InterOil
      Corporation
                Consolidated
      Financial Statements
                (Expressed
      in United States dollars)
                
                Years
      ended December 31, 2008, 2007 and 2006









InterOil
      Corporation
                Consolidated
      Financial Statements
                (Expressed
      in United States dollars)





Table
of contents





Management’s
      Report
              1Auditor’s
      Report to the Shareholders
              2Consolidated
      Balance Sheets
              4Consolidated
      Statements of Operations
              5Consolidated
      Statements of Cash Flows
              6Consolidated
      Statements of Shareholders’ Equity
              7Consolidated
      Statements of Comprehensive Income
              8Notes
      to the Consolidated Financial Statements
              9Reconciliation
      to accounting principles generally accepted in the United
      States
              44









InterOil
      Corporation
                Consolidated
      Financial Statements
                (Expressed
      in United States dollars)




MANAGEMENT’S
REPORT




The
management of InterOil Corporation is responsible for the financial information
and operating data presented in this Annual Report.





The
consolidated financial statements have been prepared by management in accordance
with Canadian Generally Accepted Accounting Principles.  When
alternative accounting methods exist, management has chosen those it deems most
appropriate in the circumstances.  Financial statements are not
precise as they include certain amounts based on estimates and
judgments.  Management has determined such amounts on a reasonable
basis in order to ensure that the financial statements are presented fairly, in
all material respects.  Financial information presented elsewhere in
this Annual Report has been prepared on a basis consistent with that in the
consolidated financial statements.





InterOil
Corporation maintains systems of internal accounting and administrative
controls.  These systems are designed to provide reasonable assurance
that the financial information is relevant, reliable and accurate and that the
Company’s assets are properly accounted for and adequately
safeguarded.





The Audit
Committee, appointed by the Board of Directors, is composed of independent
non-management directors.  The Committee meets regularly with
management, as well as the external auditors, to discuss auditing, internal
controls, accounting policy and financial reporting matters.  The
Committee reviews the annual consolidated financial statements with both
management and the independent auditors and reports its findings to the Board of
Directors before such statements are approved by the Board.





The 2008
consolidated financial statements have been audited by PricewaterhouseCoopers,
the independent auditors, in accordance with Canadian generally accepted
auditing standards on behalf of the
shareholders.  PricewaterhouseCoopers has full and free access to the
Audit Committee.




Phil
      Mulacek
            
            Collin
      VisaggioChief
      Executive Officer
            
            Chief
      Financial Officer







Consolidated Financial
Statements   INTEROIL
CORPORATION     1







INDEPENDENT
AUDIT REPORT TO THE SHAREHOLDERS OF INTEROIL CORPORATION





Independent
Auditors’ Report




To the
Shareholders of InterOil Corporation:





We have
completed integrated audits of InterOil Corporation’s 2008 and 2007 consolidated
financial statements and an audit of its 2006 consolidated financial
statements.  We have also completed an audit of its internal control
over financial reporting as at December 31, 2008.  Our opinions, based
on our audits, are presented below.




Consolidated financial
statements




We have
audited the accompanying consolidated balance sheetsofInterOil Corporation as
at December 31, 2008, 2007and 2006, and the
related consolidated statements of operations, comprehensive income,
shareholders’ equity and cash flowsfor each of the years in
the three year then ended.  These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these financial statements based on our audits.




We
conducted our audits of the Company’s financial statements as at December 31,
2008 and 2007 and for each of the years in the two year period then endedin accordance with
Canadian generally accepted auditing standards and the standards of the Public
Company Accounting Oversight Board (United States). We conducted our audit of
the Company’s financial statements for the year ended December 31, 2006in accordance with
Canadian generally accepted auditing standards.  Those standards
require that we plan and perform an audit to obtain reasonable assurance about
whether the financial statements are free of material
misstatement.  An audit of financial statements includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements.  A financial statement audit also includes assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as at December
31, 2008, 2007and  2006 and
the results of its operations and its cash flows for each of the years in the
three year period then ended in accordance with Canadian generally accepted
accounting principles.




Internal
control over financial reporting




We have
also audited InterOil Corporation’s internal control over financial reporting as
at December 31, 2008, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Company’s management is responsible
for maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting,
included in Management’s Report on Internal Control Over Financial Reporting
appearing under Item 15.  Our responsibility is to express an opinion
on the Company’s internal control over financial reporting based on our
audit.




We
conducted our audit of internal control over financial reporting in accordance
with the standards of the Public Company Accounting Oversight Board (United
States).  Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether effective internal control over
financial reporting was maintained in all material respects.  An audit
of internal control over financial reporting includes obtaining an understanding
of internal control over financial reporting, assessing the risk that a material
weakness exists, testing and evaluating the design and operating effectiveness
of internal control based on the assessed risk, and performing such other
procedures as we consider necessary in the circumstances.  We believe
that our audit provides a reasonable basis for our opinion.





A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company’s internal
control over financial reporting includes those policies and procedures that
(i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and
(iii) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the company’s assets that
could have a material effect on the financial statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.




Consolidated Financial
Statements   INTEROIL
CORPORATION     2







In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as at December 31, 2008 based on criteria
established in Internal Control — Integrated Framework issued by the
COSO.





PricewaterhouseCoopers


Melbourne,
Australia


March
      27, 2009
            except
      with respect to our opinion on the consolidated financial statements
      insofar as it relates to the revision to prepaid expenses and secured
      loans discussed in Note 29 as to which the date is December 10,
      2009




Consolidated Financial
Statements   INTEROIL
CORPORATION     3







InterOil
      Corporation
                Consolidated
      Balance Sheets
                (Expressed
      in United States dollars)




As atDecember 31,
                                    
                                    
                                    December 31,
                                    
                                    
                                    December 31,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006$
                                    
                                    
                                    $
                                    
                                    
                                    $AssetsCurrent
      assets:Cash
      and cash equivalents (note 5)
                                    
                                    
                                    48,970,572
                                    
                                    
                                    
                                    43,861,762
                                    
                                    
                                    
                                    31,681,435Cash
      restricted (note 7)
                                    
                                    
                                    25,994,258
                                    
                                    
                                    
                                    22,002,302
                                    
                                    
                                    
                                    29,301,940Trade
      receivables (note 8)
                                    
                                    
                                    42,887,823
                                    
                                    
                                    
                                    63,145,444
                                    
                                    
                                    
                                    67,542,902Commodity
      derivative contracts (note 7)
                                    
                                    
                                    31,335,050
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,759,575Other
      assets
                                    
                                    
                                    167,885
                                    
                                    
                                    
                                    146,992
                                    
                                    
                                    
                                    2,954,946Inventories
      (note 9)
                                    
                                    
                                    83,037,326
                                    
                                    
                                    
                                    82,589,242
                                    
                                    
                                    
                                    67,593,558Prepaid
      expenses
                                    
                                    
                                    4,489,574
                                    
                                    
                                    
                                    5,102,540
                                    
                                    
                                    
                                    880,640Total
      current assets
                                    
                                    
                                    236,882,488
                                    
                                    
                                    
                                    216,848,282
                                    
                                    
                                    
                                    201,714,996Cash
      restricted (note 7)
                                    
                                    
                                    290,782
                                    
                                    
                                    
                                    382,058
                                    
                                    
                                    
                                    3,217,284Deferred
      financing costs
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,716,757Plant
      and equipment (note 10)
                                    
                                    
                                    223,585,559
                                    
                                    
                                    
                                    232,852,222
                                    
                                    
                                    
                                    242,642,077Oil
      and gas properties (note 11)
                                    
                                    
                                    128,013,959
                                    
                                    
                                    
                                    84,865,127
                                    
                                    
                                    
                                    54,524,347Future
      income tax benefit (note 12)
                                    
                                    
                                    3,070,182
                                    
                                    
                                    
                                    2,867,312
                                    
                                    
                                    
                                    1,424,014Total
      assets
                                    
                                    
                                    591,842,970
                                    
                                    
                                    
                                    537,815,001
                                    
                                    
                                    
                                    505,239,475Liabilities
      and shareholders' equityCurrent
      liabilities:Accounts
      payable and accrued liabilities (note 13)
                                    
                                    
                                    78,147,736
                                    
                                    
                                    
                                    60,427,607
                                    
                                    
                                    
                                    76,095,369Commodity
      derivative contracts (note 7)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,960,300
                                    
                                    
                                    
                                    -Working
      capital facility (note 15)
                                    
                                    
                                    68,792,402
                                    
                                    
                                    
                                    66,501,372
                                    
                                    
                                    
                                    36,873,508Deferred
      hedge gain (note 7)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,385Deferred
      liquefaction project liability (note 18)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    6,553,080Current
      portion of secured loan (note 18)
                                    
                                    
                                    9,000,000
                                    
                                    
                                    
                                    136,776,760
                                    
                                    
                                    
                                    13,500,000Current
      portion of indirect participation interest - PNGDV (note
    19)
                                    
                                    
                                    540,002
                                    
                                    
                                    
                                    1,080,004
                                    
                                    
                                    
                                    730,534Total
      current liabilities
                                    
                                    
                                    156,480,140
                                    
                                    
                                    
                                    266,746,043
                                    
                                    
                                    
                                    133,753,876Accrued
      financing costs (note 18)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,087,500Secured
      loan (note 18)
                                    
                                    
                                    52,365,333
                                    
                                    
                                    
                                    61,141,389
                                    
                                    
                                    
                                    184,166,4338%
      subordinated debenture liability (note 23)
                                    
                                    
                                    65,040,067
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Preference
      share liability (note 22)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    7,797,312
                                    
                                    
                                    
                                    -Deferred
      gain on contributions to LNG project (note 14)
                                    
                                    
                                    17,497,110
                                    
                                    
                                    
                                    9,096,537
                                    
                                    
                                    
                                    -Indirect
      participation interest (note 19)
                                    
                                    
                                    72,476,668
                                    
                                    
                                    
                                    96,086,369
                                    
                                    
                                    
                                    96,861,259Indirect
      participation interest - PNGDV (note 19)
                                    
                                    
                                    844,490
                                    
                                    
                                    
                                    844,490
                                    
                                    
                                    
                                    1,190,633Total
      liabilities
                                    
                                    
                                    364,703,808
                                    
                                    
                                    
                                    441,712,140
                                    
                                    
                                    
                                    417,059,701Non-controlling
      interest (note 20)
                                    
                                    
                                    5,235
                                    
                                    
                                    
                                    4,292
                                    
                                    
                                    
                                    5,759,206Shareholders'
      equity:Share
      capital (note 21)
                                    
                                    
                                    373,904,356
                                    
                                    
                                    
                                    259,324,133
                                    
                                    
                                    
                                    233,889,366Authorised
      - unlimitedIssued
      and outstanding - 35,923,692(Dec
      31, 2007 - 31,026,356)(Dec
      31, 2006 - 29,871,180)Preference
      shares (note 22)
                                    
                                    
                                    -
                                    
                                    
                                    
                                    6,842,688
                                    
                                    
                                    
                                    -(Authorised
      - 1,035,554, issued and outstanding - nil)8%
      subordinated debentures (note 23)
                                    
                                    
                                    10,837,394
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Contributed
      surplus (note 24)
                                    
                                    
                                    15,621,767
                                    
                                    
                                    
                                    10,337,548
                                    
                                    
                                    
                                    4,377,426Warrants
      (note 25)
                                    
                                    
                                    2,119,034
                                    
                                    
                                    
                                    2,119,034
                                    
                                    
                                    
                                    2,137,852Accumulated
      Other Comprehensive Income
                                    
                                    
                                    27,698,306
                                    
                                    
                                    
                                    6,025,019
                                    
                                    
                                    
                                    1,492,869Conversion
      options (note 19)
                                    
                                    
                                    17,140,000
                                    
                                    
                                    
                                    19,840,000
                                    
                                    
                                    
                                    20,000,000Accumulated
      deficit
                                    
                                    
                                    (220,186,930
                                    )
                                    
                                    
                                    (208,389,853
                                    )
                                    
                                    
                                    (179,476,945
                                    )Total
      shareholders' equity
                                    
                                    
                                    227,133,927
                                    
                                    
                                    
                                    96,098,569
                                    
                                    
                                    
                                    82,420,568Total
      liabilities and shareholders' equity
                                    
                                    
                                    591,842,970
                                    
                                    
                                    
                                    537,815,001
                                    
                                    
                                    
                                    505,239,475





See
accompanying notes to the consolidated financial statements. Commitments and
contingencies (note 27), Going Concern (note 2(b))


On
behalf of the Board - Phil Mulacek, Director    Christian
Vinson, Director




Consolidated Financial
Statements   INTEROIL
CORPORATION     4







InterOil
      Corporation
                Consolidated
      Statement of Operations
                (Expressed
      in United States dollars)




December 31,
                            
                            
                            December 31,
                            
                            
                            December 31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $RevenueSales
      and operating revenues
                            
                            
                            915,578,709
                            
                            
                            
                            625,526,068
                            
                            
                            
                            511,087,934Interest
                            
                            
                            931,785
                            
                            
                            
                            2,180,285
                            
                            
                            
                            3,223,995Other
                            
                            
                            3,216,445
                            
                            
                            
                            2,666,890
                            
                            
                            
                            3,747,603919,726,939
                            
                            
                            
                            630,373,243
                            
                            
                            
                            518,059,532ExpensesCost
      of sales and operating expenses
                            
                            
                            888,623,109
                            
                            
                            
                            573,609,441
                            
                            
                            
                            499,494,540Administrative
      and general expenses
                            
                            
                            31,227,627
                            
                            
                            
                            31,998,655
                            
                            
                            
                            23,288,330Derivative
      (gain)/loss
                            
                            
                            (24,038,550
                            )
                            
                            
                            7,271,693
                            
                            
                            
                            (2,559,712
                            )Legal
      and professional fees
                            
                            
                            11,523,045
                            
                            
                            
                            6,532,646
                            
                            
                            
                            3,937,517Exploration
      costs, excluding exploration impairment (note 11)
                            
                            
                            995,532
                            
                            
                            
                            13,305,437
                            
                            
                            
                            6,176,866Exploration
      impairment (note 11)
                            
                            
                            107,788
                            
                            
                            
                            1,242,606
                            
                            
                            
                            1,647,185Short
      term borrowing costs
                            
                            
                            6,514,060
                            
                            
                            
                            5,565,828
                            
                            
                            
                            8,478,540Long
      term borrowing costs
                            
                            
                            17,459,186
                            
                            
                            
                            17,182,446
                            
                            
                            
                            11,856,872Depreciation
      and amortization
                            
                            
                            14,142,546
                            
                            
                            
                            13,024,258
                            
                            
                            
                            12,352,672Loss on amendment of indirect participation interest - PNGDV (note 19)
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            1,851,421Gain
      on LNG shareholder agreement (note 18)
                            
                            
                            -
                            
                            
                            
                            (6,553,080
                            )
                            
                            
                            -Gain
      on sale of oil and gas properties (note 11)
                            
                            
                            (11,235,084
                            )
                            
                            
                            -
                            
                            
                            
                            -Foreign
      exchange gain
                            
                            
                            (3,878,150
                            )
                            
                            
                            (5,078,338
                            )
                            
                            
                            (4,744,810
                            )931,441,109
                            
                            
                            
                            658,101,592
                            
                            
                            
                            561,779,421Loss
      before income taxes and non-controlling interest
                            
                            
                            (11,714,170
                            )
                            
                            
                            (27,728,349
                            )
                            
                            
                            (43,719,889
                            )Income
      taxes (note 12)Current
                            
                            
                            (1,564,038
                            )
                            
                            
                            (2,491,761
                            )
                            
                            
                            (1,232,487
                            )Future
                            
                            
                            1,482,074
                            
                            
                            
                            1,284,869
                            
                            
                            
                            (1,110,386
                            )(81,964
                            )
                            
                            
                            (1,206,892
                            )
                            
                            
                            (2,342,873
                            )Loss
      before non-controlling interest
                            
                            
                            (11,796,134
                            )
                            
                            
                            (28,935,241
                            )
                            
                            
                            (46,062,762
                            )Non-controlling
      interest (note 20)
                            
                            
                            (943
                            )
                            
                            
                            22,333
                            
                            
                            
                            263,959Net
      loss
                            
                            
                            (11,797,077
                            )
                            
                            
                            (28,912,908
                            )
                            
                            
                            (45,798,803
                            )Basic loss per share
      (note 26)
                            
                            
                            (0.35
                            )
                            
                            
                            (0.96
                            )
                            
                            
                            (1.55
                            )Diluted loss per share
      (note 26)
                            
                            
                            (0.35
                            )
                            
                            
                            (0.96
                            )
                            
                            
                            (1.55
                            )Weighted
      average number of common shares outstandingBasic
      and diluted
                            
                            
                            33,632,390
                            
                            
                            
                            29,998,133
                            
                            
                            
                            29,602,360




See
accompanying notes to the consolidated financial statements




Consolidated Financial
Statements   INTEROIL
CORPORATION     5








InterOil
      Corporation
                Consolidated
      Statement of Cash Flows
                (Expressed
      in United States dollars)





December 31,
                                              
                                              
                                              December 31,
                                              
                                              
                                              December 31,2008
                                              
                                              
                                              2007
                                              
                                              
                                              2006$
                                              
                                              
                                              $ (restated) *
                                              
                                              
                                              $Cash
      flows provided by (used in):Operating
      activitiesNet
      loss
                                              
                                              
                                              (11,797,077
                                              )
                                              
                                              
                                              (28,912,908
                                              )
                                              
                                              
                                              (45,798,803
                                              )Adjustments
      for non-cash and non-operating transactionsNon-controlling
      interest
                                              
                                              
                                              943
                                              
                                              
                                              
                                              (22,333
                                              )
                                              
                                              
                                              (263,959
                                              )Depreciation
      and amortization
                                              
                                              
                                              14,142,546
                                              
                                              
                                              
                                              13,024,258
                                              
                                              
                                              
                                              12,352,672Future
      income tax asset
                                              
                                              
                                              (202,870
                                              )
                                              
                                              
                                              (1,600,985
                                              )
                                              
                                              
                                              1,333,108Fair
      value adjustment on IPL PNG Ltd. acquisition
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (367,935
                                              )
                                              
                                              
                                              -(Gain)/loss
      on sale of plant and equipment
                                              
                                              
                                              (16,250
                                              )
                                              
                                              
                                              269,321
                                              
                                              
                                              
                                              263,945Gain
      on sale of exploration assets
                                              
                                              
                                              (11,235,084
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Impairment
      of plant and equipment
                                              
                                              
                                              -
                                              
                                              
                                              
                                              960,000
                                              
                                              
                                              
                                              755,857Amortization
      of discount on debt
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              28,891Amortization
      of discount on debentures liability
                                              
                                              
                                              1,915,910
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Amortization
      of deferred financing costs
                                              
                                              
                                              260,400
                                              
                                              
                                              
                                              421,691
                                              
                                              
                                              
                                              219,033(Gain)/loss
      on unsettled hedge contracts
                                              
                                              
                                              851,500
                                              
                                              
                                              
                                              (47,314
                                              )
                                              
                                              
                                              (71,875
                                              )(Gain)/loss
      on derivative contracts
                                              
                                              
                                              (17,034,350
                                              )
                                              
                                              
                                              3,765,800
                                              
                                              
                                              
                                              (1,220,500
                                              )Stock
      compensation expense
                                              
                                              
                                              5,741,086
                                              
                                              
                                              
                                              6,062,962
                                              
                                              
                                              
                                              1,976,072Inventory
      revaluation
                                              
                                              
                                              8,379,587
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Non-cash
      interest on secured loan facility
                                              
                                              
                                              2,189,907
                                              
                                              
                                              
                                              6,143,660
                                              
                                              
                                              
                                              2,926,025Non-cash
      interest settlement on preference shares
                                              
                                              
                                              372,950
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Non-cash
      interest settlement on debentures
                                              
                                              
                                              2,620,628
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Oil
      and gas properties expensed
                                              
                                              
                                              1,103,320
                                              
                                              
                                              
                                              14,548,043
                                              
                                              
                                              
                                              7,824,051Loss
      on amendment of indirect participation interest - PNGDV
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,851,421Gain
      on LNG shareholder agreement
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (6,553,080
                                              )
                                              
                                              
                                              -Preference
      share transaction costs
                                              
                                              
                                              -
                                              
                                              
                                              
                                              390,000
                                              
                                              
                                              
                                              -Gain
      on buy back of minority interest
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (394,290
                                              )
                                              
                                              
                                              -(Gain)/loss
      on proportionate consolidation of LNG project
                                              
                                              
                                              (811,765
                                              )
                                              
                                              
                                              2,375,278
                                              
                                              
                                              
                                              -Unrealized
      foreign exchange gain
                                              
                                              
                                              (3,728,721
                                              )
                                              
                                              
                                              (5,078,338
                                              )
                                              
                                              
                                              (4,744,810
                                              )Change
      in operating working capitalDecrease/(increase)
      in trade receivables
                                              
                                              
                                              18,684,422
                                              
                                              
                                              
                                              6,661,838
                                              
                                              
                                              
                                              (6,663,218
                                              )Increase
      in unrealised hedge gains
                                              
                                              
                                              900,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Decrease/(increase)
      in other assets and prepaid expenses
                                              
                                              
                                              592,073
                                              
                                              
                                              
                                              (2,698,546
                                              )
                                              
                                              
                                              4,051Decrease/(increase)
      in inventories
                                              
                                              
                                              (3,189,859
                                              )
                                              
                                              
                                              (6,033,038
                                              )
                                              
                                              
                                              2,642,493(Decrease)/Increase
      in accounts payable, accrued liabilitiesand
      income tax payable
                                              
                                              
                                              5,846,860
                                              
                                              
                                              
                                              (34,533,991
                                              )
                                              
                                              
                                              28,773,008Net
      cash from/(used in) operating activities
                                              
                                              
                                              15,586,156
                                              
                                              
                                              
                                              (31,619,907
                                              )
                                              
                                              
                                              2,187,462Investing
      activitiesExpenditure
      on oil and gas properties
                                              
                                              
                                              (63,890,512
                                              )
                                              
                                              
                                              (69,090,092
                                              )
                                              
                                              
                                              (47,990,758
                                              )Proceeds
      from IPI cash calls
                                              
                                              
                                              18,323,365
                                              
                                              
                                              
                                              21,782,988
                                              
                                              
                                              
                                              -Expenditure
      on plant and equipment
                                              
                                              
                                              (5,172,133
                                              )
                                              
                                              
                                              (7,289,319
                                              )
                                              
                                              
                                              (13,585,792
                                              )Proceeds
      received on sale of assets
                                              
                                              
                                              312,500
                                              
                                              
                                              
                                              65,072
                                              
                                              
                                              
                                              3,770,080Proceeds
      received on sale of exploration assets
                                              
                                              
                                              6,500,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Acquisition
      of subsidiary (note 16)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (3,326,631
                                              )
                                              
                                              
                                              (25,820,515
                                              )Proceeds
      from insurance claim
                                              
                                              
                                              -
                                              
                                              
                                              
                                              7,000,000
                                              
                                              
                                              
                                              -(Increase)/decrease
      in restricted cash held as security onborrowings
                                              
                                              
                                              (3,900,680
                                              )
                                              
                                              
                                              10,134,864
                                              
                                              
                                              
                                              (15,856,955
                                              )Change
      in non-cash working capitalIncrease/(decrease)
      in accounts payable and accrued liabilities
                                              
                                              
                                              436,775
                                              
                                              
                                              
                                              6,353,247
                                              
                                              
                                              
                                              2,412,621Net
      cash (used in)/from investing activities
                                              
                                              
                                              (47,390,685
                                              )
                                              
                                              
                                              (34,369,871
                                              )
                                              
                                              
                                              (97,071,319
                                              )Financing
      activitiesRepayments
      of secured loan
                                              
                                              
                                              (9,000,000
                                              )
                                              
                                              
                                              (4,500,000
                                              )
                                              
                                              
                                              (4,500,000
                                              )(Repayments
      of)/proceeds from bridging facility, net of transaction
    costs
                                              
                                              
                                              (70,000,000
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              125,293,488Financing
      fees related to bridging facility
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (100,000
                                              )
                                              
                                              
                                              -Proceeds
      from PNG LNG cash call
                                              
                                              
                                              9,447,250
                                              
                                              
                                              
                                              9,450,308
                                              
                                              
                                              
                                              -Payments
      for deferred financing fees
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (362,500
                                              )
                                              
                                              
                                              -Repayments
      of unsecured borrowings
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (21,453,132
                                              )Proceeds
      from Clarion Finanz for Elk option agreement
                                              
                                              
                                              5,500,000
                                              
                                              
                                              
                                              5,922,712
                                              
                                              
                                              
                                              -Proceeds
      from Petromin for Elk participation agreement
                                              
                                              
                                              4,000,000
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Proceeds
      from/(repayments of) working capital facility
                                              
                                              
                                              2,291,030
                                              
                                              
                                              
                                              29,627,864
                                              
                                              
                                              
                                              (33,850,814
                                              )Proceeds
      from/(payments for) issue ofcommon
      shares/conversion of debt, net of transaction costs
                                              
                                              
                                              (104,975
                                              )
                                              
                                              
                                              23,816,100
                                              
                                              
                                              
                                              1,473,943Proceeds
      from issue of debentures, net of transaction costs
                                              
                                              
                                              94,780,034
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Proceeds
      from preference shares, net of transaction costs
                                              
                                              
                                              -
                                              
                                              
                                              
                                              14,250,000
                                              
                                              
                                              
                                              -Proceeds
      from conversion of warrants
                                              
                                              
                                              -
                                              
                                              
                                              
                                              65,621
                                              
                                              
                                              
                                              -Net cash from/(used in) financing activities
                                              
                                              
                                              36,913,339
                                              
                                              
                                              
                                              78,170,105
                                              
                                              
                                              
                                              66,963,485Increase/(decrease)
      in cash and cash equivalents
                                              
                                              
                                              5,108,810
                                              
                                              
                                              
                                              12,180,327
                                              
                                              
                                              
                                              (27,920,372
                                              )Cash
      and cash equivalents, beginning of period
                                              
                                              
                                              43,861,762
                                              
                                              
                                              
                                              31,681,435
                                              
                                              
                                              
                                              59,601,807Cash
      and cash equivalents, end of period (note 5)
                                              
                                              
                                              48,970,572
                                              
                                              
                                              
                                              43,861,762
                                              
                                              
                                              
                                              31,681,435





See
accompanying notes to the consolidated financial statements




Consolidated Financial
Statements   INTEROIL
CORPORATION     6







InterOil
      Corporation
                Consolidated
      Statements of Shareholders' Equity
                (Expressed
      in United States dollars)




Year endedDecember 31,
                      
                      
                      December 31,
                      
                      
                      December 31,2008
                      
                      
                      2007
                      
                      
                      2006$
                      
                      
                      $
                      
                      
                      $Share
      capitalAt
      beginning of period
                      
                      
                      259,324,133
                      
                      
                      
                      233,889,366
                      
                      
                      
                      223,934,500Issue
      of capital stock (note 21)
                      
                      
                      114,580,223
                      
                      
                      
                      25,434,767
                      
                      
                      
                      9,954,866At
      end of period
                      
                      
                      373,904,356
                      
                      
                      
                      259,324,133
                      
                      
                      
                      233,889,366Preference
      sharesAt
      beginning of period
                      
                      
                      6,842,688
                      
                      
                      
                      -
                      
                      
                      
                      -Issue
      of preference shares (note 22)
                      
                      
                      -
                      
                      
                      
                      6,842,688
                      
                      
                      
                      -Converted
      to common shares
                      
                      
                      (6,842,688
                      )
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      -
                      
                      
                      
                      6,842,688
                      
                      
                      
                      -8%
      subordinated debenturesAt
      beginning of period
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issue
      of debentures (note 23)
                      
                      
                      13,036,434
                      
                      
                      
                      -
                      
                      
                      
                      -Conversion
      to common shares during the year
                      
                      
                      (2,199,040
                      )
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      10,837,394
                      
                      
                      
                      -
                      
                      
                      
                      -Contributed
      surplusAt
      beginning of period
                      
                      
                      10,337,548
                      
                      
                      
                      4,377,426
                      
                      
                      
                      2,933,586Fair
      value of options exercised transferred to share capital (note
      24)
                      
                      
                      (456,867
                      )
                      
                      
                      (102,840
                      )
                      
                      
                      (532,232
                      )Stock
      compensation expense (note 24)
                      
                      
                      5,741,086
                      
                      
                      
                      6,062,962
                      
                      
                      
                      1,976,072At
      end of period
                      
                      
                      15,621,767
                      
                      
                      
                      10,337,548
                      
                      
                      
                      4,377,426WarrantsAt
      beginning of period
                      
                      
                      2,119,034
                      
                      
                      
                      2,137,852
                      
                      
                      
                      2,137,852Movement
      for period (note 25)
                      
                      
                      -
                      
                      
                      
                      (18,818
                      )
                      
                      
                      -At
      end of period
                      
                      
                      2,119,034
                      
                      
                      
                      2,119,034
                      
                      
                      
                      2,137,852Accumulated
      Other Comprehensive IncomeAt
      beginning of period
                      
                      
                      6,025,019
                      
                      
                      
                      1,492,869
                      
                      
                      
                      477,443Deferred
      hedge gain recognised on transition
                      
                      
                      -
                      
                      
                      
                      1,385
                      
                      
                      
                      -Deferred
      hedge (loss)/gain movement for period, net of tax
                      
                      
                      18,012,500
                      
                      
                      
                      (1,385
                      )
                      
                      
                      -Foreign
      currency translation movement for period, net of tax (note
      2(g))
                      
                      
                      3,660,787
                      
                      
                      
                      4,532,150
                      
                      
                      
                      1,015,426At
      end of period
                      
                      
                      27,698,306
                      
                      
                      
                      6,025,019
                      
                      
                      
                      1,492,869Conversion
      optionsAt
      beginning of period
                      
                      
                      19,840,000
                      
                      
                      
                      20,000,000
                      
                      
                      
                      20,000,000Movement
      for period (note 19)
                      
                      
                      (2,700,000
                      )
                      
                      
                      (160,000
                      )
                      
                      
                      -At
      end of period
                      
                      
                      17,140,000
                      
                      
                      
                      19,840,000
                      
                      
                      
                      20,000,000Accumulated
      deficitAt
      beginning of period
                      
                      
                      (208,389,853
                      )
                      
                      
                      (179,476,945
                      )
                      
                      
                      (133,678,142
                      )Net
      loss for period
                      
                      
                      (11,797,077
                      )
                      
                      
                      (28,912,908
                      )
                      
                      
                      (45,798,803
                      )At
      end of period
                      
                      
                      (220,186,930
                      )
                      
                      
                      (208,389,853
                      )
                      
                      
                      (179,476,945
                      )Shareholders'
      equity at end of period
                      
                      
                      227,133,927
                      
                      
                      
                      96,098,569
                      
                      
                      
                      82,420,568





See
accompanying notes to the consolidated financial statements




Consolidated Financial
Statements   INTEROIL
CORPORATION     7







InterOil
      Corporation
                Consolidated
      Statements of Comprehensive Income
                (Expressed
      in United States dollars)




December 31,
                  
                  
                  December 31,
                  
                  
                  December 31,2008
                  
                  
                  2007
                  
                  
                  2006$
                  
                  
                  $
                  
                  
                  $Net
      loss as per Statement of Operations
                  
                  
                  (11,797,077
                  )
                  
                  
                  (28,912,908
                  )
                  
                  
                  (45,798,803
                  )Other
      comprehensive income, net of tax
                  
                  
                  21,673,287
                  
                  
                  
                  4,530,765
                  
                  
                  
                  1,015,426Comprehensive
      income/(loss)
                  
                  
                  9,876,210
                  
                  
                  
                  (24,382,143
                  )
                  
                  
                  (44,783,377
                  )





See
accompanying notes to the consolidated financial statements




Consolidated Financial
Statements   INTEROIL
CORPORATION     8








InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)




1.
            Nature
      of operations and organization





InterOil
Corporation (the "Company" or "InterOil") is a publicly traded, integrated oil
and gas company operating in Papua New Guinea (“PNG”).





