(A Development Stage Company)

Consolidated Balance Sheets

(Unaudited)

Energy Quest Inc.

(A Development Stage Company)

Consolidated Statements of Operations and Other Comprehensive Loss

(Unaudited)

Energy Quest Inc.

(A Development Stage Company)

Consolidated Statements of Cash Flows

(Unaudited)

Energy Quest Inc.

(A Development Stage company)

Notes to the Unaudited Consolidated Financial Statements

1.        Basis of Presentation

The accompanying unaudited interim consolidated financial statements of Energy Quest, Inc. (“Energy Quest” or the “Company”), have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Energy Quest’s Annual Report filed with the SEC on Form 10-K.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein.  The results of operations for interim periods are not necessarily indicative of the results to be expected for future quarters or for the full year.  Notes to the consolidated financial statements which substantially duplicate the disclosure contained in the audited consolidated financial statements for fiscal 2010 as reported in the Form 10-K have been omitted.

Reclassifications

Certain reclassifications have been made to the prior period’s financial statements to conform to the current period’s presentation.

2.        Going Concern

The Company has incurred losses from operations since December 14, 2004 (inception) to March 31, 2011, has a working capital deficiency and an accumulated deficit that creates substantial doubt about the Company’s ability to continue as a going concern.  These consolidated financial statements have been prepared on the assumption that the Company is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the ordinary course of operations.  The financial statements do not include any adjustments that might result from the outcome of this uncertainty.  The Company’s continuation as a going concern is dependent upon its ability to attain profitable operations and generate funds there-from, and/or raises equity capital or borrowings sufficient to meet current and future obligations.  Management plans to raise equity financings over the next twelve months to finance operations.  There is no guarantee that the Company will be able to complete any of these objectives.

3.        Recent Accounting Pronouncements

The Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations.

4.        Related Party Transactions

During the year ended December 31, 2010, the Company loaned a director $10,000 pursuant to a note receivable.  The Note earns interest at 6% per annum and was due on September 15, 2010 or upon demand by the Company.  This loan was in violation of applicable U.S. law prohibiting loans by public companies to their directors and executive officers. Thedirector was terminated and theoutstanding balance of the note and accrued interest $6,778 was charged to expense during the quarter ended as of March 31, 2011.  It is uncertain if fines will be imposed due the violation.  

The following details amounts due to related parties at March 31, 2011:

a)       During the three month period ended March 31, 2011, the Company recorded $37,500 (2010 - $37,500) for management services provided by the President of the Company.  At March 31, 2011, $513,720 (December 31, 2010 - $478,231) is included in due to related parties.

b)       During the three month period ended March 31, 2011, the Company recorded $37,500 (2010 - $37,500) for management services provided by the Secretary of the Company.  At March 31, 2011, $270,174 (December 31, 2010 - $227,084) is included in due to related parties.

The following details Notes payable – related parties:

c)       On March 15, 2009, the Company borrowed $15,425 (CDN$ 15,000) from a related party consultant persuant to a promissory note payable.  The note bears interest at 6% per annum and is due on demand.  At March 31, 2011, this amount is included in notes payable – related party, and the related accrued interest of $1,892 (December 31, 2010 - $1,618) is included in amounts due to related parties.

d)       On November 5, 2007, the Company received $21,000 from a director in exchange for a promissory note payable.  The note bears interest at 6% per annum, calculated annually, and is due on demand.  At March 31, 2011, accrued interest of $4,287 (December 31, 2010 - $3,977) is included in amounts due to related parties.

e)       On April 14, 2010, the Company received $50,000 from the Secretary of the Company in exchange for a promissory note payable.  The note bears interest at 6% per annum and is due on March 31, 2011.  The Company has secured the note with 1,000,000 shares of common stock to be issued upon default.  At March 31, 2011, accrued interest of $2,885 (December 31, 2010 - $2,145) is included in amounts due to related parties.

Energy Quest Inc.

