Xebec Adsorption Inc.
Annual Report 2012

Plain-text annual report

Xebec Adsorption Inc. Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) April 1, 2013 Independent Auditor’s Report To the Shareholders of Xebec Adsorption Inc. We have audited the accompanying consolidated financial statements of Xebec Adsorption Inc. and its subsidiaries, which comprise the consolidated statements of financial position as at December 31, 2012 and 2011 and the consolidated statements of earnings (loss), comprehensive income (loss), changes in equity (deficiency) and cash flows for the years then ended, and the related notes, which comprise a summary of significant accounting policies and other explanatory information. Management’s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. PricewaterhouseCoopers LLP/s.r.l./s.e.n.c.r.l. 1250 René-Lévesque Boulevard West, Suite 2800, Montréal, Quebec, Canada H3B 2G4 T: +1 514 205 5000, F: +1 514 876 1502 “PwC” refers to PricewaterhouseCoopers LLP/s.r.l./s.e.n.c.r.l., an Ontario limited liability partnership. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Xebec Adsorption Inc. and its subsidiaries as at December 31, 2012 and 2011 and their financial performance and their cash flows for the years then ended in accordance with International Financial Reporting Standards. 1 CPA auditor, CA, public accountancy permit No. A111799 (2) Xebec Adsorption Inc. Consolidated Statements of Financial Position (expressed in Canadian dollars) Assets Current assets Cash Trade and other receivables (note 7) Inventories (note 8) Short-term portion of balance of sale (note 15b)) Investment tax credits receivable Other current assets Total current assets Non-current assets Balance of sale (note 15b)) Property, plant and equipment (note 9) Intangible assets (note 10) Goodwill (note 10) Total non-current assets Total assets Liabilities Current liabilities Bank loan (note 11) Trade payables (note 12) Accrued liabilities Deferred revenues (note 13) Current portion of long-term debt and obligation (note 15a)) Current portion of government royalty program obligation (note 15c)) Provisions (note 14) Total current liabilities Non-current liabilities Loan from a related party (note 25) Long-term debt and obligation (note 15a)) Government royalty program obligation (note 15c)) Government assistance Deferred rent Provisions (note 14) Total non-current liabilities Total liabilities Equity (Deficiency) Share capital (note 16) Contributed surplus Accumulated other comprehensive loss Deficit Non-controlling interest (note 5) Total equity Total liabilities and equity As at December 31, 2012 $ As at December 31, 2011 $ 1,344,114 3,936,746 1,662,494 200,000 75,000 425,102 7,643,456 600,000 369,976 978,258 142,616 2,090,850 9,734,306 166,952 3,799,491 1,144,539 1,067,987 76,474 365,959 161,692 6,783,094 - 117,649 714,853 22,083 32,980 326,308 1,213,873 7,996,967 19,732,623 2,316,580 (48,870) (20,528,866) 1,471,467 265,872 1,737,339 9,734,306 389,090 2,444,842 1,365,260 - 75,000 329,292 4,603,484 800,000 548,671 3,988,317 342,616 5,679,604 10,283,088 500,000 4,547,515 1,195,825 2,506,474 141,786 195,949 390,549 9,478,098 23,562 236,729 752,972 27,083 6,596 65,169 1,112,111 10,590,209 19,802,272 2,168,550 (71,521) (22,211,793) (312,492) 5,371 (307,121) 10,283,088 The accompanying notes are an integral part of these consolidated financial statements. Approved by the Board of Directors ___________________________________ Director (signed) Kurt Sorchak (signed) John Shakeshaft ___________________________________ Director Xebec Adsorption Inc. Consolidated Statements of Earnings (Loss) For the years ended December 31, 2012 and 2011 (expressed in Canadian dollars) Revenue Cost of goods sold Gross margin Research and development expenses (note 19) Selling and administrative expenses Foreign exchange loss (gain) Gain on disposition of assets (note 6) Loss on loan to a joint venture (note 5) Operating income (loss) Finance income Finance expense (note 20) Finance costs – net 2012 $ 2011 $ 15,179,121 14,203,463 12,032,774 3,146,347 142,585 6,501,102 47,834 (6,445,769) - 9,999,460 4,204,003 550,345 6,846,178 (107,050) (2,275,092) 138,105 245,752 5,152,486 2,900,595 (47,561) 1,009,303 961,742 (948,483) (9,410) 517,877 508,467 Net income (loss) for the year 1,938,853 (1,456,950) Earnings (loss) attributable to: Shareholders of the Company Non-controlling interest Earnings (loss) per share Basic (note 16) Diluted (note 16) 1,682,927 255,926 1,938,853 0.04 0.04 (1,447,123) (9,827) (1,456,950) (0.04) (0.04) The accompanying notes are an integral part of these consolidated financial statements. Xebec Adsorption Inc. Consolidated Statements of Comprehensive Income (Loss) For the years ended December 31, 2012 and 2011 (expressed in Canadian dollars) Net income (loss) for the year Other comprehensive income (loss) Cumulative translation adjustment 2012 $ 2011 $ 1,938,853 (1,456,950) 27,226 (162,784) Comprehensive income (loss) for the year 1,966,079 (1,619,734) Attributable to: Shareholders of the Company Non-controlling interest (note 5) 1,705,578 260,501 1,966,079 (1,591,266) (28,468) (1,619,734) The accompanying notes are an integral part of these consolidated financial statements. Xebec Adsorption Inc. Consolidated Statements of Changes in Equity (Deficiency) For the years ended December 31, 2012 and 2011 (expressed in Canadian dollars) Number Common shares Warrants Share capital – Common shares and warrants $ Contributed surplus $ Accumulated other comprehensive income (loss) $ Equity attributable to the Company $ Non- controlling interest $ Deficit $ Amount Total $ Balance – January 1, 2011 39,363,867 15,456,424 19,964,218 1,841,741 72,622 (20,764,670) 1,113,911 - 1,113,911 Net loss for the year Other comprehensive loss Comprehensive loss for the year Expired warrants (note 16) Share-based compensation Non-controlling interest at business acquisition - - - - - - - - - (4,798,288) - - - - - (161,946) - - - - - (144,143) (1,447,123) - (1,447,123) (144,143) (9,827) (18,641) (1,456,950) (162,784) - 161,946 164,863 - (144,143) - - - (1,447,123) - - - (1,591,266) - 164,863 - (28,468) - - 33,839 (1,619,734) - 164,863 33,839 Balance – December 31, 2011 39,363,867 10,658,136 19,802,272 2,168,550 (71,521) (22,211,793) (312,492) 5,371 (307,121) Balance – January 1, 2012 39,363,867 10,658,136 19,802,272 2,168,550 (71,521) (22,211,793) (312,492) 5,371 (307,121) Net income (loss) for the year Other comprehensive loss Comprehensive loss for the year Expired warrants (note 16) Share-based compensation - - - - - - - - (566,250) - - - - (69,649) - - - - 69,649 78,381 - 22,651 22,651 - - 1,682,927 - 1,682,927 - - 1,682,927 22,651 1,705,578 - 78,381 255,926 4,575 260,501 - - 1,938,853 27,226 1,966,079 - 78,381 Balance – December 31, 2012 39,363,867 10,091,886 19,732,623 2,316,580 (48,870) (20,528,866) 1,471,467 265,872 1,737,339 Accumulated other comprehensive income relates solely to cumulative translation adjustments. The accompanying notes are an integral part of the consolidated financial statements. Xebec Adsorption Inc. Consolidated Statements of Cash Flows For the years ended December 31, 2012 and 2011 (expressed in Canadian dollars) Cash flows from Operating activities Net income (loss) for the year Items not affecting cash Amortization of property, plant and equipment Amortization of intangible assets Loss (gain) on disposal of property, plant and equipment Gain on disposition of assets (note 6) Gain on debt forgiveness Government assistance Unrealized foreign exchange loss on loan to a joint venture and restricted cash Loss on loan to a joint venture Accretion and revaluation of government royalty program obligation Stock-based compensation expense Deferred rent Changes in non-cash working capital components relating to operations Trade and other receivables Inventories Investment tax credits receivable Other current assets Trade payables Accrued liabilities Deferred revenues Income taxes recoverable Other operating liabilities Investing activities Acquisition of property, plant and equipment Acquisition of intangible assets Net proceeds from disposal of property, plant and equipment Proceeds from disposal of assets (note 6) Cash acquired on acquisition of a business Decrease in restricted cash Financing activities Repayment of bank loan Increase in long-term debt Repayment of loan from a shareholder of joint venture Repayment of long-term debt Repayment of government royalty program obligation Effect of exchange rate changes on cash Increase (decrease) in cash during the year Cash – Beginning of year Cash – End of year Additional information Interest paid 2012 $ 2011 $ 1,938,853 (1,456,950) 142,652 325,619 ,192 (6,445,961) (134,980) (5,000) - - 921,891 78,381 26,384 (3,151,969) (1,491,904) (297,234) - (95,810) (613,044) (51,286) (1,289,008) - 32,282 (3,806,004) (6,957,973) (133,105) (84,972) 19,000 9,414,519 - - 9,215,442 (333,048) 9,807 (24,123) (194,199) (790,000) (1,331,563) 29,118 955,024 389,090 1,344,114 385,073 512,597 (2,275,092) - (101,701) (5,000) (1,603) 138,105 257,382 164,863 - (2,382,326) 374,323 1,457,662 28,489 (226,618) (1,137,581) (269,126) (144,852) (8,286) (885,566) (811,555) (3,193,881) (2,191) (16,972) 2,468,981 - 47,066 576,092 3,072,976 - 9,568 23,562 (1,742,329) - (1,709,199) (43,079) (1,873,183) 2,262,273 389,090 89,011 260,108 The accompanying notes are an integral part of the consolidated financial statements. Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 1 Nature of business and liquidity risk a) Nature of business Xebec Adsorption Inc. (“Xebec” or the “Company”) is a global provider which specializes in the design and manufacture of cost-effective, environmentally responsible, purification, separation, dehydration, and filtration equipment for gases and compressed air. Xebec’s main product lines are: Biogas Plants for the purification of biogas from agricultural digesters, landfill sites and waste water treatment plants, Natural Gas Dryers for NGV refuelling stations, Associated Gas Purification Systems which enable diesel displacement on drilling sites, and Hydrogen Purification Systems for fuel cell and industrial applications. The Company is incorporated and domiciled in Canada and is listed on the Toronto Stock Exchange under the symbol XBC. The address of its registered office is 730 Industriel Boulevard, Blainville, Quebec, Canada. b) Liquidity risk The Company has realized an operating profit of $2,900,595, had cash outflows from operations of $6,957,973 for the year ended December 31, 2012 and finished the year with cash amounting to $1,344,114, working capital of $860,362 and had access to credit facilities totalling $1,500,000 of which only $166,952 has been used. The Company is currently in breach of its TPC agreement but obtained a four month extension (note 29b)). During the fourth quarter of 2012, management undertook various initiatives and developed a plan to manage its operating and liquidity risks in light of prevailing economic conditions. Management is also currently seeking alternative financings for its operations such as asset-based lending facilities. The Company has prepared a budget for 2013 for which management believes the assumptions are reasonable. Achieving budgeted results is dependent on improving the volume of revenues, delivering on sales and contracts schedules, meeting expected overall operating margin levels and controlling general and administrative costs. Management expects to meet its budget and to have enough liquidity to fund operations to at least beyond December 31, 2013. The Company is thus faced with uncertainties that may have an impact on future operating results and liquidity. These uncertainties include reduced spending in biogas projects reflecting the weakness of the market, fluctuations in foreign currency rates and achieving the Company’s business plan goals as mentioned in the previous paragraph, which includes the development of a new business segment. While management believes it has developed planned courses of action to mitigate operating and liquidity risks, there is no assurance that management will be able to achieve its business plan and maintain the necessary liquidity level if events or conditions develop that are not consistent with management’s expectations, key budget assumptions for 2013 and planned courses of action. Therefore, the Company may require additional external funding and there is no assurance that it would be successful. It is possible that future changes in capital markets conditions could result in such funding not being available when required or at acceptable costs. The Company is unable to predict the possible effects, if any, of such uncertainties and the potential adjustments to the carrying values of assets and liabilities that could be needed should the Company have insufficient liquidity. Such adjustments could be material. (1) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 2 Basis of preparation The Company prepares its financial statements in accordance with generally accepted accounting principles in Canada (“GAAP”) as set out in the Handbook of the Canadian Institute of Chartered Accountants - Part I (“CICA Handbook”) which incorporates International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). These financial statements were approved for issue by the Board of Directors of the Company on April 1st, 2013. These financial statements are based on the accounting policies as described below. These policies have been consistently applied to all the periods presented, unless otherwise stated. 3 Significant accounting policies Basis of measurement These consolidated financial statements have been prepared under the historical cost convention, except for the revaluation of certain financial assets and financial liabilities to fair value. Basis of consolidation These consolidated financial statements include the accounts of the Company and its subsidiaries. Subsidiaries are entities controlled by the Company. Control exists when Xebec is able to govern the financial and operating activities of those entities to generate returns for the Company. Intercompany transactions, balances and unrealized gains and losses on transactions between different entities within the Company are eliminated. Subsidiaries include Xebec Adsorption (Shanghai) Co. Ltd., which is wholly owned, and Xebec Adsorption South East Asia PTE. Ltd., which is 56.49% owned. Subsidiaries are fully consolidated from the date on which control is obtained by the Company and are deconsolidated from the date that control ceases. Non-controlling interest represents equity interest in a subsidiary owned by an outside party. The share of net assets of subsidiaries attributable to non-controlling interest is presented as a component of equity. Its share of net earnings and comprehensive income is recognized directly in equity. Changes in the Company’s ownership interest in a subsidiary that do not result in a loss of control are accounted for as equity transactions. Trade receivables Trade receivables are amounts due from customers for merchandise sold or services performed in the ordinary course of business. If collection is expected in one year or less (or in the normal operating cycle of the business if longer), they are classified as current assets. If not, they are presented as non-current assets. Trade receivables are recognized initially at fair value and subsequently measured at amortized cost using the effective interest method, less provision for impairment. (2) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Inventories Inventories are stated at the lower of cost and net realizable value for raw materials, work in progress and finished goods. Costs of raw materials are determined on an average cost basis. Work in progress and finished goods include materials, direct labour and production overhead (based on normal operating capacity). Net realizable value is the estimated selling price less applicable selling expenses. Inventories are recorded net of any obsolescence provision. A new assessment is made in each subsequent year when inventories are adjusted to net realizable value. When the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in net realizable value because of changed economic circumstances, the amount of the writedown is reversed (i.e., the reversal is limited to the amount of the original writedown) so that the new carrying amount is the lower of cost and the revised net realizable value. Property, plant and equipment Property, plant and equipment are stated at cost less accumulated depreciation and accumulated impairment losses. Cost includes expenditures that are directly attributable to the acquisition of the asset. Subsequent costs are included in the asset’s carrying amount or recognized as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Company and the cost can be measured reliably. The carrying amount of a replaced asset is derecognized when replaced. Repairs and maintenance costs are charged to the consolidated statement of loss during the year in which they are incurred. The major categories of property, plant and equipment are depreciated on a straight-line basis as follows: Machinery and equipment Office furniture and equipment Computers Moulds Vehicles Leasehold improvements 3 to 10 years 5 years 3 years 5 years 5 years Lesser of economic life and lease term The Company allocates the amount initially recognized in respect of an item of property, plant and equipment to its significant components and depreciates each such component separately. Residual values, method of depreciation and useful lives of the assets are reviewed annually and adjusted if appropriate. Gains and losses on disposals of property, plant and equipment are determined by comparing the proceeds with the carrying amount of the asset and are included as part of other gains and losses in the consolidated statement of earnings. (3) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Identifiable intangible assets The Company’s intangible assets include patents, customer relations, software and engineering drawings. These assets are capitalized and amortized on a straight-line basis in the consolidated statement of loss over the period of their expected useful lives. Patent costs are amortized over fifteen years. Customer relations are amortized over six years. Engineering drawings, consisting of engineering costs incurred to develop product plans, and software are amortized over a period of three years. Impairment of non-financial assets Property, plant and equipment and intangible assets are tested for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Long-lived assets that are not amortized are subject to an annual impairment test. For the purpose of measuring recoverable amounts, assets are grouped at the lowest levels for which there are separately identifiable cash flows (cash- generating units or CGUs). The recoverable amount is the higher of an asset’s fair value less costs to sell and its value in use (being the present value of the expected future cash flows of the relevant asset or CGU). An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount. The Company evaluates impairment losses, other than goodwill impairment, for potential reversals when events or circumstances warrant such consideration. Goodwill Goodwill represents the excess of the cost of an acquisition over the fair value of the Company’s share of the net identifiable assets of the acquired subsidiary at the date of acquisition. Goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. Impairment losses on goodwill are not reversed. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold. Goodwill is allocated to CGUs for the purpose of impairment testing. The allocation is made to those CGUs that are expected to benefit from the business combination in which the goodwill arose, identified according to operating segment. Trade payables Trade payables are obligations to pay for goods or services that have been acquired in the ordinary course of business from suppliers. Accounts payable are classified as current liabilities if payment is due within one year or less. If not, they are presented as non-current liabilities. Trade payables are recognized initially at fair value and subsequently measured at amortized cost using the effective interest method. (4) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Provisions Provisions for restructuring costs, warranties and legal claims, where applicable, are recognized in accrued liabilities when the Company has a present legal or constructive obligation as a result of past events, it is more likely than not that an outflow of resources will be required to settle the obligation, and the amount can be reliably estimated. Provisions are measured at management’s best estimate of the expenditure required to settle the obligation at the end of the reporting year, and are discounted to present value where the effect is material. The Company performs evaluations to identify onerous contracts and, where applicable, records provisions for such contracts. During the normal course of its operations, the Company assumes certain maintenance and repair costs under warranties offered on natural gas equipment, biogas and hydrogen purification equipment. The warranties cover a period ranging from 12 to 18 months. A liability for the expected cost of the warranty- related claims is established when the product is delivered and completed. In estimating the warranty liability, historical material replacement costs and the associated labour costs are considered. Revisions are made when actual experience differs materially from historical experience. Financial instruments Financial assets and financial liabilities are recognized when the Company becomes a party to the contractual provisions of the instrument. Financial assets are derecognized when the rights to receive cash flows from the assets have expired or have been transferred and the Company has transferred substantially all risks and rewards of ownership. At initial recognition, the Company classifies its financial instruments in the following categories depending on the purpose for which the instruments were acquired: Cash Trade and other receivables Loan to a joint venture Bank loan Trade payables and accrued liabilities Long-term debt Government royalty program obligation Subordinated loan Loans and receivables Loans and receivables Loans and receivables Other financial liabilities Other financial liabilities Other financial liabilities Other financial liabilities Other financial liabilities Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. Loans and receivables are initially recognized at the amount expected to be received, less, when material, a discount to reduce the loans and receivables to fair value. Subsequently, loans and receivables are measured at amortized cost using the effective interest method less a provision for impairment. Other financial liabilities are initially measured at fair value and subsequently at amortized cost using the effective interest method. Financial liabilities are classified as current liabilities if payment is due within 12 months. Otherwise, they are presented as non-current liabilities. (5) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) The Company classifies embedded derivative financial instruments as fair value through profit or loss, and values them at fair value at the end of each year, with changes recorded in other income. The Company does not designate these derivative financial instruments as hedges. Impairment of financial assets At each reporting date, the Company assesses whether there is objective evidence that a financial asset is impaired. If such evidence exists, the Company recognizes an impairment loss. The loss on financial assets carried at amortized cost is the difference between the amortized cost of the loan or receivable and the present value of the estimated future cash flows, discounted using the instrument’s original effective interest rate. The carrying amount of the asset is reduced by this amount either directly or indirectly through the use of an allowance account. Impairment losses on financial assets carried at amortized cost are reversed in subsequent years if the amount of the loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognized. Impairment losses on available-for-sale equity instruments are not reversed. Government royalty program obligations The Company receives from time to time, from different government agencies, funding designed to promote economic growth, create jobs and wealth, and support sustainable development. In some of these arrangements, the Company has a contractual obligation to repay the contributions to the government agency, with repayments determined as a percentage of specified revenues over a contractually defined royalty year. Such arrangements are recognized as government royalty program obligations at initial recognition when the contribution is received. These obligations are estimated based on future projections, discounted using a rate that reflects the liability-specific risks. Over time, interest expense is recognized as a result of accretion of the long-term obligations, while royalty payments are recorded against the obligations. Subsequently, the government royalty program obligations are remeasured when the future projections initially used to measure the obligations are revised using the original discount rate. Resulting changes in the carrying amount of these obligations are recognized in the consolidated statement of loss as Finance expense. Share capital Common shares are classified as equity. Incremental costs directly attributable to the issuance of shares are recognized as a deduction from share capital. (6) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Revenue recognition The Company earns revenues mainly from the sale of natural gas dryers and hydrogen purification solutions (“commercial equipment”). The Company recognizes revenue on commercial equipment sales when it is probable that the economic benefits will flow to the Company and delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. These criteria are generally met at the time the product is shipped and delivered to the customer and, depending on the delivery conditions, title and risk have passed to the customer and acceptance of the product has been obtained. Provisions are established for estimated product returns and warranty costs at the time revenue is recognized. Cash received in advance of all of these revenue recognition criteria being met is recorded as deferred revenue. Revenues from long-term production-type contracts such as biogas purification equipment and engineering service contracts are determined under the percentage-of-completion method whereby revenues are recognized based on the costs incurred to date in relation to the total expected costs of a contract (costs being composed mainly of materials and labour). Costs and estimated profit on contracts in progress in excess of amounts billed are reflected as work in progress. Cash received in advance of revenues being recognized on contracts is recorded as deferred revenue. The Company monitors its contracts with customers on a regular basis to determine if a loss is likely to occur. If a loss is anticipated on a contract, the entire estimated loss is recorded as a cost of goods sold in the period in which the loss becomes evident and reasonably estimable. Revenues from licensing arrangements are recognized when it is probable that the economic benefits will flow to the Company and that the sales price is fixed or determinable, and collectibility is reasonably assured. These criteria are generally met at the time the contract is signed and title and risk have passed to the customer. Revenue is measured based on the price specified in the sales contract, net of discounts and estimated returns at the time of sale. Historical experience is used to estimate and provide for discounts and returns. Government assistance Non-refundable grants relating to property, plant and equipment are accounted for as deferred government assistance and amortized on the same basis as the related assets. Research and experimental development tax credits are recognized using the cost reduction method when there is reasonable assurance of their recovery. Investment tax credits are subject to the customary approvals by the pertinent tax authorities. Adjustments, if required, are reflected in the year when such assessments are received. Leases Leases in which a significant portion of the risks and rewards of ownership are retained by the lessor are classified as operating leases. Payments made under operating leases (net of any incentives received from the lessor) are charged to the consolidated statement of loss on a straight-line basis over the lease term. (7) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Leases where the Company has substantially all the risks and rewards of ownership are classified as finance leases. Finance leases are capitalized at the lease’s commencement at the lower of the fair value of the leased property and the present value of the minimum lease payments. Each lease payment is allocated between the liability and finance charges. The interest element of the finance cost is charged to the consolidated statement of loss over the lease year so as to produce a constant yearly rate of interest on the remaining balance of the liability for each year. Assets acquired under finance leases are depreciated over the shorter of the useful life of the asset and the lease term. Stock-based compensation plans The Company accounts for stock options using the fair value method. Each tranche in an award is considered a separate award with its own vesting year and grant date fair value. Fair value of each tranche is measured at the date of grant using the Black-Scholes option pricing model. The Black-Scholes model was developed to estimate the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, this model usually requires the input of assumptions, including expected stock price volatility. For options granted to directors, officers and employees of the Company, compensation expense is recognized over the tranche’s vesting period by increasing contributed surplus based on the number of awards expected to vest. The number of awards expected