”). Under the terms of this Offering, the Company issued 2,675,000 shares of its common stock at $0.12 per share. No warrants are associated with this Offering. The Company's Chief Executive Officer, purchased $144,000 or 44.9% of the Offering.
As discussed in Note 16 - Related Party Transactions in the Notes to the Consolidated Financial Statements, on July 1, 2008, the Company subleased office space for $1,500 per month from Marlin Property Management, LLC an entity owned by the spouse of the Company's CEO. On December 1, 2011, the Company subsequently entered into a four year lease with Marlin Property Management for $2,500 for office space at an alternate location in Coeur d'Alene, Idaho, at market rate on terms acceptable to the Company
The Company has no policy regarding entering into transactions with affiliated parties.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
Audit Fees
The aggregate fees billed by the Company's predecessor auditors, for professional services rendered for the audit of the Company's annual financial statements for the years ended September 30, 2011 and 2010, and for the reviews of the financial statements included in the Company's Quarterly Reports on Form 10-Q during the fiscal years were $41,526 and $37,648, respectively. These amounts do not include any fees billed by the Company's current auditors, DeCoria, Maichel & Teague, PS
All Other Fees
No other fees have been billed in the last two years for products and services provided by the principal accountant other than the services reported pursuant to the above portions of this Item 14.
The Company's board of directors acts as the audit committee and had no “pre-approval policies and procedures” in effect for the auditors’ engagement for the audit years 2011 and 2010.
PART IV
ITEM 15.
ITEM 15. EXHIBITS.
Exhibit No.
Description
3.1
Articles of Incorporation, filed as an exhibit to the registration statement on Form SB-2 filed with the Securities and Exchange Commission (the "Commission") on December 7, 2004, and incorporated herein by reference.
3.2
Certificate of Amendment to Articles of Incorporation, filed as an exhibit to the 8-K filed with the Commission on June 25, 2007, and incorporated herein by reference.
3.3
Bylaws, filed as an exhibit to the registration statement on Form SB-2 filed with the Commission on December 7, 2004, and incorporated herein by reference.
10.1
Promissory Note of April 12, 2007 with Berrigan Portfolio, Inc., filed as an exhibit to the 8-K filed with the Commission on April 17, 2007, and incorporated herein by reference.
10.2
Asset Purchase and Sale agreement of July 25, 2007 with Armstrong Investments, Inc., filed as an exhibit to the 8-K filed with the Commission on July 26, 2007, and incorporated herein by reference.
10.3
Form of Warrant Agreement of July 25, 2007 with Armstrong Investments, Inc. and Berrigan Portfolio, Inc., filed as an exhibit to the 8-K filed with the Commission on July 26, 2007, and incorporated herein by reference.
14.1
Code of Ethics
23.1
Consent of Independent Registered Public Accounting Firm
23.2
Consent of Auditor
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a), promulgated under the Securities and Exchange Act of 1934, as amended
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14 and Rule 15d 14(a), promulgated under the Securities and Exchange Act of 1934, as amended
32.1
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer)
32.2
Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer)
99.1
2009 Stock Incentive Plan for Employees, Contractors, Consultants, Advisors and Board Members
101*
XBRL Exhibits
* XBRL Information is furnished and not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended and otherwise is not subject to liability under these sections.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
JAYHAWK ENERGY, INC.
Date: February 14, 2012
By: /s/ LINDSAY E. GORRILL
Lindsay E. Gorrill
Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Name
Position
Date
By: /s/ LINDSAY E. GORRILL
Lindsay E. Gorrill
Chief Executive Officer and President
February 14, 2012
By: /s/ KELLY J. STOPHER
Kelly J. Stopher
Chief Financial Officer
February 14, 2012
Directors: