**Exhibit 99.2**

 

MANAGEMENT’SREPORT TO THE SHAREHOLDERS

 

Thepreparation of the accompanying consolidated financial statements in accordancewith accounting principles generally accepted in Canada with a reconciliationto generally accepted accounting principles in the United States is theresponsibility of management.  Financialinformation contained elsewhere in this Annual Report is consistent with thatin the consolidated financial statements.

 

Managementis responsible for the integrity and objectivity of the financialstatements.  Where necessary, thefinancial statements include estimates, which are based on management’sinformed judgments.  Management hasestablished systems of internal controls, which are designed to providereasonable assurance that transactions are authorized, assets are safeguardedand financial records are properly maintained to provide reliable informationfor the preparation of financial information.

 

TheBoard of Directors is responsible for ensuring that management fulfills itsresponsibilities for financial reporting and internal control.  It exercises its responsibilities primarilythrough the Audit Committee, whose members are non-management directors.  The Audit Committee has reviewed theconsolidated financial statements with management and the auditors and hasreported to the Board of Directors who have approved the consolidated financialstatements.

 

MEYERSNORRIS PENNY LLP are independent auditors appointed by Canadian Superior EnergyInc.’s shareholders. The auditors have audited the consolidated financialstatements in accordance with Canadian generally accepted auditing standardsand the standards established by the Public Company Accounting and OversightBoard (PCAOB) to enable them to express an opinion on the fairness of thepresentation of the financial statements in accordance with Canadian generallyaccepted accounting principles.

 

 
| *(Signed)  “Craig McKenzie”* |   |   |
|----------------------------------------|--------|--------|
| Chief  Executive Officer               |   |   |
|                                   |   |   |
| Calgary,  Canada                       |   |   |
| March 27,  2008                   |   |   |

 

1

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AUDITORS’REPORT TO SHAREHOLDERS

 

Wehave audited the consolidated balance sheets of Canadian Superior Energy Inc.as at December 31, 2007 and 2006 and the consolidated statements ofoperations, comprehensive loss and deficit and cash flows for each of the yearsin the three year period ended December 31, 2007.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

Weconducted our audits in accordance with Canadian generally accepted auditingstandards and the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform an audit to obtain reasonable assurance whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.

 

Inour opinion, these financial statements present fairly, in all materialrespects, the financial position of the Company as at December 31, 2007and 2006, and the results of its operations and its cash flows for each of theyears in the three year period ended December 31, 2007 in accordance withCanadian generally accepted accounting principles.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2007, basedon the criteria established by Internal Control – Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO),and our report as at March 27, 2008 expressed an adverse opinion on theeffectiveness of the Company’s internal control over financial reporting.

 

 
| *(Signed)  “Meyers Norris Penny LLP”* | * * | * * |
|-------------------------------------------------|----------|----------|
| * *                                        | * * | * * |
| Independent  Registered Public Accounting Firm  | * * | * * |
| * *                                        | * * |     |
| March 27,  2008                            |     |     |
| Calgary,  Canada                                |     |     |

 

2

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REPORTOF INDEPENDENT REGISTERED ACCOUNTING FIRM

 

Tothe Board of Directors and Shareholders of Canadian Superior Energy Inc.:

 

Wehave audited Canadian Superior Energy Inc.’s (the “Company”) internal controlover financial reporting as of December 31, 2007, based on criteriaestablished in Internal Control – Integrated Framework issued by the Committeeof Sponsoring Organizations of the Treadway Commission (COSO).  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting,included in the accompanying management’s report on internal control overfinancial reporting. Our responsibility is to express an opinion on the Company’sinternal control over financial reporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal control over financialreporting was maintained in all material respects.  Our audit included obtaining an understandingof internal control over financial reporting, assessing the risk that amaterial weakness exists, and testing and evaluating the design and operatingeffectiveness of internal control based on the assessed risk. Our auditincludes performing such other procedures as we considered necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinion.

 

Acompany’s internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles. A company’s internal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements.  Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

 

Amaterial weakness is a deficiency or a combination of deficiencies in internalcontrol over financial reporting, such that there is a reasonable possibilitythat a material misstatement of the annual or interim financial statements willnot be prevented or detected on a timely basis. The following material weaknesses have been identified and are includedin management’s assessment:

 

·      There are no effective controls or procedures related to allsignificant accounts and processes to provide reasonable assurance thattransactions are recorded accurately, are recorded timely and are complete.

 

·      The Company was not adequately staffed with accountingpersonnel possessing an adequate level of technical expertise and did notmaintain effective segregation of duties over automated and manual transactionsleading to ineffective monitoring, supervision and reviews.

 

·      The Company did not maintain effective controls over thesafeguarding of monetary assets.  Thismaterial weakness affects cash and short-term investments.

 

3

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Inour opinion, because of the effect of the material weaknesses described aboveon the achievement of the objectives of the control criteria, the Company hasnot maintained effective internal control over financial reporting as of December 31,2007, based on criteria established in Internal Control – Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

Wehave also audited, in accordance with Canadian generally accepted auditingstandards and the standards of the Public Company Accounting Oversight Board (UnitedStates), the consolidated balance sheets as at December 31, 2007 and 2006 andthe statements of operations, comprehensive loss and deficit and cash flows foreach of the years in the three year period ended December 31, 2007, of theCompany and our report dated March 27, 2008 expressed an unqualifiedopinion. The aforementioned material weaknesses were considered in determiningthe nature, timing, and extent of audit tests applied in our audit of the 2007consolidated financial statements, and this report does not affect our opinionon those consolidated financial statements.

 

Yourstruly,

 
| *(Signed)  “Meyers Norris Penny LLP”* |   |   |
|-------------------------------------------------|--------|--------|
| Independent  Registered Public Accounting Firm  |   |   |
|                                            |   |   |
| Calgary,  Canada                                |   |   |
|                                            |   |   |
| March 27,  2008                            |   |   |

 

4

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**CANADIANSUPERIOR ENERGY INC.**

**CONSOLIDATEDBALANCE SHEETS**

Asat December 31

 
| **($ thousands)**                          | ** ** | **2007**    | ** ** | **2006**   | ** ** |
|-------------------------------------------------|------------|-------------|------------|------------|------------|
| ** **                                      | ** ** | ** **  | ** ** | ** ** | ** ** |
| **Assets*(note 7)***                            | ** ** | ** **  | ** ** | ** ** | ** ** |
| Current                                         | ** ** | ** **  | ** ** | ** ** | ** ** |
| Cash and short-term investments                 | ** ** | **13,658**  |       | 7,338      |       |
| Accounts receivable                             | ** ** | **36,448**  |       | 17,114     |       |
| Prepaid expenses and deposits                   | ** ** | **2,571**   |       | 785        |       |
| ** **                                      |       | **52,677**  |       | 25,237     |       |
| Nova Scotia offshore term deposits *(note 4)*   | ** ** | **14,559**  |       | 14,805     |       |
| Long term portion of lease prepayment *(note*5) | ** ** | **1,309**   |       | —     |       |
| Property, plant and equipment, net *(note 6)*   | ** ** | **186,154** |       | 185,426    |       |
| ** **                                      |       | **254,699** |       | 225,468    |       |
|                                            |       |        |       |       |       |
| **Liabilities**                                 |       |        |       |       |       |
| Current                                         |       |        |       |       |       |
| Accounts payable and accrued liabilities        | ** ** | **22,230**  |       | 17,997     |       |
| Revolving credit facility *(note 7)*            | ** ** | **17,784**  |       | 7,910      |       |
| ** **                                      |       | **40,014**  |       | 25,907     |       |
| Convertible preferred shares *(note 8)*         | ** ** | **13,571**  |       | 15,472     |       |
| Asset retirement obligations *(note 9)*         | ** ** | **11,325**  |       | 9,482      |       |
| Future income taxes *(note 10)*                 | ** ** | **8,853**   |       | 10,958     |       |
| ** **                                      |       | **73,763**  |       | 61,819     |       |
| Contingencies and commitments *(note 15)*       |       |        |       |       |       |
| Subsequent event *(note 18)*                    |       |        |       |       |       |
|                                            |       |        |       |       |       |
| **Shareholders’ Equity**                   |       |        |       |       |       |
| Share capital *(note 11)*                       | ** ** | **186,557** |       | 162,276    |       |
| Equity portion of preferred shares *(note 11)*  | ** ** | **2,320**   |       | 2,320      |       |
| Contributed surplus *(note 11)*                 | ** ** | **14,314**  |       | 11,372     |       |
| Deficit                                         | ** ** | **(22,255** | )          | (12,319    | )          |
| ** **                                      |       | **180,936** |       | 163,649    |       |
| ** **                                      |       | **254,699** |       | 225,468    |       |

 

*Seeaccompanying notes to the consolidated financial statements*

 

On behalf of the Board,

 
| (Signed) Craig McKenzie | (Signed) Alex Squires |
|-------------------------|-----------------------|
| *Director*              | *Director*            |

 

5

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**CANADIAN SUPERIOR ENERGY INC.**

**CONSOLIDATED STATEMENT OFOPERATIONS, COMPREHENSIVE LOSS AND DEFICIT**

Forthe years ended December 31

** **
| **($ thousands, except per share amounts)** | ** ** | **2007**    | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|----------------------------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|
| * *                                                             | * *   | * *    | * *   | * *   | * *   | * *   | * *   |
| **Revenue**                                                          | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Petroleum and natural gas sales                                      | ** ** | **48,492**  | ** ** | 49,428     |       | 55,223     |       |
| Transportation                                                       | ** ** | **(645**    | **)**      | (662       | )          | (678       | )          |
| Royalties net of royalty tax credit                                  | ** ** | **(7,914**  | **)**      | (8,245     | )          | (9,716     | )          |
| ** **                                                           |       | **39,933**  | ** ** | 40,521     |       | 44,829     |       |
| Interest and other income (expense)                                  | ** ** | **925**     | ** ** | 1,371      |       | (674       | )          |
| ** **                                                           |       | **40,858**  | ** ** | 41,892     |       | 44,155     |       |
|                                                                 |       |        | ** ** |       |       |       |       |
| **Expenses**                                                         |       |        | ** ** |       |       |       |       |
| Operating                                                            | ** ** | **9,883**   | ** ** | 9,042      |       | 7,239      |       |
| General and administrative                                           | ** ** | **13,315**  | ** ** | 9,312      |       | 5,398      |       |
| Stock based compensation*(note 11)*                                  | ** ** | **4,218**   | ** ** | 5,891      |       | 3,657      |       |
| Depletion, depreciation and accretion                                | ** ** | **26,595**  | ** ** | 25,686     |       | 23,539     |       |
| Interest                                                             | ** ** | **3,352**   | ** ** | 2,047      |       | 1,015      |       |
| Foreign exchange (gain) loss                                         | ** ** | **(653**    | **)**      | 312        |       | 41         |       |
| Loss on investment                                                   | ** ** | **—**  | ** ** | 600        |       | —     |       |
| Loss on abandonment*(note 9)*                                        | ** ** | **42**      | ** ** | —     |       | —     |       |
| ** **                                                           |       | **56,752**  | ** ** | 52,890     |       | 40,889     |       |
| **Income (loss) before income taxes**                                | ** ** | **(15,894** | **)**      | (10,998    | )          | 3,266      |       |
| **Income taxes (reduction)**                                         |       |        | ** ** |       |       |       |       |
| Capital                                                              | ** ** | **55**      | ** ** | 33         |       | 129        |       |
| Future income tax (reduction)                                        | ** ** | **(6,013**  | **)**      | (118       | )          | 81         |       |
| ** **                                                           |       | **(5,958**  | **)**      | (85        | )          | 210        |       |
| **Net income (loss) and comprehensive income  (loss)**               | ** ** | **(9,936**  | **)**      | (10,913    | )          | 3,056      |       |
| Deficit, beginning of year                                           | ** ** | **(12,319** | **)**      | (1,406     | )          | (4,462     | )          |
| **Deficit, end of year**                                             | ** ** | **(22,255** | **)**      | (12,319    | )          | (1,406     | )          |
| Basic and diluted income (loss) per share *(note 11)*                | ** ** | **$**       | **(0.07**  | **)**      | $          | (0.09      | )          | $ | 0.03 |   |
|                                                                      |            |             |            |            |            |            |            |  |  |  |

 

*Seeaccompanying notes to the consolidated financial statements*

 

6

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**CANADIAN SUPERIOR ENERGY INC.**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

Forthe years ended December 31

** **
| **($ thousands)**                                      | ** ** | **2007**    | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|-------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| * *                                                    | * *   | * *    | * *   | * *    | * *   | * *    | * *   |
| **Cash provided by (used in):**                             |       |        |       |        |       |        |       |
|                                                        |       |        |       |        |       |        |       |
| **Operating**                                               |       |        |       |        |       |        |       |
| Net Income (loss)                                           | ** ** | **(9,936**  | **)**      | **(10,913** | **)**      | **3,056**   | ** ** |
| Items not involving cash:                                   | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Depletion, depreciation and accretion                       | ** ** | **26,595**  | ** ** | **25,686**  | ** ** | **23,539**  | ** ** |
| Stock based compensation                                    | ** ** | **4,218**   | ** ** | **5,891**   | ** ** | **3,657**   | ** ** |
| Share dividends paid on preferred shares                    | ** ** | **711**     | ** ** | **641**     | ** ** | **—**  | ** ** |
| Accretion expense on preferred shares                       | ** ** | **442**     | ** ** | **357**     | ** ** | **—**  | ** ** |
| Forfeiture of Nova Scotia offshore term deposits            | ** ** | **500**     | ** ** | **558**     | ** ** | **—**  | ** ** |
| Loss on investment                                          | ** ** | **—**  | ** ** | **600**     | ** ** | **—**  | ** ** |
| Future income tax (reduction)                               | ** ** | **(6,013**  | **)**      | **(118**    | **)**      | **81**      | ** ** |
| Loss on abandonment*(note 9)*                               | ** ** | **42**      |       | —      |       | —      |       |
| Change in the carrying cost of preferred shares             | ** ** | **(2,343**  | **)**      | **381**     | ** ** | **—**  | ** ** |
| Asset retirement expenditures*(note 9)*                     | ** ** | **(361**    | **)**      | **—**  | ** ** | **—**  | ** ** |
| ** **                                                  | ** ** | **13,855**  | ** ** | **23,083**  | ** ** | **30,333**  | ** ** |
| Changes in non-cash working capital*(note 12)*              | ** ** | **(4,993**  | **)**      | **(8,453**  | **)**      | **11**      | ** ** |
| ** **                                                  | ** ** | **8,862**   | ** ** | **14,630**  | ** ** | **30,344**  | ** ** |
| ** **                                                  | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| **Financing**                                               | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Issue of shares                                             | ** ** | **26,200**  | ** ** | **26,968**  | ** ** | **20,316**  | ** ** |
| Issue of Nova Scotia offshore term deposits                 | ** ** | **(254**    | **)**      | **(963**    | **)**      | **(252**    | **)**      |
| Cash dividends paid on preferred shares                     | ** ** | **(187**    | **)**      | **—**  | ** ** | **—**  | ** ** |
| Convertible preferred share issue                           | ** ** | **—**  | ** ** | **17,455**  | ** ** | **—**  | ** ** |
| Revolving credit facility (repayments) advances             | ** ** | **9,874**   | ** ** | **(4,941**  | **)**      | **2,101**   | ** ** |
| Changes in non-cash working capital*(note 12)*              | ** ** | **238**     | ** ** | **—**  | ** ** | **—**  | ** ** |
| ** **                                                  | ** ** | **35,871**  | ** ** | **38,519**  | ** ** | **22,165**  | ** ** |
| ** **                                                  | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| **Investing**                                               | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** |
| Exploration and development expenditures                    | ** ** | **(66,282** | **)**      | **(59,548** | **)**      | **(44,083** | **)**      |
| Exploration and development divestitures                    | ** ** | **41,310**  | ** ** | **—**  | ** ** | **—**  | ** ** |
| Purchase of investments                                     | ** ** | **—**  | ** ** | **(3,106**  | **)**      | **—**  | ** ** |
| Disposal of investments                                     | ** ** | **—**  | ** ** | **2,506**   | ** ** | **—**  | ** ** |
| Change in non-cash working capital*(note 12)*               | ** ** | **(13,441** | **)**      | **2,539**   | ** ** | **1,647**   | ** ** |
| ** **                                                  | ** ** | **(38,413** | **)**      | **(57,609** | **)**      | **(42,436** | **)**      |
| **Increase (decrease) in cash and short-term  investments** | ** ** | **6,320**   | ** ** | **(4,460**  | **)**      | **10,073**  | ** ** |
| Cash and short-term investments, beginning of year          | ** ** | **7,338**   | ** ** | **11,798**  | ** ** | **1,725**   | ** ** |
| **Cash and short-term investments, end of year**            | ** ** | **13,658**  | ** ** | **7,338**   | ** ** | **11,798**  | ** ** |

 

*Seeaccompanying notes to the consolidated financial statements*

 

7

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**NOTESTO THE CONSOLIDATED FINANCIAL STATEMENTS**

December 31,2007 and 2006

*(alltabular amounts in $ thousands, except where otherwise noted)*

 

**1.     Nature of operations**

 

CanadianSuperior Energy Inc. (“Canadian Superior” or the “Company”) is engaged in theexploration for, and acquisition, development and production of petroleum andnatural gas primarily in Western Canada and offshore Nova Scotia, Canada andTrinidad and Tobago.

 

**2.     Summary of accounting policies**

 

Theseconsolidated financial statements are stated in Canadian dollars and have beenprepared in accordance with Canadian Generally Accepted Accounting Principles (“GAAP”).Certain comparative amounts have been reclassified to conform to current periodpresentation.

 

(a)   Principles of consolidation

 

Theconsolidated financial statements include the accounts of CanadianSuperior and its wholly owned subsidiary companies.  All material intercompany accounts andtransactions have been eliminated.

 

(b)   Cash and short-terminvestments

 

Cash and short-term investments consistof balances with banks and investments in highly liquid short-term depositswith a maturity date of less than ninety days.

 

(c)   Measurement uncertainty

 

Managementmakes estimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe consolidated financial statements, and revenues and expenses during thereporting period.  Such estimatesprimarily relate to unsettled transactions and events as of the date of theconsolidated financial statements. Accordingly, actual results may differ from these estimates.

 

Amountsrecorded for depreciation, depletion and accretion, asset retirement costs andobligations and amounts used for ceiling test and impairment calculations arebased on estimates of natural gas and crude oil reserves and the future costsrequired to develop those reserves.  By their nature, these estimates are subject tomeasurement uncertainty and the impact on the consolidated financial statementsof changes in such estimates in future periods could be material.

 

Inherent in the fair value calculation of assetretirement obligations are numerous assumptions and judgments, including theultimate settlement amounts, inflation factors, credit adjusted discount rates,timing of settlement and changes in the legal and regulatory environments.  To the extent future revisions to theseassumptions impact the fair value of the existing asset retirement obligationliability, a corresponding adjustment is made to the property, plant andequipment balance.

 

(d)   Property, plant and equipment

 

(i)            Capitalizedcosts

 

The Companyis engaged in the acquisition, exploration, development and production of oiland gas in Canada and Trinidad and Tobago. The Company follows the full-costmethod of accounting for oil and gas operations whereby all costs relating tothe acquisition of, exploration for and development of oil and gas reserves arecapitalized.  Such costs include landacquisition costs, geological and geophysical expenses, carrying charges onnon-producing properties, costs of drilling both productive and nonproductivewells, costs of production equipment and overhead charges related toacquisition, exploration and development activities.

 

Proceedsreceived from disposals of properties and equipment are credited againstcapitalized costs unless the disposal would alter the rate of depletion anddepreciation by more than 20%, in which case a gain or loss on disposal isrecorded.

 

8

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(ii)           Depletionand depreciation

 

Depreciationand depletion of producing oil and gas properties is recorded based on units ofproduction.  Unit rates are computed forunamortized exploration drilling and development costs using proved developedreserves and for unamortized leasehold costs using all proved reserves.  Proved reserves are estimated by independentengineers and are subject to future revisions based on availability ofadditional information.  Asset retirementcosts are amortized over proved reserves using the unit-of-productionmethod.  Gains and losses on assetdisposals or retirements are included in income as a separate component ofrevenue.

 

Costsof acquiring and evaluating unproved properties are initially excluded fromdepletion calculations.  Theseunevaluated properties are assessed periodically to ascertain whetherimpairment has occurred.  When provedreserves are assigned or the property is considered to be impaired, the cost ofthe property or the amount of the impairment is added to costs subject todepletion calculations.

 

Corporate assets are depreciated on a declining balancebasis over its estimated useful life at rates varying from 20% to 100%.

 

(iii)          Ceilingtest

 

The Companyperforms a ceiling test in a two-stage test performed quarterly.  Impairment is recognized if the carryingvalue of the oil and gas assets less accumulated depletion and the lesser ofcost and fair value of unproven properties exceeds the estimated future cashflows from proved oil and gas reserves, on an undiscounted basis, usingforecast prices and costs.  If impairmentis recognized, the Company will measure the amount of the impairment bycomparing the carrying value of the oil and gas assets less accumulateddepletion and the lesser of cost and fair value of unproven properties to theestimated future cash flows from the proved and probable oil and gas reserves,discounted at the Company’s credit adjusted risk-free rate of interest, usingforecast prices and costs.  Anyimpairment is included in the statement of operations for the respective year.

 

(e)       Joint ventures

 

The Company’sexploration and development activities related to oil and gas are conductedjointly with others, which may include related parties (Note 13). The accountsreflect only the Company’s proportionate interest in such activities.

 

(f)            Income taxes

 

The Company follows the asset andliability method of accounting for future income taxes.  Under this method, future income tax assetsand liabilities are recorded based on temporary differences between thecarrying amount of balance sheet items and their corresponding tax bases.  In addition, the future benefits of incometax assets, including unused tax losses, are recognized, subject to a valuationallowance, to the extent that it is more likely than not that such futurebenefits will ultimately be realized. Future income tax assets and liabilities are measured using enacted taxrates and laws expected to apply when the tax liabilities or assets are to beeither settled or realized.

 

(g)      Revenue recognition

 

Revenue from the sale of oil and gas isrecognized based on volumes delivered to customers at contractual deliverypoints and rates.  The costs associatedwith the delivery, including operating and maintenance costs, transportation,and production-based royalty expenses are recognized in the same period inwhich the related revenue is earned and recorded.

 

9

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(h)      Flow-through shares

 

The Company, from time to time, issuesflow-through shares to finance a portion of its oil and gas explorationactivities.  The exploration anddevelopment expenditures funded by flow-through shares are renounced tosubscribers in accordance with the Income Tax Act (Canada).  The estimated value of the tax pools foregoneis reflected as a reduction in share capital with a corresponding increase inthe future income tax liability at the time the relevant expenditures arerenounced.

 

(i)    Basic and diluted per share amounts

 

Basic per share amounts are calculated by dividing netearnings or loss by the weighted average number of common shares outstandingduring the period.  The Company utilizesthe treasury stock method in the determination of diluted per share amounts.  Under this method, the diluted weightedaverage number of shares is calculated assuming that proceeds arising from theexercise of in-the-money options and other dilutive instruments are used topurchase, for cancellation, common shares of the Company at their averagemarket price for the period.

 

(j)          Foreigncurrency translation

 

Transaction amounts denominated inforeign currencies are translated into their Canadian dollar equivalents atexchange rates prevailing at the transaction dates. Carrying values of monetaryassets and liabilities reflect the exchange rates at the balance sheet date.Gains and losses on translation or settlement are included in determination ofnet income or loss for the current period.

 

(k)      Stock basedcompensation

 

Under the Company’s stock option plan described in note11, options to purchase common shares are granted to directors, officers,employees and consultants at current market prices or higher on the date ofgrant.  Stock-based compensation expenseis recorded in the statement of operations for all options granted with acorresponding increase recorded as contributed surplus.  Compensation expense is based on theestimated fair values of the options at the time of the grant as determinedusing a Black-Scholes option pricing model. The expense is recognized on a straight-line basis over the vestingperiod of the option.  Upon the exerciseof the stock options, consideration paid together with the amount previouslyrecognized in contributed surplus is recorded as an increase in sharecapital.  In the event that vestedoptions expire, previously recognized compensation expense associated with suchstock options is not reversed.  TheCompany incorporates an estimated forfeiture rate for stock options that willnot vest.

 

(l)          Asset retirement obligation

 

The Company recognizes the estimatedliability associated with an asset retirement obligation (“ARO”) in thefinancial statements at the time the asset is acquired and the liability isincurred. The estimated fair value of the ARO liability is recorded as a longterm liability, with a corresponding increase in the carrying amount ofpetroleum and natural gas properties. The capitalized amount is depleted on aunit-of-production method over the life of the proved reserves. The liabilityamount is increased each reporting period due to the passage of time and theamount of accretion is charged to earnings in the period. The ARO can alsoincrease or decrease due to changes in the estimates of timing of cash flows orchanges in the original estimated undiscounted cost. Actual costs incurred uponsettlement of the ARO are charged against the ARO to the extent of theliability recorded.

 

10

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(m)  Convertible preferred shares

 

The Company’s convertible debtinstruments are segregated into their debt and equity components at the date ofissue, based on the relative fair market values of these components inaccordance with the substance of the contractual agreements.  The debt component of the instruments isclassified as a liability, and recorded as the present value of the Company’sobligation to make future interest payments in cash, and settle the redemptionvalue of the instrument in cash or in a variable number of shares.  The carrying value of the debt component isaccreted to the original face value of the instruments, over their deemed life,using the effective interest method.  Theconversion option, which makes up the equity component of the instruments, isrecorded using the residual value approach. Upon conversion, any gain or loss arising from extinguishment of thedebt is recorded in income of the current period.

 

**3.****    ****Adoption ofnew accounting policies**

 

OnJanuary 1, 2007, Canadian Superior adopted the following new accountingstandards issued by the Canadian Institute of Chartered Accountants (“CICA”):Comprehensive Income (Section 1530), Financial Instruments – Recognitionand Measurement (Section 3855), Financial Instruments – Disclosure andPresentation (Section 3861) and Hedges (Section 3865).  In accordance with the new standards, changesare adopted retroactively without restatement of prior period information.  The other effects of the implementation ofthese new standards are discussed below.

 

a)     ComprehensiveIncome

 

Section 1530provides for a new Statement of Comprehensive Income and establishesAccumulated Other Comprehensive Income (“AOCI”) as a separate component ofshareholders’ equity.  The Statement ofComprehensive Income is defined as a change in net assets arising fromtransactions and other events from non-owner sources.  The statement would present net income andeach component recognized in other comprehensive income (“OCI”) when suchamounts exist.  For the year ended December 31,2007, the Company did not recognize any OCI. Any future OCI recognized by the Company will be recognized in AOCI.

 

b)             Financial Instruments – Recognition and Measurement

 

Section 3855requires all financial assets and liabilities, including derivatives, to becarried at fair value on the Company’s balance sheet with the exception ofloans and receivables, investments that are intended to be held to maturity andnon-trading financial liabilities which are carried at cost or amortized cost.

 

TheCompany has reviewed and classified its financial instruments as follows:

 
| · |   | Cash,  short-term investments and Nova Scotia offshore term deposits are classified  as financial assets held for trading and are measured at their fair value.  Gains or losses related to periodic revaluation are recorded to net income or  loss.                                               |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | Accounts  receivable are classified as loans and receivables and are initially measured  at their fair value. Subsequent periodic revaluations are recorded at their  amortized cost using the effective interest rate method.                                                                      |
| · |   | Accounts  payable, accrued liabilities, revolving credit facility and convertible  preferred shares are classified as other liabilities and are initially  measured at fair value. Subsequent periodic revaluations are recorded at  their amortized cost using the effective interest rate method. |

 

11

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c)     Derivatives andHedge Accounting

 

Derivativesmay be embedded in other financial instruments (the “host instruments”).  Prior to the adoption of the new standards,such embedded derivatives were not accounted for separately from the hostinstrument.  Under the new standard,embedded derivatives are treated as separate derivatives when their economiccharacteristics and risks are not clearly and closely related to those of thehost instrument, the terms of the embedded derivative are the same as those ofthe stand-alone derivative, and the combined contract is not held for tradingor designated at fair value.  A review ofthe Company’s financial contracts determined that there were no embeddedderivatives.  In the event that theCompany enters into a contract that contains an embedded derivative, theembedded derivative will be measured at fair value with subsequent changesrecognized in earnings or loss.

 

AtJanuary 1, 2007 no transitional adjustments were required to the openingbalance of retained earnings or to the opening balance of AOCI arising from theadoption of sections 1530, 3855, and 3865.

 

In addition, the Company hasassessed new and revised accounting pronouncements that have been issued thatare not yet effective and determined that the following may have a significantimpact on the Company:

 

As of January 1, 2008,the Company will be required to adopt the following two new CICA standards:Financial Instruments - Disclosures (Section 3862) and FinancialInstruments - Presentation (Section 3863), which will replace FinancialInstruments - Disclosure and Presentation (Section 3861).  The new disclosure standard increases theemphasis on the risks associated with both recognized and unrecognized financialinstruments and how those risks are managed. The new presentation standard carries forward former presentationrequirements.

 

As of January 1, 2008,the Company will be required to adopt CICA standards, Capital Disclosures (Section 1535),which will require companies to disclose their objectives, policies andprocesses for managing capital.  Inaddition, disclosures are to include whether companies have complied withexternally imposed capital requirements.

 

A strategic plan has beenadopted by the Accounting Standards Board for the future direction ofaccounting standards in Canada.  It isexpected that Canadian accounting standards for public companies will convergewith International Financial Reporting Standards (“IFRS”).  On December 31, 2008, the Company willbe required to provide a preliminary disclosure of policy impacts of uponadopting IFRS.  The Company is in theinitial stages of assessing IFRS and its impacts on the consolidated financialstatements.

 

**4.****             ****Nova Scotia offshore term deposits**

 

Under the terms of the licensesreferred to in Note 15, the Company has assigned term deposits totalling $14.6million (2006 - $14.8 million). Accordingly, this amount has been classified as a non-current asset.  To the extent that the expenditures are notincurred within the period allowed, the Company would forfeit its proportionateshare of any remaining deposits relating to the unexpended workcommitment.  During 2007 $0.5 million(2006 - $0.6 million) was forfeited and recorded to operating expenses.  The following table summarizes the workcommitment and work deposit which would be forfeited in proportion to theamount of work commitment not completed by the expiry date:

 
| **License** | ** ** | **Work Deposit ($)** | ** ** | **Remaining Commitment ($)** | ** ** | **Expiry Date**    | ** ** |
|-------------|------------|--------------------------------|------------|----------------------------------------|------------|-------------------------|------------|
| EL 2406     |       | 11,032,500                     |       | 40,962,046                             |       | December 31,  2008 |       |
| EL 2415     |       | 3,214,250                      |       | 12,857,000                             |       | December 31,  2008 |       |
| EL 2416     |       | 312,500                        |       | 1,250,000                              |       | December 31,  2008 |       |
| Total       |       | 14,559,250                     |       | 55,069,046                             |       |                    |       |

 

**5.****             ****Long term portion of lease prepayment**

 

In February 2007, the Company paid a lumppayment to acquire new office space with lease payments under the prevailinglease rates. This lump payment is being allocated over the life of the leasewith any portions more than a year in advance being classified as a long termasset. As at December 31, 2007 there are 39 months left on the lease with27 months classified as a long term asset.

 

12

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** **

**6.****             ****Property, plant and equipment, net**

 
| ** **           | ** ** | **2007**    | ** ** | **2006**                  | ** ** |
|----------------------|------------|-------------|------------|---------------------------|------------|
| **December 31** | ** ** | **Cost**    | ** ** | **Accumulated  DD&A** | ** ** | **Net  book value** | ** ** | **Cost** | ** ** | **Accumulated  DD&A** | ** ** | **Net  book value** | ** ** |
| Oil and Gas          |       |        |       |                      |       |   |   |   |   |   |   |   |   |
| Canada               | ** ** | **278,624** | ** ** | **117,491**               | ** ** | **161,133** |   | 245,963 |   | 91,831 |   | 154,132 |   |
| Trinidad             | ** ** | **24,836**  | ** ** | **—**                | ** ** | **24,836** |   | 31,132 |   | — |   | 31,132 |   |
| ** **           | ** ** | **303,460** | ** ** | **117,491**               | ** ** | **185,969** |   | 277,095 |   | 91,831 |   | 185,264 |   |
| Corporate assets     | ** ** | **883**     | ** ** | **698**                   | ** ** | **185** |   | 788 |   | 626 |   | 162 |   |
| Total PP&E       | ** ** | **304,343** | ** ** | **118,189**               | ** ** | **186,154** |   | 277,883 |   | 92,457 |   | 185,426 |   |

 

The calculation of 2007 depletion and depreciationincluded an estimated $8.7 million (2006 - $9.3 million) for future developmentcapital associated with proven undeveloped reserves and excluded $54.4 million(2006 - $67.0 million) related to unproved properties and projects underconstruction or development.  Of thecosts excluded $20.8 million (2006 - $22.7 million) relates to Western Canada,$8.8 million (2006 - $8.8 million) to East Coast Canada and $24.8 million (2006- $35.5 million) to Trinidad and Tobago.

 

The Company is in the process of negotiating therecovery of substantial Trinidad drilling costs relating to drilling problemson the Victory well on “Intrepid” Block 5(c) offshore Trinidad.

 

On August 11, 2007, Canadian Superior farmed outa portion of its interest in the “Intrepid” Block 5(c) Production SharingContract (“PSC”) offshore Trinidad and Tobago. The farmee paid US$38.7 million to the Company representing their shareof certain capital and administrative costs incurred by Canadian Superior.  This transaction has been recorded asreduction to Trinidad capital and general and administrative costs in 2007(Note 16).

 

During the year ended December 31, 2007, theCompany capitalized $2.8 million of general and administrative (“G&A”)expenses (2006 - $7.6 million) related to exploration and developmentactivities.

 

The Company performed a ceiling test calculation at December 31,2007 resulting in the undiscounted cash flows from proved reserves and thelower of cost and market of unproved reserves exceeding the carrying value ofoil and gas assets. The prices used in the ceiling test evaluation of the Company’soil and gas assets is summarized in the following chart:

 
| ** **     | ** ** | **Crude Oil**                               | ** ** | **Natural Gas**                     | ** ** |
|----------------|------------|--------------------------------------------------|------------|------------------------------------------|------------|
| ** **     | ** ** | **West Texas  Intermediate  (Cdn$/bbl)(1)** | ** ** | **Edmonton  Par Price  (Cdn$/bbl)** | ** ** | **AECO Gas  Price  (Cdn$/mmbtu)** | ** ** |
| 2008           |       | 92.00                                            |       | 91.10                                    |       | 6.75 |   |
| 2009           |       | 88.00                                            |       | 87.10                                    |       | 7.55 |   |
| 2010           |       | 84.00                                            |       | 83.10                                    |       | 7.60 |   |
| 2011           |       | 82.00                                            |       | 81.10                                    |       | 7.60 |   |
| 2012           |       | 82.00                                            |       | 81.10                                    |       | 7.60 |   |
| 2013-2017 (2)  |       | 82.34                                            |       | 81.43                                    |       | 7.96 |   |
| Thereafter (3) |       | 2.0                                              | %          | 2.0                                      | %          | 2.0 | % |

 

----

*(1)**           **Futureprices incorporate a $1.00 US/Cdn exchange rate*

*(2)**           **Pricesshown are the average over the period*

*(3)**           **Percentagechange of 2.0% represents the change in the future prices each year after 2017to the end of the reserve life.*

 

13

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**7.****    ****Revolvingcredit facility**

 

TheCompany has a $45 million demand revolving credit facility (the “creditfacility”).  The credit facility issecured by a $100 million first floating charge demand debenture on the assetsof the Company and a general security agreement covering all of the assets ofthe Company.  The credit facility hascovenants that require the Company to maintain its working capital ratio at1:1 or greater, tangible net worth to total liabilities at 1.5:1.0 or greaterand tangible net worth at greater than $100 million while the credit facilityis outstanding.  The borrowingbase of the credit facility is subject to an annual review by the lender.  As at December 31, 2007, the Company haddrawn $17.8 million (2006 - $7.9 million) against the credit facility at avariable interest rate of prime plus 1.0% (2006 – prime plus 0.5%).

 

**8.****    ****Convertiblepreferred shares**

 

OnFebruary 1, 2006, the Company completed a private placement in the amountof US$15.0 million by way of the issuance of Units consisting of 5% USCumulative Redeemable Convertible Preferred Shares (the “Preferred Shares”) andCommon Share Purchase Warrants. Each Preferred Share will be convertible intoforty Common Shares of Canadian Superior (6,000,000 Common Shares in aggregate)at a price of US$2.50 per Common Share. If Canadian Superior elects, it alsohas the option to pay the quarterly dividend by way of issuance of CommonShares at market, based on a 5.75% annualized dividend rate in lieu of the 5%annualized cash dividend rate. In addition, the Preferred Shares are redeemableand retractable five years from the date of issue or earlier, subject toearlier redemption or retraction in certain events.  The Company, issued 15,000 Units, eachconsisting of 10 US$100 Preferred Shares and 1,200,000 Common Share PurchaseWarrants. The Warrants comprising part of the Units are exercisable for aperiod of thirty six months from the date of issue at an exercise price of US$3.00 per Common Share.

 

Thefollowing table summarizes the face and carrying value of the liability andequity component of the convertible preferred shares:

 
| ** **                               | ** ** | **Liability component** | ** ** | **Equity component** | ** ** |
|------------------------------------------|------------|------------------------------|------------|---------------------------|------------|
| ** **                               | ** ** | **Face value**          | ** ** | **Carrying value**   | ** ** | **Fair value** | ** ** |
| Balance, December 31, 2005          | ** ** | **—**                   | ** ** | **—**                | ** ** | **—** | ** ** |
| Issuance of convertible preferred shares | ** ** | **17,053**                   | ** ** | **14,734**                | ** ** | **2,320** | ** ** |
| Foreign exchange                         | ** ** | **—**                   | ** ** | **381**                   | ** ** | **—** | ** ** |
| Accreted non-cash interest               | ** ** | **—**                   | ** ** | **357**                   | ** ** | **—** | ** ** |
| Balance, December 31, 2006          | ** ** | **17,053**                   | ** ** | **15,472**                | ** ** | **2,320** | ** ** |
| Foreign exchange                         | ** ** | **—**                   | ** ** | **(2,343**                | **)**      | ** ** | ** ** |
| Accreted non-cash interest               | ** ** | **—**                   | ** ** | **442**                   | ** ** | ** ** | ** ** |
| Balance, December 31, 2007          | ** ** | **17,053**                   | ** ** | **13,571**                | ** ** | **2,320** | ** ** |

 

**9.****    ****AssetRetirement Obligations**

 

Thefollowing table presents the reconciliation of the carrying amount of theobligations associated with the retirement of the property, plant andequipment:

** **
| **December 31,**      | ** ** | **2007**   | ** ** | **2006** | ** ** |
|----------------------------|------------|------------|------------|----------|------------|
| Balance, beginning of year | ** ** | **9,482**  |       | 8,302    |       |
| Liabilities settled        | ** ** | **(319**   | **)**      | —   |       |
| Liabilities incurred       | ** ** | **1,352**  |       | 532      |       |
| Accretion expense          | ** ** | **810**    |       | 648      |       |
| Balance, end of year       | ** ** | **11,325** |       | 9,482    |       |

 

14

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Thefollowing significant assumptions were used to estimate the asset retirementobligation:

 
| **December 31,**                                   | ** ** | **2007**   | ** ** | **2006** | ** ** |
|---------------------------------------------------------|------------|------------|------------|----------|------------|
| Undiscounted cash flows                                 | ** ** | **19,691** |       | 17,350   |       |
| Credit adjusted discount rate*(%)*                      | ** ** | **7.62**   |       | 7.38     |       |
| Inflation rate*(%)*                                     | ** ** | **1.50**   |       | 1.50     |       |
| Weighted average expected timing of cash flows*(years)* | ** ** | **17.5**   |       | 18.0     |       |

 

**10.  Future Income Taxes**

 

The Company’s computation of future income taxexpenses (recovery) is as follows:

 
| **December 31,**                               | ** ** | **2007**    | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-----------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|
| Income (loss) before income taxes                   |       | **(15,894** | **)**      | (10,998    | )          | 3,266      |       |
| Combined federal and provincial income tax rate (%) |       | **32.1**    | ** ** | 34.0       |       | 37.6       |       |
| Computed income tax expense (reduction)             |       | **(5,102**  | **)**      | (3,740     | )          | 1,228      |       |
| Increase (decrease) resulting from:                 |       | ** **  | ** ** |       |       |       |       |
| Non deductible crown royalties, net                 |       | **—**  | ** ** | 1,442      |       | 1,863      |       |
| Resource allowance                                  |       | **—**  | ** ** | (606       | )          | (2,168     | )          |
| Stock based compensation                            |       | **1,354**   | ** ** | 2,003      |       | 1,376      |       |
| Unsuccessful take over costs                        |       | **—**  | ** ** | 725        |       | **—** | ** ** |
| Tax adjustment – rate change and other         |       | **(358**    | **)**      | 58         |       | 95         |       |
| Tax pool amendments                                 |       | **(1,907**  | **)**      | **—** |       | (2,313     | )          |
|                                                |       | **(6,013**  | **)**      | (118       | )          | 81         |       |

 

The net future tax liability is comprised of:

 
| ** **                                      | ** ** | **2007**   | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|------------|------------|----------|------------|
| Non-capital loss carryforwards                  |       | **(817**   | **)**      | 906      |       |
| Asset retirement obligations                    |       | **(3,114** | **)**      | (2,892   | )          |
| Share issue costs                               |       | **(1,127** | **)**      | (1,191   | )          |
| Net book value of assets in excess of tax basis |       | **18,537** | ** ** | 14,135   |       |
| Foreign exploration expense                     |       | **(4,413** | **)**      | —   |       |
| Other                                           |       | **(213**   | **)**      | —   |       |
|                                            |       | **8,853**  |       | 10,958   | ** ** |

 

Asat December 31, 2007, the Company had approximately $149.7 million in taxpools and $3.0 million in non-capital losses available for deduction againstfuture taxable income.

 

Non-capitallosses expire as follows:

 
| 2008                |   | — |   |
|---------------------|--------|--------|--------|
| 2009                |   | — |   |
| 2010                |   | — |   |
| 2011 and thereafter |   | 2,970  |   |
|                |   | 2,970  |   |

 

15

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**11.  Share Capital**

 

(a)   Authorized

 

Unlimited number of common shares, no par value.

 

Unlimited number of preferred shares, no par value.

 

(b)         Commonshares issued

 
| ** **                                       | ** ** | **2007**      | ** ** | **2006**            | ** ** |
|--------------------------------------------------|------------|---------------|------------|---------------------|------------|
| ** **                                       | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** |
| Balance, beginning of year                       |       | 131,216       |       | 161,964             |       | 119,135 |   | 135,650 |   |
| Issued upon  the conversion of purchase warrants |       | 500           |       | 1,385               |       | 375 |   | 948 |   |
| Issued upon the exercise of stock options        |       | 1,864         |       | 3,518               |       | 1,198 |   | 1,639 |   |
| Issued in settlement of lawsuit                  |       | —        |       | —              |       | 260 |   | 711 |   |
| Issued for cash                                  |       | —        |       | —              |       | 3,500 |   | 8,301 |   |
| Issued for Canada Southern shares                |       | —        |       | —              |       | 472 |   | 1,116 |   |
| Issued for preferred share dividend              |       | 259           |       | 712                 |       | 276 |   | 641 |   |
| Issued for cash on flow-through shares           |       | 6,473         |       | 22,654              |       | 6,000 |   | 15,420 |   |
| Issue costs, net of future tax reduction         |       | —        |       | (889                | )          | — |   | (649 | ) |
| Tax benefits renounced on  flow-through-shares   |       | —        |       | (4,241              | )          | — |   | (2,723 | ) |
| Stock based compensation for exercised  options  |       | —        |       | 1,454               |       | — |   | 910 |   |
| Balance, end of the year                         |       | 140,312       |       | 186,557             |       | 131,216 |   | 161,964 |   |

 

On November 16, 2007, the Company completed a private placement of6,472,500 flow-through common shares at $3.50 per share for gross proceeds of$22.7 million.

 

On December 31, 2007, 500,000 warrants were exercised into 500,000common shares at US$2.50 per share for gross proceeds of US$1.3 million.

 

On February 9, 2006, the Company completed a private placementfinancing consisting of 1.0 million Units at a price of $2.40 per Unit forgross proceeds of $2.4 million. Each Unit consists of one Common Share and one-halfof one Common Share Purchase Warrant.

 

On December 13, 2006 the Company completed a private placement of6,000,000 flow-through common shares at $2.57 per share for gross proceeds of$15.4 million.

 

On December 29, 2006 the Company completed a private placement of2,500,000 shares at $2.37 per share for gross proceeds of $5.9 million.

 

16

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(c)          Purchasewarrants issued

 
| ** **                 | ** ** | **2007**      | ** ** | **2006**            | ** ** |
|----------------------------|------------|---------------|------------|---------------------|------------|
| ** **                 | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** |
| Balance, beginning of year |       | 500           |       | 312                 |       | 2,750 |   | 165 |   |
| Issued                     |       | —        |       | —              |       | 1,000 |   | 158 |   |
| Exercised                  |       | (500          | )          | (134                | )          | (750 | ) | (11 | ) |
| Expired                    |       | —        |       | (178                | )          | (2,500 | ) | — |   |
| Balance, end of the year   |       | —        |       | —              |       | 500 |   | 312 |   |

 

On February 9,2006, the Company completed a private placement financing consisting of 1.0million Units at a price of $2.40 per Unit for gross proceeds of $2.4 million.Each Unit consists of one Common Share and one-half of one Common SharePurchase Warrant. The Warrants comprising part of the Units were exercisable untilDecember 31, 2006 at an exercise price of $2.40 per common share. Thesewarrants have all expired as of December 31, 2006.

 

On June 18,2006 the Company issued 500,000 share purchase warrants in arranging financingfor the Canada Southern Acquisition. On December 31, 2007, the warrantswere exercised into 500,000 common shares at US$ 2.50 per share.

 

In August 2005,the Company filed a short form prospectus qualifying the distribution of2,750,000 common share purchase warrants which expired on June 30, 2006.

 

(d)         TotalShare Capital

 
| ** **               | ** ** | **2007**      | ** ** | **2006**            | ** ** |
|--------------------------|------------|---------------|------------|---------------------|------------|
| ** **               | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** | **Number(#)** | ** ** | **Amount($ )** | ** ** |
| Common shares issued     |       | 140,312       |       | 186,557             |       | 131,216 |   | 161,964 |   |
| Purchase warrants issued |       | —        |       | —              |       | 500 |   | 312 |   |
| Balance, end of the year |       | 140,312       |       | 186,557             |       | 131,716 |   | 162,276 |   |

 

        (e)   Stock options

 

The Company has a stock option plan for itsdirectors, officers, employees and key consultants.  The exercise price for stock options grantedis no less than the quoted market price on the grant date with options vestingin equal increments over a three year period. An option’s maximum term is ten years.

 
| ** **                 | ** ** | **2007**                    | ** ** | **2006**                                        | ** ** |
|----------------------------|------------|-----------------------------|------------|-------------------------------------------------|------------|
| ** **                 | ** ** | **Number  of options** | ** ** | **Weighted  average price ($ )** | ** ** | **Number  of options** | ** ** | **Weighted  average price ($ )** | ** ** |
| Balance, beginning of year | ** ** | **13,062**                  | ** ** | **2.05**                                        |       | 9,488 |   | 1.83 |   |
| Forfeited                  | ** ** | **(875**                    | **)**      | **2.45**                                        |       | (747 | ) | 2.31 |   |
| Exercised                  | ** ** | **(1,864**                  | **)**      | **1.89**                                        |       | (1,198 | ) | 1.37 |   |
| Granted                    | ** ** | **5,263**                   | ** ** | **2.70**                                        |       | 5,519 |   | 2.30 |   |
| Balance, end of the year   | ** ** | **15,586**                  | ** ** | **2.27**                                        |       | 13,062 |   | 2.05 |   |

 

17

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The following table summarizes stock optionsoutstanding under the plan at December 31, 2007:

 
| ** **                             | ** ** | **Options outstanding**         | ** ** | **Options exercisable**                               | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------------------------------------------------------|------------|
| **Exercise price ($ )** | ** ** | **Number of  options (#)** | ** ** | **Average remaining  contractual life  (years)** | ** ** | **Weighted average  exercise price($)** | ** ** | **Number of  options(#)** | ** ** | **Weighted average  exercise price($)** | ** ** |
| 0.80-1.00                              |       | 97                                   |       | 2.57                                                       |       | 0.81 |   | 97 |   | 0.81 |   |
| 1.01-1.50                              |       | 925                                  |       | 4.73                                                       |       | 1.30 |   | 925 |   | 1.30 |   |
| 1.51-2.00                              |       | 2,892                                |       | 6.54                                                       |       | 1.78 |   | 2,736 |   | 1.78 |   |
| 2.01-3.00                              |       | 11,247                               |       | 8.12                                                       |       | 2.45 |   | 8,864 |   | 2.40 |   |
| 3.01-3.50                              |       | 425                                  |       | 9.15                                                       |       | 3.18 |   | 191 |   | 3.21 |   |
| 0.80-3.00                              |       | 15,586                               |       | 7.63                                                       |       | 2.27 |   | 12,813 |   | 2.19 |   |

 

The following table summarizes stock optionsoutstanding under the plan at December 31, 2006:

 
| ** **                             | ** ** | **Options outstanding**         | ** ** | **Options exercisable**                               | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------------------------------------------------------|------------|
| **Exercise price ($ )** | ** ** | **Number of  options (#)** | ** ** | **Average remaining  contractual life  (years)** | ** ** | **Weighted average  exercise price($)** | ** ** | **Number of  options(#)** | ** ** | **Weighted average  exercise price($)** | ** ** |
| 0.80-1.00                              |       | 155                                  |       | 3.57                                                       |       | 0.81 |   | 155 |   | 0.81 |   |
| 1.01-1.50                              |       | 1,110                                |       | 5.73                                                       |       | 1.30 |   | 1,110 |   | 1.30 |   |
| 1.51-2.00                              |       | 3,748                                |       | 7.54                                                       |       | 1.79 |   | 2,666 |   | 1.76 |   |
| 2.01-3.00                              |       | 8,049                                |       | 9.12                                                       |       | 2.30 |   | 3,784 |   | 2.31 |   |
| 0.80-3.00                              |       | 13,062                               |       | 8.31                                                       |       | 2.05 |   | 7,715 |   | 1.95 |   |

 

(f)            Stockbased compensation

 

The Company uses the fair value method toaccount for its stock based compensation plan.  Under this method, compensation costs arecharged over the vesting period for stock options granted to directors,officers, employees and consultants, with a corresponding increase tocontributed surplus.

 

The followingtable reconciles the Company’s contributed surplus:

 
| **December 31,**      | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------|------------|------------|------------|------------|------------|
| Balance, beginning of year | ** ** | **11,372** | ** ** | **6,391**  | ** ** |
| Issuance of stock options  | ** ** | **4,218**  | ** ** | **5,891**  | ** ** |
| Exercise of stock options  | ** ** | **(1,454** | **)**      | **(910**   | **)**      |
| Expiry of warrants         | ** ** | **178**    | ** ** | **—** | ** ** |
| Balance, end of year       | ** ** | **14,314** | ** ** | **11,372** | ** ** |

 

The fair value of optionsgranted during the period was estimated based on the date of grant using theBlack-Scholes option pricing model with weighted average assumptions andresulting values for grants as follows:

 
| **December 31,**                               | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------------------|------------|------------|------------|------------|------------|
| Risk free interest rate (%)                         | ** ** | **4.1**    | ** ** | **4.1**    | ** ** |
| Expected life (years)                               | ** ** | **10.0**   | ** ** | **10.0**   | ** ** |
| Expected dividend yield (%)                         | ** ** | **—** | ** ** | **—** | ** ** |
| Expected volatility (%)                             | ** ** | **41.7**   | ** ** | **44.3**   | ** ** |
| Weighted average fair value of options  granted ($) | ** ** | **1.57**   | ** ** | **1.41**   | ** ** |

 

18

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(g)         Employeestock savings plan

 

The Company has an employeestock savings plan (“ESSP”) in which employees are provided with theopportunity to receive a portion of their salary in common shares, which isthen matched on a share for share basis by the Company.  The Company purchased approximately 95,000shares under the ESSP in 2007 (2006 – 122,000).

 

(h)         Basic anddiluted earnings and loss per share

 

The Company used the treasury stock method tocalculate net income (loss) per common share.

 
| **December 31,**                      | ** ** | **2007**    | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|
| **(thousands,  except per share amounts)** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average common shares             | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                      | ** ** | **133,719** |       | 121,911    |       | 112,170    |       |
| Diluted                                    | ** ** | **133,719** |       | 121,911    |       | 114,279    |       |
| Basic and diluted loss per share           | ** ** | **$**       | **(0.07**  | **)**      | $          | (0.09      | )          | $ | 0.03 |   |
|                                            |            |             |            |            |            |            |            |  |  |  |

 

For the calculation of diluted net loss pershare the Company excluded the following securities that are anti-dilutive:

 
| **December 31,**        | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(thousands)**              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options                | ** ** | **15,586** |       | 13,062     |       | 593        |       |
| Convertible preferred shares | ** ** | **15,000** |       | 15,000     |       | —     |       |
| Warrants                     | ** ** | **—** |       | 500        |       | 2,750      |       |

 

Subsequent to December 31, 2007,Canadian Superior issued 1,650,000 stock options with a weighted averageexercise price of $3.53 per share.  Thesetransactions would have changed the potential common stock outstanding at theend of the period if the transactions had occurred prior to December 31,2007.

 

(i)             Equityportion of preferred shares

 
| Warrant equity on preferred shares       | ** ** | **351**   | ** ** |
|------------------------------------------|------------|-----------|------------|
| Conversion equity on preferred shares    | ** ** | **1,969** | ** ** |
| Balance, December 31, 2007 and 2006 | ** ** | **2,320** | ** ** |

 

**12.  Supplementalcash flow information**

 

a) Changes in non-cash working capital

** **
| ** **                            | ** ** | **2007**    | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|-------------|------------|----------|------------|----------|------------|
| Accounts receivable                   | ** ** | **(19,334** | **)**      | (8,146   | )          | (3,160   | )          |
| Prepaid expenses                      | ** ** | **(1,786**  | **)**      | (11      | )          | (181     | )          |
| Long term portion of lease prepayment | ** ** | **(1,309**  | **)**      | —   |       | —   |       |
| Accounts payable                      | ** ** | **4,233**   | ** ** | 2,243    |       | 4,999    |       |
| Change in non-cash working capital    | ** ** | **(18,196** | **)**      | (5,914   | )          | 1,658    |       |

 

19

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The change in non-cash working capital has been allocated to thefollowing activities:

** **
| ** ** | ** ** | **2007**    | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------|------------|-------------|------------|------------|------------|------------|------------|
| Operating  | ** ** | **(4,993**  | **)**      | **(8,453** | **)**      | **11**     | ** ** |
| Financing  | ** ** | **238**     | ** ** | **—** | ** ** | **—** | ** ** |
| Investing  | ** ** | **(13,441** | **)**      | **2,539**  | ** ** | **1,647**  | ** ** |
| ** ** | ** ** | **(18,196** | **)**      | **(5,914** | **)**      | **1,658**  | ** ** |

 

b) Other cash flow information

** **
| ** **    | ** ** | **2007**  | ** ** | **2006**   | ** ** | **2005** | ** ** |
|---------------|------------|-----------|------------|------------|------------|----------|------------|
| Interest paid | ** ** | **2,482** | ** ** | **2,061**  | ** ** | **854**  | ** ** |
| Taxes paid    | ** ** | **55**    | ** ** | **—** | ** ** | **143**  | ** ** |

 

**13.  Relatedparties transactions**

 

During the year ended December 31 2007,the Company paid $1.9 million (2006 - $0.8 million), on industry terms, forequipment rentals to a company controlled by an officer and director ofCanadian Superior.  Also during 2007, theCompany invoiced $0.7 million (2006 - nil), at market rates, to this relatedparty company for payroll services.  Inaddition, Canadian Superior paid $0.2 million (2006 - $0.2 million) to aCompany controlled by a director, for oil field construction services onindustry terms.

 

At December 31, 2007, Canadian Superioris carrying a receivable in the amount of US$19.7 million (2006 – nil) from acompany which one of Canadian Superior’s officers and directors is ashareholder and director.  Thesereceivables pertain to transactions for Canadian Superior’s “Intrepid” Block 5(c) projectat Trinidad (note 15).  Thesetransactions were incurred under normal industry terms and conditions.  Subsequent to year end, the Company receivedpayment of US$20.0 million from this company.

 

**14.  Financial Instruments**

 

(a)          Fair value of financial assets and liabilities

 

The carrying values of financial assets andliabilities approximate their fair value due to their short periods of maturityand the credit facility bearing interest at market rates.

 

(b)         Credit risk

 

The Company’s accountsreceivable are with customers and joint venture partners in the petroleum andnatural gas business under normal industry sale and payment terms and aresubject to normal credit risks. Purchasers of the Company’s oil, gas and natural gas liquids are subjectto an internal credit review to minimize the risk of nonpayment.

 

(c)          Foreignexchange risk

 

The Company is exposed toforeign currency fluctuations as oil and gas prices received are referenced toU.S. dollar denominated prices and convertible preferred shares are denominatedin U.S. dollars.  The Company also hasassets and liabilities based in U.S. currency that are subject to interest ratefluctuations.

 

(d)         Interestrate risk

 

The Company is exposed tointerest rate risk as the credit facility bears interest at floating marketinterest rates.  The Company has nointerest rate swaps or hedges at December 31, 2007.

 

20

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(d)         Commodityprice risk

 

The Company enters intocommodity sales agreements and certain derivative financial instruments toreduce its exposure to commodity price volatility.  These financial instruments are entered intosolely for hedging purposes and are not used for trading or other speculativepurposes. At December 31, 2007, the Company had no contracts in place.

 

**15.  Contingencies and commitments**

 

a)              NovaScotia

 

During 2000, 2001 and 2003, theCompany acquired six exploration licenses from the Canada-Nova Scotia OffshorePetroleum Board (“CNSOPB”).  Each ofthese licenses is for a specific period of nine years, subject to certainrequirements being met during the first five years or six years.  As a condition of the licenses, the Companyis required to post security in the amount of 25% of its work expenditure bids.The deposit is refundable only to the extent of approved allowableexpenditures.  The duration of theinitial five year term, for a given license, can be extended one additionalyear to six years by posting an additional security drilling deposit in anamount of $250,000. Recently the CNSOPB implemented an additional extensionprogram that allows the six year period to be further extended up to nine yearsby payment of annual extension fees.  Asof December 31, 2007, as a result of the Company incurring certainexpenditures and drilling two exploration wells, the Company had fullyfulfilled its work expenditures on two of the exploration licenses, allowedthree licenses to return to the Crown, extended one license and held theremaining two under the regular licensing process.  At December 31, 2007, the Company’sowned 100% of five exploration licenses that have aggregate work expenditureoutstanding of $55.1 million and $14.6 million in term deposits assigned to theCanadian Receiver General through the CNSOPB (Note 4).

 

b)             Trinidadand Tobago

 

The Company is committed todrill three exploration wells on its “Intrepid” Block 5(c) under its Block5(c) Production Sharing Contract (“PSC”) with the Government of Trinidadand Tobago funded in part by a related party participating on a promoted basis,paying 1/3 of Canadian Superior’s Block 5(c) exploration program to obtain25% of Canadian Superior’s net revenue share of these prospects; and, also by anon-related party paying approximately 40% of the exploration cost, plus otherconsiderations, for a 30% interest in the Block 5(c) PSC.  The Company has contracted the Kan Tan IVSemi-Submersible Drilling Rig for a three well commitment on the Company’sTrinidad and Tobago “Intrepid” Block 5 (c). In 2007, the Company drilled andcommenced testing of the first well.  Thesecond well in this program was spudded in February 2008.  The Company estimates that the costs to drillthe remaining two wells to be in the range of US $65.0 million to US $75.0million gross per well.  The wells willbe drilled and evaluated back to back, with this three well program expected tobe completed in 2008.

 

During the third quarter of2007, the Company received an exploration and development license from theGovernment of Trinidad and Tobago on the Mayaro-Guayaguayare block (“MG Block”)and as a result is committed to conducting 3D seismic and to drill twoexploration wells on the MG block in a joint venture with the Petroleum Companyof Trinidad and Tobago Limited (“Petrotrin”). The first well has to be drilled to a depth of 3,000 meters by January 2010and the second to a depth of 1,800 meters by July 2010. The Companyestimates that its share of the cost of these wells to be in the range of US$15.0 million per well, with the 3D seismic program to be completed in 2008 ata net cost to the Company of approximately US$ 20.0 million.

 

c)              Flow-throughshares

 

At December 31, 2007, theCompany had yet to incur approximately $22.7 million of Canadian explorationexpenses which were renounced for tax purposes. These expenses must be incurred by December 31, 2008.

 

d)             Litigationand claims

 

The Company is involved invarious claims and litigation arising in the ordinary course of business.  In the opinion of Canadian Superior thevarious claims and litigations arising there from are not expected to have amaterial adverse effect on the Company’s financial position.  The Company maintains insurance, which in theopinion of the Company, is in place to address any unforeseen claims.

 

21

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e)     Lease obligations

 

At December 31, 2007, the Company is committed to future paymentsfor office leases and equipment. Payments required under these commitments for each of the next fiveyears are as follows:

 
| ** **  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
|-------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Office rent |       | 317      |       | 249      |       | 226      |       | 57       |       | —         |       |
| Equipment   |       | 155      |       | 77       |       | 42       |       | —   |       | —         |       |
|        |       | 472      |       | 326      |       | 268      |       | 57       |       | —         |       |

 

**16.  Trinidad Farm Out**

 

In 2007, the Company enteredinto a farm in and joint operating agreement with BG International Limited (“BG”)to participate in the exploration drilling and development of the “Intrepid”Block 5(c) approximately sixty miles off the east coast of the island ofTrinidad. Under the terms of the farm-in and joint operating agreements, BGacquired a 30% working interest in Canadian Superior’s “Intrepid” Block 5(c) ProductionSharing Contract; the agreement was approved by the Government of Trinidad andTobago on October 29, 2007. Also, under the terms of the agreement withCanadian Superior, BG paid Canadian Superior approximately US$38.7 million andon a go forward basis will pay approximately 40% of the exploration costsassociated with the drilling of the three commitment wells required on Block5(c).

 

**17.  Canada Southern**

 

In June 2006, CanadianSuperior made a takeover bid for all of the issued and outstanding shares ofCanada Southern Petroleum Ltd. Canadian Superior offered 2.75 common shares ofCanadian Superior plus $2.50 for each issued and outstanding share of CanadaSouthern Petroleum Ltd.  On July 17,2006, Canadian Superior revised its offer for Canada Southern Petroleum Ltd. to2.0 Canadian Superior shares, $2.50. cash and a 25% net profit interest inCanada Southern’s approximately 927 bcfe of natural gas, being the estimatednet amount of natural gas Canada Southern attributed to it’s interest in theCanadian Arctic Islands. The offer was for Canada Southern’s approximately1,100 boe/d of oil and gas production and various lands including CanadaSouthern’s Canadian Arctic island interests. The minimum condition attached to the revised offer was not met andthere were 171,495 shares tendered to the original offer. Canadian SuperiorIssued 471,612 shares and paid $0.4 million to take up these shares. The costsincurred, including the fair value of the Canadian Superior shares issued,exceeded the $2.5 million received on the sale of the 171,495 Canada Southernshares. The difference has been recorded to loss on investment in the statementof operations, comprehensive loss and deficit.

 

**18.  Subsequent event**

 

On March 26, 2008, CanadianSuperior closed the acquisition of Seeker Petroleum Ltd. (“Seeker”), a privatecompany for consideration of approximately $51.2 million, before closingadjustments and including assumed net debt of approximately $8.5 million.  The purchase was funded through the issuanceof common shares of the Company and advances from the credit facility.

 

22

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**19.  Reconciliation with United States Generally Accepted AccountingPrincipals**

 

The Company follows Canadiangenerally accepted accounting principles (“Canadian GAAP”) which differs insome respects with generally accepted accounting principles in the United States(“U.S. GAAP”). Significant differences in accounting principles that impact theCompany’s financial statements are described below:

 
|                                                                                                                                          | **2007**     | 2006         | 2005                    |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|-------------------------|
|  

($ thousands, except per share amounts)                                                                                          | ** **   | As  restated | As  previously reported | As  restated | As  previously reported |
| Net income (loss) in  accordance with Canadian GAAP, as reported                                                                              | **(9,936)**  | (10,913)     | (10,913)                | 3,056 | 3,056 |
| Flow through shares                                                                                                                           | ** **   |         |                    |   |   |
|                 Income taxes                                       | **(2,685)**  | (1,005)      | (3,147)                 | -- | (1,283) |
| Property acquisitions                                                                                                                         | ** **   |         |                    |   |   |
|                 Depletion, amortization and accretion expense      | **304**      | 339          | 339                     | 452 | 452 |
|                 Income taxes                                       | **(93)**     | (103)        | (103)                   | (152) | (152) |
| Ceiling test                                                                                                                                  | ** **   |         |                    |   |   |
|                 Write down of petroleum and natural gas properties | **(5,709)**  | (2,873)      | (2,873)                 | -- | -- |
|                 Income taxes                                       | **1,741**    | 876          | 876                     | -- | -- |
|                 Depletion, depreciation and accretion expense      | **3,975**    | 3,884        | 3,884                   | 5,181 | 5,181 |
|                 Income taxes                                       | **(1,212)**  | (1,185)      | (1,185)                 | (1,742) | (1,742) |
| Stock based compensation                                                                                                                      | **--**       | --           | --                      | 3,657 | 3,657 |
| Change in valuation  allowance                                                                                                                | **(2,542)**  | 2,811        | 2,811                   | 1,754 | 1,754 |
| Convertible preferred  share treatment                                                                                                        | **(1,186)**  | 1,244        | 1,244                   | -- | -- |
| Net income (loss) in  accordance with U.S. GAAP                                                                                               | **(17,343)** | (6,925)      | (9,067)                 | 12,206 | 10,923 |
| Convertible preferred  share treatment                                                                                                        | **(915)**    | (662)        | (662)                   | -- | -- |
| Net income (loss)  attributable to common shareholders in accordance with U.S. GAAP                                                           | **(18,258)** | (7,587)      | (9,729)                 | 12,206 | 10,923 |
| Net income (loss) per  share in accordance with U.S. GAAP                                                                                     | ** **   |         |                    |   |   |
| Basic                                                                                                                                         | **(0.13)**   | (0.06)       | (0.08)                  | 0.11 | 0.10 |
| Diluted                                                                                                                                       | **(0.13)**   | (0.06)       | (0.08)                  | 0.11 | 0.10 |

 

The application of U.S. GAAPresults in differences to the following balance sheet items:

 
| ** **                                 | ** ** | **2007**     | ** ** | **2006**               | ** ** |
|--------------------------------------------|------------|--------------|------------|------------------------|------------|
| ** **                                 | ** ** | ** **   | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | **As previously** | ** ** |
| ** **                                 | ** ** | ** **   | ** ** | ** **             | ** ** | ** ** | ** ** | **As restated** | ** ** | **reported** | ** ** |
| **Year ended December 31,** | ** ** | **Canadian** | ** ** | **United States** | ** ** | **Canadian** | ** ** | **United States** | ** ** | **United States** | ** ** |
| Property, plant and equipment, net         |       | 186,154      |       | 154,724                |       | 185,426 |   | 155,425 |   | 155,425 |   |
| Accounts payable and accrued liabilities   |       | 22,230       |       | 26,308                 |       | 17,997 |   | 19,555 |   | 17,997 |   |
| Convertible preferred shares               |       | 13,571       |       | —                 |       | 15,472 |   | — |   | — |   |
| Future income tax liability                |       | 8,853        |       | —                 |       | 10,958 |   | — |   | — |   |
| Share capital                              |       | 186,557      |       | 226,487                |       | 162,276 |   | 202,043 |   | 207,026 |   |
| Share capital – preferred shares      |       | —       |       | 16,311                 |       | — |   | 16,107 |   | 16,107 |   |
| Contributed surplus                        |       | 14,314       |       | 8,834                  |       | 11,372 |   | 5,892 |   | 5,892 |   |
| Equity portion of preferred shares         |       | 2,320        |       | —                 |       | 2,320 |   | — |   | — |   |
| Deficit, opening                           |       | (12,319      | )          | (65,522                | )          | (1,406 | ) | (57,935 | ) | (59,218 | ) |
| Deficit, closing                           |       | (22,255      | )          | (83,780                | )          | (12,319 | ) | (65,522 | ) | (68,947 | ) |

 

(a)   Flow-through shares

 

The Company finances a portionof its activities with flow through share issues whereby the tax deductions arerenounced to the share subscribers.  Thetax cost of the deductions renounced to shareholders is reflected as anincrease in the future income tax liability and a reduction from the statedvalue of the shares. Under U.S. GAAP, share capital for flow-through sharesissued after 1998 is stated at the quoted value of the shares at the date ofissuance; the tax cost resulting from deduction renouncements, less anyproceeds received in excess of the quoted value of the shares, must be includedin the determination of the tax expense.

 

During the year, the Companydetermined that the 2006 and 2005 financial statements contained erroneouslyrecorded adjustments related to the issuance and renouncement of flow throughshares for U.S. GAAP. The table above outlines the adjustments to the 2005 and2006 financial statements for U.S. GAAP purposes. 

 

23

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(b)   Property Acquisitions

 

In prior years, the Companyrecorded property acquisitions from related parties in exchange for commonshares at the exchange amount, pursuant to Canadian GAAP. Under U.S. GAAP,these related party acquisitions are recorded at the seller’s carrying amount.The resulting differences in the recorded carrying amounts of the propertiesresults in differences in depletion and amortization expense in subsequentyears.

 

(c)   Ceiling Test

 

At December 31, 2007, theCompany applied a ceiling test to its petroleum and natural gas properties.Under Canadian GAAP, the application of this test required no adjustment to thecarrying value of the Company’s petroleum and natural gas properties.

 

At December 31, 2007, underU.S. GAAP the Company applied a full cost ceiling test using a 10% discountrate to its petroleum and natural gas properties using December 31, 2007prices of:

 
| Gas (per thousand cubic feet)            |   | $ | 6.97 CDN  |   |
|------------------------------------------|--------|---|-----------|--------|
| Oil and natural gas liquids (per barrel) |   | $ | 93.39 CDN |   |

 

The application of the testresulted in a $5.7 million pre-tax reduction ($4.0 million after tax) in thecarrying value of the Company’s petroleum and natural gas properties under U.S.GAAP.

 

At December 31, 2006, theCompany applied a ceiling test to its petroleum and natural gas properties.Under Canadian GAAP, the application of this test required no adjustment to thecarrying value of the Company’s petroleum and natural gas properties.

 

At December 31, 2006, theCompany applied a ceiling test to its petroleum and natural gas propertiesusing December 31, 2006 prices of:

 
| Gas (per thousand cubic feet)            |   | $ | 6.25 CDN  |   |
|------------------------------------------|--------|---|-----------|--------|
| Oil and natural gas liquids (per barrel) |   | $ | 67.58 CDN |   |

 

The application of the testresulted in a $2.9 million pre-tax reduction ($2.0 million after tax) in thecarrying value of the Company’s petroleum and natural gas properties under U.S.GAAP.

 

At December 31, 2005, theCompany applied the ceiling test to its petroleum and natural gas propertiesusing December 31, 2005 prices of:

 
| Gas (per thousand cubic feet)            |   | $ | 10.35 CDN |   |
|------------------------------------------|--------|---|-----------|--------|
| Oil and natural gas liquids (per barrel) |   | $ | 66.25 CDN |   |

 

The application of the testresulted in no reduction in the carrying value of the Company’s petroleum andnatural gas properties under either U.S. or Canadian GAAP for 2005.

 

The resulting differences in therecorded carrying amounts of the properties results in differences indepletion, amortization and accretion expenses in subsequent years.

 

(d)   Stock Based Compensation

 

On January 1, 2006 theCompany adopted Statement of Financial Standards (SFAS), “Share-Based Payment.”This statement requires the Company to recognize the cost of employee servicesreceived in exchange for the Company’s equity instruments. Under SFAS No. 123(R) theCompany is required to record compensation expense over an award’s vestingperiod based on the award’s fair value at the date of grant. The Company haselected to adopt SFAS No. 123(R) on a modified prospective basis;accordingly the financial statements for the period prior to January 1,2006 will not include compensation cost calculated under the fair value method.

 

Prior to January 1, 2006the Company applied Accounting Principles Board Opinion 25, “Accounting forStock Issued to Employees” and therefore recorded the intrinsic value of stock –based compensation as expense and applied the disclosure provisions of SFAS No. 123,“Accounting for Stock-Based Compensation.”

 

24

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(e)   Valuation Allowance

 

This adjustment reflects theaccounting of an additional valuation allowance for U.S. GAAP purposes arisingfrom the differences in treatment regarding write downs of Petroleum andNatural Gas Properties and reduced depletion, depreciation and accretionexpense.

 

(f)    Preferred shares

 

The Company has reviewed theConvertible preferred shares and their treatment under SFAS No. 150 “accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” and SFAS No. 133 “accounting for Derivative Instruments andHedging Activities”. While the shares are redeemable they are not manditoralyredeemable as defined by SFAS No. 150 and therefore would not cause theshares to be recorded as liabilities. In evaluating the embedded conversionoption component in accordance with SFAS No. 133 the shares are indexed tothe Company’s own stock and would not be required to be accounted for as aderivative under SFAS No. 133. Under EITF 00-19 the preferred shares would be considered “conventional”and therefore not subject to the provisions of EITF 00-19. Accordingly thepreferred shares have been accounted for as described by APB 14 resulting inthe allocation of proceeds between the shares and warrants based on theirrelative fair values.

 

Additional U.S. GAAP Disclosures

 

FAS 133

 

At times the Company will usederivative financial instruments to manage commodity price exposure. Effective January 1,2001 the Company adopted the provisions of FAS 133 which requires that allderivatives be recognized as assets and liabilities on the balance sheet andmeasured at fair value. Gains or losses, including unrealized amounts, onderivatives that have not been designated as hedges, or were not effective ashedges, are included in income as they arise.

 

For derivatives designated asfair value hedges, changes in the fair value are recognized in income togetherwith changes in the fair value of the hedged item.  For derivatives designated as cash flow hedges,changes in the fair value of the derivatives are recognized in othercomprehensive income until the hedged items are recognized in income. Anychange in the fair value of the derivatives that is not effective in hedgingthe changes in future cash flows is included in income as they arise.

 

At December 31, 2007 and2006 the Company did not have any derivative financial instruments that werenot designated as fair value hedges.

 

FAS 153

 

In December 2004, the FASBissued FAS 153 which deals with the accounting for the exchanges of nonmonetaryassets.  FAS 153 is an amendment of APBOpinion 29.  APB Opinion 29 requires thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged.  FAS 153 amends APBOpinion 29 to eliminate the exception from using fair market value fornonmonetary exchanges of similar productive assets and introduces a broaderexception for exchanges of nonmonetary assets that do not have commercialsubstance.  FAS 153 is effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005.  The adoption of this standard didnot impact the Company’s Financial Statements.

 

FAS 155 - Accounting for CertainHybrid Financial Instruments

 

On February 16, 2006, FASBissued FASB Statement No. 155, Accounting for Certain Hybrid Instruments –an amendment of FASB Statement No. 133 and 140 (FAS 155), which allows anentity to elect to measure certain hybrid financial instruments at fair valuein their entirety, with changes in fair value recognized in earnings. The fairvalue election will eliminate the need to separately recognize certainderivatives embedded in hybrid financial instruments under FASB Statement No. 133,Accounting for Derivative Instruments & Hedging Activities. Thisstatement is effective for financial statements issued for fiscal yearsbeginning after September 15, 2006. The adoption of this standard did not impact the Company’s FinancialStatements.

 

25

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FAS 157 - Fair Value Measurement

 

FASB issued statement ofFinancial Accounting No. 157 Fair Value Measurement, this statement iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  Early adoption is permitted.  The standard provides enhanced guidance forusing fair value to measure assets and liabilities, the information used tomeasure fair value, and the effect of fair value measurement on earnings.  The standard applies whenever other standardsrequire (or permit) assets or liabilities to be measured at fair value. It doesnot expand the use of fair value in any new circumstances. The Company does notexpect there to be any material impact on the Consolidated Financial Statementsupon adoption of the standard.

 

FIN 46 - Accounting for VariableInterest Entities

 

In January 2003, the FASBissued Financial Interpretation 46 “Accounting for Variable Interest Entities”(“FIN 46”) that requires the consolidation of Variable Interest Equities (“VIEs”).  VIEs are entities that have insufficientequity or their equity investors lack one or more of the specified elementsthat a controlling entity would have. The VIEs are controlled through financial interests that indicatecontrol (referred to as “variable interests”). Variable interests are the rights or obligations that expose the holderof the variable interest to expected losses or expected residual gains of theentity.  The holder of the majority of anentity’s variable interests is considered the primary beneficiary of the VIEand is required to consolidate the VIE. In December 2003 the FASB issuedFIN 46R which superseded FIN 46 and restricts the scope of the definition ofentities that would be considered VIEs that require consolidation. The Companydoes not believe FIN 46R results in the consolidation of any additionalentities.

 

FIN 47 - Conditional AssetRetirement Obligations

 

Effective December 31 2005,the Company adopted FIN 47, Accounting for Conditional Asset RetirementObligations, an interpretation of FASB Statement No. 143. FIN 47 clarifiesthat the term conditional asset retirement obligation as used in SFAS No. 143,Accounting for Asset Retirement Obligations, refers to a legal obligation toperform an asset retirement activity in which the timing and/or method ofsettlement are conditional on a future event that may or may not be within thecontrol of the entity. According to FIN 47, uncertainty about the timing and/ormethod of settlement of a conditional asset retirement obligation should befactored into the measurement of a liability when sufficient information existsrather than preclude the need to record a liability. The adoption of thisinterpretation did not impact the Company’s Financial Statements.

 

FIN 48 - Accounting forUncertainty in Income Taxes

 

Effective January 1, 2007,the Company adopted FIN 48, “Accounting for Uncertainty in Income Taxes – aninterpretation of FASB Statement No. 109.” This interpretation requires that an entity recognize in the financialstatements, the impact of a tax position, if that position is more likely thannot to be sustained on examination by the taxing authorities, based ontechnical merits of the position.  Taxbenefits resulting from such a position should be measured as the amount thatis more likely than not on a cumulative basis to be sustained onexamination.  FIN 48 also providesguidance on de-recognition, classification, interest and penalties on incometaxes and accounting in interim periods. The adoption of this interpretation did not impact the Company’sFinancial Statements.

 

SAB 106

 

In September 2004, theSecurities and Exchange Commission issued Staff Accounting Bulletin 106 (“SAB106”) regarding the application of FAS 143 by oil and gas producing entitiesthat follow the full cost accounting method. SAB 106 states that after theadoption of FAS 143 the future cash flows associated with the settlement ofasset retirement obligations that have been accrued on the balance sheet shouldbe excluded from the computation of the present value of estimated future netrevenues for purposes of the full cost ceiling test calculation. The Companyexcludes the future cash outflows associated with settling asset retirementobligations from the present value of estimated future net cash flows and doesnot reduce the capitalized oil and gas costs by the asset retirement obligationaccrued on the balance sheet.  Costssubject to depletion and depreciation include estimated costs required todevelop proved undeveloped reserves and the associated addition to the assetretirement obligations.  The adoption ofSAB 106 in the fourth quarter of 2004 did not have a material effect on theresults of the ceiling test or depletion, depreciation and amortizationcalculations.

 

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SFAS No. 154 - AccountingChanges and Error Corrections

 

On 1 January 2006, theCompany adopted the provisions of SFAS No. 154, Accounting Changes andError Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.  This statement applies to all voluntarychanges in accounting principle and changes the requirements for accounting forand reporting of a change in accounting principle. The statement requiresretrospective application to prior periods’ Financial Statements of a voluntarychange in accounting principle versus including the cumulative effect ofchanging to the new accounting principle in net income.  SFAS No. 154 carries forward manyprovisions of APB Opinion No. 20 without change, including the provisionsrelated to the reporting of a change in accounting estimate, a change in thereporting entity, and the correction of an error.  The adoption of this standard did not impactthe Company’s Financial Statements.

 

SFAS No. 159 - The Fair ValueOption for Financial Assets and Financial Liabilities

 

In February 2007, the FASBissued SFAS No. 159, The Fair Value Option for Financial Assets andFinancial Liabilities, including an amendment of FASB Statement No. 115(SFAS No. 159). This statement permits entities to choose to measure manyfinancial instruments and certain other items at fair value that are notcurrently required to be measured at fair value and establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 is effective on January 1, 2008. TheCompany is currently evaluating the impact of this standard on its FinancialStatements.

 

PRESENTATION

 

There are differentpresentations between Canadian and U.S. GAAP which are as follows:

 

1)              UnderU.S. GAAP, there is no difference between net income and other comprehensiveincome.

2)              Nosubtotal is permitted under U.S. GAAP within cashflow from operations on thestatement of cashflows.

 

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