to vest is reviewed at least annually. For options granted to non-employees, the transaction is measured with reference to the fair value of the goods or services when received. Related expense is recognized over the period during which the goods or services from the non-employees are received. A corresponding increase is recorded in contributed surplus when stock options are expensed. When stock options are exercised, capital stock is credited by the sum of the consideration paid and the related amount previously recorded in contributed surplus. Research and development expenses Research expenses are charged to expenses as incurred. Development expenses are charged to expenses as incurred unless they meet criteria for deferral and amortization. To date, no development expenses have been deferred. Income taxes Income tax comprises current and deferred tax. Income tax is recognized in the consolidated statement of earnings (loss) except to the extent that it relates to items recognized directly in other comprehensive income or equity, in which case the income tax is also recognized directly as such. Current income tax is the expected tax payable on the taxable income for the year, using tax rates enacted or substantively enacted at the end of the reporting year, and any adjustment to tax payable in respect of previous years. (8) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) In general, deferred income tax is recognized in respect of temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. Deferred income tax is determined on a non-discounted basis using tax rates and laws that have been enacted or substantively enacted at the statement of financial position date and are expected to apply when the deferred tax asset or liability is settled. Deferred income tax assets are recognized to the extent that it is probable that the assets can be recovered. Deferred income tax is provided on temporary differences arising on investments in subsidiaries and associates, except where the timing of the reversal of the temporary difference is controlled by the Company and it is probable that the temporary difference will not reverse in the foreseeable future. Deferred income tax assets and liabilities are presented as non-current. Earnings per share Basic earnings per share (“EPS”) is calculated by dividing the net income for the year attributable to equity owners of the Company by the weighted average number of common shares outstanding during the year. Diluted EPS is calculated by adjusting the weighted average number of common shares outstanding for dilutive instruments. The number of shares included with respect to options, warrants and similar instruments is computed using the treasury stock method, which assumes that if all dilutive securities had been exercised at the later of the beginning of the year and the date of issuance, as the case may be, the proceeds would be used to purchase common shares of the Company at the average market value during the year. Foreign currency translation a) Functional and presentation currency Items included in the financial statements of each consolidated entity in the Company group are measured using the currency of the primary economic environment in which the entity operates (the “functional currency”). The consolidated financial statements are presented in Canadian dollars, which is the Company’s functional currency. The financial statements of entities that have a functional currency different from that of the Company (“foreign operations”) are translated into Canadian dollars as follows: assets and liabilities – at the closing rate at the date of the statement of financial position, and income and expenses – at the average rate of the year (to the extent this is considered a reasonable approximation to actual rates). All resulting changes are recognized in other comprehensive income as cumulative translation adjustment. When an entity disposes of its entire interest in a foreign operation, or loses control, joint control or significant influence over a foreign operation, the foreign currency gains or losses accumulated in other comprehensive income related to the foreign operation are recognized in profit or loss. If an entity disposes of part of an interest in a foreign operation which remains a subsidiary, a proportionate amount of foreign currency gains or losses accumulated in other comprehensive income related to the subsidiary is reallocated between controlling and non-controlling interests. (9) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) b) Transactions and balances Foreign currency transactions are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Generally, foreign exchange gains and losses resulting from the settlement of foreign currency transactions and from the translation at year-end exchange rates of monetary assets and liabilities denominated in currencies other than an operation’s functional currency are recognized in the consolidated statement of income. Segment reporting Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as the management committee. Accounting standards issued but not yet applied that have relevance to the Company Unless otherwise noted, the following revised standards and amendments are effective for the Company for annual periods beginning on or after January 1, 2013 with earlier application permitted. The Company does not expect to adopt any of these standards before their effective date. Except as otherwise indicated, based upon current facts and circumstances, the Company does not expect a material impact on its consolidated statement of earnings (loss) and financial position upon the adoption of those standards which are effective on January 1, 2013. The Company continues to evaluate the impact of these standards on its consolidated financial statements. (i) IFRS 9, Financial Instruments, issued in November 2009, is mandatory for accounting periods beginning after January 1, 2015 and addresses classification and measurement of financial assets. It replaces the multiple category and measurement models in IAS 39, Financial Instruments: Recognition and Measurement, for debt instruments with a new mixed measurement model having only two categories: amortized cost and fair value through profit or loss. IFRS 9 also replaces the models for measuring equity instruments. Such instruments are either recognized at fair value through profit or loss or at fair value through other comprehensive income. Where equity instruments are measured at fair value through other comprehensive income, dividends are recognized in profit or loss to the extent that they do not clearly represent a return of investment; however, other gains and losses (including impairments) associated with such instruments remain in accumulated comprehensive income indefinitely. Requirements for financial liabilities were added to IFRS 9 in October 2010 and they largely carried forward existing requirements in IAS 39, Financial Instruments: Recognition and Measurement, except that fair value changes due to credit risk for liabilities designated at fair value through profit or loss are generally recorded in other comprehensive income. IFRS 9 is applicable to the Company for the year beginning on January 1, 2015, with earlier application permitted. (10) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) (ii) IFRS 10, Consolidated Financial Statements, requires an entity to consolidate an investee when it has power over the investee, is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Under existing IFRS, consolidation is required when an entity has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. IFRS 10 replaces SIC 12, Consolidation—Special Purpose Entities, and parts of IAS 27, Consolidated and Separate Financial Statements. (iii) IFRS 11, Joint Arrangements, requires a venturer to classify its interest in a joint arrangement as a joint venture or joint operation. Joint ventures will be accounted for using the equity method of accounting whereas for a joint operation, the venturer will recognize its share of the assets, liabilities, revenue and expenses of the joint operation. Under existing IFRS, entities have the choice to proportionately consolidate or equity account for interests in joint ventures. IFRS 11 supersedes IAS 31, Interests in Joint Ventures, and SIC 13, Jointly Controlled Entities—Non-monetary Contributions by Venturers. (iv) IFRS 12, Disclosure of Interests in Other Entities, establishes disclosure requirements for interests in other entities such as subsidiaries, joint arrangements, associates and unconsolidated structured entities. The standard carries forward existing disclosures and also introduces significant additional disclosures that address the nature of, and risks associated with, an entity’s interests in other entities. (v) IFRS 13, Fair Value Measurement, is a comprehensive standard for fair value measurement and disclosure for use across all IFRS standards. The new standard clarifies that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants, at the measurement date. Under existing IFRS, guidance on measuring and disclosing fair value is dispersed among the specific standards requiring fair value measurements and does not always reflect a clear measurement basis or consistent disclosures. (vi) IAS 1, Presentation of Financial Statements, has been amended to require entities to separate items presented in other comprehensive income into two groups, based on whether or not items may be recycled in the future. Entities that choose to present other comprehensive income items before tax will be required to show the amount of tax related to the two groups separately. (11) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 4. Significant accounting judgments and estimation uncertainties Critical accounting estimates and judgments The Company makes estimates and assumptions concerning the future that will, by definition, seldom equal actual results. The following are the estimates and judgments applied by management that most significantly affect the Company’s consolidated financial statements. These estimates and judgments have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year. i. Inventories must be valued at the lower of cost and net realizable value. A writedown of the inventory will occur when its estimated market value less applicable variable selling expenses is below its carrying amount. Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. This estimation process involves significant management judgment and is based on the Company’s assessment of market conditions for its products determined by historical usage, estimated future demand and, in some cases, the specific risk of loss on specifically identified inventory. Any change in the assumptions used in assessing this valuation will impact the carrying amount of the inventory and have a corresponding impact on cost of goods sold. ii. Impairment of customer relations The Company performs a test for customer relations impairment when there is any indication whether customer relations has suffered any impairment in accordance with the accounting policy stated in the summary of significant accounting policies of these financial statements. The recoverable amounts of customer relations have been determined based on value-in-use calculations. The value in use calculation is based on a discounted cash flow model. These calculations require the use of estimates and forecasts of future cash flows. Qualitative factors, including strength of customer relationships, degree of variability in cash flows as well as other factors are considered when making assumptions with regard to future cash flows and the appropriate discount rate. A change in any of the significant assumptions or estimates used to evaluate customer relations could result in a material change to the results of operations. iii. Percentage of completion and revenues from long-term production-type contracts Revenues recognized on long-term production-type contracts reflect management’s best assessment, by taking into consideration all information available at the reporting date, of the result on each ongoing contract and its estimated costs. The management assesses the profitability of the contract by applying important judgments regarding milestones marked, actual work performed and estimated costs to complete. Actual results could differ because of these unforeseen changes in the ongoing contracts’ models. (12) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 5. Business acquisition a) Transaction for the year ended December 31, 2011 On July 1, 2011, the Company acquired an additional 16.49% of the outstanding shares of Xebec Adsorption South East Asia PTE. Ltd. Accordingly, the Company now owns 56.49% of the outstanding shares and acquired control of the joint venture. The acquisition was settled by the conversion of its loan that it had previously made to the joint venture. The acquisition was accounted for under the purchase method, and the full operating results of the subsidiary are included in the consolidated financial statements from the acquisition date. The fair value of the net assets acquired is attributed as follows: Assets acquired: Cash Accounts receivable Inventories Prepaid expenses Property, plant and equipment Liabilities assumed: Accounts payable and accrued liabilities Deferred revenues Provision Net assets acquired at fair value Net assets attributable to non-controlling interest Net assets attributable to initial investment held before acquisition Consideration paid in form of conversion of loan Total consideration deemed paid $ 78,443 320,174 26,971 3,046 15,411 444,045 178,179 229,086 1,925 409,190 34,855 15,166 13,942 5,747 34,855 (13) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 6. Gain on disposition of assets On March 22, 2012, the Company sold to Air Products and Chemicals Inc. (“Air Products”) its intellectual property (“IP”) portfolio, including the patents and patent applications relating to its gas separation technology. In this transaction, the Company has also transferred ownership of its research and development facilities in Burnaby and Surrey, as well as other equipment located in British Columbia. Pursuant to this transaction, the Company has received aggregate gross proceeds of $8,600,000 and net proceeds of approximately $8,415,000. This agreement also foresees future proceeds related to the achievement of certain conditions to be met by Xebec within the next 24 months. With the net proceeds received, the Company reimbursed its bank loan of $500,000 and its subordinated loan of $83,700. On October 23, 2012, the Company received additional gross proceeds of $1,000,000 in relation to the achievement of certain conditions. The Company has also entered into a perpetual license agreement with Air Products with no additional costs allowing it to continue using the gas separation technology to sell its systems, predominantly in the biogas, natural gas and associated gas purification markets. The Company has utilized its non-capital losses carried forward to offset the taxable gain resulting from this sale (see note 22). The following table summarizes the gain on disposition of assets: Gross proceeds Additional proceeds Transaction fees Net proceeds Goodwill allocated to the disposition Carrying value of assets Others Gain on disposition of assets March 22, 2012 $ 8,600,000 1,000,000 (185,481) 9,414,519 (200,000) (2,918,037) 149,479 6,445,961 (14) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 7 Trade and other receivables Trade receivables Unbilled receivable Other receivables Less: Allowance for doubtful accounts Trade receivables - net December 31, 2012 $ December 31, 2011 $ 3,154,623 209,012 805,327 (232,216) 3,936,746 2,009,939 162,697 466,479 (194,273) 2,444,842 Trades receivables include holdbacks amounting to $183,887 for the year ended December 31, 2012 (2011 -$202,995). Trade receivables are pledged as security for the credit facilities (see note 11, Bank loan). 8 Inventories Raw materials Work in progress Finished goods Inventories December 31, 2012 $ December 31, 2011 $ 1,188,653 361,898 111,943 1,662,494 1,006,247 330,355 28,658 1,365,260 Cost of goods sold includes cost of inventories amounting to $7,019,549 in 2012 (2011 - $5,289,956). Cost of goods sold includes an amount of nil (2011 – $11,698) and $103,987 in selling and administrative expenses (2011 – $366,314) for the writedown of inventories to the lower of cost and net realizable value. Work-in-progress inventories are pledged as security for the credit facilities (see note 11, Bank loan). (15) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 9 Property, plant and equipment Machinery and equipment $ Office furniture and equipment $ Computers $ Moulds $ Vehicles $ Leasehold improvements $ Cost Balance at December 31, 2011 Additions Disposals Effect of movements in exchange rates Balance at December 31, 2012 Accumulated amortization Balance at December 31, 2011 Amortization Disposal Effect of movements in exchange rates Balance at December 31, 2012 Carrying Amount At December 31, 2011 At December 31, 2012 742,821 68,738 (363,788) (1,033) 446,738 445,861 53,578 (312,993) (,397) 186,049 296,960 260,689 107,230 3,878 (11,911) (,237) 98,960 71,076 19,050 (10,641) (,49) 79,436 36,154 19,524 338,157 45,004 (155,863) (,582) 226,716 324,639 16,912 (155,863) (,353) 185,335 67,648 15,485 - (,766) 82,367 38,897 13,426 - (,346) 51,977 71,968 - (35,984) - 35,984 21,590 13,194 (16,792) - 17,992 13,518 41,381 28,751 30,390 50,378 17,992 663,023 - (646,301) (7,180) 9,542 540,113 26,492 (549,881) (7,182) 9,542 122,910 - Total $ 1,990,847 133,105 (1,213,847) (9,798) 900,307 1,442,176 142,652 (1,046,170) (8,327) 530,331 548,671 369,976 (16) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 10 Intangible assets and goodwill Other Internally generated Patents $ Customer relations $ Software $ Engineering drawings $ Total intangible assets $ Goodwill $ Cost Balance at December 31, 2011 Disposals Additions Effect of movements in exchange rates Balance at December 31, 2012 Accumulated amortization 3,315,985 (3,368,662) 52,677 - - 1,900,000 - - - 1,900,000 Balance at December 31, 2011 Amortization of the year Accumulated depreciation of assets disposed Effect of movements in exchange rates Balance at December 31, 2012 549,835 49,275 (599,110) - - 678,572 271,428 - - 950,000 214,074 - 32,294 (,795) 245,573 213,335 4,916 - (,936) 217,315 4,700 - - - 4,700 4,700 - - - 4,700 5,434,759 (3,368,662) 84,971 (,795) 2,150,273 342,616 (200,000) - - 142,616 1,446,442 325,619 (599,110) (,936) 1,172,015 - - - - - Carrying Amount At December 31, 2011 At December 31, 2012 2,766,150 - 1,221,428 950,000 739 28,258 - - 3,988,317 978,258 342,616 142,616 Amortization of $325,619 (2011 - $512,597) is included in the consolidated statement of loss: $50,357 (2011 - $231,334) in “cost of goods sold” and $275,262 (2011 - $281,263) in “selling and administrative expenses”. As at December 31, 2012, management determined that an indicator of impairment existed for the customer relations while comparing its financial forecasts to prior period forecasts and considering other market factors and indicators. The recoverable amount of the customer relations has been determined based on a value-in-use calculation using cash flow projections from financial budgets approved by senior management covering a six-year period. The pre-tax discount rate applied to cash flow projections is 15%. As a result of this analysis, management determined that no impairment charge was required. (17) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 11 Bank loan As at December 31, 2012, the Company had a revolving demand facility by way of letters of credit and letters of guarantee amounting to $1,000,000 with Royal Bank of Canada which bore interest at the Royal Bank’s prime rate plus 2.50% per annum and which were limited by certain margin requirements concerning accounts receivable. In addition, the Company had access to credit facilities in the amount of $500,000 with Royal Bank of Canada which were guaranteed by Export Development of Canada and bore interest at the Royal Bank’s prime rate plus 2.5% per annum and were limited by certain requirements concerning pre-shipment costs. These credit facilities were used up to $166,952 as at December 31, 2012. The bank loan is secured by a first ranking hypothec of $4,000,000 on all movable property of the Company and is renewable annually. 12 Trade and other payables Trade payables Payables to related parties (note 25) Other payable Trade and other payables 13 Deferred revenues Deferred revenue from long-term contracts Deferred revenue other contracts Deferred revenue December 31, 2012 $ December 31, 2011 $ 3,472,289 8,574 318,628 3,799,491 4,516,080 31,435 - 4,547,515 December 31, 2012 $ December 31, 2011 $ 684,344 383,643 1,067,987 1,816,275 690,199 2,506,474 Revenue recognized for long-term contracts amounted to $7,791,344 for the year ended December 31, 2012 (2011 - $4,369,730). Costs incurred for long-term contracts in progress as at December 31, 2012 amounted to $2,833,296 for a profit of $767,335 (2011 – costs of $1,667,986 and $226,516 respectively). (18) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 14 Provisions Restructuring costs $ Anticipated loss on long- term contract $ Warranty costs $ Total provision $ At December 31, 2011 61,000 95,000 299,718 455,718 Additional provisions Unused amount reversed Used during year At December 31, 2012 (a) Restructuring costs - - (61,000) - - (18,813) (76,187) 258,054 (11,292) (58,480) 258,054 (30,105) (195,667) - 488,000 488,000 A provision of $61,000 related to the termination benefits of one employee has been paid during 2012. (b) Warranty costs The Company offers warranties 18 months after shipping or 12 months after start-up to the purchasers of its gas purification and natural gas dryers. (19) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 15 Long-term debt a) Loans Loan from Canada Economic Development for a maximum of $99,994 (2011 - $133,318), matures December 2015, bears no interest and is repayable in monthly instalments of $2,777 Loan from Canada Economic Development for a maximum of $62,500 (2011 - $87,500), matures January 2015, bears no instalments of interest and is repayable in eight semi-annual $12,500 Term finance contract, matures June 2015, bears annual interest of 5.99% and is secured by a lien on a vehicle (net book value of $17,992). Repayable in monthly instalments of $785 including capital and interest Loan from Investissement Québec, bears annual interest at the lender’s floating rate plus 2%, paid during the year Term finance contracts, mature December 2013, and are secured by a lien on equipment (net book value of $9,807). It is repayable in monthly instalments of $831 including capital and interest Less: Current portion b) Disposition of building and land: 2012 $ 2011 $ 99,994 133,318 62,500 87,500 21,822 - 9,807 194,123 76,474 117,649 58,729 98,968 - 378,515 141,786 236,729 On September 30, 2011, the Company sold and leased back its building. With the proceeds, the Company repaid its mortgages and used the remainder to fund its working capital. There is also a balance of sale of $800,000 that will become available to the Company consisting of an amount of $200,000 on the second anniversary date of the sale and $600,000 on the fourth anniversary date of the sale. The balance of sale bears interest at four percent and the interest is receivable on each anniversary date of the sale. The balance of sale has since been renegotiated (note 29a)). (20) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) c) Government royalty program obligations: The Company signed a settlement agreement with Technology Partnership Canada (“TPC”) with regard to its Fast Cycle Pressure Swing Adsorption and Gas Management systems and Pulsar Pressure Swing Adsorption project. The Company had to pay $250,000 at the execution of the agreement and $1,000,000 spread over four equal annual non-interest bearing payments, starting on January 31, 2013 (note 29b)). Furthermore, the Company is liable to pay up to $750,000 in contingent payments based on proceeds from the sale by the Company of its intellectual property. Upon closing of the transaction (see note 6), the Company paid $540,000 out of the $750,000 total contingent- based payments. On October 23, 2012, the Company accrued another $150,000 out of the $750,000 total contingent based payments, following additional proceeds received (see note 6), leaving a potential maximum amount to be paid of $60,000 as at December 31, 2012. The following table summarizes the activity related to the government royalty program obligation during the period: Balance - Beginning of year Accretion interests Additional contingent debt Loss on debt settlement Repayment Balance - End of year Current portion 2012 $ 948,921 89,611 150,000 682,280 (790,000) 1,080,812 (365,959) 714,853 2011 $ 691,539 257,382 - - - 948,921 (195,949) 752,972 The settlement agreement was accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability as the terms and conditions are substantially different. The Company recorded a loss on debt settlement of $682,280 in the consolidated statement of earnings (see note 20). The carrying amount of the government royalty program obligation has been calculated by discounting the future cash flows at the interest rate of five percent. Prior to this settlement agreement, the Company had an agreement with Industry Canada under the TPC Program to receive financial contributions regarding the development and commercial exploitation of its Fast Cycle Pressure Swing Adsorption (“FCPSA”), Gas Management Systems (“GMS”) and Pulsar Pressure Swing Adsorption project (“PSA”). Pursuant to the FCPSA and GMS agreement, total project costs for the period from October 1, 2002 to September 30, 2008 were to be shared, subject to certain contribution limits, such that the Ministry’s contribution would not exceed the lesser of 30% of eligible project costs and $8,139,937. The agreement further provided that the contributions were repayable on a royalty of 0.471% of gross business revenues during the royalty period. (21) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Pursuant to the PSA agreement, total project costs for the period from October 1, 1998 to March 31, 2002 were to be shared, subject to annual contribution limits, such that the Ministry’s contribution would not exceed the lesser of 35% of eligible project costs and $4,947,330. The Company had received contributions aggregating $4,762,503. The agreement the contributions were repayable based on a royalty of 1.8% of gross project revenues and revenues from fuel-cell related products during the royalty period to a maximum cumulative repayment of $8,750,000. further provided that 16 Share capital a) The Company is incorporated under the Canada Business Corporations Act and its authorized share capital consists of an unlimited number of common and preferred shares, without par value. b) Share purchase warrants Information that summarizes the activity related to the Company’s share purchase warrants for the year ended December 31, 2012: Number of warrants Balance – Beginning of year Granted Exercised Expired 10,658,136 - - (566,250) Balance – End of year 10,091,886 2012 Weighted average exercise price $ 0.45 . - . - 0.40 0.45 Number of warrants 15,456,424 - - (4,798,288) 10,658,136 2011 Weighted average exercise price $ 0.64 . - . - 1.07 0.45 The following table summarizes the share purchase warrants outstanding as at December 31, 2012, all of which are exercisable: Warrants outstanding Exercise price $ 0.45 Number of warrants outstanding 10,091,886 10,091,886 Weighted average remaining contractual life (years) 2.84 2.84 Weighted average exercise price $ 0.45 0.45 (22) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) c) Earnings (loss) per share i. Basic Basic loss per share is calculated by dividing the net income attributable to owners of the parent by the weighted average number of common shares in issue during the year. For the year ended December 31, 2012 $ For the year ended December 31, 2011 $ Net income (loss) attributable to owners of the parent Weighted average number of common shares in issue 1,682,927 39,363,867 (1,447,123) 39,363,867 $0.04 ($0.04) ii. Diluted Diluted earnings per share is calculated by adjusting the weighted average number of common shares outstanding to assume conversion of all dilutive potential common shares. The Company has two categories of dilutive potential common shares: warrants and stock options. For both, a calculation is performed to determine the number of shares that could have been acquired at fair value (determined as the average market share price of the Company’s outstanding shares for the period), based on the monetary value of the subscription rights attached to the warrants and stock options. The number of shares calculated below is compared with the number of shares that would have been issued assuming exercise of the warrants and stock options. For the year ended December 31, 2011, the diluted net loss per share was the same as the basic net loss per share, since the effect of assumed exercise of share options and warrants to purchase common shares was anti-dilutive. (23) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) For the year ended December 31, 2012 $ For the year ended December 31, 2011 $ Net income (loss) attributable to owners of the parent 1,682,927 (1,447,123) Weighted average number of common shares in issue Dilutive effect of stock options Diluted weighted average number of shares 39,363,867 3,169,961 42,533,828 39,363,867 - 39,363,867 $0.04 ($0.04) Items excluded from the calculation of diluted net income (loss) per share because the exercise price was greater than the average market price of the common shares or due to their anti-dilutive effect Stock options Warrants (number of equivalent shares) 21,538 4,541,349 2,454,789 4,767,849 17 Stock options The stock option plan (the “Plan”) allows for the issuance of stock options, stock appreciation rights, restricted stock, restricted stock units, performance awards and other stock-based awards. Under the Plan, common shares approved for issuance under all stock-based compensation arrangements are limited to the greater of 591,560 and 10% of the common shares issued and outstanding. As at December 31, 2012, the maximum number of common shares available for issuance under all stock-based compensation arrangements is 3,936,387. Under the terms of the Plan, stock options are granted with an exercise price not less than the volume- weighted average trading price of the common shares for the five trading days prior to the date of grant. The terms and conditions for acquiring and exercising options are set by the Board of Directors. Stock options for employees vest no less than at grant date and no more than quarterly. The vesting right acquisitions are gradual and equal over two years for the 2012 grants except for 460,000 stock options which vested at the grant date (2011 - 2,215,544) and over four years for previous grants and are exercisable for seven years from the date of grant. Stock options for directors vest at the grant date and are exercisable for seven years from the grant date. (24) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Stock option activity for the years ended December 31 is presented below: 2012 Weighted average exercise price $ 0.26 0.15 0.67 . - 0.19 0.19 Number of options 107,361 3,465,544 (146,782) - 3,426,123 2,454,789 Number of options 3,426,123 460,000 (455,666) - 3,430,457 3,191,499 Outstanding – Beginning of year Granted Forfeited Expired Outstanding – End of year Exercisable – End of year As at December 31, 2012, options outstanding in the Plan and options exercisable are as follows: 2011 Weighted average exercise price $ 5.99 0.15 1.78 . - 0.26 0.27 2012 Exercise price range $ 0.10 - 0.20 0.22 - 0.27 0.44 - 1.50 9.00 - 13.90 16.20 - 17.50 Options outstanding Options exercisable Weighted average remaining contractual life (years) 6.00 5.57 1.36 3.70 2.00 2.06 Number of options 2,620,000 788,919 6,100 15,263 175 3,430,457 Weighted average exercise price $ 0.11 0.24 1.09 11.95 17.00 0.19 Number of options 2,620,000 549,961 6,100 15,263 175 3,191,499 Weighted average exercise price $ 0.11 0.24 1.09 11.95 17.00 0.19 (25) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) The fair value of the options granted has been estimated according to the Black-Scholes option pricing model and based on the weighted average of the following assumptions for options granted during the year: Non-employees Employees Non-employees Employees 2012 2011 Dividend yield Exercise price Risk-free interest rate Estimated life Expected volatility Stock price 0% $ 0.10 0.90% 2.00 81% $ 0.09 0% $ 0.20 1.20% 2.00 81% $ 0.22 0% $ 0.14 0.91% 2.00 81% $ 0.13 0% $ 0.15 0.98% 2.00 81% $ 0.14 The weighted average fair value of the options granted to employees during the year is $0.10 (2011 $0.14) and $0.04 (2011 $0.13) for the options granted to non-employees. Compensation expenses with respect to these options amounted to $70,264 for employees and $8,117 for non-employees for the year ended December 31, 2012 (2011 – $127,741 and $37,122). 18 Expenses by nature Material Employee salaries and benefits Rent and repairs and maintenance Professional fees Subcontracting costs Travel expenses Office expense Amortization Other Commission Stock-based compensation 2012 $ 7,020,136 6,558,487 907,813 779,412 751,748 744,817 671,950 468,272 463,358 89,502 78,381 2011 $ 5,350,771 6,631,496 811,444 1,096,386 479,178 537,744 549,180 897,671 326,905 - 164,863 18,533,876 16,845,638 (26) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 19 Research and development expenses Research and development expenses Government grants Research and development tax credits 20 Finance expenses Interest and bank charges Interest on bank loan Interest on long-term debt and subordinated loan Interest charges Accretion and revaluation of government royalty program obligation (see note 15c)) 21 Compensation of key management Compensation awarded to key management included: Salaries and short-term employee benefits Stock-based compensation 2012 $ 147,585 (5,000) - 2011 $ 627,672 (5,000) (72,327) 142,585 550,345 2012 $ 56,176 ,025 4,308 26,903 921,891 1,009,303 2011 $ 64,651 34,744 109,789 51,311 257,382 517,877 2012 $ 676,301 54,230 2011 $ 1,005,980 96,721 730,531 1,102,701 Key management included the Company’s senior management and members of the Board of Directors. (27) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 22 Income taxes a) Income tax expense Income taxes included in the consolidated statements of earnings (loss) are as follows: Current Deferred b) Effective tax rate 2012 $ - - - 2011 $ - - - The Company’s effective income tax rate differs from the statutory federal and provincial income tax rate in Canada. This difference arises from the following: Combined statutory rate applied to pre-tax loss Non-deductible items Non-taxable portion of gain on disposal of assets Net change in unrecognized deferred income tax assets Impact of changes in income tax rates on deferred income taxes Other Effective income tax rate 2012 % 26.59 2.90 (51.63) 14.92 8.02 (0.80) . - 2011 % 27.90 (14.73) 42.29 (38.71) (18.56) (1.81) . - The applicable statutory tax rates are 26.59% in 2012 and 27.90% in 2011. The Company’s applicable tax rate is the Canadian combined rates applicable in the jurisdictions in which the Company operates. The decrease is mainly due to the reduction of the federal income tax rate in 2012 from 16.5% to 15%. (28) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) c) Deferred income tax assets and liabilities Deferred income tax assets Property, plant and equipment Net operating losses carried forward Financing costs Intangible assets Scientific research and development expenses Investment tax credits Other Deferred income tax liabilities Intangible assets 2012 $ 2011 $ 176,874 14,850,513 92,860 - 6,264,483 3,847,117 104,433 452,785 15,173,061 146,356 147,595 6,329,223 5,917,676 111,206 25,336,280 28,277,902 (258,440) - 25,077,840 28,277,902 Unrecognized deferred income tax assets (25,077,840) (28,277,902) Net deferred income tax assets (liabilities) - - In assessing the realizability of deferred income tax assets, management considers whether it is probable that some portion or all of the deferred income tax assets will be realized. The ultimate realization of deferred income tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. As management believes there is sufficient uncertainty regarding the realization of deferred income tax assets, these deferred income tax assets have not been recognized. Most of these unrecognized deferred income tax assets relate to QuestAir’s deferred income tax asset balance at the acquisition date. When a deferred income tax asset acquired in a business combination is not recognized at the date of acquisition, any subsequent recognition of the tax benefit will reduce income tax expense, resulting in an increase in net earnings. (29) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) d) Other The Company has non-capital losses carried forward in Canada of approximately $55,800,000 (2011 - 57,400,000) which are available to reduce taxable income in future years, the benefit of which has not been recorded in the accounts, and which expire as follows: 2014 2025 2026 2027 2028 2029 2030 2031 2032 $ 2,800,000 6,900,000 7,200,000 6,800,000 10,800,000 7,200,000 12,400,000 700,000 1,000,000 55,800,000 The Company has scientific research and experimental development expenses of approximately $23,500,000 which are available to be carried forward indefinitely and deducted against future taxable income otherwise calculated. As at December 31, 2012, the Company also has investment tax credits of approximately $5,244,000 available to offset future Canadian federal income taxes payable. The potential benefit of the investment tax credits has not been recognized in the accounts and expires as follows: 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2029 2032 $ 10,000 30,000 100,000 470,000 910,000 240,000 920,000 480,000 740,000 650,000 410,000 240,000 32,000 12,000 5,244,000 (30) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 23 Commitments Following is a summary of Xebec’s contractual obligations and commitments: As at December 31, 2012 Operating leases(1) As at December 31, 2011 Operating leases(1) Payment Due by Period Beyond 5 years 2 - 5 years Total $ 1,445,887 $ 2,853,225 $ 4,968,756 1 year $ 669,644 Payment Due by Period Beyond 5 years 2 - 5 years $ 1,855,211 $ 3,163,416 1 year $ 826,736 Total $ 5,845,363 (1) Operating leases include one building in Blainville (2011 – two buildings in Vancouver and one in Blainville) and various equipment leases. 24 Contingent liabilities The Company is party to various ongoing and pending litigation along with other contingencies arising out of normal course of business. Management believes that these claims, when resolved, will not have any material adverse effect on the consolidated financial position or results of operations of the Company. 25 Related party transactions The following table presents a summary of the related party transactions during the year: Marketing and professional service expenses paid to companies controlled by members of the immediate family of an officer Sales to an entity controlled by a Company director Loan from a Company director Repayment of loan from a Company director Accrued interest on a loan from a Company director 2012 $ 73,408 24,324 - 24,123 1,841 2011 $ 46,355 74,372 23,562 - 315 These transactions are measured at the exchange amount, which is the amount of consideration established and agreed to by the related parties. (31) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 26 Capital management The Company’s objective when managing capital is to use short-term funding sources to manage its working capital requirements and fund capital expenditures required to execute its operating and strategic plans. The Company’s capital structure is composed of the following: Cash Bank loan Long-term debt Government royalty program obligation (note 15c)) Equity (Deficiency) 2012 $ 1,344,114 (166,952) (194,123) (1,080,812) (97,773) 1,737,339 2011 $ 389,090 (500,000) (378,515) - (489,425) (307,121) 1,639,566 (796,546) The Company is not subject to any capital requirements imposed by regulators. 27 Segmented information The Company has only one segment and specializes in the design and manufacture of filtration, purification, separation and dehydration equipment for gases and compressed air. The Company has five product lines and provides related engineering services. Revenue summarized by country, as determined by location of the customers, is as follows: Revenue Canada India South Korea United States Republic of China Other 2012 $ 3,524,821 2,513,898 2,256,855 2,207,137 2,160,933 2,515,477 2011 $ 1,819,934 21,062 251,742 8,355,044 1,246,519 2,509,162 15,179,121 14,203,463 (32) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Revenue summarized by product line is as follows: Product line Gas purification Natural gas dryers Compressed gas filtration Engineering services Air dryers Associated gas Licensing Major customers representing 10% or more of total sales include: Customer A Customer B 2012 $ 8,169,548 4,338,956 2,092,661 427,192 121,474 29,290 - 2011 $ 4,876,066 4,459,762 1,558,387 1,665,589 178,772 - 1,464,887 15,179,121 14,203,463 2012 $ 2,256,275 1,555,342 3,811,617 2011 $ 21,062 352,146 373,208 The location of the Company’s non-current assets by geographic region is as follows: Non-current assets Canada Asia 2012 $ 2011 $ 1,982,855 107,995 5,563,424 116,180 2,090,850 5,679,604 (33) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) 28 Financial instruments (a) Measurement categories and fair values, including valuation methods and assumptions The following table shows the carrying values and the fair values of assets and liabilities for each of these categories as at December 31, 2012 and 2011: December 31, 2012 Cash Trade and other receivables Bank loan Trade payables Accrued liabilities Long-term debt Government royalty program obligation December 31, 2011 Cash Trade and other receivables Bank loan Trade payables Accrued liabilities Long-term debt Government royalty program obligation Subordinated loan Loan from a related party Loans and receivables Carrying amount $ 1,344,114 3,936,746 - - - - Fair value $ 1,344,114 3,936,746 - - - - Other financial liabilities Carrying amount $ - - 166,952 3,799,491 1,144,539 194,123 Fair value $ - - 166,952 3,799,491 1,144,539 183,979 - - 1,080,812 1,036,488 Loans and receivables Carrying amount $ 389,090 2,444,842 - - - - Fair value $ 389,090 2,444,842 - - - - Other financial liabilities Carrying amount $ - - 500,000 4,547,515 1,195,825 279,547 Fair value $ - - 500,000 4,547,515 1,195,825 279,547 - - - - - - 948,921 98,968 23,562 948,921 98,968 23,562 The carrying values of cash, trade and other receivables, trade payables and accrued liabilities and bank loan approximate their fair value due to their short-term maturities. The methods and assumptions used in estimating the fair values of other financial assets and financial liabilities are as follows:  Loan to a joint venture: Fair value of the loan has been calculated by discounting the loan on a one- year period to the interest rate of a similar investment. (34) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars)  Long-term debt and subordinated loan: The Company’s long-term debt and subordinated loan carry fixed interest rates. The fair value of the Company’s debt obligations and subordinated loan has been calculated by discounting the future cash flows of the respective long-term debt and subordinated loan at the interest rate of similar debt instruments.  Government royalty program obligation: Fair value of the government royalty program obligation has been calculated by discounting the future cash flows at the interest rate for a similar loan in the market. (b) Credit risk Credit risk is the risk of an unexpected loss if a customer or third party fails to meet its contractual obligations. The Company’s primary credit risk is its cash and outstanding trade accounts receivable. The carrying amount of its outstanding trade accounts receivable represents the Company’s estimate of its maximum credit exposure. The Company regularly monitors its credit risk exposure and takes steps such as employing credit approval procedures, establishing credit limits, using credit assessments and monitoring practices to mitigate the likelihood of these exposures from resulting in an actual loss. An allowance for doubtful accounts amounting to $232,216 (2011 – $194,273) was established based on prior experience and an assessment of current financial conditions of customers as well as the general economic environment. In the case where an allowance for doubtful accounts provision is recorded and a receivable balance is considered uncollectible, it is written off against the allowances for doubtful accounts. Bad debt expense amounted to $50,375 in 2012 (2011 – $138,348). As at December 31, 2012, the Company’s three largest trade debtors accounted for 36% (16%, 13% and 7%) of the total accounts receivable balance (2011 – 28% (11%, 9% and 8%)). Details of accounts receivable were as follows: Current trade receivables Trade receivables past due by: 1–30 days 31–60 days 61–90 days Over 90 days Total trade receivables Allowances for doubtful accounts Other receivables December 31, 2012 $ December 31, 2011 $ 669,381 247,964 361,223 376,467 561,400 1,186,152 3,154,623 (232,216) 1,014,339 304,949 111,037 122,177 1,223,812 2,009,939 (194,273) 629,176 Total accounts receivable 3,936,746 2,444,842 (35) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) The following table summarizes the changes in the allowance for doubtful accounts for trade receivables: At December 31, 2011 Provision for impairment Receivables written off during the year as uncollectible Unused amounts reversed At December 31, 2012 (194,273) (50,375) 12,432 - (232,216) The Company’s cash is maintained at financial institutions with high credit ratings; therefore, the Company considers the risk of non-performance on these instruments to be remote. To date, the Company has not incurred any losses related to these instruments. (c) Market risk (i) Currency risk Certain financial assets and financial liabilities are exposed to foreign exchange fluctuations. Taking into account the amounts denominated in the currencies indicated below and assuming that all of the other variables remain unchanged, a fluctuation in exchanges rates would have an impact on the Company’s net loss. Management believes that a 10% change in exchange rates would be reasonably possible and that the impact on the net loss of such a change would be approximately $(46,846) for 2012 ( 2011 $(9,160)). As at December 31, 2012, the following amounts are shown in their original currencies but converted into Canadian dollars. The Company does not use financial instruments to reduce this risk. Thai baht US dollar Euro Cash Accounts receivable Accounts payable and accrued liabilities - 15,661,786 - 165,154 1,078,533 (268,949) 4,291 60,990 (164,810) 15,661,786 974,738 (99,529) Equivalent in Canadian dollars 509,321 969,767 (130,563) 2012 British pound sterling - - - - - (36) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) US dollar 50,828 1,734,397 (961,399) Euro 1,630 2,991 (66,486) 2011 British pound sterling - - (6,142) 823,826 (61,865) (6,142) 837,831 (81,617) (9,704) Thai baht - - - - - Cash Accounts receivable Accounts payable and accrued liabilities Equivalent in Canadian dollars (ii) Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of financial instruments will fluctuate as market interest rates change. The Company is exposed to interest rate risk on its bank loan and long-term debt, for which the interest rates charged fluctuate based on the bank prime rate. As at December 31, 2012, the short-term bank loan amounted to $166,952 (2011 – $598,968). If the interest rate on the bank debt had been 50 basis points higher (lower), related to the bank loan as at December 31, 2012, net loss would have been $417 (2011 – $2,995) higher (lower). (d) Liquidity risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they come due. The following are the contractual maturities of financial liabilities as at December 31: Carrying amount $ Contractual cash flow $ 0 to 12 months $ 13 to 24 months $ Thereafter $ 2012 166,952 3,799,491 1,144,539 166,952 3,799,491 1,144,539 166,952 3,799,491 1,144,539 - - - - - - Financial liabilities Bank loan Accounts payable Accrued liabilities Government royalty program obligation Long-term debt 1,080,812 194,123 1,150,000 196,012 400,000 77,711 250,000 67,745 500,000 50,556 6,385,917 6,456,994 5,588,693 317,745 550,556 (37) Xebec Adsorption Inc. Notes to Consolidated Financial Statements December 31, 2012 and 2011 (expressed in Canadian dollars) Carrying amount $ Contractual cash flow $ 0 to 12 months $ 13 to 24 months $ Thereafter $ 2011 500,000 4,547,515 1,195,825 500,000 4,547,515 1,195,825 500,000 4,547,515 1,195,825 23,562 23,562 23,562 - - - - - - - - Financial liabilities Bank loan Accounts payable Accrued liabilities Loan from a related party Government royalty program obligation 948,921 11,376,701 313,852 134,331 10,928,518 Long-term debt and subordinated loan 378,515 379,721 139,667 108,419 131,635 7,594,338 18,023,324 6,720,421 242,750 11,060,153 Contractual interest amounts that are on floating interest rates are established based on the spot rates as at the respective balance sheet dates. The Company’s development is financed through a combination of borrowing under the existing credit facilities, the issuance of debt and the issuance of equity (note 1). 29 Subsequent events a) On January 30, 2013, the Company renegotiated the balance of sale of $800,000 receivable pursuant to the sale and lease back of its building. It is now consisting of an amount of $300,000 paid on March 1, 2013, and $300,000 to be paid on March 1, 2014 and $200,000 to be paid on March 1, 2015. The balance of sale bears interest at four percent and the interest is receivable on each anniversary date of the sale. b) On February 1, 2013, the Company became in default with regard to its TPC agreement. The Company negotiated and obtained a four-month extension to repay its annual payment (note 15c)). (38) 

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