(A Development Stage company)

Notes to the Unaudited Consolidated Financial Statements

5.        Convertible Debt

a)       On January 29, 2010, the Company borrowed $50,000 from a private investor and issued a callable convertible note with an 8% interest rate, 22% interest rate upon default and a maturity of nine months.  The Company paid a finders’ fee of $2,500.  The note is convertible into common shares at 55% of the average of the lowest three closing prices for the Company’s common shares during the ten trading day period ending one trading day prior to the date the conversion notice is sent by the investor to the borrower.

The embedded conversion option contains a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  Due to this provision, the embedded conversion option qualifies for derivative accounting under ASC 815-15 (See Note 8 below).  This fair value of the derivative liability at issuance of $81,995 resulted in a full discount to the note payable and a loss on the fair value of derivatives of $31,995.  The carrying value of the convertible note was accreted over the term of the convertible note up to their value of $50,000.

During the three months ended March 31, 2011 the Company converted the remaining $4,000 principle balance and $2000 of accrued interest into 241,935 shares of common stock. As at March 31, 2011, the total balance of $50,000 plus $2,000 accrued interest (December 31, 2010 - $46,000), has been converted into 1,059,245 (December 31, 2010 – 817,310) common shares.

The following table summarizes the change in convertible debt as of March 31, 2011:

As of March 31, 2011, the Company recorded $50,000 as the accretion of interest expense on the convertible note and recorded the cost associated with obtaining the convertible note as deferred financing cost of $2,500 on February 8, 2010, the amount had been fully amortized as of December 31, 2010. 

b)       On November 24, 2010, the Company borrowed $50,000 from a private investor and issued a callable convertible note with an 8% interest rate, 22% interest rate upon default and a maturity of nine months.  The Company paid a finders’ fee of $3,000.  The note is convertible into common shares at 55% of the average of the lowest three closing prices for the Company’s common shares during the ten trading day period ending one trading day prior to the date the conversion notice is sent by the investor to the borrower.

The embedded conversion option contains a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  Due to this provision, the embedded conversion option qualifies for derivative accounting under ASC 815-15 (See Note 8 below).  This fair value of the derivative liability at issuance of $71,911 resulted in a full discount to the note payable and a loss on the fair value of derivatives of $21,911.  The carrying value of the convertible note is to be accreted over the term of the convertible note up to their value of $50,000.

As at March 31, 2011, the carrying values of the convertible note and accrued convertible interest payable thereon were $23,260, (December 31, 210 - $6,777), and $1,392, (December 31, 2010 - $406), respectively.

The following table summarizes the change in convertible debt as of March 31, 2011:

During the three month period ended March 31, 2011, the Company recorded $16,483 (December 31, 210 - $6,777) as the accretion of interest expense on the convertible note and recorded the cost associated with obtaining the convertible note as deferred financing cost of $3,000 on November 24, 2010.  During the three month period ended March 31, 2011, the Company recorded $989, (December 31, 2010 - $593) on amortization of deferred financing cost.

Energy Quest Inc.
(A Development Stage company)
Notes to the Unaudited Consolidated Financial Statements 

6.        Equity

During the three month period ended March 31, 2011, the Company issued 241,935 shares of common stock upon the partial conversion of the Note referred to in Note 5 (a).

7.        Fair Value Measurements

ASC 825 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  In determining fair value for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

Fair Value Hierarchy

ASC 825 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  ASC 825 establishes three levels of inputs that may be used to measure fair value.

Level 1 applies to assets and liabilities for which there are quoted prices in active markets for identical assets or liabilities.  Valuations are based on quoted prices that are readily and regularly available in an active market and do not entail a significant degree of judgment.

Level 2 applies to assets and liabilities for which there are other than Level 1 observable inputs such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.  Level 2 instruments require more management judgment and subjectivity as compared to Level 1 instruments.  For instance: determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced; and determining whether a market is considered active requires management judgment.

Level 3 applies to assets and liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.  The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity.

Pursuant to ASC 825, the fair value of the cash equivalent is determined based on “Level 1” inputs, which consists of quoted prices in active markets for identical assets.  Convertible notes payable are valued based on “Level 2” inputs, consisting of quoted prices in less active markets.  The Company believes that the recorded values of all of the other financial instruments approximate their current fair values because of their nature and respective relatively short maturity dates or durations.

Assets and liabilities measured at fair value on a recurring basis were presented on the Company’s balance sheet as at March 31, 2011 as follows:

The fair values of other financial instruments, which include amounts receivable, accounts payable, and accrued liabilities approximate their carrying values due to the relatively short-term maturity of these instruments.

Energy Quest Inc.
(A Development Stage company)
Notes to the Unaudited Consolidated Financial Statements

8.        Derivative Liability

ASC 815-15 lays out a procedure to determine if an equity-linked financial instrument (or embedded feature) is indexed to its own common stock.

Convertible Debt - The embedded conversion option in the Company’s two $50,000 notes described in Note 5 contain a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  The fair value of these liabilities will be re-measured at the end of every reporting period and the change in fair value will be reported in our consolidated statement of operations as a gain or loss on derivative financial instruments.

The following table summarizes the change in derivative liabilities as of March 31, 2011:

The following table summarizes the cummulative loss on derivatives as of March 31, 2011:

Safe Harbor Statement

This report on Form 10-Q contains certain forward-looking statements.  All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenues, or other financial items; any statements of the plans, strategies, and objectives of management for future operation; any statements concerning proposed new products, services, or developments; any statements regarding future economic conditions or performance; statements of belief; and any statement of assumptions underlying any of the foregoing. Such forward-looking statements are subject to inherent risks and uncertainties, and actual results could differ materially from those anticipated by the forward-looking statements.

These forward-looking statements involve significant risks and uncertainties, including, but not limited to, the following: competition, promotional costs, and risk of declining revenues.  Our actual results could differ materially from those anticipated in such forward-looking statements as a result of a number of factors.  These forward-looking statements are made as of the date of this filing, and we assume no obligation to update such forward-looking statements.  The following discusses our financial condition and results of operations based upon our consolidated financial statements which have been prepared in conformity with accounting principles generally accepted in the United States.  It should be read in conjunction with our financial statements and the notes thereto included elsewhere herein.

The following discussion should be read in conjunction with our consolidated financial statements, including the notes thereto, appearing elsewhere in this Form 10-Q.  The discussions of results, causes and trends should not be construed to imply any conclusion that these results or trends will necessarily continue into the future.

Overview

We are engaged in the development and production of hydrogen-enriched alternative fuels.  We plan to employ gasification technologies and catalytic conversion processes to produce clean fuels.  We design, build, lease and in some cases operate the gasification technologies with broad potential application within the energy field.  Our various technologies allow for the use of steam for reformation of coal and other carbonaceous feedstocks, conversion of waste solid fuel sources into gaseous form and allow for incineration of waste in an environmentally friendly manner.

We have one wholly-owned subsidiary, Syngas Energy Corp., and its principal business involves an integrated gasification production system technology that combines modern gasification with turbine technologies to produce synthetic gas, hydrogen or electricity.

On May 31, 2010, we entered into a Joint Venture Agreement with ZAO Transmashholding, a company registered in Moscow, Russia.  The business purpose of the Joint Venture is to use the knowledge, connections and efforts of both parties to enhance their financial capacities in order to achieve their common business goals.  Transmashholding has set up a bank account with $102,368,000 (Rub 3,200,000,000) to act as collateral for the Joint Venture to acquire lines of credit for financing its business projects.  We are solely responsible for acquiring the lines of credit against the provided collateral, and will assume the main responsibility of finding and arranging investment opportunities for the Joint Venture.  All revenues generated by the Joint Venture will be divided equally between both parties.  Each party will be responsible for their own costs and neither party shall be liable for mistakes made by the other.

Liquidity and Capital Resources

As of March 31, 2011, we had cash of $1,211 and a working capital deficiency of $940,878.  As of March 31, 2011 our accumulated deficit was $10,008,767.  For the three months ended March 31, 2011 our net loss was $111,143 compared to $136,755 during the same period in 2010.

Our loss was funded by proceeds from shareholder loans.  During the three months ended March 31, 2011, we raised in net proceeds $nil through financing activities and our cash position decreased by $7,035. 

We used net cash of $9,458 in operating activities for the three months ended March 31, 2011 compared to net cash of $48,139 in operating activities for the same period in 2010.  We did not use any money in investing activities for the three months ended March 31, 2011 nor did we use any money for investing activities during the same period in 2010.  The effect of exchange rates on cash was an increase in cash of $nil for the three months ended March 31, 2011 compared to an increase of $4 during three months ended March 31, 2010.

During the three months ended March 31, 2011 our monthly cash requirement was approximately $3,153, compared to approximately $16,046 for the same period in 2010.  We expect to require a total of approximately $26,585,000 to fully carry out our business plan over the next twelve months beginning June 2011 as set out in this table: 

We intend to meet our cash requirements for the next 12 months through external sources: a combination of debt financing and equity financing through private placements.  We are currently not in good short-term financial standing.

We anticipate that we may not generate any revenues in the near future and we will not have enough positive internal operating cash flow until we can generate substantial revenues, which may take the next few years to fully realize.  There is no assurance we will achieve profitable operations.  We have historically financed our operations primarily by cash flows generated from the sale of our equity securities and through cash infusions from officers and outside investors in exchange for debt and/or common stock.

These consolidated financial statements have been prepared on the assumption that the company is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the ordinary course of operations.  Different bases of measurement may be appropriate when a company is not expected to continue operations for the foreseeable future.  The company’s continuation as a going concern is dependent upon its ability to attain profitable operations and generate funds there-from, and/or raises equity capital or borrowings sufficient to meet current and future obligations.  Management plans to raise equity financings over the next twelve months to finance operations.  There is no guarantee that the company will be able to complete any of these objectives.  The company has incurred losses from operations since inception and at March 31, 2011, have a working capital deficiency and an accumulated deficit that creates substantial doubt about the company’s ability to continue as a going concern.

We intend to raise the funds to meet our cash requirements (approximately $26,585,000) from private placements, loans, or possibly a registered public offering (either self-underwritten or through a broker-dealer) within the next few months.

At this time we do not have any commitments from any broker-dealer to provide us with financing.  There is no guarantee that we will be successful in raising any capital.  There is no assurance that we will be able to obtain such additional funds on favorable terms, if at all.  If we fail in raising capital, our business may fail and we may curtail or cease our operations.   

Results of Operations for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 and from inception to March 31, 2011.

Limited Revenues

Net Loss

We incurred a net loss of $111,143 for the three months ended March 31, 2011, compared to a net loss of $136,755 for the same period in 2010.  From inception on December 14, 2004 to March 31, 2011, we have incurred a net loss of $10,008,767.  Our basic and diluted loss per share was $0.01 for the three months ended March 31, 2011, and $0.01 for the same period in 2010.  

Expenses

Our total operating expenses decreased from $130,648 to $95,230 for the three months ended March 31, 2011 compared to the same period in 2010.  This decrease in expenses is mostly due to lower consulting and management fees.  Since our inception on December 14, 2004 to March 31, 2011, we have incurred total operating expenses of $9,925,632.

Our consulting and management fees did not increase or decreased $75,000 for the three months ended March 31, 2011 compared to the same period in 2010.  Since our inception on December 14, 2004 until March 31, 2011 we have spent $5,516,394 on consulting and management fees.

Our general and administrative expenses consist of bank charges, travel, meals and entertainment, office maintenance, communication expenses (internet, fax, and telephone), courier, postage costs, office supplies.  Our general and administrative expenses increased $8,967 from $6,263 to $15,230 for the three months ended March 31, 2011 compared to the same period in 2010.  Since our inception on December 14, 2004 until March 31, 2010 we have spent $538,730 on general and administrative expenses.

We spent $nil on research and development expenses for the three months ended March 31, 2011 compared to $1,500 spent on research and development during the three months ended March 31, 2010.  Since our inception on December 14, 2004 until March 31, 2011 we have spent $266,494 on research and development.  Going forward, we anticipate that we will spend approximately $1,600,000 on research and development during the next 12 months. 

Inflation

Off-Balance Sheet Arrangements

As of March 31, 2011, we had no off-balance sheet transactions that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Recent Accounting Pronouncements 

In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-06, Improving Disclosures about Fair Value Measurements (ASU 2010-06).  This update provides amendments to Subtopic 820-10 and requires new disclosures for 1) significant transfers in and out of Level 1 and Level 2 and the reasons for such transfers and 2) activity in Level 3 fair value measurements to show separate information about purchases, sales, issuances and settlements.  In addition, this update amends Subtopic 820-10 to clarify existing disclosures around the disaggregation level of fair value measurements and disclosures for the valuation techniques and inputs utilized (for Level 2 and Level 3 fair value measurements).  The provisions in ASU 2010-06 are applicable to interim and annual reporting periods beginning subsequent to December 15, 2009, with the exception of Level 3 disclosures of purchases, sales, issuances and settlements, which will be required in reporting periods beginning after December 15, 2010.  The adoption of ASU 2010-06 did not impact the Company’s operating results, financial position or cash flows, but did impact the Company’s disclosures on fair value measurements.  See Note 6, “Fair Value Measurements.”

In February 2010, FASB issued ASU No. 2010-09, Amendments to Certain Recognition and Disclosure Requirements (ASU 2010-09).  This update amends Subtopic 855-10 and gives a definition to SEC filer, and requires SEC filers to assess for subsequent events through the issuance date of the financial statements.  This amendment states that an SEC filer is not required to disclose the date through which subsequent events have been evaluated for a reporting period.  ASU 2010-09 becomes effective upon issuance of the final update.  The Company adopted the provisions of ASU 2010-09 for the period ended March 31, 2010.

In April 2010, the FASB issued ASU No. 2010-12, Accounting for Certain Tax Effects of the 2010 Health Care Reform Acts (ASU 2010-12).  This update clarifies questions surrounding the accounting implications of the different signing dates of the Health Care and Education Reconciliation Act (signed March 30, 2010) and the Patient Protection and Affordable Care Act (signed March 23, 2010).  ASU 2010-12 states that the FASB and the Office of the Chief Accountant at the SEC would not be opposed to view the two Acts together for accounting purposes.  The Company is currently assessing the impact, if any, the adoption of ASU 2010-12 will have on the Company’s disclosures, operating results, financial position and cash flows.

Related Party Transactions 

During the three month period ended March 31, 2011, we recorded $37,500 (2010 - $37,500) for management services provided by our President.  

During the three month period ended March 31, 2011, we recorded $37,500 (2010 - $37,500) for management services provided by our Secretary.

ITEM 4.  Control and Procedures

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures have been designed to ensure that information required to be disclosed by the Company is collected and communicated to management to allow timely decisions regarding required disclosures.  The Chief Executive Officer and the Chief Financial Officer have concluded, based on their evaluation as of March 31, 2011 that, as a result of the following material weaknesses in internal control over financial reporting as described further in our Annual Report on Form 10-K filed with the SEC on March 30, 2011, disclosure controls and procedures were ineffective in providing reasonable assurance that material information is made known to them by others within the Company:

a)    We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of generally accepted accounting principles commensurate with our complexity and our financial accounting and reporting requirements.  We have limited experience in the areas of financial reporting and disclosure controls and procedures.  Also, we do not have an independent audit committee.  As a result, there is a lack of monitoring of the financial reporting process and there is a reasonable possibility that material misstatements of the consolidated financial statements, including disclosures, will not be prevented or detected on a timely basis; and

b)    Due to our small size, we do not have a proper segregation of duties in certain areas of our financial reporting process.  The areas where we have a lack of segregation of duties include cash receipts and disbursements, approval of purchases and approval of accounts payable invoices for payment.  This control deficiency, which is pervasive in nature, results in a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis.

Changes in Internal Control Over Financial Reporting 

There were no changes in our internal control over financial reporting during the fiscal quarter ended March 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Limitations On The Effectiveness Of Internal Controls

Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all fraud and material error.  An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of the control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the internal control.  The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, control may become inadequate because of changes in conditions, and/or the degree of compliance with the policies or procedures may deteriorate.

ITEM 1.  Legal Proceedings.

ITEM 2.  Unregistered Sales of Equity Securities.

On January 18, 2011, we issued 241,935 shares of common stock upon the full conversion of convertible note.

ITEM 3.  Defaults Upon Senior Securities.

ITEM 4.  Submission of Matters to a Vote of Security Holders.

ITEM 5.  Other Information.

None.

ITEM 6.  Exhibits.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized.