CLEAN ENERGY COMBUSTION SYSTEMS, INC.
(a development stage enterprise)
(expressed in U.S. dollars)
CONSOLIDATED STATEMENTS OF CAPITAL DEFICIENCY

	Series 'A' Preferred Stock		Series 'B' Preferred Stock		Common Stock		Additional Paid-in Capital	Accumulated During The Development Stage
	Shares	Amount	Shares	Amount	Shares	Amount		Period	Cumulative
	(Three-Month Interim Period Ended March 31, 2003-unaudited)
Issued on incorporation	1,000	$      1	-	$          -	9,643,750	$       964	$            535	$                    -	$          1,500
Private placement	-	-	250,001	250	-	-	499,752	-	500,002
Vesting of previously issued but unexercised warrants granted to consultant (note 6)	-	-	-	-	-	-	2,000	-	2,000
Net loss for the period ended December 31, 1999	-	-	-	-	-	-	-	(639,404)	(639,404)
Balance, December 31, 1999	1,000	1	250,001	250	9,643,750	964	502,287	(639,404)	(135,902)
Vesting of previously issued but unexercised warrants granted to consultant (note 6)	-	-	-	-	-	-	18,500	-	18,500
Issued on conversion of  promissory note	-	-	-	-	487,944	49	975,838	-	975,887
Net loss for the year ended  December 31, 2000	-	-	-	-	-	-	-	(907,826)	(907,826)
Balance, December 31, 2000	1,000	1	250,001	250	10,131,694	1,013	1,496,625	(1,547,230)	(49,341)
Vesting of previously issued but unexercised warrants granted to consultant (note 6)	-	-	-	-	-	-	30,601	-	30,601
Disposition of subsidiary (note 4)	-	-	-	-	-	-	294,522	-	294,522
Net loss for the year ended  December 31, 2001	-	-	-	-	-	-	-	(812,445)	(812,445)
Balance, December 31, 2001	1,000	1	250,001	250	10,131,694	1,013	1,821,748	(2,359,675)	(536,663)
Conversion of series 'B' convertible preferred stock into common stock	-	-	(8,333)	(8)	8,333	1	7	-	-
Conversion of loans and other debt to common stock	-	-	-	-	1,267,242	127	823,581		823,708
Reduction of provision for liability related to transfer of subsidiary  (note 4)	-	-	-	-	-	-	191,226	-	191,226
Net loss for the year ended  December 31, 2002	-	-	-	-	-	-	-	(894,473)	(894,473)
Balance, December 31, 2002	1,000	1	241,668	242	11,407,269	1,141	2,836,562	(3,254,148)	(416,202)
Reduction of provision for liability related to transfer of subsidiary  (note 4)	-	-	-	-	-	-	79,633	-	79,633
Net loss for the three-month period ended March 31, 2003	-	-	-	-	-	-	-	(181,984)	(181,984)
Balance, March 31, 2003	1,000	$      1	241,668	$     242	11,407,269	$    1,141	$  2,916,195	$  ( 3,436,132)	$   (518,553)

 

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements of capital deficiency

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CLEAN ENERGY COMBUSTION SYSTEMS, INC.
(a development stage enterprise)
(expressed in U.S. dollars)
CONSOLIDATED STATEMENTS OF CASH FLOW

				Three-months Ended March 31,		Jan. 1, 1999 to March 31, 2003
				2003	2002	(Cumulative)
				(unaudited)	(unaudited)	(unaudited)
OPERATING ACTIVITIES
	Total expenses and net loss			$     (181,984)	$      (195,261)	$  (3,436,132)
	Adjustments to reconcile total expenses and net loss to net cash utilized in operating activities:
		Amortization		-	-	45,027
		Non-cash consulting expense		-	-	51,101
		Write-down of patents		9,199	-	9,199
	Change in operating assets and liabilities:
		Accounts receivable and prepaid expenses		48	-	(21,144)
		Accounts payable		40,687	150,004	1,016,994
		Accrued liabilities		8,433	4,923	238,925
Net cash used in operating activities				(123,617)	(40,334)	(2,096,030)
INVESTING ACTIVITIES
	Additions to patents			-	(798)	(39,327)
	Purchase of property and equipment			-	-	(92,791)
Net cash provided by (used in) investing activities				-	(798)	(132,118)
FINANCING ACTIVITIES
	Advances from (to) an affiliated company			79,420	21,132	63,715
	Advances from (to) shareholders (note 5)			-	-	273,779
	Advances from (to) related parties			44,315	20,000	415,434
	Net proceeds from disposal of subsidiary			-	-	(2,051)
	Proceeds from issue of common stock			-	-	976,887
	Proceeds from issue of series 'A' convertible preferred stock			-	-	500
	Proceeds from issue of series 'B' convertible preferred stock			-	-	500,002
Net cash provided by financing activities				123,735	41,132	2,228,266
NET DECREASE IN CASH AND CASH EQUIVALENTS				118	-	118
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD				-	-	-
CASH AND CASH EQUIVALENTS, END OF PERIOD				$               118	$                     -	$               118

 

SUPPLEMENTAL SCHEDULE OF INTEREST AND INCOME TAXES PAID Interest paid for the periods ended March 31, 2003 and March 31, 2002 and the cumulative period ended March 31, 2003 was $706, $4,923 and $90,696, respectively, and income taxes paid for each of the periods ended March 31, 2003 and March 31, 2002 and the cumulative period ended March 31, 2003 was $0.

The accompanying notes to consolidated financial statements are an integral part of these consolidated statements of cash flows

-4-

1. Nature Of Business; Organization And Operations; Going Concern

   Clean Energy Combustion Systems, Inc. ("we", "our company" or "Clean Energy") was incorporated under the laws of the State of Delaware and organized and commenced operations on March 1, 1999. These financial statements include select pre-organization transactions and commitments incurred between January 1, 1999 and the date of incorporation on March 1, 1999, that were accepted by our board of directors in connection with our organization as obligations of our company.

   We are engaged in the business of designing, engineering, manufacturing, marketing, distributing, licensing and otherwise commercially exploiting our suite of proprietary mid- to high-frequency oscillating valveless combustion or 'burner" technologies, including our patented pulse blade combustion or "PBC" technology. This technology, which is our principal technology, has completed the primary development stage and is in a position to be commercially exploited. Our objective is to enter into licensing, royalty, joint venture, or manufacturing agreements with established national and international heat transfer industry manufacturers.

   Since we have not generated operating revenues to date, we should be considered a development stage enterprise. As of March 31, 2003, we have incurred losses from inception totalling $3,436,132, have a working capital deficiency of $508,260, and do not currently have the financial resources to complete our business plan. Our ability to continue as a going concern will be dependent upon our ability to attain future profitable operations and to obtain the necessary financing to meet our obligations and repay our liabilities arising from normal business operations when they come due. External financing, predominately in the short-term by loans from affiliated parties and project grants or financings, in the longer-term through the issuance of equity or debt, will be sought to finance development of our products; however, there can be no assurance that sufficient funds will be raised. These factors, among others, indicate that we may be unable to continue as a going concern for a reasonable period of time. In the event that we are unable to generate sufficient capital to meet our current operating expenses, Clean Energy will be required to reevaluate our planned expenditures and allocate our total resources in such manner as our board of directors and management deem to be in our best interest. This may result in a substantial reduction of the scope of our existing and planned operations. Our consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or the amount and classifications of liabilities that might be necessary, should we be unable to continue as a going concern.

   We are authorized under our Certificate of Incorporation to issue shares of common stock, series 'A' preferred stock, series 'B' preferred stock and series 'C' preferred stock (sometimes referred to in our consolidated financial statements and this quarterly report as "common shares", "series 'A' preferred shares", "series 'B' preferred shares" and "series 'C' preferred shares", respectively). See note 6.

2. Significant Accounting Policies

   Basis Of Presentation

   We prepared these consolidated financial statements in conformity with accounting principles generally accepted in the United States.

Consolidation

We have consolidated the accounts of our wholly-owned subsidiary, Clean Energy USA Inc. ("Clean Energy USA") with those of Clean Energy. All significant intercompany balances and transactions between Clean Energy and Clean Energy USA were eliminated as a consequence of the consolidation process.

Reclassifications

Certain items in our prior year's consolidated financial statements have been reclassified to conform to our current year's consolidated financial statement presentation.

Foreign Currency Translation

Clean Energy is a Delaware corporation and considers the United States dollar to be the appropriate functional currency for our operations and these financial statements, notwithstanding that we do business in Canada in transactions denominated in Canadian dollars. It is anticipated that the majority of our business will be conducted in United States dollars and our anticipated customer base will be within the United States. For purposes of preparing these financial statements, foreign currency monetary assets and liabilities are translated into U.S. dollars at the exchange rates in effect at the balance sheet date. Other balance sheet items and revenues and expenses are translated at the rates prevailing on the respective transaction dates. Translation gains and losses are included in operations.

Estimates And Assumptions

The preparation of these consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of these consolidated financial statements and the reported amount of revenues and expenses during the reporting periods. Actual results may differ from those estimates.

Cash And Cash Equivalents

Cash and cash equivalents consist of cash on hand, funds on deposit and short-term investments with an original maturity of ninety days or less. Clean Energy holds no cash or cash equivalents at the date of these financial statements.

Short-Term Investments

Short-term investments consist of term deposits with a one-year maturity. These investments are cashable and can be drawn on at any time. Clean Energy holds no short-term investments at the date of these financial statements.

Research And Development

Research and development costs are expensed as incurred.

Marketing Costs

Marketing costs, including advertising costs, are expensed as incurred.

Patents

Costs related to the acquisition of patents are capitalized and, upon production of revenues, are amortized on a straight-line basis, commencing upon the production of revenues from the patent, over the shorter of the duration of the patent, which is twenty years, or the estimated life of the associated technology. As we have not commenced production of revenues to date, no amortization has been recorded to date in these consolidated financial statements. The costs of servicing our patents are expensed as incurred. Clean Energy assesses potential impairment of patents by measuring the expected net recovery based on cash flows from products based on these rights on an annual basis. These capitalized costs are valued at the lower of amortized cost and net recoverable amount.

Property And Equipment

We have historically stated property and equipment at cost, and then recorded amortization on these assets on a straight-line basis over their respective estimated service lives. As a consequence of the divestiture of our research and development subsidiary on December 31, 2001, Clean Energy holds no property or equipment at the date of these financials statements. All property and equipment used by Clean Energy is currently leased from McSheahan Enterprises Ltd. as part of an overhead charge. See note 3.

Income Taxes

Current income tax expense, if any, is the amount of income taxes expected to be payable for the current year. A deferred tax asset and/or liability is computed for both the expected future impact of differences between the financial statement and tax bases of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carryforwards. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be 'more likely than not' realized in future tax returns. Tax rate changes are reflected in income in the period such changes are enacted.

Impairment Of Long-Lived Assets And Long-Lived Assets To Be Disposed

We evaluate our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets or intangibles may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the assets. If any assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the net recoverable value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

Basic And Diluted Loss Per Share

Our basic loss per share is computed in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share", by dividing the net loss for the period attributable to holders of our common shares by the weighted average number of common shares outstanding for the period. Our diluted loss per share is computed, also in accordance with SFAS No. 128, by including the potential dilution that could occur if holders of our dilutive securities were to exercise or convert these securities into common shares. Common share equivalents are excluded from the computation if their effect is anti-dilutive. Common share equivalents consist of common shares issuable upon the conversion of the convertible loans, notes and special warrants (using the if-converted method) and incremental shares issuable upon the exercise of common share purchase options and warrants (using the treasury stock method).

Stock-Based Compensation

We have adopted the disclosure-only provisions of Statement of Financial Accounting Standards Statement ("SFAS") No. 123, Accounting For Stock Based Compensation, issued by the Financial Accounting Standards Board ("FASB"), and the subsequent amendment of SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure, while following Accounting Principles Board No. 25, "Accounting for Stock Issued to Employees", ("APB 25"), and related interpretations, in accounting for the grant of common share purchase options to our employees and directors. Under APB 25, companies are not required to record any compensation expense relating to the grant of options to employees or directors where the awards are granted upon fixed terms with an exercise price equal to fair value and the only condition of exercise is continued employment.

Comprehensive Income

Comprehensive income is reported and displayed in these consolidated financial statements in conformity with Statement of Financial Accounting Standards Statement ("SFAS") No. 130, Reporting Comprehensive Income, issued by the Financial Accounting Standards Board ("FASB"). SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements.

Recent Adopted Accounting Standards

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets to be held and used, to be disposed of other than by sale, and to be disposed of by sale. We adopted SFAS No. 144 in the first quarter of 2002 on a prospective basis. The adoption of SFAS No. 144 did not have a significant impact on our consolidated financial position or results of operations.

In June 2001, the FASB introduced SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition of intangible assets acquired outside of a business combination whether acquired individually or with a group of other assets. These standards require all future business combinations to be accounted for using the purchase method of accounting. Goodwill will no longer be amortized but instead will be subject to impairment tests at least annually. We adopted SFAS No. 141 on a prospective basis as of July 2001, and SFAS No. 142 in January 2002. The adoption of SFAS No. 141 and SFAS No. 142 did not have an impact on our consolidated financial position or results of operations.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements Nos. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. Among other things, SFAS No. 145 rescinds both SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and the amendment to SFAS No 4, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. Through this rescission, SFAS No. 145 eliminates the requirement (in both SFAS No. 4 and SFAS No. 64) that gains and losses from the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. Generally, SFAS No. 145 is effective for transactions occurring after May 15, 2002. The adoption of SFAS No. 145 did not have a significant impact on our consolidated financial position or results of operations.

In October 2002, the FASB issued SFAS No. 147, Acquisitions of Certain Financial Institutions. SFAS No. 147 requires that acquisitions of financial institutions be accounted in accordance with SFAS Nos. 141 and 142, and put any intangible asset therefrom under the guidance of SFAS No. 144. We adopted SFAS No. 147 in the fourth quarter of 2002 on a prospective basis. The adoption of SFAS No. 147 did not have a significant impact on our consolidated financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock Based Compensation-Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock Based Compensation, to provide methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation, as well as requiring prominent disclosure about the method and effect of accounting for stock-based compensation. We adopted SFAS No. 148 in the fourth quarter of 2002 on a prospective basis. The adoption of SFAS No. 148 did not have a significant impact on our consolidated financial position or results of operations.

In August 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligation. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related obligation for its recorded amount or incurs a gain or loss upon settlement. SFAS No. 143 will be effective for exit or disposal activities initiated after December 31, 2002. We do not anticipate that our adoption of SFAS No. 146 will have a material impact on our consolidated financial position or results of operations. The adoption of SFAS No. 143 did not have a significant impact on our consolidated financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires that the liability for a cost associated with an exit or disposal activity be recognized at its fair value when the liability is incurred. Under previous guidance, a liability for certain exit costs was recognized at the date that management committed to an exit plan, which was generally before the actual liability has been incurred. SFAS No. 146 will be effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a significant impact on our consolidated financial position or results of operations.

3. Research And Development Activities

   The bulk of our research and development activities are currently conducted through McSheahan Enterprises Ltd. ("McSheahan Enterprises"), a personal service corporation owned and controlled by Mr. Barry A. Sheahan, our Chief Financial Officer and a director, pursuant to a cost plus research and development contract entered into effective January 1, 2003. Under that agreement, McSheahan Enterprises agreed to provide pre-approved budgeted pulse combustion research and development services to Clean Energy USA, and to invoice the latter company for its budgeted costs, related overhead and a 10% mark-up.

   Prior to entering into the noted agreement with McSheahan Enterprises, we conducted the bulk of our research and development activities from January 1, 2002 pursuant to a letter of intent containing similar provisions entered into between Clean Energy USA and Clean Energy Technologies (Canada) Inc., a British Columbia corporation ("Clean Energy Technologies"), which was our wholly-owned research and development subsidiary through December 31, 2001. Effective January 1, 2003, Clean Energy Technologies transferred its property and equipment and assigned its leasehold interests to McSheahan Enterprises, while McSheahan Enterprises assumed certain liabilities of Clean Energy Technologies, including advances made by Clean Energy to Clean Energy Technologies. Concurrent with this transaction, the relationship with Clean Energy Technologies was terminated. See note 4.

   The purpose of conducting research and development activities on an arms'-length basis as described above was to continue to preserve our ability to indirectly benefit from certain grants and tax-incentive programs offered in both the United States and Canada.

4. Provisions And Liabilities Related To Transfer Of Subsidiary

   On December 31, 2001, we sold all of the shares of our research and development subsidiary, Clean Energy Technologies, to one of our principal shareholders and directors as of that date, Mr. John D. Chato, for the sum of $1, and concurrently entered into a research and development letter of intent with that company on a cost-plus basis. See note 3. No pro forma disclosure has been provided in connection with the transfer, as there has been no significant change to our operating expenses in connection with the transfer and related transactions.

   In connection with the disposition of Clean Energy Technologies, we recorded an increase of $294,522 to our additional paid-in capital on December 31, 2001, calculated as follows:

   Proceeds from disposition	$                     1
   Net liabilities of Clean Energy Technologies on date of disposition	2,095,253
   Offset of provisions and liabilities related to transfer of ownership	(659,403)
   Offset against amount due from Clean Energy Technologies related to research and development charges	(1,141,328)
   Net increase in additional paid-in capital	$         294,522

   The provisions and liabilities related to transfer of ownership in the amount of $659,403 itemized in the above table reflects total amounts advanced to Clean Energy Technologies and amounts payable by Clean Energy Technologies which we may have to satisfy by reason of our prior relationship with Clean Energy. Since originally recording this charge on December 31, 2001, our liability for advances decreased by the net amount of $22,593, while our liability for obligations decreased by $248,266 (including, with respect to the three-month interim period ended March 31, 2003, a decrease in our liability for advances by the net amount of $79,420, and a decrease in our liability for obligations of $213). The net of these amounts since December 31, 2001 is a decrease of $270,859 (including, with respect to the three-month interim period ended March 31, 2003, a net decrease of $79,633), which net amount has been credited to additional paid-in capital as a reduction of provision for liabilities related to the transfer of subsidiary. Details of provisions and liabilities related to transfer of ownership of Clean Energy Technologies are as follows:

   	March 31, 2003	December 31, 2002
   Valuation allowance related to advances to an affiliated company	$        348,123	$          427,543
   Liabilities related to transfer of ownership	40,421	40,634
   	$        388,544	$          468,177

   A