Management
has organized the Company’s operations into four major segments - Upstream,
Midstream, Downstream and Corporate.





Upstream
includes Exploration and Production operations for crude oil and natural gas in
PNG. Midstream Refining includes refining of products for domestic market in
Papua New Guinea and exports, and Midstream Liquefaction includes the work being
undertaken to further the LNG project in PNG.  Downstream includes
Wholesale and Retail Distribution of refined products in PNG. Corporate engages
in business development and improvement, common services and management,
financing and treasury, government and investor relations.  Common and
integrated costs are recovered from business segments on an equitable driver
basis.




2.
            Significant
      accounting policies





The
principal accounting policies adopted in the preparation of the financial report
are set out below.  These policies have been consistently applied for
all years presented, unless otherwise stated.





(a)
            Basis
      of preparation





These
financial statements are prepared in accordance with Canadian Generally Accepted
Accounting Principles (“GAAP”) applicable to a going concern, which, in the case
of the Company, differ in certain respects from those in the United
States.  These differences are described in note 29, Reconciliation to
Generally Accepted Accounting Principles in the United States.





The
consolidated financial statements for the year ended December 31, 2008 are in
accordance with Canadian GAAP which requires the use of certain critical
accounting estimates.  It also requires management to exercise its
judgment in the process of applying Company’s accounting
policies.  These estimates and judgments may affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reported period.  Actual results
could differ from these estimates. The effect of changes in estimates on future
periods have not been disclosed in these consolidated financial statements as
estimating it is impracticable.





(b)
            Going
      concern





These
consolidated financial statements have been prepared using Canadian GAAP
applicable to a going concern, which contemplates the realization of assets and
settlement of liabilities in the normal course of business as they become
due.





For the
year ended December 31, 2008, the Company reported a loss of $11.8 million as
compared to a loss of $28.9 million for the same period of 2007.  The
total operating cash inflow was $15.6 million for the year compared to a cash
outflow of $31.6 million in 2007.  The Company reported a net
operating cash outflow, before working capital movements, of $7.2 million for
the year compared to $5.0 million inflow during 2007.  The net current
assets for the year ended December 31, 2008 was $80.4 million compared to a net
current asset deficit of $49.9 million in 2007.





The
Company has cash, cash equivalents and cash restricted of $75.3 million as at
December 31, 2008 (December 2007 - $66.3 million), of which $26.3 million is
restricted (December 2007 - $22.4 million).  The Company has a short
term working capital facility of $190.0 million for its Midstream – Refining
operation that is renewable annually with BNP Paribas.  This facility
is secured by the assets it is drawn down against.  The overall
facility limit has been increased by $20.0 million as part of the annual renewal
process.  As at December 31, 2008 only $81.0 million has been
utilized, and the remaining facility remains available for use.  This
facility is due to be renewed in August 2009.  During 2008 the Company
also secured a $57.5 million (Papua New Guinea Kina 150.0 million) revolving
working capital facility for its Downstream operations in Papua New Guinea from
Bank of South Pacific Limited and Westpac Bank PNG Limited. Westpac facility
limit is Papua New Guinea Kina 80.0 million (approximately $30.7 million) and
BSP facility limit is Papua New Guinea Kina 70.0 million (approximately $26.8
million).  The Westpac facility is for an initial term of three years
and is due for renewal in October 2011. The BSP facility is renewable annually
and is due for renewal in August 2009.  As at December 31, 2008 only
$15.4 million of this combined facility has been utilized, and the remaining
facility remains available for use.  Management expects these
facilities to be renewed in due course as these working capital facilities are
fully secured against trade debtors, inventory and cash deposits.





With
respect to its Upstream operations, the Company has no obligation to execute
exploration activities within a set timeframe and therefore has the ability to
postpone these activities in the event sufficient funding is not
available.




Consolidated Financial
Statements   INTEROIL
CORPORATION     9







InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)




2.
            Significant
      accounting policies (cont’d)





The
Company believes that it has sufficient funds for the Midstream Refinery and
Downstream operations; however, existing cash balances and ongoing cash
generated from operations will not be sufficient to facilitate further
development of the Elk/Antelope well prospect and the Midstream Liquefaction LNG
plant development.  Therefore the Company must extend or secure
sufficient funding through renewed borrowings, equity raising and or asset sales
to enable sufficient cash to be available to further its development
plans.  Management expects that the Company will be able to secure the
necessary financing through one of, or a combination or the aforementioned
alternatives.  Accordingly, these financial statements have been
prepared on a going concern basis in the belief that the Company will realize
its assets and settle its liabilities and commitments in the normal course of
business and for at least the amounts stated.





(c)
            Principles
      of consolidation





Subsidiaries





The
consolidated financial statements of the Company incorporates the assets,
liabilities and results of InterOil Corporation and of all subsidiaries as at
December 31, 2008, December 31, 2007, December 31, 2006 and for the years then
ended.  Subsidiaries of InterOil Corporation as at December 31, 2008
include SP InterOil, LDC (“SPI”) (99.9%), SPI Exploration and Production
Corporation (100%), SPI Distribution Limited (100%), InterOil LNG Holdings Inc.
(100%), InterOil Australia Pty Ltd (100%), SPI InterOil Holdings Limited (100%),
Direct Employment Services Company (100%), InterOil New York Inc. (100%) and
their subsidiaries.  InterOil Corporation and its subsidiaries
together are referred to in these financial statements as the Company or the
consolidated entity.





Effective
October 1, 2006 the Company acquired 100% shareholding of Shell Papua New Guinea
Ltd from Shell.  The acquired entity has been renamed IPL (PNG) Ltd
and became a fully owned subsidiary of InterOil Products Limited.  The
results of IPL (PNG) Ltd have been incorporated into the Company consolidation
from October 1, 2006.





During
the year 2006, the Company set up PNG LNG Inc., a Bahamas incorporated entity,
to construct and operate a Liquefied Natural Gas facility (‘LNG Project’) in
PNG.  In June 2007, InterOil LNG Holdings Inc. was incorporated as a
holding company of InterOil’s investment in PNG LNG Inc.. InterOil LNG Holdings
Inc. is a 100% subsidiary of InterOil Corporation.  During July 2007,
the investment in PNG LNG Inc. was transferred from InterOil Corporation to
InterOil LNG Holdings Inc.  Refer to the section ‘Proportionate
consolidation of Joint Venture interests’ below for the changes to InterOil’s
shareholding in PNG LNG Inc. due to the signing of the Shareholders’ Agreement
in July 2007.





In April
2008, InterOil New York Inc. was incorporated as a 100% subsidiary of InterOil
Corporation to evaluate potential financing arrangements in the
U.S.





Subsidiaries
are all those entities over which the Company has the right and ability to
obtain future economic benefits from the resources of the enterprise and is
exposed to the related risks.  Control of an enterprise is the
continuing power to determine strategic operating, investing and financing
policies without the cooperation of others.  The existence and effect
of potential voting rights that are currently exercisable or convertible are
considered when assessing whether the Company controls another
entity.  Subsidiaries are fully consolidated from the date on which
control is transferred to the Company.  They are de-consolidated from
the date that control ceases.





The
purchase method of accounting is used to account for the acquisition of
subsidiaries by the Company, refer to note 2(j).  Intercompany
transactions, balances and unrealized gains on transactions between Company
companies are eliminated on consolidation.  Minority interest in the
results and equity of subsidiaries are shown separately in the consolidated
statements of operations and balance sheets.





Proportionate
consolidation of Joint Venture interests





During
July 2007, the investment in PNG LNG Inc. (“Joint Venture Company” – previously
100% subsidiary of InterOil) was transferred from InterOil Corporation to
InterOil LNG Holdings Inc. On July 30, 2007, a Shareholders’ Agreement was
signed between InterOil LNG Holdings Inc., Pacific LNG Operations Ltd., Merrill
Lynch Commodities (Europe) Limited and PNG LNG Inc..  The signing of
this Shareholders’ Agreement meant that PNG LNG Inc. was no longer a subsidiary
of InterOil and was a jointly controlled entity, between the parties to the
Shareholders’ Agreement, from the date of the agreement.  As the
entity became a joint venture in July 2007, guidance under CICA 3055 – ‘Interest
in Joint Ventures’ has been followed and the entity has been proportionately
consolidated in InterOil’s consolidated financial statements from the date of
the Shareholders’ Agreement.  The consolidated results of InterOil’s
proportionate shareholding in the LNG Project has been disclosed separately
within the segment notes, refer to note 4.  For further details on the
impact of Shareholders Agreement and proportionate consolidation of the joint
venture balances, refer to note 14 below.




Consolidated Financial
Statements   INTEROIL
CORPORATION     10







InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)




2.
            Significant
      accounting policies (cont’d)





(d)
            Changes
      in accounting policies




Effective
January 1, 2008 the Company adopted the following new Canadian Institute of
Chartered Accountants (CICA) sections:


·
            CICA
      1400 – General standards of financial statement
    presentation




·
            CICA
      1535 – Capital Disclosures




·
            CICA
      3031 – Inventories




·
            CICA
      3862 – Financial Instruments – Disclosures;
and




·
            CICA
      3863 – Financial Instruments –
Presentation




These new
accounting standards provide requirements for the presentation and disclosure of
financial instruments and capital disclosures.  The standards have
been adopted prospectively and as such the comparative consolidated financial
statements have not been restated.  The adoption of these Handbook
sections had no impact on opening retained earnings or accumulated other
comprehensive income.




General
standards of financial statement presentation





This
Section has been amended to include requirements to assess and disclose an
entity's ability to continue as a going concern.  The new requirements are
applicable to all entities and are effective for interim and annual financial
statements relating to fiscal years beginning on or after January 1,
2008.





Capital
Disclosures





This
Section establishes standards for disclosing information about an entity's
capital and how it is managed.  This section has resulted in InterOil
disclosing information in note 3(h) below that enables users of its financial
statements to evaluate the Company's objectives, policies and processes for
managing capital.





Inventories





This
section establishes standards for the measurement and disclosure of
inventories.  It provides the Canadian equivalent to International
Financial Reporting Standard IAS 2, "Inventories".  There is no impact
due to this new standard on the accounting policies of the Company.





Financial
Instruments – Disclosure and Presentation





The
objectives of these Sections are to require entities to provide disclosures in
their financial statements that enable users to evaluate:





a. the
significance of financial instruments for the entity's financial position and
performance


b. the
nature and extent of risks arising from financial instruments to which the
entity is exposed during the period and at the balance sheet date, and how the
entity manages those risks; and


c. to
enhance financial statement users' understanding of the significance of
financial instruments to an entity's financial position, performance and cash
flows.





These
revised sections have resulted in InterOil disclosing additional information on
the risk arising from financial instruments to which InterOil is exposed to,
refer note 3 below for detailed information.





(e)
            New
      standards issued but not yet
effective





Based on
the detailed review conducted by the Company of the new CICA sections, or
revisions to current sections, that are effective January 1, 2009, no items have
been identified as having any material impact on the Company’s financial
statements.





(f)
            Segment
      reporting





An
operating segment (also referred to as a ‘business segment’) is a component of
an enterprise:


a.     that
engages in business activities from which it may earn revenues and incur
expenses (including revenues and expenses relating to transactions with other
segments of the same enterprise),


b.     whose
operating results are regularly reviewed by the Company’s management to make
decisions about resources to be allocated to the segment and assess its
performance, and


c.     for
which discrete financial information is available.




Consolidated Financial
Statements   INTEROIL
CORPORATION     11







InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





2.
            Significant
      accounting policies (cont’d)





The
Company’s assets and operations are predominantly based in Papua New Guinea and
therefore are disclosed as one geographical segment.  Refer to note 1
for the management’s organization of the Company by business
segment.





(g)
            Foreign
      currency translation





Functional
and reporting currency


Items
included in the financial statements of each of the Company’s entities are
measured using the currency of the primary economic environment in which the
entity operates (‘the functional currency’).  The consolidated
financial statements are presented in United States Dollars which is InterOil’s
functional and reporting currency.





Self
Sustaining and Integrated Foreign Operations


For
subsidiaries considered to be self-sustaining foreign operations, all assets and
liabilities denominated in foreign currency are translated to United States
dollars at exchange rates in effect at the balance sheet date and all revenue
and expense items are translated at the rates of exchange in effect at the time
of the transactions.  Foreign exchange gains or losses are reported as
a separate component of shareholders' equity as a Foreign currency translation
adjustment.





For
subsidiaries considered to be an integrated foreign operation, monetary items
denominated in foreign currency are translated to United States dollars at
exchange rates in effect at the balance sheet date and non-monetary items are
translated at rates of exchange in effect when the assets were acquired or
obligations incurred.  Revenue and expense items are translated at the
rates of exchange in effect at the time of the transactions.  Foreign
exchange gains or losses are included in the statement of
operations.





(h)
            Revenue
      recognition





Revenue
is measured at the fair value of the consideration received or receivable.
Amounts disclosed as revenue are net of returns, trade allowances and duties and
taxes paid.  The following particular accounting policies, which
significantly affect the measurement of results, have been applied.





Revenue from midstream
operations:


Revenue
from sales of products is recognized when products are shipped and the customer
takes ownership and assumes risk of loss, collection of the relevant receivable
is probable, persuasive evidence of an arrangement exists and the sales price is
fixed or determinable.  Sales between the business segments of the
Company have been eliminated from sales and operating revenues and cost of
sales.





Revenue
from downstream operations:


Sales of
goods are recognized when the Company has delivered products to the customer,
the customer takes ownership and assumes risk of loss, collection of the
receivable is probable, persuasive evidence of an arrangement exists and the
sale price is fixed or determinable. It is not the Company’s policy to sell
products with a right of return.





Interest
income:


Interest
income is recognized on a time-proportionate basis.





(i)
            Income
      tax





The
income tax expense or revenue for the period is the tax payable on the current
period’s taxable income based on the national income tax rate for each
jurisdiction adjusted by changes in deferred tax assets and liabilities
attributable to temporary differences between the tax bases of assets and
liabilities and their carrying amounts in the financial statements and to unused
tax losses.





Deferred
tax assets and liabilities are recognized for temporary differences at the tax
rates expected to apply when the assets are recovered or liabilities are
settled, based on those tax rates which are enacted or substantively enacted for
each jurisdiction.  The relevant tax rates are applied to the
cumulative amounts of deductible and taxable temporary differences to measure
the deferred tax asset or liability.





Deferred
tax assets are recognized for deductible temporary differences and unused tax
losses only if it is more likely than not that future taxable amounts will be
available to utilize those temporary differences and losses.  A
valuation allowance is provided against any portion of a future tax asset which
will more likely not be recovered.





In
addition to income taxes, InterOil is subject to Goods and Services Tax, Excise
duty and other taxes in Papua New Guinea, Australia and Canada.  The
consolidated statement of operations is prepared on a net basis by the
Company.




Consolidated Financial
Statements   INTEROIL
CORPORATION     12







InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)




2.
            Significant
      accounting policies (cont’d)





(j)
            Acquisitions
      of assets





The
purchase method of accounting is used to account for all acquisitions of assets
(including business combinations) regardless of whether equity instruments or
other assets are acquired. Cost is measured as the fair value of the assets
given, shares issued or liabilities assumed at the date of exchange plus costs
directly attributable to the acquisition.





Identifiable
assets acquired and liabilities and contingent liabilities assumed in a business
combination are measured initially at their fair values at the acquisition
date.  The excess of the cost of acquisition over the fair value of
the Company’s share of the identifiable net assets is recorded as goodwill. If
the cost of acquisition is less than the fair value of the net assets of the
subsidiary acquired, the difference, to the extent possible, is allocated
against acquired fixed assets in accordance with the standards on a pro rata
basis.  Any further excess is presented as an extraordinary gain in
the statement of operations.





Where
settlement of any part of cash consideration is deferred, the amounts payable in
future are discounted to their present value as at the date of
exchange.  The discount rate is the Company’s incremental borrowing
rate, being the rate at which similar borrowing could be obtained from an
independent financier under comparable terms and conditions.





(k)
            Impairment
      of assets





Assets
that are subject to amortization are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount may not be
recoverable.  The carrying amount of a long-lived asset is not
recoverable if the carrying amount exceeds the sum of the undiscounted cash
flows expected to result from its use and eventual disposition.





An
impairment loss is recognized for the amount by which the asset’s carrying
amount exceeds its fair value.  Fair value is the amount of the
consideration that would be agreed upon in an arm's length transaction between
knowledgeable, willing parties who are under no compulsion to
act.  When no liquid market exists, the fair value is the present
value of future cash flows discounted at the risk free rate of interest plus a
risk premium.  If an impairment loss is recognized, the adjusted
carrying amount becomes the new cost basis.





For the
purposes of assessing impairment, assets are grouped at the lowest levels for
which there are separately identifiable cash flows.





(l)
            Cash
      and cash equivalents





Cash and
cash equivalents includes cash on hand, deposits held at call with financial
institutions, other short-term, highly liquid investments with original
maturities of three months or less that are readily convertible to known amounts
of cash and which are subject to insignificant risk of changes in
value.





(m)
            Restricted
      cash





Restricted
cash consists of cash on deposit with a maturity of less than three months at
the time of purchase but which is restricted from being used in daily
operations.  Restricted cash is carried at cost and any accrued
interest is classified under other assets.





(n)
            Trade
      receivables





The
collectability of trade receivables is assessed on an ongoing
basis.  Debts which are known to be uncollectible are written
off.  A provision for doubtful receivables is established when there
is objective evidence that the Company will not be able to collect all amounts
due according to the original terms of the receivables.  The amount of
provision is recognized in the statement of operations.





The
Company sells certain trade receivables with recourse to BNP Paribas under its
working capital facility.  The receivables are retained on the balance
sheet as the Company retains control over these receivables.





(o)
            Inventory





Raw
materials and stores and finished goods


Raw
materials and finished goods are stated at the lower of costs and net realizable
value.  Costs comprise direct materials, direct labor and an
appropriate proportion of variable and fixed overhead
expenditure.  Net realizable value is the estimated selling price in
the ordinary course of the business less the estimated costs of completion and
the estimated costs necessary to make the sale.  Stores are stated at
cost less provision for obsolescence.




Consolidated Financial
Statements   INTEROIL
CORPORATION     13





InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





2.
            Significant
      accounting policies (cont’d)





Crude
oil and refined petroleum products


Crude oil
and refined petroleum products are recorded on a first-in, first-out basis and
the net realizable value test for crude oil and refined petroleum products are
performed separately.  The cost of midstream refined petroleum product
consists of raw material, labor, direct overheads and transportation
costs.  The cost of downstream refined petroleum product includes the
cost of the product plus related freight, wharfage and insurance.





(p)
            Assets
      held for sale





Non-current
assets are classified as held for sale and stated at the lower of their carrying
amount and fair value less costs to sell if their carrying amount will be
recovered principally through a sale transaction rather than through continuing
use.





An
impairment loss is recognized for any initial or subsequent write down of the
asset (or disposal group) to fair value less costs to sell.  A gain is
recognized for any subsequent increase in fair value less costs to sell an asset
but not in excess of any cumulative impairment loss previously
recognized.  A gain or loss not previously recognized by the date of
sale of the non-current asset is recognized at the date of
derecognition.





Non-current
assets are not depreciated or amortized while they are classified as held for
sale.  Interest and other expenses attributable to the liabilities of
a disposal group classified as held for sale continue to be
recognized.





Non-current
assets classified as held for sale are presented separately from other assets in
the balance sheet.  The liabilities of a disposal group classified as
held for sale are presented separately from other liabilities in the balance
sheet.





(q)
            Derivative
      financial instruments





Derivative
financial instruments are utilized by the Company in the management of its crude
purchase cost exposures and its finished products sales price
exposures.  The Company's policy is not to utilize derivative
financial instruments for trading or speculative purposes.  The
Company may choose to designate derivative financial instruments as
hedges.





When
applicable, at the inception of the hedge, the Company formally documents all
relationships between hedging instruments and hedged items, as well as its risk
management objective and strategy for undertaking various hedge transactions,
the nature of the risk being hedged, how the hedging instruments’ effectiveness
in offsetting the hedged risk will be assessed and a description of the method
for measuring effectiveness.  This process includes linking all
derivatives to specific assets and liabilities on the balance sheet or to
specific firm commitments or anticipated transactions.  The Company
also assesses whether the derivatives that are used in hedging transactions are
highly effective in offsetting changes in fair value or cash flows of hedged
items at inception and on an ongoing basis.





Changes
in the fair value of a derivative that is highly effective and that is
designated and qualifies as a cash-flow hedge are recorded as a component of
Other comprehensive Income until earnings are affected by the variability in
cash flows of the designated hedged item.  For cash flow hedges that
have been terminated or cease to be effective, prospective gains or losses on
the derivative are recognized in earnings.  Any gain or loss that has
been included in accumulated other comprehensive income at the time the hedge is
discontinued continues to be deferred in accumulated other comprehensive income
until the original hedged transaction is recognized in earnings.  If
the likelihood of the original hedged transaction occurring is no longer
probable, the entire gain or loss in accumulated other comprehensive income
related to this transaction is immediately reclassified to
earnings.





The
Company discontinues hedge accounting prospectively when it is determined that
the derivative is no longer effective in offsetting changes in cash flows of the
hedged item, the derivative expires or is sold, terminated or exercised, the
derivative is no longer designated as a hedging instrument because it is
unlikely that a forecasted transaction will occur, a hedged firm commitment no
longer meets the definition of a firm commitment or management determines that
designation of the derivative as a hedging instrument is no longer
appropriate.





(r)
            Deferred
      financing costs





Deferred
financing costs represent the unamortized financing costs paid to secure
borrowings.  Amortization is provided on an effective yield basis over
the term of the related debt and is included in expenses for the
period.  In accordance with revised guidance under CICA Section 3861 –
Financial Instruments – disclosure and presentation, InterOil has reclassified
the unamortized deferred financing costs amounting to $1,716,757 as at January
1, 2007, previously disclosed as a separate item under Non-current assets, to
offset the respective liability accounts.







Consolidated
Financial Statements   INTEROIL
CORPORATION     14


InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





2.
            Significant
      accounting policies (cont’d)





(s)
            Plant
      and equipment





Refinery
assets


The
Company’s most significant item of plant and equipment is the oil refinery in
Papua New Guinea which is included within midstream assets.  The
pre-operating stage of the refinery ceased on January 1,
2005.  Project costs, net of any recoveries, incurred during the
pre-operating stage were capitalized as part of plant and
equipment.  Development costs and the costs of acquiring or
constructing support facilities and equipment are also capitalized.





The
refinery assets are recorded at cost.  Interest costs relating to the
construction and pre-operating stage of the development project prior to
commencement of commercial operations were capitalized as part of the cost of
such plant and equipment.





Refinery
related assets are depreciated on straight line basis over their useful lives,
at an average rate of 4% per annum.  The refinery is built on land
leased from the Independent State of Papua New Guinea.  The lease
expires on July 26, 2097 and does not outline any terms for restoration and
closure costs.





Repairs
and maintenance costs, other than major turnaround costs, are charged to
earnings as incurred.  Major turnaround costs will be deferred to
other assets when incurred and amortized over the estimated period of time to
the next scheduled turnaround.  No major turnaround costs have been
incurred during the year ended December 31, 2008.





Other
assets


Property,
plant and equipment are recorded at cost.  Depreciation of assets
begins when the asset is in place and ready for its intended use. Assets under
construction and deferred project costs are not
depreciated.  Depreciation of plant and equipment is calculated using
the straight line method, based on the estimated service life of the
asset.  Maintenance and repair costs are expensed as
incurred.  Improvements that increase the capacity or prolong the
service life of an asset are capitalized.  The depreciation rates by
category are as follows:





Downstream
                  
                  
                  0%
      - 25
                  %Midstream
                  
                  
                  1%
      - 33
                  %Upstream
                  
                  
                  4%
      - 100
                  %Corporate
                  
                  
                  13%
      - 33
                  %





During
the year 2006, InterOil adopted a deminimus threshold of $5,000 below which all
capital purchases are expensed in the period of purchase.  This was
effected retrospectively and all individual items not meeting the capitalization
criteria adopted, were written off in 2006.





Leased
assets


Leases of
property, plant and equipment where the Company has substantially all the risks
and rewards of ownership are classified as finance leases.  Finance
leases are classified at the lease’s inception at the lower of the fair value of
the leased property and the present value of the minimum lease
payments.  The corresponding rental obligations, net of finance
charges, are included in other long term payables.  Each lease payment
is allocated between the liability and the finance charges so as to achieve a
constant rate on the finance balance outstanding.  The interest
element of the finance cost is charged to the statement of operations over the
lease period so as to produce a constant periodic rate of interest on the
remaining balance of the liability for each period.  The property,
plant and equipment acquired under finance leases are depreciated over the
shorter of the asset’s useful life and the lease term.





Leases in
which a significant portion of the risks and rewards of ownership are retained
by the lessor are classified as operating leases.  Operating lease
payments are representative of the pattern of benefit derived from the leased
asset and accordingly are included in expenses in the periods in which they are
incurred.





Asset
retirement obligations


Estimated
costs of future dismantlement, site restoration and abandonment of properties
are provided based upon current regulations and economic circumstances at year
end.  Management estimates there are no material obligations
associated with the retirement of the refinery or with its normal operations
relating to future restoration and closure costs.





The
refinery is built on land leased from the Independent State of Papua New
Guinea.  The lease expires on July 26, 2097.





Environmental
remediation


Remediation
costs are accrued based on estimates of known environmental remediation
exposure.  Ongoing environmental compliance costs, including
maintenance and monitoring costs, are expensed as
incurred.  Provisions are determined on an assessment of current
costs, current legal requirements and current technology.  Changes in
estimates are dealt with on a prospective basis.  As at December 31,
2008, no provision has been raised.







Consolidated
Financial Statements   INTEROIL
CORPORATION     15


InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





2.
            Significant
      accounting policies (cont’d)





Disposal
of property, plant and equipment


At the
time of disposition of plant and equipment, accounts are relieved of the asset
values and accumulated depreciation and any resulting gain or loss is included
in the statement of operations.





(t)
            Oil
      and gas properties





The
Company uses the successful-efforts method to account for its oil and gas
exploration and development activities.  Under this method, costs are
accumulated on a field-by-field basis with certain exploratory expenditures and
exploratory dry holes being expensed as incurred.  The Company
continues to carry as an asset the cost of drilling exploratory wells if the
required capital expenditure is made and drilling of additional exploratory
wells is underway or firmly planned for the near future or when exploration and
evaluation activities have not yet reached a stage to allow reasonable
assessment regarding the existence of economic reserves.  Capitalized
costs for producing wells will be subject to depletion on the
units-of-production method.





Geological
and geophysical costs are expensed as incurred, except when they have been
incurred to facilitate production techniques, to increase total recoverability
and to determine the desirability of drilling additional development wells
within a proved area.  Geological and geophysical costs capitalized
would be included as part of the cost of producing wells and be subject to
depletion on the units-of-production method.





(u)
            Accounts
      payable and accrued liabilities





These
amounts represent liabilities for goods and services provided to the Company
prior to the end of financial year which are unpaid.  These amounts
are unsecured and are usually paid within 30 days of recognition.





(v)
            Employee
      entitlements





Wages
and salaries, and annual leave


Liabilities
for wages and salaries, including annual leave expected to be settled within 12
months of the reporting date are recognized in accounts payables in respect of
employees’ services up to the reporting date and are measured at the amounts
expected to be paid when liabilities are settled.





Long
Service Leave


The
liability for long service leave is recognized in the provision for employee
benefits and measured as the present value of expected future payments to be
made in respect of services provided by employees up to the reporting
date.  Consideration is given to expected future wage and salary
levels, experience of employee departures, periods of service and statutory
obligations.





Retirement
benefit obligations


The
Company contributed to a defined contribution plan and the Company’s legal or
constructive obligation is limited to these
contributions.  Contributions to the defined contribution fund are
recognized as an expense as they become payable.





Stock-based
compensation


Stock-based
compensation benefits are provided to employees pursuant to the 2006 Stock
Incentive Plan (with some options still in existence having been granted under
the now superseded Incentive Stock Option Plan of 2002).  The fair
value at grant date is determined using a Black-Scholes option pricing model
that takes into account the exercise price, the terms of the option, the vesting
criteria, the share price at grant date and expected price volatility of the
underlying share, the expected yield and risk-free interest rate for the term of
the option.  Upon exercise of options, the balance of the contributed
surplus relating to those options is transferred to share
capital.  The Company uses the fair value based method to account for
employee stock options.  Under the fair value based method,
compensation expense is measured at fair value at the date of grant and is
expensed over the award's vesting period.





Profit-sharing
and bonus plans


The
Company recognizes a provision where contractually obliged or where there is a
past practice that has created a constructive obligation.





(w)
            Earnings
      per share





Basic
earnings per share


Basic
common shares outstanding are the weighted average number of common shares
outstanding for each period.  The calculation of basic per share
amounts is based on net earnings/(loss) divided by the weighted average of
common shares outstanding.




Consolidated
Financial Statements   INTEROIL
CORPORATION     16








InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





2.
            Significant
      accounting policies (cont’d)





Diluted
earnings per share


Diluted
per share amounts are computed similarly to basic per share amounts except that
the weighted average shares outstanding are increased to include additional
shares from the assumed exercise of stock options, conversion options and
warrants, if dilutive.  The number of additional shares is calculated
by assuming that outstanding stock options were exercised and the proceeds from
such exercises were used to acquire shares of common stock at the average price
during the reporting period.





(x)
            Reclassification





Certain
prior years’ amounts have been reclassified to conform to current
presentation.





Nine
month period ended September 30, 2008, six month period ended June 30, 2008,
three month period ended March 31, 2008 and year ended December 31, 2007 cash
flows have been adjusted to correctly reflect the classification of deferred
gain in relation to the LNG project.  For details of adjustments made
to the previously published financial statements, refer to the following
table:





Nine
      Month period
                          ended
                        
                        
                        Six
      Month
                          period
      ended
                        
                        
                        Three
      Month
                          period
      ended
                        
                        
                        Year
      endedSeptember
      30, 2008
                        
                        
                        June
      30, 2008
                        
                        
                        March
      31, 2008
                        
                        
                        December
      31, 2007$
                        
                        
                        $
                        
                        
                        $
                        
                        
                        $Cash
      flows provided by (used in):Operating
      activities - Canadian GAAP (as per published financial
      statements)
                        
                        
                        (23,024,574
                        )
                        
                        
                        (25,662,285
                        )
                        
                        
                        6,997,815
                        
                        
                        
                        (40,716,444
                        )Reclassification
      made:Being
      reclassified due to movement in Deferred gain in relation to the LNG
      Project previously classified in Investing activities as compared to
      Operating activites.
                        
                        
                        8,400,573
                        
                        
                        
                        3,107,330
                        
                        
                        
                        3,107,330
                        
                        
                        
                        9,096,537Operating
      activities - Canadian GAAP (revised)
                        
                        
                        (14,624,001
                        )
                        
                        
                        (22,554,955
                        )
                        
                        
                        10,105,145
                        
                        
                        
                        (31,619,907
                        )Investing
      activities - Canadian GAAP (as per published financial
      statements)
                        
                        
                        (19,029,830
                        )
                        
                        
                        (24,805,959
                        )
                        
                        
                        (2,921,286
                        )
                        
                        
                        (25,273,334
                        )Reclassification
      made:Being
      reclassified due to movement in Deferred gain in relation to the LNG
      Project previously classified in Investing activities as compared to
      Operating activites.
                        
                        
                        (8,400,573
                        )
                        
                        
                        (3,107,330
                        )
                        
                        
                        (3,107,330
                        )
                        
                        
                        (9,096,537
                        )Investing
      activities - Canadian GAAP (revised)
                        
                        
                        (27,430,403
                        )
                        
                        
                        (27,913,289
                        )
                        
                        
                        (6,028,616
                        )
                        
                        
                        (34,369,871
                        )Financing
      activities - Canadian GAAP (as per published financial
      statements)
                        
                        
                        45,158,740
                        
                        
                        
                        35,417,731
                        
                        
                        
                        (30,849,094
                        )
                        
                        
                        78,170,105Reclassification
      made:None
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Financing
      activities -  Canadian GAAP (revised)
                        
                        
                        45,158,740
                        
                        
                        
                        35,417,731
                        
                        
                        
                        (30,849,094
                        )
                        
                        
                        78,170,105





During
the year, the Company has transferred notional interest cost from Corporate
segment to the Upstream and Midstream – Liquefaction segments to reflect a more
accurate view of its segment results. The prior year comparatives have been
reclassified to conform to the current classification.





3.
            Financial
      Risk Management





The
Company’s activities expose it to a variety of financial risks; market risk,
credit risk, liquidity risk and cash flow interest rate risk.  The
Company’s overall risk management program focuses on the unpredictability of
markets and seeks to minimize potential adverse effects on the financial
performance of the Company.  The Company uses derivative financial
instruments to hedge certain price risk exposures.





Risk
Management is carried out by the Finance Department under policies approved by
the Board of Directors.  The Finance Department identifies, evaluates
and hedges financial risks in close cooperation with the Company’s operating
units.  The Board provides written principles for overall risk
management, as well as written policies covering specific areas, such as use of
derivative financial instruments.




Consolidated
Financial Statements   INTEROIL
CORPORATION    17




InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





(a)         Market
risk





(i)
Foreign exchange risk


Foreign
exchange risk arises when future commercial transactions and recognized assets
and liabilities are denominated in a currency that is not the Company’s
functional currency.  The Company operates internationally and is
exposed to foreign exchange risk arising from currency exposures to the United
States Dollar.





Most of
the Company’s transactions are undertaken in United States Dollars (USD) and
Papua New Guinea Kina (PGK).  Currently there are no foreign exchange
hedge programmes in place.  The Papua New Guinea Kina exposures are
minimal at the transactional level as the Downstream sales in local currency are
used to adequately cover the operating expenses of the Midstream refinery and
Downstream operations.  However, the translation of USD intercompany
balances in PGK operating entities at period ends can result in material impact
on the foreign exchange gains/losses on consolidation.





Changes
in the PGK to USD exchange rate can affect our Midstream refinery results as
there is a timing difference between the foreign exchange rates utilized when
setting the monthly PGK IPP price and the foreign exchange rate used to convert
the subsequent receipt of PGK proceeds to USD to repay our crude cargo
borrowings.  The foreign exchange movement also impacts equity as
translation gains/losses of our Downstream operations from PGK to USD is
included in other comprehensive income as these are self-sustaining
operations.  The PGK strengthened against the USD during the year
ended December 31, 2008 (from 0.3525 to 0.3735).





The
financial instruments denominated in Papua New Guinea Kina as at December 31,
2008 are as follows:




December
      31,2008$Financial
      AssetsCash
      and cash equivalents
                  
                  
                  28,865,339Receivables
                  
                  
                  39,307,624Other
      financial assets
                  
                  
                  3,348,716Financial
      liabilitiesPayables
                  
                  
                  17,766,660Working
      capital facility
                  
                  
                  15,405,627





The
following table summarizes the sensitivity of financial instruments held at
balance sheet date to movement in the exchange rate of the US dollar to the
Papua New Guinea Kina, with all other variables held
constant.  Certain USD debt and other financial assets and
liabilities, including intra-group balances, are not held in the functional
currency of the relevant subsidiary.  This results in an accounting
exposure to exchange gains and losses as the financial assets and liabilities
are translated into the functional currency of the subsidiary that accounts for
those assets and liabilities.  These exchange gains and losses are
recorded in the consolidated income statement except to the extent that they can
be taken to equity under the Company’s accounting policy.  If PGK
strengthens against the USD, it will result in a gain, and vice
versa.




Year endedDecember 31, 2008Impact on profit
                      
                      
                      Impact on equity –
                        excluding profit impact$
                      
                      
                      $Post-tax
      gain/(loss)USD/PGK
      - effect of 5% change
                      
                      
                      4,245,399
                      
                      
                      
                      3,072,446





(ii)
Price risk


The
Midstream refining operations of the Company are largely exposed to price
fluctuations during the period between the crude purchases and the refined
products leaving the refinery on sales to Downstream operations and other
distributors.  The Company actively tries to manage the price risk by
entering into derivative contracts to buy and sell crude and finished
products.





Consolidated
Financial Statements   INTEROIL
CORPORATION    18




InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





The
derivative contracts are entered into by Management based on documented risk
management strategies which have been approved by the Risk Management
Committee.  All derivative contracts entered into are reviewed by the
Risk Management Committee as part of the meetings of the Committee.





The
following table summarizes the sensitivity of the crude and finished product
inventory held at balance date to $10.0 movement in benchmark pricing, with all
other variables held constant.




Year endedDecember 31, 2008Impact on profit
                      
                      
                      Impact on equity -
                        excluding profit impact$
                      
                      
                      $Post-tax
      gain/(loss)$10
      increase in benchmark pricing
                      
                      
                      8,144,261
                      
                      
                      
                      -





(iii)
Interest rate risk


Interest
rate risk is the risk that the Company’s financial position will be adversely
affected by movements in interest rates that will increase the cost of floating
rate debt or opportunity losses that may arise on fixed rate borrowings in a
falling interest rate environment.





As the
Company has no significant interest-bearing assets other than cash and cash
equivalents, the Company’s income and operating cash flows are substantially
independent of changes in market interest rates.





The
Company’s interest-rate risk arises from borrowings and working capital
financing facilities. Borrowings issued at variable rates expose the Company to
cash flow interest-rate risk.  Borrowings issued at fixed rates expose
the Company to fair value interest-rate risk.  The Company is actively
seeking to manage its cash flow interest-rate risks.





The
financial instruments exposed to cash flow and fair value interest rate risk are
as follows:





December 31,
                          2008
                        
                        
                        Cash flow/fair value
                          interest rate risk$Financial
      AssetsCash
      and cash equivalents
                        
                        
                        6,571,375
                        
                        
                        fair
      value interest rate riskCash
      and cash equivalents
                        
                        
                        42,399,197
                        
                        
                        cash
      flow interest rate riskCash
      restricted
                        
                        
                        290,782
                        
                        
                        fair
      value interest rate riskCash
      restricted
                        
                        
                        25,994,258
                        
                        
                        cash
      flow interest rate riskFinancial
      liabilitiesOPIC
      secured loan
                        
                        
                        62,500,000
                        
                        
                        fair
      value interest rate riskBNP
      working capital facility
                        
                        
                        53,386,775
                        
                        
                        cash
      flow interest rate riskWestpac
      working capital facility
                        
                        
                        15,405,627
                        
                        
                        cash
      flow interest rate risk8%
      subordinated debentures
                        
                        
                        78,975,000
                        
                        
                        fair
      value interest rate risk





The
following table summarizes the sensitivity of the cash flow interest-rate risk
of financial instruments held at balance date, following a movement to LIBOR,
with all other variables held constant.  Increase in LIBOR rates will
result in a higher expense for the Company.





Year endedDecember 31, 2008Impact on profit
                        
                        
                        Impact on equity -
                          excluding profit impact$
                        
                        
                        $Post-tax
      loss/(gain)LIBOR
      +1%
                        
                        
                        260,944
                        
                        
                        
                        -





Consolidated
Financial Statements   INTEROIL
CORPORATION     19


InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





(iv)
Product risk


The
composition of the crude feedstock will vary the refinery output of
products.  The 2008 output achieved includes distillates fuels, which
includes diesel and jet fuels (56%) (Dec 2007 - 60%) and naphtha and low sulphur
waxy residue (40%) (Dec 2007 – 30%).  The product yields obtained will
vary going forward as the refinery operations are optimized and will vary based
on the type of crude feedstock used.





Management
endeavors to manage the product risk by actively reviewing the market for demand
and supply, trying to maximize the production of the higher margin products and
also renegotiating the selling prices for the lower margin
products.





(b)         Liquidity
risk





Prudent
liquidity risk management implies maintaining sufficient cash and the
availability of funding through an adequate amount of committed credit
facilities.  Due to the nature of the Upstream segment of the Company,
funding is secured by means of indirect participation interests, capital
raisings and other financing sources as required.  The Company
endeavors to manage the liquidity risk by continually reviewing the liquidity
position including cash flow forecasts to determine the forecast cash
requirements and maintain appropriate liquidity levels.  All accounts
payable and accrued liabilities are payable within one year. Changes in crude
price environment will have impact on our liquidity position due to our working
capital requirements.  For further details on our working capital
facilities, refer to (e) below.





The
ageing of accounts payables and accrued liabilities are as follows:




Payable
      ageing betweenDecember
      31, 2008
                              
                              Total
                              
                              
                              <30 days
                              
                              
                              30-60 days
                              
                              
                              >60 days$
                              
                              
                              $
                              
                              
                              $
                              
                              
                              $Accounts
      payable and accrued liabilities
                              
                              
                              78,147,736
                              
                              
                              
                              76,556,334
                              
                              
                              
                              1,181,334
                              
                              
                              
                              410,068





(c)         Credit
risk





Credit
risk is the risk that a contracting entity will not complete its obligation
under a financial instrument that will result in a financial loss to the
Company.  The carrying amount of financial assets represents the
maximum credit exposure.





The
Company’s credit risk is limited to the carrying value of its financial
assets.  A significant amount of the Company’s export sales are made
to one customer in Singapore which represented $156,518,509 (Dec 2007 -
$124,502,170) or 17% (Dec 2007 – 20%) of total sales in the year ended December
31, 2008.  The Company’s domestic sales for the year ended December
31, 2008 were not dependent on a single customer or geographic region of Papua
New Guinea.  The export sales to one customer is not considered a key
risk as there is a ready market for InterOil export products and the prices are
quoted on active markets.  The Company actively manages credit risk by
routinely monitoring the credit ratings of Company’s customers and ageing of
trade receivables.  The credit terms provided to customers are revised
if any changes are noted to customer ratings or payment cycles.





Credit
risk on cash and cash equivalents held directly by the Company are minimized as
all cash amounts and certificates of deposit are held with large banks which
have acceptable credit ratings determined by a recognized rating
agency.





The
maximum exposure to credit risk at the reporting date was as
follows:





December
      31,2008$CurrentCash
      and cash equivalents
                    
                    
                    48,970,572Cash
      restricted
                    
                    
                    25,994,258Trade
      receivables
                    
                    
                    42,887,823Commodity
      derivative contracts
                    
                    
                    31,335,050Non-currentCash
      restricted
                    
                    
                    290,782





Consolidated Financial
Statements   INTEROIL
CORPORATION     20








InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





The
ageing of receivables at the reporting date was as follows (the ageing days
relates to balances past due):





Receivable ageing betweenDecember 31, 2008
                            
                            Total
                            
                            
                            Current and
                            
                            
                            30-60 days
                            
                            
                            >60 days$
                            
                            
                            <30 days $
                            
                            
                            $
                            
                            
                            $Net
      trade receivables
                            
                            
                            42,887,823
                            
                            
                            
                            33,515,675
                            
                            
                            
                            5,128,127
                            
                            
                            
                            4,244,022





The
impairment of receivables at the reporting date was as follows:





Overdue
                              
                              
                              OverdueDecember 31, 2008
                              
                              Total
                              
                              
                              Current
                              
                              
                              (not impaired)
                              
                              
                              (impaired)$
                              
                              
                              $
                              
                              
                              $
                              
                              
                              $Gross
      trade receivables
                              
                              
                              47,496,119
                              
                              
                              
                              18,592,467
                              
                              
                              
                              24,295,356
                              
                              
                              
                              4,608,296





Impairment
is assessed by our Credit department on an individual customer basis, based on
customer ratings and payment cycles of the customers.  An impairment
provision is taken for all receivables where objective evidence of impairment
exists.  The movement in impairment is also influenced by the
translation rates used to convert these amounts from local currency to
USD.





The
movement in impaired receivables for the year ended December 31, 2008 was as
follows:




Year
      ended$Trade
      receivables - Impairment provisionsOpening
      balance
                              
                              
                              3,176,807Movement for period
                              
                              
                              1,431,490Closing balance
                              
                              
                              4,608,296





(d)         Geographic
risk





The
operations of InterOil are concentrated in Papua New Guinea.





(e)         Financing
facilities





As at
December 31, 2008, the Company had drawn down against the following financing
facilities:





●
              BNP
      working capital facility (refer note
15)


●
              Westpac
      working capital facility (refer note
15)


●
              OPIC
      secured loan facility (refer note
18)


●
              8%
      subordinated debentures (refer note
23)





Repayment
obligations in respect of the amount of the facilities utilized are as
follows:




December
      31,2008$Due:No
      later than one year
                                
                                
                                77,792,402Later
      than one year but not later than two years
                                
                                
                                9,000,000Later
      than two years but not later than three years
                                
                                
                                9,000,000Later
      than three years but not later than four years
                                
                                
                                9,000,000Later
      than four years but not later than five years
                                
                                
                                87,975,000Later than five years
                                
                                
                                17,500,000210,267,402




Consolidated
Financial Statements   INTEROIL
CORPORATION     21




InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





(f)         Effective
interest rates and maturity profile




Floating
                        
                        
                        Fixed
      interest maturing between
                        
                        
                        Non-interest
                        
                        
                        Total
                        
                        
                        Effectiveinterest
                        
                        
                        1
      year
                        
                        
                        
                        1-2
                        
                        
                        
                        2-3
                        
                        
                        
                        3-4
                        
                        
                        
                        4-5
                        
                        
                        more
      than
                        
                        
                        bearing
                        
                        
                        
                        
                        
                        interestDecember
      31, 2008
                        
                        rate
                        
                        
                        or
      less
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        5
      years
                        
                        
                        
                        
                        
                        
                        
                        
                        rate$'000
                        
                        
                        $'000
                        
                        
                        $000
                        
                        
                        $'000
                        
                        
                        $'000
                        
                        
                        $'000
                        
                        
                        $'000
                        
                        
                        $'000
                        
                        
                        $'000
                        
                        
                        %Financial
      assetsCash
      and cash equivalents
                        
                        
                        42,108,415
                        
                        
                        
                        6,862,157
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        48,970,572
                        
                        
                        
                        3.21
                        %Cash
      restricted
                        
                        
                        26,285,040
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        26,285,040
                        
                        
                        
                        1.93
                        %Receivables
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        42,887,823
                        
                        
                        
                        42,887,823
                        
                        
                        
                        -Other
      financial assets
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        35,824,624
                        
                        
                        
                        35,824,624
                        
                        
                        
                        -68,393,455
                        
                        
                        
                        6,862,157
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        78,712,447
                        
                        
                        
                        153,968,059Financial
      liabilitiesPayables
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        78,147,736
                        
                        
                        
                        78,147,736
                        
                        
                        
                        -Interest
      bearing liabilities
                        
                        
                        68,792,402
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        17,500,000
                        
                        
                        
                        -
                        
                        
                        
                        131,292,402
                        
                        
                        
                        6.30
                        %Debentures
      liability
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        78,975,000
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        78,975,000
                        
                        
                        
                        13.50
                        %Other
      financial liabilities
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -68,792,402
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        87,975,000
                        
                        
                        
                        17,500,000
                        
                        
                        
                        78,147,736
                        
                        
                        
                        288,415,138





(g)         Fair
values




December
      31, 2008Carrying
      amount
                          
                          
                          Fair
      value$
                          
                          
                          $Financial
      instrumentsLoans
      and receivablesReceivables
                          
                          
                          42,887,823
                          
                          
                          
                          42,887,823Held
      for tradingCommodity
      derivative contracts (note 7)
                          
                          
                          31,335,050
                          
                          
                          
                          31,335,050Financial
      assetsCash
      and cash equivalents
                          
                          
                          48,970,572
                          
                          
                          
                          48,970,572Cash
      restricted
                          
                          
                          26,285,040
                          
                          
                          
                          26,285,040Financial
      liabilities at amortized costCurrent
      liabilities:Accounts
      payable and accrued liabilities (note 13)
                          
                          
                          78,147,736
                          
                          
                          
                          78,147,736Working
      capital facility (note 15)
                          
                          
                          68,792,402
                          
                          
                          
                          68,792,402Current
      portion of secured loan (note 18)
                          
                          
                          9,000,000
                          
                          
                          
                          9,012,228Non-current
      liabilitiesSecured
      loan (note 18)
                          
                          
                          52,365,333
                          
                          
                          
                          58,753,2768%
      Subordinated debenture liability (note 23)
                          
                          
                          65,040,067
                          
                          
                          
                          65,040,067





The fair
value of the secured loan is based on discounted cash flow analysis using a
current market interest rate applicable for similar loan
arrangements.   The 8% Subordinated debenture liability has an
equity component on the balance sheet of $10,837,394 and a redemption amount of
$78,975,000 as shown in table (f) above.





(h)         Capital
management





The
Finance department of the Company is responsible for capital
management.  This involves the use of corporate forecasting models
which facilitates analysis of the Company’s financial position including cash
flow forecasts to determine the future capital management
requirements.  Capital management is undertaken to ensure a secure,
cost-effective and flexible supply of funds is available to meet the Company’s
operating and capital expenditure requirements.





The
Company is actively managing the gearing levels and raising capital/debt as
required for optimizing shareholder returns.  The Company is actively
trying to manage its gearing levels by maintaining the Debt-To-Capital Ratio
(Long term Debt/(Shareholders’ equity + Long term Debt)) at 50% or less, and has
made considerable progress in achieving this as at December 31,
2008.  The gearing levels were reduced to 36% in December 2008 from
67% in December 2007.








Consolidated
Financial Statements   INTEROIL
CORPORATION     22







InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





3.
            Financial
      Risk Management (cont’d)





The
optimum gearing levels for the Company are set by Management based on the stage
of development of the Company, future needs for development and capital market
conditions, and will be reassessed as situations change.





This
reduction in gearing levels as at December 31, 2008 as compared to December 31,
2007 was mainly due to the conversion of $60,000,000 of the $130,000,000
Bridging facility into common shares in May 2008.





On May
13, 2008, the Company completed the issue of $95,000,000 unsecured 8%
subordinated convertible debentures with a maturity of five
years.  The conversion price applicable to these debentures is $25.00
per share, with mandatory conversion if the daily Volume Weighted Average Price
(‘VWAP’) of the common shares is at or above $32.50 for at least 15 consecutive
trading days.  Accrued interest on these debentures is to be paid
semi-annually in arrears, in May and November of each year, commencing November
2008.  During July 2008, $15,000,000 of the outstanding debentures
were converted to common shares, leading to the issue of 600,000 common
shares.  During November 2008, a further $1,025,000 of the outstanding
debentures was converted to common shares, leading to the issue of 41,000 common
shares.





We are
also evaluating further opportunities of raising capital in the short term for
our capital expenditure requirements.  In order to achieve this
objective, the Company has filed a preliminary short form base shelf prospectus
with the Ontario Securities Commission and a corresponding registration
statement on Form F-10 with the United States Securities and Exchange Commission
(the "SEC") pursuant to the multi-jurisdictional disclosure
system.  These filings will enable the Company to add financial
flexibility in the future and issue, from time to time, up to $200.0 million of
its debt securities, common shares, preferred shares and/or warrants
("Securities") in one or more offerings.  This preliminary short form
base shelf prospectus has since been replaced with an omnibus shelf prospectus
filed and accepted by the Ontario Securities Commission on August 7,
2008.  The corresponding registration statement on Form-10/A has also
been filed with the SEC.





4.
            Segmented
      financial information





As stated
in note 1, management has identified four major business segments - upstream,
midstream, downstream and corporate.  The corporate segment includes
assets and liabilities that do not specifically relate to the other business
segments.  Results in this segment primarily include financing costs
and interest income.





During
the year 2006, the Company started incurring costs in relation to the
Liquefaction project, which have been reported separately under Midstream –
Liquefaction project below. During 2007 a joint venture was formed to further
the LNG project as disclosed in note 2(c) above.  The joint venture
balances have been proportionately consolidated and disclosed within the
Midstream Liquefaction segment in addition to InterOil LNG Holdings Inc. which
was incorporated to hold InterOil’s interest in the Joint Venture
Company.





Consolidation
adjustments relating to total assets relates to the elimination of intercompany
loans and investments in subsidiaries.





Notes
to and forming part of the segment information





Segment
information is prepared in conformity with the accounting policies of the entity
as disclosed in note 2.





Segment
revenues, expenses and total assets are those that are directly attributable to
a segment and the relevant portion that can be allocated to the segment on a
reasonable basis.  Upstream, midstream and downstream include costs
allocated from the corporate activities based on a fee for services
provided.  The eliminations relate to sales and operating revenues
between segments recorded at transfer prices based on current market prices and
to unrealized intersegment profits in inventories.





During
the year, the Company has transferred notional interest cost from Corporate
segment to the Upstream and Midstream – Liquefaction segments to reflect a more
accurate view of its segment results. During the year management decided to
transfer notional interest to development segments for the intercompany loans
that have been provided interest free.  The prior year comparatives
have been reclassified to conform to the current classification. For the year
2007, notional interest of $1,033,661 and $105,304 has been transferred from
Corporate Segment to Upstream and Midstream – Liquefaction
respectively.




Consolidated
Financial Statements   INTEROIL
CORPORATION     23




InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)




4.
            Segmented
      financial information (cont’d)





Year
      ended December 31, 2008
                                  
                                  Upstream
                                  
                                  
                                  Midstream
      -
                                    Refining
                                  
                                  
                                  Midstream
      -
                                    Liquefaction
                                  
                                  
                                  Downstream
                                  
                                  
                                  Corporate
                                  
                                  
                                  Consolidation
                                    adjustments
                                  
                                  
                                  TotalRevenues
      from external customers
                                  
                                  
                                  -
                                  
                                  
                                  
                                  358,895,683
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  556,683,026
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  915,578,709Intersegment
      revenues
                                  
                                  
                                  -
                                  
                                  
                                  
                                  427,218,086
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  185,474
                                  
                                  
                                  
                                  24,567,895
                                  
                                  
                                  
                                  (451,971,455
                                  )
                                  
                                  
                                  -Interest
      revenue
                                  
                                  
                                  190,195
                                  
                                  
                                  
                                  78,023
                                  
                                  
                                  
                                  90,757
                                  
                                  
                                  
                                  17,566
                                  
                                  
                                  
                                  10,302,959
                                  
                                  
                                  
                                  (9,747,715
                                  )
                                  
                                  
                                  931,785Other
      revenue
                                  
                                  
                                  2,507,499
                                  
                                  
                                  
                                  11,623
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  697,323
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  3,216,445Total
      segment revenue
                                  
                                  
                                  2,697,694
                                  
                                  
                                  
                                  786,203,415
                                  
                                  
                                  
                                  90,757
                                  
                                  
                                  
                                  557,583,389
                                  
                                  
                                  
                                  34,870,854
                                  
                                  
                                  
                                  (461,719,170
                                  )
                                  
                                  
                                  919,726,939Cost
      of sales and operating expenses
                                  
                                  
                                  -
                                  
                                  
                                  
                                  779,831,893
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  536,919,622
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (428,128,406
                                  )
                                  
                                  
                                  888,623,109Administrative,
      professional and general expenses
                                  
                                  
                                  5,919,528
                                  
                                  
                                  
                                  10,080,835
                                  
                                  
                                  
                                  7,022,363
                                  
                                  
                                  
                                  14,669,401
                                  
                                  
                                  
                                  33,752,746
                                  
                                  
                                  
                                  (24,753,366
                                  )
                                  
                                  
                                  46,691,507Derivative
      (gain)/loss
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (24,038,550
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (24,038,550
                                  )Foreign
      exchange (gain)/loss
                                  
                                  
                                  132,874
                                  
                                  
                                  
                                  (5,263,901
                                  )
                                  
                                  
                                  559,793
                                  
                                  
                                  
                                  206,614
                                  
                                  
                                  
                                  486,470
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (3,878,150
                                  )Gain
      on sale of exploration assets
                                  
                                  
                                  (11,235,084
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (11,235,084
                                  )Exploration
      costs, excluding exploration impairment
                                  
                                  
                                  995,532
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  995,532Exploration
      impairment
                                  
                                  
                                  107,788
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  107,788Depreciation
      and amortisation
                                  
                                  
                                  597,343
                                  
                                  
                                  
                                  10,969,099
                                  
                                  
                                  
                                  69,142
                                  
                                  
                                  
                                  2,570,503
                                  
                                  
                                  
                                  66,427
                                  
                                  
                                  
                                  (129,968
                                  )
                                  
                                  
                                  14,142,546Interest
      expense
                                  
                                  
                                  4,027,223
                                  
                                  
                                  
                                  9,908,268
                                  
                                  
                                  
                                  240,782
                                  
                                  
                                  
                                  4,838,094
                                  
                                  
                                  
                                  10,765,759
                                  
                                  
                                  
                                  (9,747,715
                                  )
                                  
                                  
                                  20,032,411Total
      segment expenses
                                  
                                  
                                  545,204
                                  
                                  
                                  
                                  781,487,644
                                  
                                  
                                  
                                  7,892,080
                                  
                                  
                                  
                                  559,204,234
                                  
                                  
                                  
                                  45,071,402
                                  
                                  
                                  
                                  (462,759,455
                                  )
                                  
                                  
                                  931,441,109Income/(loss)
      before income taxes and non-controlling interest
                                  
                                  
                                  2,152,490
                                  
                                  
                                  
                                  4,715,771
                                  
                                  
                                  
                                  (7,801,323
                                  )
                                  
                                  
                                  (1,620,845
                                  )
                                  
                                  
                                  (10,200,548
                                  )
                                  
                                  
                                  1,040,285
                                  
                                  
                                  
                                  (11,714,170
                                  )Income
      tax expense
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (110,037
                                  )
                                  
                                  
                                  414,193
                                  
                                  
                                  
                                  (386,120
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (81,964
                                  )Non
      controlling interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (943
                                  )
                                  
                                  
                                  (943
                                  )Total
      net income/(loss)
                                  
                                  
                                  2,152,490
                                  
                                  
                                  
                                  4,715,771
                                  
                                  
                                  
                                  (7,911,360
                                  )
                                  
                                  
                                  (1,206,652
                                  )
                                  
                                  
                                  (10,586,668
                                  )
                                  
                                  
                                  1,039,342
                                  
                                  
                                  
                                  (11,797,077
                                  )Total
      assets
                                  
                                  
                                  134,485,386
                                  
                                  
                                  
                                  326,007,879
                                  
                                  
                                  
                                  7,269,000
                                  
                                  
                                  
                                  100,452,756
                                  
                                  
                                  
                                  442,464,921
                                  
                                  
                                  
                                  (418,836,972
                                  )
                                  
                                  
                                  591,842,970





Year
      ended December 31, 2007
                                  
                                  Upstream
                                  
                                  
                                  Midstream
      -
                                    Refining
                                  
                                  
                                  Midstream
      -
                                    Liquefaction
                                  
                                  
                                  Downstream
                                  
                                  
                                  Corporate
                                  
                                  
                                  Consolidation
                                    adjustments
                                  
                                  
                                  TotalRevenues
      from external customers
                                  
                                  
                                  -
                                  
                                  
                                  
                                  233,868,997
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  391,657,071
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  625,526,068Intersegment
      revenues
                                  
                                  
                                  -
                                  
                                  
                                  
                                  289,947,580
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  81,062
                                  
                                  
                                  
                                  9,482,002
                                  
                                  
                                  
                                  (299,510,644
                                  )
                                  
                                  
                                  -Interest
      revenue
                                  
                                  
                                  407,348
                                  
                                  
                                  
                                  69,721
                                  
                                  
                                  
                                  41,215
                                  
                                  
                                  
                                  13,679
                                  
                                  
                                  
                                  15,093,044
                                  
                                  
                                  
                                  (13,444,722
                                  )
                                  
                                  
                                  2,180,285Other
      revenue
                                  
                                  
                                  2,139,336
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  527,554
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  2,666,890Total
      segment revenue
                                  
                                  
                                  2,546,684
                                  
                                  
                                  
                                  523,886,298
                                  
                                  
                                  
                                  41,215
                                  
                                  
                                  
                                  392,279,366
                                  
                                  
                                  
                                  24,575,046
                                  
                                  
                                  
                                  (312,955,366
                                  )
                                  
                                  
                                  630,373,243Cost
      of sales and operating expenses
                                  
                                  
                                  -
                                  
                                  
                                  
                                  495,058,782
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  368,803,507
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (290,252,848
                                  )
                                  
                                  
                                  573,609,441Administrative,
      professional and general expenses
                                  
                                  
                                  5,020,371
                                  
                                  
                                  
                                  9,077,365
                                  
                                  
                                  
                                  5,688,932
                                  
                                  
                                  
                                  10,774,921
                                  
                                  
                                  
                                  20,276,009
                                  
                                  
                                  
                                  (9,563,067
                                  )
                                  
                                  
                                  41,274,531Derivative
      (gain)/loss
                                  
                                  
                                  -
                                  
                                  
                                  
                                  7,271,693
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  7,271,693Foreign
      exchange (gain)/loss
                                  
                                  
                                  622,821
                                  
                                  
                                  
                                  (5,889,324
                                  )
                                  
                                  
                                  19,954
                                  
                                  
                                  
                                  (15,379
                                  )
                                  
                                  
                                  183,591
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (5,078,337
                                  )Gain
      on LNG shareholder agreement
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (6,553,080
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (6,553,080
                                  )Exploration
      costs, excluding exploration impairment
                                  
                                  
                                  13,305,437
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  13,305,437Exploration
      impairment
                                  
                                  
                                  1,242,606
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,242,606Depreciation
      and amortisation
                                  
                                  
                                  482,448
                                  
                                  
                                  
                                  10,404,953
                                  
                                  
                                  
                                  15,431
                                  
                                  
                                  
                                  2,204,782
                                  
                                  
                                  
                                  48,037
                                  
                                  
                                  
                                  (131,393
                                  )
                                  
                                  
                                  13,024,258Interest
      expense
                                  
                                  
                                  1,033,661
                                  
                                  
                                  
                                  16,798,634
                                  
                                  
                                  
                                  105,304
                                  
                                  
                                  
                                  4,437,994
                                  
                                  
                                  
                                  11,074,173
                                  
                                  
                                  
                                  (13,444,723
                                  )
                                  
                                  
                                  20,005,043Total
      segment expenses
                                  
                                  
                                  21,707,344
                                  
                                  
                                  
                                  532,722,103
                                  
                                  
                                  
                                  5,829,621
                                  
                                  
                                  
                                  386,205,825
                                  
                                  
                                  
                                  25,028,730
                                  
                                  
                                  
                                  (313,392,031
                                  )
                                  
                                  
                                  658,101,592(Loss)/income
      before income taxes and non-controlling interest
                                  
                                  
                                  (19,160,660
                                  )
                                  
                                  
                                  (8,835,805
                                  )
                                  
                                  
                                  (5,788,406
                                  )
                                  
                                  
                                  6,073,541
                                  
                                  
                                  
                                  (453,684
                                  )
                                  
                                  
                                  436,665
                                  
                                  
                                  
                                  (27,728,349
                                  )Income
      tax expense
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (12,665
                                  )
                                  
                                  
                                  (1,365,674
                                  )
                                  
                                  
                                  171,447
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (1,206,892
                                  )Non
      controlling interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  20,899
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,434
                                  
                                  
                                  
                                  22,333Total
      net income/(loss)
                                  
                                  
                                  (19,160,660
                                  )
                                  
                                  
                                  (8,814,906
                                  )
                                  
                                  
                                  (5,801,071
                                  )
                                  
                                  
                                  4,707,867
                                  
                                  
                                  
                                  (282,237
                                  )
                                  
                                  
                                  438,099
                                  
                                  
                                  
                                  (28,912,908
                                  )Total
      assets
                                  
                                  
                                  100,054,671
                                  
                                  
                                  
                                  318,454,252
                                  
                                  
                                  
                                  6,595,722
                                  
                                  
                                  
                                  133,598,054
                                  
                                  
                                  
                                  494,852,295
                                  
                                  
                                  
                                  (515,739,993
                                  )
                                  
                                  
                                  537,815,001








Consolidated
Financial Statements   INTEROIL
CORPORATION     24








InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





4.
            Segmented
      financial information (cont’d)





Year
      ended December 31, 2006
                                  
                                  Upstream
                                  
                                  
                                  Midstream
      -
                                    Refining
                                  
                                  
                                  Midstream
      -
                                    Liquefaction
                                  
                                  
                                  Downstream
                                  
                                  
                                  Corporate
                                  
                                  
                                  Consolidation
                                    adjustments
                                  
                                  
                                  TotalRevenues
      from external customers
                                  
                                  
                                  -
                                  
                                  
                                  
                                  315,211,130
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  195,876,804
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  511,087,934Intersegment
      revenues
                                  
                                  
                                  -
                                  
                                  
                                  
                                  136,583,916
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  22,480
                                  
                                  
                                  
                                  8,669,933
                                  
                                  
                                  
                                  (145,276,329
                                  )
                                  
                                  
                                  -Interest
      revenue
                                  
                                  
                                  2,820,888
                                  
                                  
                                  
                                  360,319
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  100,750
                                  
                                  
                                  
                                  1,601,491
                                  
                                  
                                  
                                  (1,659,453
                                  )
                                  
                                  
                                  3,223,995Other
      revenue
                                  
                                  
                                  2,427,816
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,319,787
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  3,747,603Total
      segment revenue
                                  
                                  
                                  5,248,704
                                  
                                  
                                  
                                  452,155,365
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  197,319,821
                                  
                                  
                                  
                                  10,271,424
                                  
                                  
                                  
                                  (146,935,782
                                  )
                                  
                                  
                                  518,059,532Cost
      of sales and operating expenses
                                  
                                  
                                  -
                                  
                                  
                                  
                                  451,374,165
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  183,511,182
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (135,390,806
                                  )
                                  
                                  
                                  499,494,541Administrative,
      professional and general expenses
                                  
                                  
                                  6,370,436
                                  
                                  
                                  
                                  10,576,957
                                  
                                  
                                  
                                  694,416
                                  
                                  
                                  
                                  7,671,208
                                  
                                  
                                  
                                  15,378,963
                                  
                                  
                                  
                                  (8,552,604
                                  )
                                  
                                  
                                  32,139,376Derivative
      (gain)/loss
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,559,712
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,559,712
                                  )Foreign
      exchange (gain)/loss
                                  
                                  
                                  (61,423
                                  )
                                  
                                  
                                  (4,635,878
                                  )
                                  
                                  
                                  (219
                                  )
                                  
                                  
                                  (192,433
                                  )
                                  
                                  
                                  145,142
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (4,744,811
                                  )Exploration
      costs, excluding exploration impairment
                                  
                                  
                                  6,176,866
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  6,176,866Exploration
      impairment
                                  
                                  
                                  1,647,185
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,647,185Depreciation
      and amortisation
                                  
                                  
                                  806,142
                                  
                                  
                                  
                                  10,729,546
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  909,767
                                  
                                  
                                  
                                  37,247
                                  
                                  
                                  
                                  (130,030
                                  )
                                  
                                  
                                  12,352,672Interest
      expense
                                  
                                  
                                  5,428
                                  
                                  
                                  
                                  10,880,779
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  151,730
                                  
                                  
                                  
                                  7,894,820
                                  
                                  
                                  
                                  (1,659,453
                                  )
                                  
                                  
                                  17,273,304Total
      segment expenses
                                  
                                  
                                  14,944,634
                                  
                                  
                                  
                                  476,365,857
                                  
                                  
                                  
                                  694,197
                                  
                                  
                                  
                                  192,051,454
                                  
                                  
                                  
                                  23,456,172
                                  
                                  
                                  
                                  (145,732,893
                                  )
                                  
                                  
                                  561,779,421(Loss)/income
      before income taxesand
      non-controlling interest
                                  
                                  
                                  (9,695,930
                                  )
                                  
                                  
                                  (24,210,492
                                  )
                                  
                                  
                                  (694,197
                                  )
                                  
                                  
                                  5,268,367
                                  
                                  
                                  
                                  (13,184,748
                                  )
                                  
                                  
                                  (1,202,889
                                  )
                                  
                                  
                                  (43,719,889
                                  )Income
      tax expense
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,273,773
                                  )
                                  
                                  
                                  (69,100
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (2,342,873
                                  )Non
      controlling interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  259,169
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  4,790
                                  
                                  
                                  
                                  263,959Total
      net income/(loss)
                                  
                                  
                                  (9,695,930
                                  )
                                  
                                  
                                  (23,951,323
                                  )
                                  
                                  
                                  (694,197
                                  )
                                  
                                  
                                  2,994,594
                                  
                                  
                                  
                                  (13,253,848
                                  )
                                  
                                  
                                  (1,198,099
                                  )
                                  
                                  
                                  (45,798,803
                                  )Total
      assets
                                  
                                  
                                  85,335,500
                                  
                                  
                                  
                                  325,351,819
                                  
                                  
                                  
                                  (683,582
                                  )
                                  
                                  
                                  98,722,803
                                  
                                  
                                  
                                  393,700,711
                                  
                                  
                                  
                                  (397,187,776
                                  )
                                  
                                  
                                  505,239,475





5.
            Cash
      and cash equivalents





The
components of cash and cash equivalents are as follows:





December
      31,
                            
                            
                            December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $Cash
      on deposit
                            
                            
                            46,761,362
                            
                            
                            
                            43,861,762
                            
                            
                            
                            31,681,435Bank
      term deposits- Papua New Guinea kina
      deposits
                            
                            
                            2,209,210
                            
                            
                            
                            -
                            
                            
                            
                            -48,970,572
                            
                            
                            
                            43,861,762
                            
                            
                            
                            31,681,435


Consolidated
Financial Statements   INTEROIL
CORPORATION     25





InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





6.
            Supplemental
      cash flow information





December
      31,
                            
                            
                            December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $Cash
      paid during the yearInterest
                            
                            
                            10,705,499
                            
                            
                            
                            16,934,058
                            
                            
                            
                            8,548,552Income
      taxes
                            
                            
                            6,738,175
                            
                            
                            
                            2,344,282
                            
                            
                            
                            2,306,218Interest
      received
                            
                            
                            926,878
                            
                            
                            
                            2,176,678
                            
                            
                            
                            3,154,380Non-cash
      investing and financing activities:Deferred
      financing costs included in accounts payable and accrued
      liabilities
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            500,000Increase
      in deferred gain on contributions to LNG project
                            
                            
                            8,400,573
                            
                            
                            
                            9,096,537
                            
                            
                            
                            -(Gain)/loss
      on proportionate consolidation of LNG project
                            
                            
                            (811,765
                            )
                            
                            
                            2,375,278
                            
                            
                            
                            -Fair
      value adjustment on IPL PNG Ltd. acquisition (note 16)
                            
                            
                            -
                            
                            
                            
                            (367,935
                            )
                            
                            
                            -Decrease
      in plant and equipment as a result of impairment
                            
                            
                            -
                            
                            
                            
                            960,000
                            
                            
                            
                            755,857Transfer
      to plant and equipment to assets held for sale
                            
                            
                            -
                            
                            
                            
                            -(Decrease)/increase
      in deferred liquefaction project liability
                            
                            
                            -
                            
                            
                            
                            (6,553,080
                            )
                            
                            
                            6,553,080Reduction
      to plant and equipment due to negative goodwill on Enron
      buy-back
                            
                            
                            -
                            
                            
                            
                            4,841,776
                            
                            
                            
                            -Increase
      in share capital from:the
      exercise of share options
                            
                            
                            456,867
                            
                            
                            
                            102,840
                            
                            
                            
                            532,232the
      exercise of warrants
                            
                            
                            -
                            
                            
                            
                            18,818
                            
                            
                            
                            -conversion
      of debentures into share capital
                            
                            
                            15,118,483
                            
                            
                            
                            -
                            
                            
                            
                            -conversion
      of preference shares into share capital
                            
                            
                            14,640,000
                            
                            
                            
                            -
                            
                            
                            
                            -conversion
      of indirect participation interest into share capital
                            
                            
                            15,776,270
                            
                            
                            
                            934,890
                            
                            
                            
                            7,948,691conversion
      of debt into share capital
                            
                            
                            60,000,000
                            
                            
                            
                            -
                            
                            
                            
                            -placement
      fee obligation on conversion of debt
                            
                            
                            1,800,000
                            
                            
                            
                            -
                            
                            
                            
                            -preference
      share interest obligation settled in shares
                            
                            
                            372,950
                            
                            
                            
                            -
                            
                            
                            
                            -placement
      fee obligation on debentures issued
                            
                            
                            5,700,000
                            
                            
                            
                            -
                            
                            
                            
                            -debentures
      interest obligation settled in shares
                            
                            
                            2,620,628
                            
                            
                            
                            -
                            
                            
                            
                            -buyback of minority
interest
                            
                            
                            -
                            
                            
                            
                            496,500
                            
                            
                            
                            -





7.
            Financial
      instruments





Cash
and cash equivalents





With the
exception of cash and cash equivalents and restricted cash, all financial assets
are non-interest bearing. In 2008, the Company earned 1.9% (2007 – 5.0%, 2006 –
5.0%) on the cash on deposit which related to the working capital facility. In
2008, cash and cash equivalents earned an average interest rate of 3.21% per
annum (2007 – 4.76%, 2006 – 5.1%) on cash, other than the cash on deposit that
was related to the working capital facility.





Restricted
cash, which mainly relates to the working capital facility, is comprised of the
following:




December
      31,
                        
                        
                        December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007
                        
                        
                        2006$
                        
                        
                        $
                        
                        
                        $Cash
      deposit on working capital facility (1.9%)
                        
                        
                        25,994,258
                        
                        
                        
                        20,240,553
                        
                        
                        
                        29,301,940Debt
      reserve for secured loan
                        
                        
                        -
                        
                        
                        
                        1,761,749
                        
                        
                        
                        -Cash
      restricted - Current
                        
                        
                        25,994,258
                        
                        
                        
                        22,002,302
                        
                        
                        
                        29,301,940Cash
      deposit on secured loan
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        647,502Debt
      reserve for secured loan
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        2,420,000Bank
      term deposits on Petroleum Prospecting Licenses (0.9%)
                        
                        
                        124,097
                        
                        
                        
                        116,090
                        
                        
                        
                        107,997Cash
      deposit on office premises (6.7%)
                        
                        
                        166,685
                        
                        
                        
                        265,968
                        
                        
                        
                        41,785Cash
      restricted - Non-current
                        
                        
                        290,782
                        
                        
                        
                        382,058
                        
                        
                        
                        3,217,28426,285,040
                        
                        
                        
                        22,384,360
                        
                        
                        
                        32,519,224




Consolidated
Financial Statements   INTEROIL
CORPORATION     26





InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





7.
            Financial
      instruments (cont’d)





Cash held
as deposit on the working capital facility supports the Company’s working
capital facility with BNP Paribas.  The balance is based on 20% of the
outstanding balance of the base facility plus any amounts that are fully cash
secured.  The cash held as deposit on secured loan used to support the
Company’s secured loan borrowings with the Overseas Private Investment
Corporation (“OPIC”).  This cash deposit requirement was waived until
December 31, 2008 by way of an amendment in December 2006.





Debt
reserve for secured loan was maintained in accordance to the terms of the
Merrill Lynch bridging facility.  This facility was fully repaid in
May 2008 resulting in no further requirement to maintain any funds in the debt
reserve account.





Bank term
deposits on Petroleum Prospecting Licenses are unavailable to the Company while
Petroleum Prospecting Licenses 236, 237 and 238 are being utilized by the
Company.





Commodity
derivative contracts





InterOil
uses derivative commodity instruments to manage exposure to price volatility on
a portion of its refined product and crude inventories.





At
December 31, 2008, InterOil had a net receivable of $31,335,050 (2007 – payable
of $1,960,300, 2006 – receivable of $1,759,575) relating to commodity hedge
contracts.  Of this total, a receivable of $16,261,000 (2007 - $nil,
2006 – payable of $45,925) relates to hedge accounted contracts as at December
31, 2008 and a receivable of $15,074,050 (2007 – payable of $1,960,300, 2006 –
receivable of $1,805,500) relates to outstanding derivative contracts for which
hedge accounting was not applied or had been discontinued.  The gain
on hedges for which final pricing will be determined in future periods was
$18,012,500 (2007 - $nil) and has been included in comprehensive
income.  Subsequent to year end, these unrealized hedges were
terminated and the mark-to-market gains were realized.  However, these
gains will be released into the Statement of Operations as the anticipated
transactions that these hedges were initially taken to cover will
occur.  The gain on hedges in 2006 for which final pricing was to be
determined in future periods was $1,385, and was included within liabilities in
compliance with the superseded hedging standards applicable for that
year.





a.
Hedge accounted contracts:





The
following summarizes the effective hedge contracts by derivative type on which
final pricing was determined in future periods as at December 31,
2008:




Notional
                                          
                                          
                                          
                                          
                                          
                                          
                                          Fair
      ValueVolumes
                                          
                                          
                                          
                                          
                                          
                                          
                                          December
      31, 2008Derivative
                                          
                                          Type
                                          
                                          (bbls)
                                          
                                          
                                          Expiry
                                          
                                          Derivative
      type
                                          
                                          $Crude
      Swap
                                          
                                          Buy
      Brent
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q1
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          (25,493,100
                                          )Crude
      Swap
                                          
                                          Buy
      Brent
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q2
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          (19,529,200
                                          )Crude
      Swap
                                          
                                          Buy
      Brent
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q3
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          (18,441,700
                                          )Crude
      Swap
                                          
                                          Buy
      Brent
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q4
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          (17,682,200
                                          )Gasoil
      Swap
                                          
                                          Sell
      Gasoil
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q1
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          29,068,800Gasoil
      Swap
                                          
                                          Sell
      Gasoil
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q2
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          23,425,400Gasoil
      Swap
                                          
                                          Sell
      Gasoil
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q3
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          22,461,200Gasoil
      Swap
                                          
                                          Sell
      Gasoil
                                          
                                          
                                          300,000
                                          
                                          
                                          
                                          Q4
      2009
                                          
                                          Cash
      flow hedge - Manages the crack spread
                                          
                                          
                                          21,672,80015,482,000Add:
      Priced out but unsettled hedge accounted contracts as at December 31,
      2008
                                          
                                          
                                          779,00016,261,000





A profit
of $3,745,500 was recognized from the effective portion of priced out hedge
accounted contracts for the year ended December 31, 2008 (Dec 2007 – loss of
$2,527,648).





There was
no outstanding hedge accounted contracts on which final pricing were to be
determined in future periods as at December 31, 2007.





The
following summarizes the effective hedge contracts by derivative type on which
final pricing was determined in future periods as at December 31,
2006:





Derivative
                      
                      Type
                      
                      Notional volumes (bbls)Naphtha
      swap
                      
                      Sell
      Naphtha
                      
                      
                      175,000




Consolidated
Financial Statements   INTEROIL
CORPORATION     27








InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)





7.
            Financial
      instruments (cont’d)





b.
Non-hedge accounted derivative contracts:





In
addition to the above hedge accounted contracts, as at December 31, 2008, the
Company had the following open non-hedge accounted derivative contracts
outstanding. Any gains/losses on these contracts are included in derivative
(gain)/loss for the period.





As at
December 31, 2008:




Notional
                                    
                                    
                                    
                                    
                                    
                                    
                                    Fair
      ValueVolumes
                                    
                                    
                                    
                                    
                                    
                                    
                                    December
      31, 2008Derivative
                                    
                                    Type
                                    
                                    (bbls)
                                    
                                    
                                    Expiry
                                    
                                    Derivative
      type
                                    
                                    $Brent
      Swap
                                    
                                    Sell
      Brent
                                    
                                    
                                    195,000
                                    
                                    
                                    
                                    Q1
      2009
                                    
                                    Cash
      flow hedge - Manages the export price risk of LSWR
                                    
                                    
                                    3,965,000Brent
      Swap
                                    
                                    Buy
      Brent
                                    
                                    
                                    130,000
                                    
                                    
                                    
                                    Q1
      2009
                                    
                                    Cash
      flow hedge - Manages the export price risk of LSWR
                                    
                                    
                                    (1,129,750
                                    )Brent
      Swap
                                    
                                    Sell
      Brent
                                    
                                    
                                    165,000
                                    
                                    
                                    
                                    Q2
      2009
                                    
                                    Cash
      flow hedge - Manages the export price risk of
      LSWR
                                    
                                    
                                    (413,200
                                    )2,422,050Add:
      Priced out non-hedge accounted contracts as at December 31,
      2008
                                    
                                    
                                    12,652,00015,074,050





A profit
of $24,038,550 was recognized on the non-hedge accounted derivative contracts
for the year ended December 31, 2008 (Dec 2007 – loss of
$7,271,693).





As at
December 31, 2007:





Derivative
                        
                        Type
                        
                        Notional volumes (bbls)Brent
      contracts to manage export price risk
                        
                        Sell
      Brent
                        
                        
                        130,000Naphtha
      swap
                        
                        Sell
      Naphtha
                        
                        
                        150,000





As at
December 31, 2006:





Derivative
                        
                        Type
                        
                        Notional volumes (bbls)Brent
      contracts to manage export price risk
                        
                        Sell
      Brent
                        
                        
                        320,000





8.
            Trade
      receivables





InterOil
has a discounting facility with BNP Paribas on specific monetary receivables
under which the Company is able to sell, on a revolving basis, receivables up to
$60,000,000 (refer to note 15).  As at December 31, 2008, $3,141,238
(Dec 2007 - $nil, Dec 2006 - $23,671,568) in outstanding trade receivables had
been sold with recourse under the facility.  As the sale is with
recourse, the discounted receivables, if any, are retained on the balance sheet
and included in the accounts receivable and the proceeds are recognized in the
working capital facility.  The Company has retained the responsibility
for administering and collecting accounts receivable sold.  The
discounted receivables are usually settled within a month of their discounting
and there have not been any collection issues relating to these discounted
receivables.





At
December 31, 2008, $10,300,542 (Dec 2007 - $38,033,715, Dec 2006 - $55,955,400)
of the trade receivables secures the BNP Paribas working capital facility
disclosed in note 15.  This balance includes $6,912,883 (Dec 2007 -
$33,703,069, Dec 2006 - $20,186,665) of intercompany receivables which were
eliminated on consolidation.




Consolidated
Financial Statements   INTEROIL
CORPORATION     28





InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 9.
              Inventories
 
 December 31,
                        
                        
                        December 31,
                        
                        
                        December 31,2008
                        
                        
                        2007
                        
                        
                        2006$
                        
                        
                        $
                        
                        
                        $Midstream
      - refining and marketing (crude oil feedstock)
                        
                        
                        25,556,463
                        
                        
                        
                        3,587,786
                        
                        
                        
                        12,795,356Midstream
      - refining and marketing (refined petroleum product)
                        
                        
                        30,167,417
                        
                        
                        
                        43,173,806
                        
                        
                        
                        22,329,270Midstream
      - refining and marketing (parts inventory)
                        
                        
                        288,643
                        
                        
                        
                        201,526
                        
                        
                        
                        46,636Downstream
      (refined petroleum product)
                        
                        
                        27,024,803
                        
                        
                        
                        35,626,124
                        
                        
                        
                        32,422,29683,037,326
                        
                        
                        
                        82,589,242
                        
                        
                        
                        67,593,558
 
 At
December 31, 2008, inventory had been written down to its net realizable
value.  The write down of $8,529,016 relating to refined petroleum
products is included in ‘Cost of sales and operating expenses’ within the
‘Consolidated Statement of Operations’.  No write down was necessary
at December 31, 2007 or 2006.
 
 At
December 31, 2008, $56,012,523 (Dec 2007 - $46,963,118, Dec 2006 - $35,171,262)
of the midstream inventory balance secures the BNP Paribas working capital
facility disclosed in note 15.
 
 Inventories
recognized as expense during the year ended December 31, 2008 amounted to
$902,765,655 (2007 - $586,633,699, 2006 - $511,847,212).
 
 10.
              Plant
      and equipment
 
 The
majority of the Company’s plant and equipment is located in Papua New Guinea,
except for items in the corporate segment with a net book value of $343,069
(2007 - $313,946, 2006 - $118,644) which are located in
Australia.  Amounts in deferred project costs and work in progress are
not being amortized.
 
 Consolidation
entries relates to midstream assets which were created when the gross margin on
2004 refinery sales to the downstream segment were eliminated in the development
stage of the refinery.
 
 December 31, 2008
                              
                              Upstream
                              
                              
                              Midstream -
                                Refining
                              
                              
                              Midstream -
                                Liquefaction
                              
                              
                              Downstream
                              
                              
                              Corporate &
                                Consolidated
                              
                              
                              TotalsPlant
      and equipment
                              
                              
                              47,315
                              
                              
                              
                              247,520,562
                              
                              
                              
                              219,315
                              
                              
                              
                              46,299,775
                              
                              
                              
                              485,628
                              
                              
                              
                              294,572,595Deferred
      project costs and work in progress
                              
                              
                              -
                              
                              
                              
                              27,211
                              
                              
                              
                              2,134,858
                              
                              
                              
                              1,979,253
                              
                              
                              
                              -
                              
                              
                              
                              4,141,322Consolidation
      entries
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (2,729,327
                              )
                              
                              
                              (2,729,327
                              )Accumulated
      depreciation and amortisation
                              
                              
                              (43,568
                              )
                              
                              
                              (43,768,810
                              )
                              
                              
                              (80,554
                              )
                              
                              
                              (28,363,540
                              )
                              
                              
                              (142,559
                              )
                              
                              
                              (72,399,031
                              )Net book value
                              
                              
                              3,747
                              
                              
                              
                              203,778,963
                              
                              
                              
                              2,273,619
                              
                              
                              
                              19,915,488
                              
                              
                              
                              (2,386,258
                              )
                              
                              
                              223,585,559Capital expenditure for year ended December 31,
      2008
                              
                              
                              -
                              
                              
                              
                              529,033
                              
                              
                              
                              92,494
                              
                              
                              
                              4,108,630
                              
                              
                              
                              95,493
                              
                              
                              
                              4,825,651
 
 December 31, 2007
                              
                              Upstream
                              
                              
                              Midstream -
                                Refining
                              
                              
                              Midstream -
                                Liquefaction
                              
                              
                              Downstream
                              
                              
                              Corporate &
                                Consolidated
                              
                              
                              TotalsPlant
      and equipment
                              
                              
                              1,247,201
                              
                              
                              
                              246,561,648
                              
                              
                              
                              140,051
                              
                              
                              
                              42,709,718
                              
                              
                              
                              390,135
                              
                              
                              
                              291,048,753Deferred
      project costs and work in progress
                              
                              
                              -
                              
                              
                              
                              457,092
                              
                              
                              
                              2,622,735
                              
                              
                              
                              3,405,625
                              
                              
                              
                              -
                              
                              
                              
                              6,485,452Consolidation
      entries
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (2,859,295
                              )
                              
                              
                              (2,859,295
                              )Accumulated
      depreciation and amortisation
                              
                              
                              (1,193,374
                              )
                              
                              
                              (32,799,711
                              )
                              
                              
                              (15,431
                              )
                              
                              
                              (27,737,982
                              )
                              
                              
                              (76,190
                              )
                              
                              
                              (61,822,688
                              )Net book value
                              
                              
                              53,827
                              
                              
                              
                              214,219,029
                              
                              
                              
                              2,747,355
                              
                              
                              
                              18,377,361
                              
                              
                              
                              (2,545,350
                              )
                              
                              
                              232,852,222Capital expenditure for year ended December 31,
      2007
                              
                              
                              -
                              
                              
                              
                              777,962
                              
                              
                              
                              2,777,112
                              
                              
                              
                              5,200,427
                              
                              
                              
                              243,338
                              
                              
                              
                              8,998,839
  Consolidated
Financial Statements   INTEROIL
CORPORATION     29
 
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
  10.
              Plant
      and equipment (cont’d)
 
 December 31, 2006
                              
                              Upstream
                              
                              
                              Midstream -
                                Refining
                              
                              
                              Midstream -
                                Liquefaction
                              
                              
                              Downstream
                              
                              
                              Corporate &
                                Consolidated
                              
                              
                              TotalsPlant
      and equipment
                              
                              
                              1,247,201
                              
                              
                              
                              249,741,042
                              
                              
                              
                              -
                              
                              
                              
                              37,697,458
                              
                              
                              
                              146,797
                              
                              
                              
                              288,832,498Deferred
      project costs and work in progress
                              
                              
                              -
                              
                              
                              
                              723,566
                              
                              
                              
                              -
                              
                              
                              
                              715,653
                              
                              
                              
                              -
                              
                              
                              
                              1,439,219Consolidation
      entries
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (2,990,688
                              )
                              
                              
                              (2,990,688
                              )Accumulated
      depreciation and amortisation
                              
                              
                              (153,455
                              )
                              
                              
                              (21,760,341
                              )
                              
                              
                              -
                              
                              
                              
                              (22,697,003
                              )
                              
                              
                              (28,153
                              )
                              
                              
                              (44,638,952
                              )Net book value
                              
                              
                              1,093,746
                              
                              
                              
                              228,704,267
                              
                              
                              
                              -
                              
                              
                              
                              15,716,108
                              
                              
                              
                              (2,872,044
                              )
                              
                              
                              242,642,077Capital expenditure for year ended December 31,
      2006
                              
                              
                              -
                              
                              
                              
                              11,948,960
                              
                              
                              
                              -
                              
                              
                              
                              10,543,842
                              
                              
                              
                              156,817
                              
                              
                              
                              22,649,619
 
 During
the year ended December 31, 2008, InterOil recognized a gain of $285,206 on the
disposal of assets (2007 – loss of $269,320, 2006 - loss of
$263,945).
 
 During
the year 2007, there was a reduction to plant and equipment in Midstream –
Refining of $4,841,776 due to negative goodwill on buyback of non controlling
interest (refer note 20).
 
 During
the year 2007, InterOil booked an impairment loss of $960,000 on a barge owned
by the Company.  The sale of the barge was completed in the first
quarter of 2008.  During 2006, InterOil sold one of the two barges
included in the upstream segment.  Prior to the sale, an impairment
assessment was performed and an impairment loss of $755,857 was
recognized.  These impairment losses are included in office and
administrative expenses in the statement of operations.
 
 11.
              Oil
      and gas properties
 
 Costs of
oil and gas properties which are not subject to depletion are as
follows:
 
 December
      31,
                          
                          
                          December
      31,
                          
                          
                          December
      31,2008
                          
                          
                          2007
                          
                          
                          2006$
                          
                          
                          $
                          
                          
                          $Drilling
      equipment
                          
                          
                          13,857,772
                          
                          
                          
                          14,664,179
                          
                          
                          
                          13,949,238Inventory
                          
                          
                          10,113,808
                          
                          
                          
                          7,661,992
                          
                          
                          
                          4,293,734Petroleum
      Prospecting License drilling programs at cost
                          
                          
                          104,042,379
                          
                          
                          
                          62,538,956
                          
                          
                          
                          36,281,375128,013,959
                          
                          
                          
                          84,865,127
                          
                          
                          
                          54,524,347
 
 The
following table discloses a breakdown of the gain realized on sale of oil and
gas properties for the periods ended:
 
 December
      31,
                            
                            
                            December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $Gain
      on sale of oil and gas propertiesSale
      of PRL 4 interest (43.13% of the property)
                            
                            
                            1,500,000
                            
                            
                            
                            -
                            
                            
                            
                            -Sale
      of PRL 5 interest (28.576% of the property)
                            
                            
                            5,000,000
                            
                            
                            
                            -
                            
                            
                            
                            -Conveyance accounting of IPI Agreement (note
      19)
                            
                            
                            4,735,084
                            
                            
                            
                            -
                            
                            
                            
                            -11,235,084
                            
                            
                            
                            -
                            
                            
                            
                            -
 
 During
the year ended December 31, 2008, the Company has divested fully its interests
in Petroleum Retention Licenses 4 and 5 in Papua New Guinea.  As these
properties did not have any cost base associated with them carried forward in
the balance sheet, the entire sale proceeds were treated as a gain on sale of
these properties.
 
 In
addition to the above divestments, on May 5, 2008, one of the investors who had
a 4.1% interest in the eight well drilling program (19.1% of the IPI Agreement)
waived their right to convert their IPI percentage into common shares pursuant
to the agreement dated February 25, 2005.  On September 23, 2008,
another investor who had a 1.125% interest in the eight well drilling program
(5.3% of the IPI agreement) also waived its right to convert its IPI percentage
into common shares.
  Consolidated
Financial Statements   INTEROIL
CORPORATION     30
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 11.
              Oil
      and gas properties
 
 These
waivers have triggered a conveyance under the IPI Agreement for their share of
interest in the program.  An amount of $4,735,084 was recognized as a
gain on conveyance following the guidance in paragraphs 47(h) and 47(j) of SFAS
19 (refer note 19 for further details).
 
 Refer to
Note 13 below for details of Petromin participation in the Elk/Antelope field
and the treatment of the $4,000,000 advance received from them in relation to
this participation agreement.
 
 The
following table discloses a breakdown of the exploration expenses presented in
the statements of operations for the periods ended:
 
 Year endedDecember
      31,
                        
                        
                        December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007
                        
                        
                        2006$
                        
                        
                        $
                        
                        
                        $Exploration
      costs, excluding exploration impairment
                        
                        
                        995,532
                        
                        
                        
                        13,305,437
                        
                        
                        
                        6,176,866Exploration
      impairmentCosts
      incurred in prior years
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Costs incurred in current
    year
                        
                        
                        107,788
                        
                        
                        
                        1,242,606
                        
                        
                        
                        1,647,185Total exploration
impairment
                        
                        
                        107,788
                        
                        
                        
                        1,242,606
                        
                        
                        
                        1,647,1851,103,320
                        
                        
                        
                        14,548,043
                        
                        
                        
                        7,824,051
 
 12.
              Income
    taxes
 
 The
combined income tax expense in the consolidated statements of operations
reflects an effective tax rate which differs from the expected statutory rate
(combined federal and provincial rates).  Differences for the years
ended were accounted for as follows:
 
 December
      31,
                            
                            
                            December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $(Loss)
      before income taxes and non controlling interest
                            
                            
                            (11,714,170
                            )
                            
                            
                            (27,728,349
                            )
                            
                            
                            (43,719,889
                            )Statutory income tax rate
                            
                            
                            34.50
                            %
                            
                            
                            35.10
                            %
                            
                            
                            35.10
                            %Computed
      tax (benefit)
                            
                            
                            (4,041,389
                            )
                            
                            
                            (9,732,650
                            )
                            
                            
                            (15,345,681
                            )Effect
      on income tax of:Losses/(income)
      in foreign jurisdictions not deductible/(assessable)
                            
                            
                            (61,702
                            )
                            
                            
                            (2,481,828
                            )
                            
                            
                            251,639Non-deductible
      stock compensation expense
                            
                            
                            720,825
                            
                            
                            
                            2,128,100
                            
                            
                            
                            693,601LNG
      Project Establishment costs
                            
                            
                            2,584,562
                            
                            
                            
                            3,306,847
                            
                            
                            
                            1,925,090Non-taxable
      gain on sale of exploration assets
                            
                            
                            (3,876,104
                            )
                            
                            
                            -
                            
                            
                            
                            -Gains
      and losses on foreign exchange unrealized
                            
                            
                            (14,059,228
                            )
                            
                            
                            2,069,183
                            
                            
                            
                            (1,687,001
                            )Tax
      rate differential in foreign jurisdictions
                            
                            
                            (134,619
                            )
                            
                            
                            720,014
                            
                            
                            
                            1,103,122Over
      provision for tax in prior years
                            
                            
                            148,823
                            
                            
                            
                            (218,403
                            )
                            
                            
                            (51,632
                            )Tax
      losses for which no future tax benefit has been brought to
      account
                            
                            
                            19,569,753
                            
                            
                            
                            5,012,598
                            
                            
                            
                            10,241,534Temporary
      differences for which no future tax benefit has been brought to
      account
                            
                            
                            (253,262
                            )
                            
                            
                            192,826
                            
                            
                            
                            3,124,836Temporary
      differences brought to account on acquisition of
subsidiary
                            
                            
                            -
                            
                            
                            
                            546,026
                            
                            
                            
                            1,135,181Other - net
                            
                            
                            (515,695
                            )
                            
                            
                            (335,821
                            )
                            
                            
                            952,18481,964
                            
                            
                            
                            1,206,892
                            
                            
                            
                            2,342,873
 
 All
future tax assets recorded in the consolidated balance sheet relate to
downstream assets in Papua New Guinea. The amounts are noncurrent at December
31, 2008.  The valuation allowance for deferred tax assets decreased
by $51,821,135 (2007 – increased by $10,569,456, 2006 – increased by
$27,317,010) in the year ended December 31, 2008.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     31
  InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 12.
              Income
      taxes (cont’d)
 
 The
future income tax asset comprised the tax effect of the following:
 
 December
      31,
                              
                              
                              December
      31,
                              
                              
                              December
      31,2008
                              
                              
                              2007
                              
                              
                              2006$
                              
                              
                              $
                              
                              
                              $Future
      tax assetsTemporary
      differencesPlant
      and equipment
                              
                              
                              (7,051,509
                              )
                              
                              
                              (8,338,671
                              )
                              
                              
                              3,030,479Exploration
      expenditure
                              
                              
                              26,901,138
                              
                              
                              
                              32,563,507
                              
                              
                              
                              41,870,390Unrealised
      foreign exchange losses / (gains)
                              
                              
                              (17,177,649
                              )
                              
                              
                              19,742,048
                              
                              
                              
                              -Other - net
                              
                              
                              1,820,931
                              
                              
                              
                              1,549,740
                              
                              
                              
                              122,7134,492,911
                              
                              
                              
                              45,516,624
                              
                              
                              
                              45,023,582Losses carried forward
                              
                              
                              28,679,655
                              
                              
                              
                              39,274,207
                              
                              
                              
                              27,754,49533,172,566
                              
                              
                              
                              84,790,831
                              
                              
                              
                              72,778,077Less valuation allowance
                              
                              
                              (30,102,384
                              )
                              
                              
                              (81,923,519
                              )
                              
                              
                              (71,354,063
                              )3,070,182
                              
                              
                              
                              2,867,312
                              
                              
                              
                              1,424,014
 
 The
decrease in valuation allowance during the year was mainly due to the exchange
rate movements between the reporting currency, being USD, and the local
jurisdiction currencies of Canadian Dollars (CAD) and PGK, increasing the
deferred tax liabilities in relation to unrealized foreign exchange local
currency gains.  During the year, the Company has elected to lodge USD
tax returns in Canada – this legislation has been substantially enacted
subsequent to the yearend which will enable to Company to prepare its tax
returns in Canada, effective January 1, 2008, in USD.  In assessing
the realizability of deferred tax assets, management considers whether it is
more likely than not that some portion or all of the deferred tax assets will
not be realized.  The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible.  Management
considers the actual levels of past taxable income, scheduled reversal of
deferred tax liabilities, projected future taxable income, projected tax rates
and tax planning strategies in making this assessment.  Management has
determined that a 100% valuation allowance of the net operating loss
carry-forward is appropriate as of December 31, 2008 in respect of losses
generated from the operations, carried forward exploration expenditure and other
temporary differences.
 
 The
Refinery Project Agreement gives “pioneer” status to InterOil Limited
(‘IOL’).  This status gives IOL a tax holiday beginning upon the date
of the commencement of commercial production, January 1, 2005 and ending
December 31, 2010.  In relation to the refinery, tax losses incurred
prior to January 1, 2005 will be frozen during the tax holiday and will become
available for use after the tax holiday ceases on December 31,
2010.  Tax losses incurred during the tax holiday will also be
available for use after December 31, 2010.  Tax losses carried forward
to offset against future earnings total K200,433,616 (US $74,861,956) at
December 31, 2008.  All losses incurred by InterOil Limited have a
twenty year carry forward period.
 
 13.
              Accounts
      payable and accrued liabilities
 
 December
      31,
                          
                          
                          December
      31,
                          
                          
                          December
      31,2008
                          
                          
                          2007
                          
                          
                          2006$
                          
                          
                          $
                          
                          
                          $Accounts
      payable - crude import
                          
                          
                          25,233,525
                          
                          
                          
                          -
                          
                          
                          
                          41,006,000Other
      accounts payable and accrued liabilities
                          
                          
                          52,914,211
                          
                          
                          
                          57,162,039
                          
                          
                          
                          32,304,793Income
      tax payable
                          
                          
                          -
                          
                          
                          
                          3,265,568
                          
                          
                          
                          2,784,576Total accounts payable and accrued
      liabilities
                          
                          
                          78,147,736
                          
                          
                          
                          60,427,607
                          
                          
                          
                          76,095,369
 
 Petromin
participation in Elk/Antelope field
 On
October 30, 2008, Petromin PNG Holdings Limited (‘Petromin’), a government
entity mandated to invest in resource projects on behalf of the Independent
State of Papua New Guinea (“the State”), agreed to take a 20.5% direct interest
in the Elk/Antelope field.  Petromin will contribute an initial
deposit and will conditionally fund 20.5% of the costs of developing the
Elk/Antelope field.  The relevant legislation on the State’s right to
invest arises upon issuance of the Prospecting Development Licence (‘PDL’),
which has not yet occurred.  The agreement contains certain provisions
applicable in the event that the PDL is not issued within a certain timeframe,
or the State does not designate Petromin to hold its interest at that
time.  In the event the PDL is not granted for the Elk/Antelope field,
Petromin will be issued InterOil common shares based on a five day Volume
Weighted Average Price (‘VWAP’) immediately prior to the date of
issue.  As at December 31, 2008, $4,000,000 advance payment received
from Petromin has been held under ‘Other accounts payable and accrued
liabilities’ above. Once the PDL is formed, conveyance accounting following the
guidance in paragraphs 47(h) and 47(j) of SFAS 19 will be
triggered.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     32
  InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 14.
              Deferred
      gain on contributions to LNG
Project
 
 As noted
under Note 2(c) above, On July 30, 2007, a Shareholders’ Agreement was signed
between InterOil LNG Holdings Inc., Pacific LNG Operations Ltd., Merrill Lynch
Commodities (Europe) Limited and PNG LNG Inc.. The signing of the Agreement was
a key milestone in furthering the proposal for the construction of a
liquefaction plant to be built adjacent to our refinery.  As part of
the Shareholders’ Agreement, five ‘A’ Class shares were issued by PNG LNG Inc.
with full voting rights with each share controlling one board
position.  Two ‘A’ Class shares are owned by InterOil, two by Merrill
Lynch Commodities (Europe) Limited, and one by Pacific LNG Operations
Ltd.  All key operational matters require ‘Unanimous’ or
‘Super-majority’ Board resolution which confirms that none of the joint ventures
is in a position to exercise unilateral control over the joint
venture.
 
 InterOil
was also provided with ‘B’ Class shares in the Joint Venture Company with a fair
value of $100,000,000 in recognition of its contribution to the LNG Project at
the time of signing the Shareholders’ Agreement.  The main items
contributed by InterOil into the Joint venture Company were infrastructure
developed by InterOil near the proposed LNG site at Napa Napa, stakeholder
relations within Papua New Guinea, General Supply Agreements secured with other
landowners for supply of gas, advanced stage of project development,
etc.  Fair value was determined based on the agreement between the
independent joint venture partners.
 
 The other
Joint Venture partners are being issued ‘B’ Class shares as they contribute cash
into the Joint Venture Company by way of cash calls. Based on the Agreement,
InterOil is not required to contribute towards cash calls from the Joint Venture
Company until a total of $200,000,000 has been contributed by the other Joint
Venture partners to equalize their shareholding in the Joint Venture Company
with that of InterOil.
 
 InterOil
has a recognized deferred gain on its contributions to the Joint Venture based
on the share of other joint venture partners in the project. As InterOil’s
shareholding within the Joint Venture Company as at December 31, 2008 is 82.15%,
the gain on contribution of non cash assets to the project by InterOil relating
to other joint venture partners’ shareholding (17.85% - amounting to
$17,497,110) has been recognized by InterOil in its balance sheet as a deferred
gain. This deferred gain will increase as the other Joint Venture partners
increase their shareholding in the project.  The gain has been
deferred in accordance with the principles of proportionate consolidation as per
CICA 3055 – ‘Interests in Joint Ventures’ and will be taken to income based on
the value to be obtained from their use by the Joint Venture Company in the
future.  The intangible assets of the Joint Venture Company,
contributed by InterOil, have been eliminated on proportionate consolidation of
the joint venture balances.
 
 Subsequent
to year ended December 31, 2008, on February 27, 2009, InterOil LNG Holdings
Inc. and Pacific LNG Operations Ltd, acquired Merrill Lynch’s interest in the
Joint Venture Company. InterOil issued 652,931 common shares for its share of
$11,250,000 in relation to the settlement.  The final number of shares
is subject to a post closing balancing payment.  After the completion
of this transaction, Merrill Lynch does not retain any ownership in the PNG LNG
project.
 
 15.
              Working
      capital facility
 
 December
      31,
                          
                          
                          December
      31,
                          
                          
                          December
      31,2008
                          
                          
                          2007
                          
                          
                          2006$
                          
                          
                          $
                          
                          
                          $BNP
      Paribas working capital facility - midstream
                          
                          
                          53,386,775
                          
                          
                          
                          66,501,372
                          
                          
                          
                          36,873,508Westpac working capital facility -
      downstream
                          
                          
                          15,405,627
                          
                          
                          
                          -
                          
                          
                          
                          -Total working capital
    facility
                          
                          
                          68,792,402
                          
                          
                          
                          66,501,372
                          
                          
                          
                          36,873,508
 
 BNP
Paribas working capital facility
 
 InterOil
has a working capital credit facility with BNP Paribas (Singapore branch) with a
maximum availability of $190,000,000.  The facility is renewable
annually and as part of the current year renewal process, which was completed in
the quarter ended September 30, 2008, the overall facility limit was increased
by $20,000,000 to $190,000,000 to accommodate higher crude prices and resulting
increases in working capital requirements.  For the period until
December 1, 2008 in the quarter ended December 31, 2008, the facility limit was
temporarily increased to $210,000,000, reducing back to $190,000,000 on December
1, 2008.
 
 This
financing facility supports the ongoing procurement of crude oil for the
refinery and includes related hedging transactions.  The facility
comprises a base facility to accommodate the issuance of letters of credit
followed by secured loans in the form of short term advances.  In
addition to the base facility, the agreement offers both; cash secured short
term facility, and a discounting facility on specific monetary receivables (note
8).  The facility is secured by sales contracts, purchase contracts,
certain cash accounts associated with the refinery, all crude and refined
products of the refinery and trade receivables.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     33
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 15.
              Working
      capital facility (cont’d)
 
 The
facility bears interest at LIBOR + 3.5% on the short term
advances.  During the year the weighted average interest rate was
5.11% (2007 – 7.01%, 2006 - 7.28%).
 
 The
following table outlines the facility and the amount available for use at year
end:
 
 December
      31,
                            
                            
                            December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007
                            
                            
                            2006$
                            
                            
                            $
                            
                            
                            $Working
      capital credit facility
                            
                            
                            190,000,000
                            
                            
                            
                            170,000,000
                            
                            
                            
                            170,000,000Less
      amounts included in the working capital facility
liability:Short
      term advances
                            
                            
                            (50,245,537
                            )
                            
                            
                            (66,501,372
                            )
                            
                            
                            (13,201,940
                            )Discounted receivables (note
    8)
                            
                            
                            (3,141,238
                            )
                            
                            
                            -
                            
                            
                            
                            (23,671,568
                            )(53,386,775
                            )
                            
                            
                            (66,501,372
                            )
                            
                            
                            (36,873,508
                            )Less:
      other amounts outstanding under the facility:Letters
      of credit outstanding
                            
                            
                            (27,600,000
                            )
                            
                            
                            (32,000,000
                            )
                            
                            
                            (79,000,000
                            )Bank guarantees on hedging
      facility
                            
                            
                            -
                            
                            
                            
                            (2,500,000
                            )
                            
                            
                            (1,500,000
                            )Working capital credit facility available for
      use
                            
                            
                            109,013,225
                            
                            
                            
                            68,998,628
                            
                            
                            
                            52,626,492
 
 At
December 31, 2008, the company had one letter of credit outstanding totaling
$27,600,000. The letter of credit was for a crude cargo and was drawn down on
January 13, 2009.
 
 The cash
deposit on working capital facility, as separately disclosed in note 7, included
restricted cash of $25,994,258 (2007 - $20,240,553, 2006 - $29,301,940) which is
being maintained as a security margin for the facility.  In addition,
inventory of $56,012,523 (2007 - $46,963,118, 2006 - $35,171,272) and trade
receivables of $10,300,542 (2007 – $38,033,715, 2006 - $55,955,400) also secured
the facility.  The trade receivable balance securing the facility
includes $6,912,883 (2007 - $33,703,069, 2006 - $20,186,665) of inter-company
receivables which were eliminated on consolidation.
 
 Westpac
and Bank South Pacific working capital facility
 
 On
October 24, 2008 the Company secured a Papua New Guinea Kina 150,000,000
(approximately $57,500,000) combined revolving working capital facility for its
wholesale and retail petroleum products distribution business in Papua New
Guinea from Bank of South Pacific Limited (‘BSP’) and Westpac Bank PNG Limited.
Westpac facility limit is Papua New Guinea Kina 80,000,000 (approximately
$30,700,000) and BSP facility limit is Papua New Guinea Kina 70,000,000
(approximately $26,800,000).  The Westpac facility is for an initial
term of three years and is due for renewal in October 2011.  The BSP
facility is renewable annual and is due for renewal in August
2009.  As at December 31, 2008 only the Westpac facility has been
utilized for $15,405,627, and the entire BSP facility remains available for
use.  These facilities are secured by a fixed and floating charge over
the assets and liabilities of Downstream operations.
 
 16.
              Acquisition
      of a subsidiary
 
 InterOil
New York Inc
 
 In April
2008, InterOil New York Inc. was incorporated as a 100% subsidiary of InterOil
Corporation to evaluate potential financing arrangements in the
U.S.  The Company had not undertaken any activities as at December 31,
2008.
 
 InterOil
LNG Holdings Inc.
 
 In June
2007, InterOil LNG Holdings Inc. was incorporated as a holding company of
InterOil’s investment in PNG LNG Inc.  InterOil LNG Holdings Inc. is a
100% subsidiary of InterOil Corporation.  During July 2007, the
investment in PNG LNG Inc. was transferred from InterOil Corporation to InterOil
LNG Holdings Inc.
 
 PNG
LNG Inc. and Liquid Niugini Gas Ltd
 
 In 2006,
InterOil acquired 100% of the issued share capital of PNG LNG, Inc. and Liquid
Niugini Gas Ltd for a total cost of $1,001.  The purchase price
reflected the book value of the shares at the time of acquisition as both were
dormant shelf companies at the time of acquisition.  These companies
comprise the Midstream – liquefaction segment reported in these
financials.  In July 2007, InterOil Corporation transferred its
investment in PNG LNG Inc. to InterOil LNG Holdings Inc. Refer to Note 2(c) for
changes to InterOil’s shareholding in these entities due to the signing of the
Shareholders’ Agreement on July 30, 2007.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     34
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 16.
              Acquisition
      of a subsidiary (cont’d)
 
 IPL
PNG Ltd.
 
 On
October 1, 2006, InterOil, through its wholly owned subsidiary, InterOil
Products Limited acquired 100% of the outstanding common shares of Shell Papua
New Guinea Limited which was subsequently renamed IPL PNG Ltd ("IPL
PNG").  IPL PNG is a distributor of refined petroleum products in
Papua New Guinea.  The operations of IPL PNG was merged with InterOil
Products Limited, and the entity registration cancelled in July
2008.
 
 The
results of IPL PNG’s operations have been included in the consolidated financial
statements since October 1, 2006, the date on which control of IPL PNG's shares
was transferred to InterOil.The
purchase price was $10,000,000 plus an amount equal to the net current assets of
Shell based on the year ended 2005 accounts.  However, if the net
current assets at the transfer date exceeded the net current assets in the year
end 2005 accounts by more than Kina 500,000, then InterOil would pay the amount
of excess to the vendor.
 
 As at
December 31, 2006, InterOil had paid $30,639,000 in cash to Shell and a further
balance was to be paid subject to a working capital
adjustment.  During the year ended December 31, 2007, InterOil paid
$2,679,435 as final payment of the purchase price for the working capital
adjustment.  In addition to the amounts paid and accrued by IPL,
$818,606 of acquisition related costs were incurred on the
transaction.
 
 The
following table summarizes the estimated fair value of the assets acquired and
liabilities assumed at the date of acquisition.
 
 $Cash
                              
                              
                              4,989,895Trade
      receivables
                              
                              
                              6,288,834Inventory
                              
                              
                              20,429,728Other
      assets
                              
                              
                              2,190,226Future
      income tax benefit
                              
                              
                              1,698,224Property, plant and
    equipment
                              
                              
                              10,355,322Total
      assets acquired
                              
                              
                              45,952,229Accounts
      payable and accrued liabilities
                              
                              
                              (11,815,188
                              )Net assets acquired
                              
                              
                              34,137,041
 
 The net
cash paid on purchase of IPL PNG of $29,147,146 is comprised of $33,318,435 paid
to Shell and $818,606 transaction costs incurred, less $4,989,895 held by IPL
PNG at the time of acquisition.
 
 17.
              Related
      parties
 
 Petroleum
Independent and Exploration Corporation (“P.I.E”)
 
 P.I.E is
controlled by Phil Mulacek, an officer and director of InterOil and acts as a
sponsor of the Company's oil refinery project.  Articles of
association of SPI InterOil LDC (“SPI”) provide for the business and affairs of
the entity to be managed by a general manager appointed by the shareholders of
SPI and its U.S. sponsor under the Overseas Private Investment Corporation
(“OPIC” - which is an agency of the U.S. Government) loan
agreement.  SPI does not have a Board of Directors, instead P.I.E has
been appointed as the general manager of SPI.  Under the laws of the
Commonwealth of The Bahamas, the general manager exercises all powers which
would typically be exercised by a Board of Directors, being those which are not
required by laws or by SPI’s constituting documents to be exercised by the
members (shareholders) of SPI.  InterOil is the majority shareholder
of SPI and therefore has the power to appoint the general manager.
 
 During
the year, $150,000 (2007 - $150,000, 2006 - $150,000) was expensed for the
sponsor's legal, accounting and reporting costs.  These costs were
included in accrued liabilities at December 31, 2008.
 
 Breckland
Limited
 
 This
entity is controlled by Roger Grundy, a director of InterOil, and provides
technical and advisory services to the Company on normal commercial
terms.  Amounts paid or payable to Breckland for technical services
during the year amounted to $nil (2007 - $39,416, 2006 -
$140,165).  An amount of $9,562 was reimbursed by the Company in
February 2008 for expenses associated with Mr. Grundy’s travel for board
meetings.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     35
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 17.
              Related
      parties
 
 Director
fees
 
 Amounts
due to Directors at December 31, 2008 totaled $27,750 for Directors fees (2007 -
$nil, 2006 - $18,000) and $nil for Executive Director bonuses (2007 - $nil, 2006
- $nil,).  These amounts are included in accounts payable and accrued
liabilities.  An amount of $120,000 (2007 - $130,000, 2006 - $91,500)
was paid to the Directors for Directors fees during the year. In addition to the
above fees, each director is issued with 15,000 options each year for their
services.
 
 BNP
Paribas
 
 One of
our Directors, Edward Speal, is the Managing Director of BNP Paribas (New
York).  InterOil has a working capital facility with BNP Paribas
(Singapore) of $190,000,000 (as per note 15) - Management does not consider this
to be related party transaction as the Director does not have the ability to
exercise, directly or indirectly, control, joint control or significant
influence over BNP (Singapore).
  18.
              Secured
      loan
 
 December
      31,
                              
                              
                              December
      31,
                              
                              
                              December
      31,2008
                              
                              
                              2007
                              
                              
                              2006$
                              
                              
                              $
                              
                              
                              $Secured
      loan (OPIC)  - current portion
                              
                              
                              9,000,000
                              
                              
                              
                              9,000,000
                              
                              
                              
                              13,500,000Secured
      loan (bridging facility) - current portion
                              
                              
                              -
                              
                              
                              
                              127,810,093
                              
                              
                              
                              -Secured loan (bridging facility) - deferred
      financing costs
                              
                              
                              -
                              
                              
                              
                              (33,333
                              )
                              
                              
                              -Total
      current secured loan
                              
                              
                              9,000,000
                              
                              
                              
                              136,776,760
                              
                              
                              
                              13,500,000Secured
      loan (OPIC)  - non current portion
                              
                              
                              53,500,000
                              
                              
                              
                              62,500,000
                              
                              
                              
                              62,500,000Secured
      loan (OPIC)  - deferred financing costs
                              
                              
                              (1,134,667
                              )
                              
                              
                              (1,358,611
                              )
                              
                              
                              -Secured loan (bridging facility) - non current
      portion
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              121,666,433Total
      non current secured loan
                              
                              
                              52,365,333
                              
                              
                              
                              61,141,389
                              
                              
                              
                              184,166,433Total secured loan
                              
                              
                              61,365,333
                              
                              
                              
                              197,918,149
                              
                              
                              
                              197,666,433
 
 OPIC
Secured Loan
 
 On
      June 12, 2001, the Company entered into a loan agreement with OPIC to
      secure a project financing facility of $85,000,000.  The loan
      agreement was last amended under which the half yearly principal payments
      of $4,500,000 due in December 2006 and June 2007 each were deferred to the
      end of the loan agreement, being June 30, 2015 and December 31,
      2015.  As part of the amendment, OPIC also waived the
      requirement to have cash deposits against the next two interest payments
      until December 31, 2008.  The loan is secured over the assets of
      the refinery project which have a carrying value of $203,778,963 at
      December 31, 2008 (2007 - $214,219,029, 2006 -
    $228,704,267).
 
 The
interest rate on the loan is equal to the treasury cost applicable to each
promissory note (at the date of draw down) outstanding plus the OPIC spread
(3%).  During 2008 the weighted average interest rate was 7.10% (2007
– 7.10%, 2006 - 7.01%) and the total interest expense included in long term
borrowing costs was $5,147,768 (2007 - $5,339,500, 2006 -
$5,512,975).
 
 During
      the quarter ending December 31, 2008, an installment of $4,500,000 and the
      accrued interest on the loan was paid.  As at December 31, 2008,
      two installment payments amounting to $4,500,000 each which will be due
      for payment on June 30, 2009 and December 31, 2009 have been reclassified
      into the current portion of the liability.  The agreement
      contains certain financial covenants which include the maintenance of
      minimum levels of tangible net worth and limitations on the incurrence of
      additional indebtedness.  As of December 31, 2008, the company
      was in compliance with all applicable
covenants.
 
 Deferred
financing costs relating to the OPIC loan of $1,134,667 (2007 - $1,358,611, 2006
- $1,582,555) are being amortized over the period until December
2014.  Effective January 1, 2007 the deferred financing costs have
been offset against the long term liability in compliance with CICA 3855
Financial Instruments and are being amortized using the effective interest
method.
 
 The
accrued financing costs of $nil (2007 - $1,087,500, 2006 - $1,450,000) included
discounting of the liability and costs in relation to the modification of the
loan repayments.  The total liability of $1,450,000 was due for
payment in four quarterly installments of $362,500 commencing on December 31,
2007.  The installments due for payment within twelve months were
included within accounts payable and accrued liabilities.  All four of
these installments have been made as at December 31, 2008.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     36
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 18.
              Secured
      loan (cont’d)
 
 Bank
covenants under the above facility currently restrict the payment of dividends
by the Company.
 
 Bridging
Facility
 
 InterOil
entered into a loan agreement for $130,000,000 on May 3, 2006 with Merrill
Lynch.  On May 6, 2008, $60,000,000 of the $130,000,000 facility was
converted into common shares at a price of $22.65 per share.  On May
12, 2008 the remaining $70,000,000 of the bridging facility was repaid from the
proceeds of 8% subordinated convertible debentures (refer note 23).
 
 The
interest rate on the loan was 4% per annum over the life of the loan as the
conditions for maintaining the discounted interest rate, i.e., signing of a
definitive LNG/NGL Project Agreement, was met within an agreed time
frame.
 
 The loan
was initially valued on the balance sheet based on the present value of the
expected cash flows.  The interest expense was recognized based on the
market rate of interest InterOil would be expected to pay on such a borrowing
should it not be connected to an LNG/NGL Project.  The effective rate
used in the present value calculation was 9.18%.
 
 The
difference between the book value of the loan at the time of the cash being
received and the actual funds drawn down was initially reflected in the current
liability section of the balance sheet as a deferred liquefaction project
liability.   This deferred liability of $6,553,080 was
transferred to the profit and loss account as income on the execution of the
definitive LNG/NGL Project Agreement by InterOil and the lenders on July 31,
2007.
 
 19.
              Indirect
      participation interests
 
 Indirect
participation interest (“IPI”)
 
 December
      31,
                        
                        
                        December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007
                        
                        
                        2006$
                        
                        
                        $
                        
                        
                        $Indirect participation interest
      ("IPI")
                        
                        
                        72,476,668
                        
                        
                        
                        96,086,369
                        
                        
                        
                        96,861,259
 
 The IPI
balance relates to $125,000,000 received by InterOil subject to the terms of the
agreement dated February 25, 2005 between the Company and a number of
investors.  In exchange InterOil has provided the investors with a 25%
interest in an eight well drilling program to be conducted in InterOil’s
petroleum prospecting licenses 236, 237 and 238.
 
 Under the
IPI agreement, InterOil is responsible for drilling the eight exploration wells,
four of which will be in PPL 238, one in PPL 236, and one in PPL
237.  The investors will be able to approve the location of the final
two wells to be drilled.  In the instance that InterOil proposes
appraisal or completion of an exploration or development well, the investors
will be asked to contribute to the completion work in proportion to their IPI
percentage and InterOil will bear the remaining cost.  Should an
investor choose not to participate in the completion works of an exploration
well, the investor will forfeit their right to the well in question as well as
their right to convert into common shares.  InterOil has drilled four
exploration wells under the IPI agreement as at December 31, 2008.
 
 The
non-financial liability has been valued at $105,000,000, being the estimated
expenditures to complete the eight well drilling program, and the residual value
of $20,000,000 has been allocated to the conversion option presented under
Shareholder’s equity.  InterOil paid financing fees and transaction
costs of $8,138,741 related to the indirect participation interest on behalf of
the indirect participation interest investors in 2005.  These fees
have been allocated against the non-financial liability, reducing the liability
to $96,861,259.  InterOil will maintain the liability at its initial
value until conveyance is triggered on the lapse of the conversion option
available to the investors and they elect to participate in the Petroleum
Development License (‘PDL’) for a successful well.  InterOil will
account for the exploration costs relating to the eight well program under the
successful efforts accounting policy adopted by the Company.  All
Geological & Geophysical (‘G&G’) costs relating to the exploration
program will be expensed as incurred and all drilling costs will be capitalized
and assessed for recovery at each period.  When conveyance is
triggered on election by the investors to participate in a PDL or when the
investor forfeits the conversion option, conveyance accounting will be
applied.  This would entail determination of proceeds for the
interests conveyed and the cost of that interest as represented in the ‘Oil and
gas properties’ in the balance sheet.  The difference between proceeds
on conveyance and capitalized costs to the interests conveyed will be recognized
as gain or loss in the Statement of operations following the guidance in
paragraphs 47(h) and 47(j) of SFAS 19.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     37
 
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 19.
              Indirect
      participation interests (cont’d)
 
 Under the
agreement, all or part of this indirect participation interest may be converted
to a maximum of 3,333,334 common shares in the company between June 15, 2006 and
the later of December 15, 2006, or until 90 days after the completion of the
eighth well at a price of $37.50 per share.  Should the option to
convert to shares not be exercised, the indirect participation interest in the
eight well drilling program will be maintained and distributions from success in
these wells will be paid in accordance with the agreements.  Any
partial conversion of an indirect participation interest into common shares will
result in a corresponding decrease in the investors’ interest in the eight well
drilling program.  The balance of the indirect participation interest
that may be converted into shares is a maximum of 2,160,000 common shares (Dec
2007 – 3,306,667, Dec 2006 – 3,333,334) due to the conversion of 476,667 shares
and waiver of rights to 696,667 shares as explained below.
 
 During
2007, one of the IPI investors exercised their right to convert their interest
into 26,667 common shares.  During the quarter ended September 30,
2008 two IPI investors also exercised their conversion rights into 450,000
InterOil common shares.  The conversions during quarter ended
September 30, 2008 reduced the IPI liability balance by $13,076,270 and the
conversion option balance by $2,700,000 as compared to the balance at December
31, 2007.
 
 During
the year ended December 31, 2008, two of the investors’ with a combined 5.225%
interest in the eight well drilling program waived their right to convert their
IPI percentage into 696,667 common shares.  These waivers have
resulted in conveyance being triggered on this portion of the IPI agreement for
the year ended December 31, 2008.
 
 The
Company has applied the guidance in paragraph 47(h) of SFAS 19 in relation to
sale of these unproved properties and directly apportioned the proceeds to each
of the 8 wells in the program.  Based on the guidance, the proceeds
attributed to each well have been assessed against the capitalized costs
relating to each of these properties.  Proceeds of $4,735,084 relating
to wells that have no capitalized costs on the balance sheet, which have been
expensed in previous years, have been recognized as a gain in the Statement of
Operations.  Proceeds of $5,798,347 have been allocated to the
capitalized costs in relation to the conveyance of wells that do have
capitalized costs on the balance sheet.  The proceeds on conveyance
for the portion relating to the remaining obligations under the IPI Agreement,
is still being maintained as part of the IPI liability.
 
 Indirect
participation interest – PNGDV
 
 December
      31,
                          
                          
                          December
      31,
                          
                          
                          December
      31,2008
                          
                          
                          2007
                          
                          
                          2006$
                          
                          
                          $
                          
                          
                          $Current
      portion
                          
                          
                          540,002
                          
                          
                          
                          1,080,004
                          
                          
                          
                          730,534Non current portion
                          
                          
                          844,490
                          
                          
                          
                          844,490
                          
                          
                          
                          1,190,633Total indirect participation interest -
      PNGDV
                          
                          
                          1,384,492
                          
                          
                          
                          1,924,494
                          
                          
                          
                          1,921,167
 
 As at
December 31, 2008, the balance of the PNG Drilling Ventures Limited ("PNGDV")
indirect participation interest in the Company’s phase one exploration program
within the area governed by petroleum prospecting licenses 236, 237 and 238 is
$1,384,492 (2007 - $1,924,494, 2006 - $1,921,167).  In 2006 an
amendment was made to the original agreement whereby PNG Drilling Ventures
Limited converted their remaining balance of $9,685,830 into 575,575 InterOil
common shares and also retained a 6.75% interest in the next four exploration
wells (the first of the four wells is Elk-1, with an additional two exploration
wells to be drilled after Elk-4/A).  PNGDV also has the right to
participate in the 16 wells that follow the first four mentioned above up to an
interest of 5.75% at a cost of $112,500 per 1% per well (with higher amounts to
be paid if the depth exceed 3,500 meters and the cost exceeds
$8,500,000).
 
 The
accounting for the amendment to the agreement resulted in the fair value of the
shares issue of $7,948,691 being recognized as share capital.  The
Company has also recognized an initial liability relating to its obligation to
drill the above four wells on behalf of the investors of
$3,588,560.  The difference between the opening balance and the amount
allocated to share capital and the revised amount allocated to the liability of
$1,851,421 has been expensed as a cost of amending the original
transaction.
 
 During
the year ended December 31, 2008, $540,002 (Dec 2007 – a credit of $3,327, Dec
2006 – a debit of $1,667,396) of geological and geophysical costs and drilling
costs in relation to the Elk-4A exploratory well have been allocated against the
liability bringing the remaining balance to $1,384,492.  PNGDV
liability has been accounted using conveyance accounting as there are no
conversion options attached to the liability, unlike the IPI non-financial
liability noted above.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     38
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 19.
              Indirect
      participation interests (cont’d)
 
 Other
 
 In
addition to the above, PNG Energy Investors (“PNGEI”), an indirect participation
interest investor who converted all of its interest to common shares in fiscal
year 2004, has the right to participate up to a 4.25% interest in 16 wells
commencing from exploration wells numbered 9 to 24.  As at the end of
December 31, 2008 we have drilled 6 exploration wells since inception of our
exploration program within PPL 236, 237 and 238 in Papua New
Guinea.   In order to participate, PNGEI would be required to
contribute a proportionate amount of drilling costs related to these
wells.
 
 20.
              Non
      controlling interest
 
 On
December 31, 2007 an agreement was reached with Enron Papua New Guinea Ltd
(“Enron”), SPI’s former joint venture partner, to buy back the 1.07% minority
interest held by them in the refinery in exchange of 25,000 InterOil
Corporation’s shares.  At December 31, 2008, a subsidiary, SP InterOil
LDC, holds 100% (Dec 2007 – 100%, Dec 2006 - 98.92%) of the non-voting
participating shares issued from EP InterOil Ltd.
 
 The non
controlling interest as at December 31, 2008 relates to Petroleum Independent
and Exploration Corporation’s (“PIE Corp.”) 0.02% minority shareholding in SPI
InterOil LDC.  InterOil has entered into an agreement with PIE Corp.
under which PIE Corp. can exchange its remaining 5,000 shares of SPI InterOil
LDC for Common Shares on a one-for-one basis.  This election may be
made by PIE Corp. at any time.
 
 21.
              Share
      capital
 
 The
authorized share capital of the Company consists of an unlimited number of
common shares with no par value.  Each common share entitles the
holder to one vote.
 
 Common shares -Changes to issued share capital were as follows:
 
 Number of shares
                                          
                                          
                                          $January
      1, 2006
                                          
                                          
                                          29,163,320
                                          
                                          
                                          
                                          223,934,500Shares
      issued on exercise of options
                                          
                                          
                                          132,285
                                          
                                          
                                          
                                          2,006,175Shares issued on conversion of indirect
      participation interest
                                          
                                          
                                          575,575
                                          
                                          
                                          
                                          7,948,691December 31, 2006
                                          
                                          
                                          29,871,180
                                          
                                          
                                          
                                          233,889,366Shares
      issued on exercise of options
                                          
                                          
                                          22,000
                                          
                                          
                                          
                                          418,938Shares
      issued on conversion of indirect participation interest
                                          
                                          
                                          26,667
                                          
                                          
                                          
                                          934,890Shares
      issued on conversion of warrants
                                          
                                          
                                          2,995
                                          
                                          
                                          
                                          84,439Shares
      issued on buyback of minority interest
                                          
                                          
                                          25,000
                                          
                                          
                                          
                                          496,500Shares
      issued on Private Placement
                                          
                                          
                                          1,078,514
                                          
                                          
                                          
                                          23,500,000December 31, 2007
                                          
                                          
                                          31,026,356
                                          
                                          
                                          
                                          259,324,133Shares
      issued on Private Placement
                                          
                                          
                                          2,728,477
                                          
                                          
                                          
                                          58,938,305Shares
      issued on exercise of options
                                          
                                          
                                          58,000
                                          
                                          
                                          
                                          1,413,587Shares
      issued on preference share conversion and interest
payments
                                          
                                          
                                          532,754
                                          
                                          
                                          
                                          15,012,950Share
      issued as placement fee on debenture issue
                                          
                                          
                                          228,000
                                          
                                          
                                          
                                          5,700,000Share
      issued on debenture conversions
                                          
                                          
                                          641,000
                                          
                                          
                                          
                                          15,118,483Shares
      issued on debenture interest payments
                                          
                                          
                                          259,105
                                          
                                          
                                          
                                          2,620,628Shares
      issued on conversion of indirect participation interest
                                          
                                          
                                          450,000
                                          
                                          
                                          
                                          15,776,270December 31, 2008
                                          
                                          
                                          35,923,692
                                          
                                          
                                          
                                          373,904,356
 
 On May 6,
2008, $60,000,000 of the $130,000,000 Bridging facility was converted into
common shares at a price of $22.65 per share resulting in the issue of 2,649,007
shares.  In addition to the issue of these shares, there was also a 3%
fee payable in additional shares resulting in an additional 79,470 shares being
issued.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     39
 
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 21.
              Share
      capital
 
 On May
13, 2008, the Company completed the issue of $95,000,000 unsecured 8%
subordinated convertible debentures with a maturity of five years.  As
part of the debenture agreement, the investors were to be given a placement fee
of 6% which could be settled in shares or cash.  During the year ended
December 31, 2008, the Company issued 228,000 shares amounting to $5,700,000 to
settle this liability.  During the year, 641,000 debentures have been
converted into common shares of the Company.  In addition to the issue
of these shares, the interest payable on the debentures for the period up to
November 9, 2008 were paid in shares and cash resulting in an additional 259,105
shares being issued.
 
 During
the year ended 31 December, 2008, 517,777 preference shares were converted into
common shares.  In addition to the issue of these shares, the interest
payable on the preference shares for the first and second quarter of 2008 were
paid in shares resulting in an additional 14,977 shares being
issued.
 
 On August
15, 2008, two IPI investors converted their interest into 450,000 common
shares.
 
 The
numbers in the table above are net of transaction costs.
 
 22.
              Preference
      Shares
 
 In
November 2007, the Company authorized the issue of 1,035,554 convertible
preference shares at an issue price of $28.97 to investors amounting to a total
of $30,000,000. 517,777 of the authorized preference shares were issued to an
investor in November 2007 for $15,000,000.  The preferred stock
carried a fixed divided of 5% per annum payable quarterly in arrears in cash or
stock at the issuers’ option on March 31, June 30, September 30 and December 31
of each year, commencing on December 31, 2007. The holder can convert into
common shares at any time.
 
 Based on
guidance under CICA 3863, the preference shares were assessed based on the
rights attached to those shares in determining whether it exhibited the
fundamental characteristic of a financial liability or
equity.  Management has assessed that although the preference shares
issued exhibit some characteristics of an equity instrument, the fixed interest
right is in the nature of a liability.  Management had applied
residual basis and has valued the liability component first and assigned the
residual value to the equity component. Management has fair valued the liability
component by discounting the expected interest payments using a nominal rate of
8.9% being Management’s estimate of the expected interest payments for a similar
instrument without the conversion feature.  The liability component
was valued at $7,797,312 and the remaining balance of $7,202,688 was allocated
to the equity component before offsetting transaction costs.  The
transaction costs relating to the preference share issue amounting to $750,000
has been split based on the percentages allocated to the liability and equity
components; the costs relating to the liability component has been expensed, and
costs relating to the equity component have been allocated against the equity
component recognized.
 
 The
preference dividend payment of 5% per annum is treated as an interest expense
and is expensed in the Statement of Operations for the year.  The
preference dividend paid for the year ended December 31, 2008 was $418,526 (2007
- $84,247).  During the quarter ended September 30, 2008 all
preference shares issued (517,777 shares) were converted into common
shares.
  23.
                8%
      subordinated debentures
 
 On May
13, 2008, the Company completed the issue of $95,000,000 unsecured 8%
subordinated convertible debentures with a maturity of five
years.  The debenture holders have the right to convert their
debentures into common shares at any time at a conversion price of $25.00 per
share.  The Company has the right to require the debenture holders to
convert if the daily Volume Weighted Average Price (‘VWAP’) of the common shares
is at or above $32.50 for at least 15 consecutive trading
days.  Accrued interest on these debentures is to be paid
semi-annually in arrears, in May and November of each year, commencing November
2008.
 
 Based on
guidance under CICA 3863, the debentures should be assessed based on the
substance of the contractual arrangement in determining whether it exhibits the
fundamental characteristic of a financial liability or
equity.  Management has assessed that the debenture instrument mainly
exhibits characteristics that are liability in nature; however, the embedded
conversion feature is equity in nature and needs to be bifurcated and disclosed
separately within equity.  Management has applied residual basis and
has valued the liability component first and assigned the residual value to the
equity component.
 
 Management
has fair valued the liability component by discounting the expected interest
payments using a nominal rate of 13.5% being Management’s estimate of the
expected interest payments for a similar instrument without the conversion
feature.  The liability component was valued at $81,933,311 and the
remaining balance of $13,066,689 was allocated to the equity component before
offsetting transaction costs.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     40
 
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 23.
                8%
      subordinated debentures
(cont’d)
 
 The
placement fee of $5,700,000 paid to the investors in common shares of the
Company was treated to be in the nature of a debt discount and was offset
against the liability component.  The transaction costs relating to
the issue amounting to $219,966 has been split based on the percentages
allocated to the liability and equity components; the costs relating to the
liability component of $189,711 has been offset against the liability component,
and costs relating to the equity component of $30,255 have been allocated
against the equity component recognized.
 
 The
liability component on initial recognition after adjusting for the placement fee
and transaction costs amounted to $76,043,600 and the equity component amounted
to $13,036,434.  The liability component will be accreted over the
five year maturity period to bring the liability back to the carrying
value.  The accretion expense relating to the debenture liability for
the period since issue up to December 31, 2008 was $1,915,910.  In
addition to the accretion, interest at 8% per annum has been expensed for the
period since issue up to December 31, 2008 amounting to $4,361,889. The interest
payable up to November 9, 2008 was paid in a combination of cash and
shares.  The interest accrued at December 31, 2008 is
$897,611.
 
 During
the year ended December 31, 2008, certain debenture holders exercised their
conversion rights for $16,025,000 resulting in issue of 641,000 common shares of
the Company.  As at December 31, 2008, of the 3,800,000 convertible
debentures issued, 3,159,000 (December 2007 – nil), were
outstanding.
 
 24.
              Stock
      compensation
 
 Options
are issued at no less than market price to directors, certain employees and to a
limited number of contractor personnel.  Options are exercisable on a
1:1 basis. Options vest at various dates in accordance with the applicable
option agreement, vesting generally between one to four years after the date of
grant, have an exercise period of three to five years after the date of grant,
and are subject to the option plan rules.  Upon resignation or
retirement, vested options must be exercised within 90 days or before expiry of
the options if this occurs earlier.
 
 December 31, 2008
                      
                      
                      December 31, 2007
                      
                      
                      December 31, 2006Stock options outstanding
                      
                      Number of
                        options
                      
                      
                      Weighted
                        average
                        exercise
                        price $
                      
                      
                      Number of
                        options
                      
                      
                      Weighted
                        average
                        exercise
                        price $
                      
                      
                      Number of
                        options
                      
                      
                      Weighted
                        average
                        exercise
                        price $Outstanding
      at beginning of period
                      
                      
                      1,200,500
                      
                      
                      
                      23.70
                      
                      
                      
                      1,013,500
                      
                      
                      
                      20.59
                      
                      
                      
                      746,800
                      
                      
                      
                      22.23Granted
                      
                      
                      952,500
                      
                      
                      
                      18.48
                      
                      
                      
                      354,750
                      
                      
                      
                      33.51
                      
                      
                      
                      725,500
                      
                      
                      
                      15.87Exercised
                      
                      
                      (58,000
                      )
                      
                      
                      (16.50
                      )
                      
                      
                      (22,000
                      )
                      
                      
                      (14.37
                      )
                      
                      
                      (132,285
                      )
                      
                      
                      (11.14
                      )Forfeited
                      
                      
                      (11,500
                      )
                      
                      
                      (28.68
                      )
                      
                      
                      (143,250
                      )
                      
                      
                      (25.94
                      )
                      
                      
                      (285,433
                      )
                      
                      
                      (18.01
                      )Expired
                      
                      
                      (244,000
                      )
                      
                      
                      (25.80
                      )
                      
                      
                      (2,500
                      )
                      
                      
                      (27.00
                      )
                      
                      
                      (41,082
                      )
                      
                      
                      (15.36
                      )Outstanding
      at end of period
                      
                      
                      1,839,500
                      
                      
                      
                      21.03
                      
                      
                      
                      1,200,500
                      
                      
                      
                      23.70
                      
                      
                      
                      1,013,500
                      
                      
                      
                      20.59
 
 At
December 31, 2008, in addition to the options outstanding as per the above
table, there were an additional 309,500 (2007 – 1,137,250, 2006 - 2,570,500)
common shares reserved for issuance under the Company’s stock option
plans.  The decrease in the shares reserved from 2007 is mainly due to
the cancellation of certain shares reserved under the 2002 plan after the new
stock option plan was issued in 2006.
 
 Options issued and outstanding
                    
                    
                    Options exercisableRange of exercise
                      prices $
                    
                    Number of options
                    
                    
                    Weighted average
                      exercise price $
                    
                    
                    Weighted average
                      remaining term
                      (years)
                    
                    
                    Number of options
                    
                    
                    Weighted average
                      exercise price $8.01
      to 12.00
                    
                    
                    545,000
                    
                    
                    
                    9.81
                    
                    
                    
                    4.90
                    
                    
                    
                    40,000
                    
                    
                    
                    9.9212.01
      to 24.00
                    
                    
                    645,000
                    
                    
                    
                    17.71
                    
                    
                    
                    2.45
                    
                    
                    
                    452,000
                    
                    
                    
                    17.4524.01
      to 31.00
                    
                    
                    245,500
                    
                    
                    
                    29.10
                    
                    
                    
                    2.63
                    
                    
                    
                    93,000
                    
                    
                    
                    29.4031.01
      to 41.00
                    
                    
                    314,000
                    
                    
                    
                    34.67
                    
                    
                    
                    6.57
                    
                    
                    
                    90,000
                    
                    
                    
                    33.8241.01
      to 51.00
                    
                    
                    90,000
                    
                    
                    
                    43.22
                    
                    
                    
                    1.90
                    
                    
                    
                    90,000
                    
                    
                    
                    43.221,839,500
                    
                    
                    
                    21.03
                    
                    
                    
                    3.93
                    
                    
                    
                    765,000
                    
                    
                    
                    23.47
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     41
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 24.
              Stock
      compensation (cont’d)
 
 Aggregate
intrinsic value of the 1,839,500 options issued and outstanding as at December
31, 2008 is $22,465,826. Aggregate intrinsic value of 765,000 options
exercisable as at December 31, 2008 is $10,147,743.
 
 The
weighted-average grant-date fair value of options granted during the years 2008,
2007, and 2006 was $9.07, $19.34 and $8.89 respectively.  The total
intrinsic value of options exercised during the years ended December 31, 2008,
2007, and 2006, was $456,867, $102,840 and $532,232
respectively.  Cash received from option exercise under all
share-based payment arrangements for the years ended December 31, 2008, 2007,
and 2006, was $956,720, $316,100 and $1,473,942 respectively.
 
 The fair
value of the 952,500 (2007 – 354,750, 2006 - 725,500) options granted subsequent
to January 1, 2008 has been estimated at the date of grant in the amount of
$11,077,126 (2007 - $6,859,131, 2006 - $6,447,315) using a Black-Scholes pricing
model.  An amount of $5,741,086 (2007 - $6,062,962, 2006 - $1,976,072)
has been recognized as compensation expense for the year ended December 31,
2008.  The current year compensation expense of $5,741,086 (2007 -
$6,062,962, 2006 - $1,976,072) was adjusted against contributed surplus under
equity, out of which $456,867 (2007 - $102,840, 2006 - $532,230) was transferred
to share capital on exercise of options, leaving a net impact of $5,284,219
(2007 - $5,960,122, 2006 - $1,443,840) on contributed surplus.
 
 The
assumptions contained in the Black Scholes pricing model are as
follows:
 
 Year
                          
                          Period
                          
                          Risk
      free interest
                            rate (%)
                          
                          
                          Dividend yield
                          
                          
                          Volatility (%)
                          
                          
                          Weighted
      average
                            expected
      life for
                            options2008
                          
                          Oct
      1 to Dec 31
                          
                          
                          1.5
                          
                          
                          
                          -
                          
                          
                          
                          83
                          
                          
                          
                          4.32008
                          
                          April
      1 to Sep 30
                          
                          
                          2.7
                          
                          
                          
                          -
                          
                          
                          
                          80
                          
                          
                          
                          5.02008
                          
                          January
      1 to March 31
                          
                          
                          2.2
                          
                          
                          
                          -
                          
                          
                          
                          73
                          
                          
                          
                          5.02007
                          
                          October
      1 to Dec 31
                          
                          
                          3.4
                          
                          
                          
                          -
                          
                          
                          
                          74
                          
                          
                          
                          5.02007
                          
                          January
      1 to Sep 30
                          
                          
                          5
                          
                          
                          
                          -
                          
                          
                          
                          63
                          
                          
                          
                          5.02006
                          
                          October
      1 to December 31
                          
                          
                          4.6
                          
                          
                          
                          -
                          
                          
                          
                          65
                          
                          
                          
                          5.02006
                          
                          July
      1 to September 30
                          
                          
                          5.1
                          
                          
                          
                          -
                          
                          
                          
                          68
                          
                          
                          
                          4.22006
                          
                          January
      1 to June 30
                          
                          
                          4.4
                          
                          
                          
                          -
                          
                          
                          
                          60
                          
                          
                          
                          4.8
 
 25.
              Warrants
 
 In 2004,
InterOil issued five-year warrants to purchase 359,415 common shares at an
exercise price equal to $21.91.  A total of 337,252 (2007 – 337,252,
2006 – 340,247) were outstanding at December 31, 2008.  The warrants
are exercisable between August 27, 2004 and August 27, 2009.  The
warrants are recorded at the fair value calculated at inception as a separate
component of equity.  The fair value was calculated using a
Black-Scholes pricing model with the following assumptions: risk-free interest
rate of 2.5%, dividend yield of nil, volatility factor of the expected market
price of the Company’s common stock of 45% and a weighted average expected life
of the warrants of five years.
 
 26.
              Earnings/(Loss)
      per share
 
 Preferred
stock, warrants, conversion options and stock options totaling 7,500,752 common
shares at prices ranging from $9.80 to $43.22 were outstanding as at December
31, 2008 but were not included in the computation of the diluted earnings per
share because they caused the loss per share to be anti-dilutive.
 
 Potential dilutive instruments outstanding
                  
                  Number of shares
                    December 31, 2008
                  
                  
                  Number of shares
                    December 31, 2007
                  
                  
                  Number of shares
                    December 31, 2006Preferred
      stock
                  
                  
                  -
                  
                  
                  
                  517,777
                  
                  
                  
                  -Employee
      stock options
                  
                  
                  1,839,500
                  
                  
                  
                  1,200,500
                  
                  
                  
                  1,013,500IPI
      Indirect Participation interest - conversion options
                  
                  
                  2,160,000
                  
                  
                  
                  3,306,667
                  
                  
                  
                  3,333,3348%
      Convertible debentures
                  
                  
                  3,159,000
                  
                  
                  
                  -
                  
                  
                  
                  -Warrants
                  
                  
                  337,252
                  
                  
                  
                  337,252
                  
                  
                  
                  340,247Others
                  
                  
                  5,000
                  
                  
                  
                  5,000
                  
                  
                  
                  5,000Total
      stock options/shares outstanding
                  
                  
                  7,500,752
                  
                  
                  
                  5,367,196
                  
                  
                  
                  4,692,081
  Consolidated
Financial Statements   INTEROIL
CORPORATION     42
 InterOil
      Corporation
                Notes
      to Consolidated Financial Statements
                (Expressed
      in United States dollars)
 
 27.
              Commitments
      and contingencies
 
 Commitments
 
 Payments
due by period contractual obligations are as follows:
 
 Total
                    
                    
                    Less than
                      1year
                    
                    
                    1-2 years
                    
                    
                    2-3years
                    
                    
                    3-4
                      years
                    
                    
                    4-5
                      years
                    
                    
                    More
                      than5
                      years'000
                    
                    
                    '000
                    
                    
                    '000
                    
                    
                    '000
                    
                    
                    '000
                    
                    
                    '000
                    
                    
                    '000Secured
      loan and debenture obligations
                    
                    
                    141,475
                    
                    
                    
                    9,000
                    
                    
                    
                    9,000
                    
                    
                    
                    9,000
                    
                    
                    
                    9,000
                    
                    
                    
                    87,975
                    
                    
                    
                    17,500Accrued
      financing costs
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Indirect
      participation interest - PNGDV (note 19)
                    
                    
                    1,384
                    
                    
                    
                    540
                    
                    
                    
                    844
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -PNG
      LNG Inc. Joint Venture (proportionate share of
commitments)
                    
                    
                    904
                    
                    
                    
                    884
                    
                    
                    
                    20
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Petroleum
      prospecting and retention licenses (a)
                    
                    
                    95,000
                    
                    
                    
                    16,500
                    
                    
                    
                    4,500
                    
                    
                    
                    23,333
                    
                    
                    
                    35,333
                    
                    
                    
                    15,334
                    
                    
                    
                    -238,763
                    
                    
                    
                    26,924
                    
                    
                    
                    14,364
                    
                    
                    
                    32,333
                    
                    
                    
                    44,333
                    
                    
                    
                    103,309
                    
                    
                    
                    17,500
 
 (a)
              The
      amount pertaining to the petroleum prospecting and retention licenses
      represents the amount Interoil has committed as a condition on renewal of
      these licenses.  Of this commitment, as at December 31, 2008,
      management estimates that $43,926,310 would satisfy the commitments in
      relation to the IPI investors .
 
 Contingencies:
 
 a)
              The
      Company, certain of its subsidiaries, the Company’s Chief Executive
      Officer, Phil Mulacek, and his controlled entities Petroleum Independent
      & Exploration Corporation and P.I.E. Group, LLC are defendants in Todd
      Peters, et. al. v. Phil Mulacek et. al.; Cause No. 05-040035920-CV; in the
      284th District Court of Montgomery County, Texas.  The
      plaintiffs claim to be members of a partnership that bought a modular oil
      refinery and subsequently, through a series of transactions, sold it to a
      subsidiary of the Company.  Plaintiffs contend that the
      defendants, including the Company, breached their fiduciary duties to the
      plaintiffs as part of these transactions and also assert claims for
      knowing participation in a breach of a fiduciary duty, common law fraud,
      fraudulent inducement, statutory fraud, securities fraud, breach of
      contract, investor oppression and conspiracy.  Plaintiffs are
      seeking actual damages of up to $118,068,759 and unspecified punitive
      damages, attorneys’ fees, expenses and court costs, an accounting and
      access to books and records.  The Company and other defendants
      are vigorously contesting the matter.  Management does not
      believe the litigation will have a material adverse effect on the Company
      or its subsidiaries.
 
 b)
              During
      2008, certain disputes and litigation arose between us and Merrill Lynch,
      Pierce, Fenner and Smith Inc. and Merrill Lynch and Co (“Merrill Lynch”)
      and companies affiliated to it relating to or arising from the LNG Project
      and PNG LNG Inc.  On February 27, 2009, a settlement agreement
      was entered into whereby the parties settled and agreed to release all of
      their outstanding claims against each other and dismissed the litigation
      with prejudice.  In addition, the parties granted mutual
      releases and entered into arrangements for the acquisition of Merrill
      Lynch’s interests in the Joint Venture Company and in the LNG Project by
      its other existing shareholders, InterOil LNG Holdings Inc and Pacific LNG
      Operations Ltd.
 
 In
addition to the above, from time to time the Company is involved in various
claims and litigation arising in the normal course of business.  While
the outcome of these matters is uncertain and there can be no assurance that
such matters will be resolved in the Company’s favor, the Company does not
currently believe that the outcome of adverse decisions in any pending or
threatened proceedings related to these and other matters or any amount which it
may be required to pay by reason thereof would have a material adverse impact on
its financial position, results of operations or liquidity.
 
 Consolidated
Financial Statements   INTEROIL
CORPORATION     43





InterOil Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





27.
            Commitments
      and contingencies (cont’d)





Regulatory
Actions





During
the second half of the 2008 year, the Ontario Securities Commission (the
“Commission”) directed that the Company undertake a review of its option
granting practices from January 1, 2001 and provide the Commission with certain
specific information and documentation.





A Special
Committee of InterOil, comprised solely of independent directors, recently
completed the internal review of InterOil's historical option granting
practices.  The Special Committee concluded its review and found
irregularities with respect to the administration of certain historical stock
options grants, with the majority of these irregularities occurring prior to
2002 and well prior to the retention of those currently responsible for
administration of stock options at InterOil. The Special Committee determined
that these irregularities were not the result of any internal misconduct, but
due to the failure to maintain adequate internal and accounting controls and
some lack of understanding by those involved at the time.  The Special
Committee concluded that the total value of such errors is small and, relative
to the InterOil's current operations, not material.  No restatement of
the Company’s financial statements is required as a result of these
determinations.





Based on
the results of its investigation, the Special Committee provided a report to the
Board of Directors and recommended to the Board of Directors that it adopt a
number of remedial actions, which the Board, by vote, promptly accepted. Such
remedial actions include: re-pricing the small number of existing options held
by current employees, contractors, officers or directors where the options were
granted below market price or prior to the commencement of employment;
requesting that the current officer who has exercised options granted below
market price refund InterOil the difference between the exercise price of such
options and the proper market price as provided for under the relevant stock
incentive plan; requiring the Compensation Committee provide written
confirmation to the Board of Directors in respect of all future grants of
options that such options were granted in accordance with the applicable stock
incentive plan rules; adopting further specific, written procedures for the
administrative tasks surrounding the granting of options; and adopting a
specific option granting procedure for grants to new hires.  These
remedial actions have been or are being implemented by management.  A
report of the results of the review and containing the information and
documentation requested was provided to the Commission at the end of February
2009.  The Commission is currently reviewing the report.





Import
Parity Price (‘IPP’) formula





The
Company has also been negotiating with the Papua New Guinea government to revise
the Import Parity Price (‘IPP’) formula which governs refined product sales in
Papua New Guinea. Since the period beginning November 30, 2007, an interim
arrangement has been in place with the PNG Government to apply a revised IPP
formula for all sales from that date.  This interim formula was
adjusted in June 2008 based on ongoing discussions with the government with a
view to finalizing a permanent replacement to the IPP formula as is required
under our agreement





28.
            Subsequent
      events





Commodity
derivative contracts


As at
December 31, 2008, InterOil had $18.0 million of unrealized hedging gains
carried forward in the balance sheet for unsettled hedge accounted transactions
as at year end.  Subsequent to year end, these unrealized hedges were
terminated and the mark-to-market gains were realized. However, these gains will
be released into the Statement of Operations as the anticipated transactions
that these hedges were initially taken to cover will occur.





Merrill
Lynch’s PNG LNG Inc interest buyback


Subsequent
to year ended December 31, 2008, on February 27, 2009, InterOil LNG Holdings
Inc. and Pacific LNG Operations Ltd, acquired Merrill Lynch’s interest in the
Joint Venture Company. InterOil issued 652,931 common shares for its share of
$11.25 million in relation to the settlement.  The final number of
shares is subject to a post closing balancing payment.





29.
            Reconciliation
      to generally accepted accounting principles in the United
      States





The
audited consolidated financial statements of the Company for the year ended
December 31, 2008, 2007, and 2006 have been prepared in accordance with
generally accepted accounting principles in Canada (“Canadian GAAP”) which, in
most respects, conforms to generally accepted accounting principles in the
United States (“U.S. GAAP”).  The reconciliations and other
information presented in this note are solely in relation to the consolidated
financial statements.  The significant differences between Canadian
GAAP and U.S. GAAP as they relate to the Company are presented throughout this
note.  Additionally, where there is no significant conflict with
Canadian GAAP requirements some of the additional U.S. GAAP disclosure
requirements have been incorporated throughout the Canadian GAAP financial
statements.







Consolidated
Financial Statements   INTEROIL
CORPORATION     44








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Consolidated Balance Sheets
                        
                        As atDecember 31, 2008
                        
                        
                        December 31, 2007
                        
                        
                        December 31, 2006$ (revised) (*)
                        
                        
                        $
                        
                        
                        $Canadian GAAP
                        
                        
                        US GAAP
                        
                        
                        Canadian GAAP
                        
                        
                        US GAAP
                        
                        
                        Canadian GAAP
                        
                        
                        US GAAPAssetsCurrent
      assets:Cash
      and cash equivalents (5)
                        
                        
                        48,970,572
                        
                        
                        
                        44,051,224
                        
                        
                        
                        43,861,762
                        
                        
                        
                        40,152,026
                        
                        
                        
                        31,681,435
                        
                        
                        
                        31,681,435Cash
      restricted (5)
                        
                        
                        25,994,258
                        
                        
                        
                        25,933,184
                        
                        
                        
                        22,002,302
                        
                        
                        
                        21,916,736
                        
                        
                        
                        29,301,940
                        
                        
                        
                        29,301,940Trade
      receivables
                        
                        
                        42,887,823
                        
                        
                        
                        42,887,823
                        
                        
                        
                        63,145,444
                        
                        
                        
                        63,145,444
                        
                        
                        
                        67,542,902
                        
                        
                        
                        67,542,902Commodity
      derivative contracts
                        
                        
                        31,335,050
                        
                        
                        
                        31,335,050
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,759,575
                        
                        
                        
                        1,759,575Other
      assets (5)
                        
                        
                        167,885
                        
                        
                        
                        125,119
                        
                        
                        
                        146,992
                        
                        
                        
                        120,460
                        
                        
                        
                        2,954,946
                        
                        
                        
                        2,954,946Inventories
                        
                        
                        83,037,326
                        
                        
                        
                        83,037,326
                        
                        
                        
                        82,589,242
                        
                        
                        
                        82,589,242
                        
                        
                        
                        67,593,558
                        
                        
                        
                        67,593,558Prepaid
      expenses (5)
                        
                        
                        4,489,574
                        
                        
                        
                        4,489,574
                        
                        
                        
                        5,102,540
                        
                        
                        
                        5,076,006
                        
                        
                        
                        880,640
                        
                        
                        
                        880,640Total
      current assets
                        
                        
                        236,882,488
                        
                        
                        
                        231,859,300
                        
                        
                        
                        216,848,282
                        
                        
                        
                        212,999,914
                        
                        
                        
                        201,714,996
                        
                        
                        
                        201,714,996Cash
      restricted
                        
                        
                        290,782
                        
                        
                        
                        290,782
                        
                        
                        
                        382,058
                        
                        
                        
                        382,058
                        
                        
                        
                        3,217,284
                        
                        
                        
                        3,217,284Deferred
      financing costs (4), (6)
                        
                        
                        -
                        
                        
                        
                        1,279,145
                        
                        
                        
                        -
                        
                        
                        
                        1,395,066
                        
                        
                        
                        1,716,757
                        
                        
                        
                        1,716,757Investment
      in LNG Project (5)
                        
                        
                        -
                        
                        
                        
                        6,610,480
                        
                        
                        
                        -
                        
                        
                        
                        5,848,612
                        
                        
                        
                        -
                        
                        
                        
                        -Plant
      and equipment (1), (5)
                        
                        
                        223,585,559
                        
                        
                        
                        210,803,013
                        
                        
                        
                        232,852,222
                        
                        
                        
                        219,117,006
                        
                        
                        
                        242,642,077
                        
                        
                        
                        231,175,281Oil
      and gas properties (2)
                        
                        
                        128,013,959
                        
                        
                        
                        127,653,411
                        
                        
                        
                        84,865,127
                        
                        
                        
                        84,865,127
                        
                        
                        
                        54,524,347
                        
                        
                        
                        54,524,347Future
      income tax benefit
                        
                        
                        3,070,182
                        
                        
                        
                        3,070,182
                        
                        
                        
                        2,867,312
                        
                        
                        
                        2,867,312
                        
                        
                        
                        1,424,014
                        
                        
                        
                        1,424,014Total
      assets
                        
                        
                        591,842,970
                        
                        
                        
                        581,566,313
                        
                        
                        
                        537,815,001
                        
                        
                        
                        527,475,095
                        
                        
                        
                        505,239,475
                        
                        
                        
                        493,772,679Liabilities
      and shareholders' equityCurrent
      liabilities:Accounts
      payable and accrued liabilities (6), (5)
                        
                        
                        78,147,736
                        
                        
                        
                        77,460,413
                        
                        
                        
                        60,427,607
                        
                        
                        
                        59,682,621
                        
                        
                        
                        76,095,369
                        
                        
                        
                        76,095,369Commodity
      derivative contracts
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,960,300
                        
                        
                        
                        1,960,289
                        
                        
                        
                        -
                        
                        
                        
                        -Working
      capital facility
                        
                        
                        68,792,402
                        
                        
                        
                        68,792,402
                        
                        
                        
                        66,501,372
                        
                        
                        
                        66,501,372
                        
                        
                        
                        36,873,508
                        
                        
                        
                        36,873,508Deferred
      hedge gain (2)
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,385
                        
                        
                        
                        -Deferred
      liquefaction project liability
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6,553,080
                        
                        
                        
                        6,553,080Current
      portion of secured loan
                        
                        
                        9,000,000
                        
                        
                        
                        9,000,000
                        
                        
                        
                        136,776,760
                        
                        
                        
                        136,810,093
                        
                        
                        
                        13,500,000
                        
                        
                        
                        13,500,000Current
      portion of indirect participation interest - PNGDV
                        
                        
                        540,002
                        
                        
                        
                        540,002
                        
                        
                        
                        1,080,004
                        
                        
                        
                        1,080,004
                        
                        
                        
                        730,534
                        
                        
                        
                        730,534Total
      current liabilities
                        
                        
                        156,480,140
                        
                        
                        
                        155,792,817
                        
                        
                        
                        266,746,043
                        
                        
                        
                        266,034,379
                        
                        
                        
                        133,753,876
                        
                        
                        
                        133,752,491Accrued
      financing costs
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,087,500
                        
                        
                        
                        1,087,500Secured
      loan (6)
                        
                        
                        52,365,333
                        
                        
                        
                        53,500,000
                        
                        
                        
                        61,141,389
                        
                        
                        
                        62,500,000
                        
                        
                        
                        184,166,433
                        
                        
                        
                        184,166,4338%
      subordinated debenture liability (4)
                        
                        
                        65,040,067
                        
                        
                        
                        69,710,182
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Preference
      share liability (3)
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        7,797,312
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Deferred
      gain on contributions to LNG project (5)
                        
                        
                        17,497,110
                        
                        
                        
                        -
                        
                        
                        
                        9,096,537
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Indirect
      participation interest (2)
                        
                        
                        72,476,668
                        
                        
                        
                        88,211,120
                        
                        
                        
                        96,086,369
                        
                        
                        
                        115,926,369
                        
                        
                        
                        96,861,259
                        
                        
                        
                        116,861,259Indirect
      participation interest - PNGDV
                        
                        
                        844,490
                        
                        
                        
                        844,490
                        
                        
                        
                        844,490
                        
                        
                        
                        844,490
                        
                        
                        
                        1,190,633
                        
                        
                        
                        1,190,633Total
      liabilities
                        
                        
                        364,703,808
                        
                        
                        
                        368,058,609
                        
                        
                        
                        441,712,140
                        
                        
                        
                        445,305,238
                        
                        
                        
                        417,059,701
                        
                        
                        
                        437,058,316Non-controlling
      interest (8)
                        
                        
                        5,235
                        
                        
                        
                        5,427
                        
                        
                        
                        4,292
                        
                        
                        
                        4,388
                        
                        
                        
                        5,759,206
                        
                        
                        
                        5,416,831Preference
      shares (3)
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        14,250,000
                        
                        
                        
                        -
                        
                        
                        
                        -Shareholders'
      equity:Share
      capital
                        
                        
                        373,904,356
                        
                        
                        
                        373,514,356
                        
                        
                        
                        259,324,133
                        
                        
                        
                        259,324,133
                        
                        
                        
                        233,889,366
                        
                        
                        
                        233,889,366Preference
      shares (3)
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6,842,688
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -8%
      subordinated debentures (4)
                        
                        
                        10,837,394
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Contributed
      surplus (4)
                        
                        
                        15,621,767
                        
                        
                        
                        24,422,662
                        
                        
                        
                        10,337,548
                        
                        
                        
                        10,337,548
                        
                        
                        
                        4,377,426
                        
                        
                        
                        4,377,426Warrants
                        
                        
                        2,119,034
                        
                        
                        
                        2,119,034
                        
                        
                        
                        2,119,034
                        
                        
                        
                        2,119,034
                        
                        
                        
                        2,137,852
                        
                        
                        
                        2,137,852Accumulated
      Other Comprehensive Income
                        
                        
                        27,698,306
                        
                        
                        
                        27,698,306
                        
                        
                        
                        6,025,019
                        
                        
                        
                        6,025,019
                        
                        
                        
                        1,492,869
                        
                        
                        
                        1,494,258Conversion
      options (2)
                        
                        
                        17,140,000
                        
                        
                        
                        -
                        
                        
                        
                        19,840,000
                        
                        
                        
                        -
                        
                        
                        
                        20,000,000
                        
                        
                        
                        -Accumulated
      deficit
                        
                        
                        (220,186,930
                        )
                        
                        
                        (214,252,081
                        )
                        
                        
                        (208,389,853
                        )
                        
                        
                        (209,890,265
                        )
                        
                        
                        (179,476,945
                        )
                        
                        
                        (190,601,370
                        )Total
      shareholders' equity
                        
                        
                        227,133,927
                        
                        
                        
                        213,502,277
                        
                        
                        
                        96,098,569
                        
                        
                        
                        67,915,469
                        
                        
                        
                        82,420,568
                        
                        
                        
                        51,297,532Total
      liabilities and shareholders' equity
                        
                        
                        591,842,970
                        
                        
                        
                        581,566,313
                        
                        
                        
                        537,815,001
                        
                        
                        
                        527,475,095
                        
                        
                        
                        505,239,475
                        
                        
                        
                        493,772,679





(*)  Certain
balances for the year ended December 31, 2008 have been revised to rectify
for misclassification of the following items in the U.S. GAAP consolidated
balance sheet as at December 31, 2008:





December
      31, 2008 (as per U.S. GAAP reconciliation)
                        
                        Original
                        
                        
                        Revised
                        
                        
                        AdjustmentsPrepaid
      expenses being understated
                        
                        
                        (50,145,093
                        )
                        
                        
                        4,489,574
                        
                        
                        
                        54,634,667Secured
      loan being understated
                        
                        
                        (1,134,667
                        )
                        
                        
                        53,500,000
                        
                        
                        
                        54,634,667Net
      impact to Shareholders' Equity
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -




Consolidated
Financial Statements   INTEROIL
CORPORATION     45








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Consolidated
statements of operations





The
following table presents the consolidated statements of operations under U.S.
GAAP compared to Canadian GAAP:





Year endedDecember 31, 2008
                        
                        
                        December 31, 2007
                        
                        
                        December 31, 2006$
                        
                        
                        $ (restated) (*)
                        
                        
                        $Canadian GAAP
                        
                        
                        U.S. GAAP
                        
                        
                        Canadian GAAP
                        
                        
                        U.S. GAAP
                        
                        
                        Canadian GAAP
                        
                        
                        U.S. GAAPRevenueSales
      and operating revenues
                        
                        
                        915,578,709
                        
                        
                        
                        915,578,709
                        
                        
                        
                        625,526,068
                        
                        
                        
                        625,526,068
                        
                        
                        
                        511,087,934
                        
                        
                        
                        511,189,438Interest
      income
                        
                        
                        931,785
                        
                        
                        
                        -
                        
                        
                        
                        2,180,285
                        
                        
                        
                        -
                        
                        
                        
                        3,223,995
                        
                        
                        
                        -Other
      income
                        
                        
                        3,216,445
                        
                        
                        
                        -
                        
                        
                        
                        2,666,890
                        
                        
                        
                        -
                        
                        
                        
                        3,747,603
                        
                        
                        
                        -919,726,939
                        
                        
                        
                        915,578,709
                        
                        
                        
                        630,373,243
                        
                        
                        
                        625,526,068
                        
                        
                        
                        518,059,532
                        
                        
                        
                        511,189,438ExpensesCost
      of sales and operating expenses (excluding depreciation shown
      below)
                        
                        
                        888,623,109
                        
                        
                        
                        888,623,109
                        
                        
                        
                        573,609,441
                        
                        
                        
                        573,609,441
                        
                        
                        
                        499,494,540
                        
                        
                        
                        499,584,532Administrative
      and general expenses (5)
                        
                        
                        31,227,627
                        
                        
                        
                        28,354,064
                        
                        
                        
                        31,998,655
                        
                        
                        
                        30,881,433
                        
                        
                        
                        23,288,330
                        
                        
                        
                        23,322,286Derivative
      (gain)/loss
                        
                        
                        (24,038,550
                        )
                        
                        
                        (24,038,550
                        )
                        
                        
                        7,271,693
                        
                        
                        
                        7,271,693
                        
                        
                        
                        (2,559,712
                        )
                        
                        
                        (2,559,712
                        )Legal
      and professional fees (5)
                        
                        
                        11,523,045
                        
                        
                        
                        7,692,045
                        
                        
                        
                        6,532,646
                        
                        
                        
                        4,471,684
                        
                        
                        
                        3,937,517
                        
                        
                        
                        3,937,517Exploration
      costs, excluding exploration impairment
                        
                        
                        995,532
                        
                        
                        
                        995,532
                        
                        
                        
                        13,305,437
                        
                        
                        
                        13,305,437
                        
                        
                        
                        6,176,866
                        
                        
                        
                        6,176,866Exploration
      impairment
                        
                        
                        107,788
                        
                        
                        
                        107,788
                        
                        
                        
                        1,242,606
                        
                        
                        
                        1,242,606
                        
                        
                        
                        1,647,185
                        
                        
                        
                        1,647,185Short
      term borrowing costs
                        
                        
                        6,514,060
                        
                        
                        
                        6,514,060
                        
                        
                        
                        13,212,112
                        
                        
                        
                        13,212,112
                        
                        
                        
                        8,478,540
                        
                        
                        
                        8,478,540Long
      term borrowing costs (3), (4)
                        
                        
                        17,459,186
                        
                        
                        
                        19,529,798
                        
                        
                        
                        9,536,162
                        
                        
                        
                        9,061,915
                        
                        
                        
                        11,856,872
                        
                        
                        
                        11,856,872Depreciation
      and amortization (1), (5)
                        
                        
                        14,142,546
                        
                        
                        
                        13,594,481
                        
                        
                        
                        13,024,258
                        
                        
                        
                        12,529,892
                        
                        
                        
                        12,352,672
                        
                        
                        
                        11,591,513Loss
      on amendment of indirect participation interest - PNGDV
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,851,421
                        
                        
                        
                        1,851,421Gain
      on LNG shareholder agreement
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (6,553,080
                        )
                        
                        
                        (6,553,080
                        )
                        
                        
                        -
                        
                        
                        
                        -Gain
      on equity accounted investment (5)
                        
                        
                        -
                        
                        
                        
                        (1,047,795
                        )
                        
                        
                        -
                        
                        
                        
                        (5,561,684
                        )
                        
                        
                        -
                        
                        
                        
                        -Gain
      on sale of oil and gas properties (2)
                        
                        
                        (11,235,084
                        )
                        
                        
                        (12,280,084
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Foreign
      exchange loss/(gain) (5)
                        
                        
                        (3,878,150
                        )
                        
                        
                        (4,437,943
                        )
                        
                        
                        (5,078,338
                        )
                        
                        
                        (5,099,651
                        )
                        
                        
                        (4,744,810
                        )
                        
                        
                        (4,744,810
                        )Non-controlling
      interest (8)
                        
                        
                        943
                        
                        
                        
                        1,040
                        
                        
                        
                        (22,333
                        )
                        
                        
                        (22,236
                        )
                        
                        
                        (263,959
                        )
                        
                        
                        (265,865
                        )Interest
      income (5)
                        
                        
                        -
                        
                        
                        
                        (841,028
                        )
                        
                        
                        -
                        
                        
                        
                        (2,146,183
                        )
                        
                        
                        -
                        
                        
                        
                        (3,223,995
                        )Other
      income
                        
                        
                        -
                        
                        
                        
                        (3,216,445
                        )
                        
                        
                        -
                        
                        
                        
                        (2,666,890
                        )
                        
                        
                        -
                        
                        
                        
                        (3,747,603
                        )931,442,052
                        
                        
                        
                        919,550,072
                        
                        
                        
                        658,079,259
                        
                        
                        
                        643,536,489
                        
                        
                        
                        561,515,462
                        
                        
                        
                        553,904,747Loss
      before income taxes
                        
                        
                        (11,715,113
                        )
                        
                        
                        (3,971,363
                        )
                        
                        
                        (27,706,016
                        )
                        
                        
                        (18,010,421
                        )
                        
                        
                        (43,455,930
                        )
                        
                        
                        (42,715,309
                        )Income
      tax expense (5), (7)
                        
                        
                        (81,964
                        )
                        
                        
                        28,073
                        
                        
                        
                        (1,206,892
                        )
                        
                        
                        (1,194,227
                        )
                        
                        
                        (2,342,873
                        )
                        
                        
                        (2,342,873
                        )Net
      loss
                        
                        
                        (11,797,077
                        )
                        
                        
                        (3,943,290
                        )
                        
                        
                        (28,912,908
                        )
                        
                        
                        (19,204,648
                        )
                        
                        
                        (45,798,803
                        )
                        
                        
                        (45,058,182
                        )





(*)  Comparative
results for the year ended December 31, 2007 have been adjusted to rectify for
misclassification of the following items in the U.S. GAAP Consolidated statement
of operations as per the December 31, 2007 consolidated financial
statements:


December 31, 2007 (as per U.S. GAAP reconciliation)
                      
                      Original
                      
                      
                      Revised
                      
                      
                      AdjustmentsExpensesLegal
      and professional fees
                      
                      
                      6,038,280
                      
                      
                      
                      4,471,684
                      
                      
                      
                      1,566,596Short
      term borrowing costs
                      
                      
                      11,151,150
                      
                      
                      
                      13,212,112
                      
                      
                      
                      (2,060,962
                      )Long
      term borrowing costs
                      
                      
                      9,536,162
                      
                      
                      
                      9,061,915
                      
                      
                      
                      474,247Depreciation
      and amortization
                      
                      
                      12,550,011
                      
                      
                      
                      12,529,892
                      
                      
                      
                      20,119Net
      impact to the U.S. GAAP Statement of Operations
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      -







Consolidated
Financial Statements   INTEROIL
CORPORATION     46








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Reconciliation
of Canadian GAAP net income/(loss) to U.S. GAAP net income/(loss)





Year endedDecember 31,
                      
                      
                      December 31,
                      
                      
                      December 31,2008
                      
                      
                      2007
                      
                      
                      2006$
                      
                      
                      $
                      
                      
                      $Net
      loss as shown in the Canadian GAAP financial statements
                      
                      
                      (11,797,077
                      )
                      
                      
                      (28,912,908
                      )
                      
                      
                      (45,798,803
                      )Description
      of items having the effect of increasing reported incomeDecrease
      in depreciation and amortization due to difference in date of commencement
      of operations of refinery (1)
                      
                      
                      478,923
                      
                      
                      
                      478,935
                      
                      
                      
                      761,159Decrease
      in non-controlling interest expense (8)
                      
                      
                      (96
                      )
                      
                      
                      (96
                      )
                      
                      
                      1,907Increase
      in reporting income due to reversal of proportionate consolidation of LNG
      Project and equity accounting the investment (5)
                      
                      
                      8,400,571
                      
                      
                      
                      9,097,535
                      
                      
                      
                      -Increase
      in sales from ineffective portion of hedges
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      101,504Decrease
      in long term borrowing costs relating to financing costs on preference
      shares expensed
                      
                      
                      -
                      
                      
                      
                      390,000
                      
                      
                      
                      -Decrease
      in long term borrowing costs relating to dividends paid to preference
      share holders expensed under Canadian GAAP (3)
                      
                      
                      418,526
                      
                      
                      
                      84,247
                      
                      
                      
                      -Decrease
      in long term borrowing costs relating to reduced accretion expense on
      increased 8% subordinated debentures liability (4)
                      
                      
                      291,137
                      
                      
                      
                      -
                      
                      
                      
                      -Increase
      in gain on sale of oil and gas properties arising from conveyance
      accounting due to the initial IPI proceeds not being bifurcated under U.S.
      GAAP (2)
                      
                      
                      1,045,000
                      
                      
                      
                      -
                      
                      
                      
                      -Description
      of items having the effect of decreasing reported incomeIncrease
      in long term borrowing costs relating to immediate expense of portion of
      placement fees and accretion of BCF on conversion of 8% subordinated
      debentures (4)
                      
                      
                      (2,780,274
                      )
                      
                      
                      -
                      
                      
                      
                      -Reduced
      gain on sale of minority interest under U.S. GAAP
                      
                      
                      -
                      
                      
                      
                      (342,361
                      )
                      
                      
                      -Increase
      in cost of sales from ineffective portion of hedges
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (89,993
                      )Increase
      in administrative and general expenses from ineffective portion of
      hedges
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (33,956
                      )Net
      loss according to US GAAP
                      
                      
                      (3,943,290
                      )
                      
                      
                      (19,204,648
                      )
                      
                      
                      (45,058,182
                      )





Statements
of comprehensive income/(loss), net of tax





Year endedDecember 31,
                    
                    
                    December 31,
                    
                    
                    December 31,2008
                    
                    
                    2007
                    
                    
                    2006$
                    
                    
                    $
                    
                    
                    $Net
      loss in accordance with U.S. GAAP, net of tax
                    
                    
                    (3,943,290
                    )
                    
                    
                    (19,204,648
                    )
                    
                    
                    (45,058,182
                    )Foreign
      currency translation reserve, net of tax
                    
                    
                    3,660,787
                    
                    
                    
                    4,532,150
                    
                    
                    
                    1,015,426Deferred
      hedge gain, net of tax
                    
                    
                    18,012,500
                    
                    
                    
                    (1,389
                    )
                    
                    
                    (993,153
                    )Total
      other comprehensive income, net of tax
                    
                    
                    21,673,287
                    
                    
                    
                    4,530,761
                    
                    
                    
                    22,273Comprehensive
      income/(loss), net of tax
                    
                    
                    17,729,997
                    
                    
                    
                    (14,673,887
                    )
                    
                    
                    (45,035,909
                    )




Consolidated
Financial Statements   INTEROIL
CORPORATION     47








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Consolidated
Statements of Shareholders' Equity





Year endedDecember 31, 2008
                      
                      
                      December 31, 2007
                      
                      
                      December 31, 2006$
                      
                      
                      $
                      
                      
                      $Canadian GAAP
                      
                      
                      US GAAP
                      
                      
                      Canadian GAAP
                      
                      
                      US GAAP
                      
                      
                      Canadian GAAP
                      
                      
                      US GAAPShare
      capitalAt
      beginning of period
                      
                      
                      259,324,133
                      
                      
                      
                      259,324,133
                      
                      
                      
                      233,889,366
                      
                      
                      
                      233,889,366
                      
                      
                      
                      223,934,500
                      
                      
                      
                      223,934,500Issue
      of capital stock
                      
                      
                      114,580,223
                      
                      
                      
                      114,190,223
                      
                      
                      
                      25,434,767
                      
                      
                      
                      25,434,767
                      
                      
                      
                      9,954,866
                      
                      
                      
                      9,954,866At
      end of period
                      
                      
                      373,904,356
                      
                      
                      
                      373,514,356
                      
                      
                      
                      259,324,133
                      
                      
                      
                      259,324,133
                      
                      
                      
                      233,889,366
                      
                      
                      
                      233,889,366Preference
      SharesAt
      beginning of period
                      
                      
                      6,842,688
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issue
      of preference shares
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      6,842,688
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Converted
      to common shares
                      
                      
                      (6,842,688
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      6,842,688
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -8%
      subordinated debenturesAt
      beginning of period
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issue
      of debentures
                      
                      
                      13,036,434
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Conversion
      to common shares
                      
                      
                      (2,199,040
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      10,837,394
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Contributed
      surplusAt
      beginning of period
                      
                      
                      10,337,548
                      
                      
                      
                      10,337,548
                      
                      
                      
                      4,377,426
                      
                      
                      
                      4,377,426
                      
                      
                      
                      2,933,586
                      
                      
                      
                      2,933,586Options
      exercised transferred to share capital
                      
                      
                      (456,867
                      )
                      
                      
                      (456,867
                      )
                      
                      
                      (102,840
                      )
                      
                      
                      (102,840
                      )
                      
                      
                      (532,232
                      )
                      
                      
                      (532,232
                      )Stock
      compensation expense
                      
                      
                      5,741,086
                      
                      
                      
                      5,741,086
                      
                      
                      
                      6,062,962
                      
                      
                      
                      6,062,962
                      
                      
                      
                      1,976,072
                      
                      
                      
                      1,976,0728%
      Debenture issue BCF (note 4)
                      
                      
                      -
                      
                      
                      
                      8,800,895
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      15,621,767
                      
                      
                      
                      24,422,662
                      
                      
                      
                      10,337,548
                      
                      
                      
                      10,337,548
                      
                      
                      
                      4,377,426
                      
                      
                      
                      4,377,426WarrantsAt
      beginning of period
                      
                      
                      2,119,034
                      
                      
                      
                      2,119,034
                      
                      
                      
                      2,137,852
                      
                      
                      
                      2,137,852
                      
                      
                      
                      2,137,852
                      
                      
                      
                      2,137,852Movement
      for period
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (18,818
                      )
                      
                      
                      (18,818
                      )
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      2,119,034
                      
                      
                      
                      2,119,034
                      
                      
                      
                      2,119,034
                      
                      
                      
                      2,119,034
                      
                      
                      
                      2,137,852
                      
                      
                      
                      2,137,852Accumulated
      Other Comprehensive IncomeAt
      beginning of period
                      
                      
                      6,025,019
                      
                      
                      
                      6,025,019
                      
                      
                      
                      1,492,869
                      
                      
                      
                      1,494,258
                      
                      
                      
                      477,443
                      
                      
                      
                      1,471,985Deferred
      hedge gain recognised on transition
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,385
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Deferred
      hedge (loss)/gain movement for period, net of tax
                      
                      
                      18,012,500
                      
                      
                      
                      18,012,500
                      
                      
                      
                      (1,385
                      )
                      
                      
                      (1,389
                      )
                      
                      
                      -
                      
                      
                      
                      (993,153
                      )Foreign
      currency translation adjustment movement for period, net of
      tax
                      
                      
                      3,660,787
                      
                      
                      
                      3,660,787
                      
                      
                      
                      4,532,150
                      
                      
                      
                      4,532,150
                      
                      
                      
                      1,015,426
                      
                      
                      
                      1,015,426At
      end of period
                      
                      
                      27,698,306
                      
                      
                      
                      27,698,306
                      
                      
                      
                      6,025,019
                      
                      
                      
                      6,025,019
                      
                      
                      
                      1,492,869
                      
                      
                      
                      1,494,258Conversion
      optionsAt
      beginning of period
                      
                      
                      19,840,000
                      
                      
                      
                      -
                      
                      
                      
                      20,000,000
                      
                      
                      
                      -
                      
                      
                      
                      20,000,000
                      
                      
                      
                      -Movement
      for period
                      
                      
                      (2,700,000
                      )
                      
                      
                      -
                      
                      
                      
                      (160,000
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      17,140,000
                      
                      
                      
                      -
                      
                      
                      
                      19,840,000
                      
                      
                      
                      -
                      
                      
                      
                      20,000,000
                      
                      
                      
                      -Accumulated
      deficitAt
      beginning of period
                      
                      
                      (208,389,853
                      )
                      
                      
                      (209,890,265
                      )
                      
                      
                      (179,476,945
                      )
                      
                      
                      (190,601,370
                      )
                      
                      
                      (133,678,142
                      )
                      
                      
                      (145,543,188
                      )Net
      loss for period
                      
                      
                      (11,797,077
                      )
                      
                      
                      (3,943,290
                      )
                      
                      
                      (28,912,908
                      )
                      
                      
                      (19,204,648
                      )
                      
                      
                      (45,798,803
                      )
                      
                      
                      (45,058,182
                      )Deduct:Preference
      Share Dividends
                      
                      
                      -
                      
                      
                      
                      (418,526
                      )
                      
                      
                      -
                      
                      
                      
                      (84,247
                      )
                      
                      
                      -
                      
                      
                      
                      -At
      end of period
                      
                      
                      (220,186,930
                      )
                      
                      
                      (214,252,081
                      )
                      
                      
                      (208,389,853
                      )
                      
                      
                      (209,890,265
                      )
                      
                      
                      (179,476,945
                      )
                      
                      
                      (190,601,370
                      )Shareholders'
      equity at end of period
                      
                      
                      227,133,927
                      
                      
                      
                      213,502,277
                      
                      
                      
                      96,098,569
                      
                      
                      
                      67,915,469
                      
                      
                      
                      82,420,568
                      
                      
                      
                      51,297,532




Consolidated
Financial Statements   INTEROIL
CORPORATION     48








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Reconciliation
of Canadian GAAP Statement of cash flows to U.S. GAAP:





Year endedDecember 31, 2008
                              
                              
                              December 31, 2007
                              
                              
                              December 31, 2006$
                              
                              
                              $ (restated) (*)
                              
                              
                              $Cash
      flows provided by (used in):Operating
      activities - Canadian GAAP (as per consolidated cash
flows)
                              
                              
                              15,586,156
                              
                              
                              
                              (31,619,907
                              )
                              
                              
                              2,187,462Reconciling
      items:Reclass
      exploration costs expensed including exploration impairment as investing
      activity for US GAAP
                              
                              
                              (1,103,320
                              )
                              
                              
                              (14,548,043
                              )
                              
                              
                              (7,824,051
                              )Being
      LNG project related operating cash flows reversed for US GAAP cash flow
      statement
                              
                              
                              8,666,724
                              
                              
                              
                              2,892,220
                              
                              
                              
                              -Operating
      activities - U.S. GAAP
                              
                              
                              23,149,560
                              
                              
                              
                              (43,275,730
                              )
                              
                              
                              (5,636,589
                              )Investing
      activities - Canadian GAAP (as per consolidated cash
flows)
                              
                              
                              (47,390,685
                              )
                              
                              
                              (34,369,871
                              )
                              
                              
                              (97,071,319
                              )Reconciling
      items:Reclass
      exploration costs expensed including exploration impairment as investing
      activity for US GAAP
                              
                              
                              1,103,320
                              
                              
                              
                              14,548,043
                              
                              
                              
                              7,824,051Being
      reversal of LNG Project expenditure for US GAAP cash flows
                              
                              
                              (404,594
                              )
                              
                              
                              2,762,786
                              
                              
                              
                              -Being
      reversal of movement in restricted cash held relating to LNG Project for
      US GAAP cash flows
                              
                              
                              (24,492
                              )
                              
                              
                              85,566
                              
                              
                              
                              -Investing
      activities - U.S. GAAP
                              
                              
                              (46,716,451
                              )
                              
                              
                              (16,973,476
                              )
                              
                              
                              (89,247,268
                              )Financing
      activities - Canadian GAAP (as per consolidated cash
flows)
                              
                              
                              36,913,339
                              
                              
                              
                              78,170,105
                              
                              
                              
                              66,963,485Reconciling
      items:Being
      reversal of PNG LNG cash calls from unrelated joint venture partners
      proportionately consolidated in Canadian GAAP cash flow
      statement
                              
                              
                              (9,447,250
                              )
                              
                              
                              (9,450,308
                              )
                              
                              
                              -Financing
      activities - U.S. GAAP
                              
                              
                              27,466,089
                              
                              
                              
                              68,719,797
                              
                              
                              
                              66,963,485(Decrease)/increase
      in cash and cash equivalents
                              
                              
                              3,899,198
                              
                              
                              
                              8,470,591
                              
                              
                              
                              (27,920,372
                              )Cash
      and cash equivalents, beginning of period (U.S.GAAP)
                              
                              
                              40,152,026
                              
                              
                              
                              31,681,435
                              
                              
                              
                              59,601,807Cash
      and cash equivalents, end of period (U.S. GAAP)
                              
                              
                              44,051,224
                              
                              
                              
                              40,152,026
                              
                              
                              
                              31,681,435





Under
Canadian GAAP, InterOil’s share in the LNG Joint venture project is
proportionately consolidated and InterOil’s share of the JV cash flows will be
taken up in InterOil consolidated cash flow statement.  The cash flows
would be classified between operating, investing and financing as per the nature
of the transaction.  Under U.S. GAAP, when an investment in an entity
is accounted for by use of the equity method, an investor restricts its
reporting in the cash flow statement to the cash flows between itself and the
investee, for example, to dividends and advances.  The above cash and
cash equivalents is different to the Canadian cash and cash equivalents balance
due to the proportionate take up of the cash balance under Canadian GAAP, but
equity accounting of the LNG investment in U.S. GAAP (refer (5)
below).




Consolidated
Financial Statements   INTEROIL
CORPORATION     49








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





(*)  Comparative
results for the year ended December 31, 2007 have been adjusted to correctly
reflect the reconciling items related to the LNG Project.  For details
of adjustments made to the Reconciliation of Canadian GAAP Statement of cash
flows to U.S. GAAP as per the December 31, 2007 consolidated financial
statements, refer to the following table:





Operating activities
                        
                        
                        Investing activities
                        
                        
                        Financing activities
                        
                        
                        Total$
                        
                        
                        $
                        
                        
                        $
                        
                        
                        $Cash
      flows provided by/(used in) - (as per original U.S. GAAP
      reconciliation)
                        
                        
                        (57,062,320
                        )
                        
                        
                        (12,637,194
                        )
                        
                        
                        78,170,105
                        
                        
                        
                        8,470,591Adjustments:Transfer
      of reversal of PNG LNG cash call proportionately consolidated in cash flow
      statement reconciling item from Investing activities to Financing
      activities (at amount originally disclosed in
    reconciliation)
                        
                        
                        -
                        
                        
                        
                        (65,072
                        )
                        
                        
                        65,072
                        
                        
                        
                        -Adjust
      reversal of PNG LNG cash call proportionately consolidated in cash flow
      statement reconciling item to correct amount
                        
                        
                        9,515,380
                        
                        
                        
                        -
                        
                        
                        
                        (9,515,380
                        )
                        
                        
                        -Add
      reversal of movement in non-cash working capital relating to LNG Project
      (increase in accounts payable and accrued liabilities)
                        
                        
                        7,119,562
                        
                        
                        
                        (7,119,562
                        )
                        
                        
                        -
                        
                        
                        
                        -Add
      reconciling item for reversal of expenditure on plant and equipment
      relating to LNG Project
                        
                        
                        (2,762,786
                        )
                        
                        
                        2,762,786
                        
                        
                        
                        -
                        
                        
                        
                        -Add
      reconciling item for reversal of movement in restricted cash held relating
      to LNG Project
                        
                        
                        (85,566
                        )
                        
                        
                        85,566
                        
                        
                        
                        -
                        
                        
                        
                        -Cash
      flows provided by/(used in) - (as per adjusted U.S. GAAP
      reconciliation)
                        
                        
                        (43,275,730
                        )
                        
                        
                        (16,973,476
                        )
                        
                        
                        68,719,797
                        
                        
                        
                        8,470,591





Per
share amounts





Basic per
share amounts are computed by dividing net income available to shareholders by
the weighted average number of shares outstanding for the reporting
period.  Diluted per share amounts reflects the potential dilution
that could occur if options or contracts to issue shares were exercised or
converted into shares.





For the
calculation of diluted per share amounts, the basic weighted average number of
shares is increased by the dilutive effect of stock options determined using the
treasury method.  No potential shares in options on issue were
dilutive for the years ended December 31, 2008, 2007 and 2006.





Weighted average number of shares on which earnings per share
                  
                  Year ended December 31,calculations are based in accordance with U.S. GAAP
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Basic
                  
                  
                  33,632,390
                  
                  
                  
                  29,998,133
                  
                  
                  
                  29,602,360Effect
      of dilutive options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Diluted
                  
                  
                  33,632,390
                  
                  
                  
                  29,998,133
                  
                  
                  
                  29,602,360Net
      income/(loss) per share in accordance with U.S. GAAPBasic
                  
                  
                  (0.12
                  )
                  
                  
                  (0.64
                  )
                  
                  
                  (1.52
                  )Diluted
                  
                  
                  (0.12
                  )
                  
                  
                  (0.64
                  )
                  
                  
                  (1.52
                  )




Consolidated
Financial Statements   INTEROIL
CORPORATION     50








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





(1)
            Operations





The
Company determined that refinery operations commenced under U.S. GAAP at
December 1, 2004, which is the date management assessed that construction of the
refinery was substantially complete and ready for its intended
use.  The Company ceased capitalization of certain costs to the
refinery project at this date and recognized one month’s results from sales,
related costs of sales and operating expenses and administrative and general
expenses in the statement of operations for the year ended December 31,
2004.




As
disclosed in note 2(s) in the consolidated financial statements, operations
commenced on January 1, 2005 under Canadian GAAP.  Therefore, the
Company continued to capitalize December 2004’s results to the refinery
project.  Due to the difference in the cost basis of the refinery, the
depreciation expense recorded under U.S. GAAP differs from that recorded under
Canadian GAAP.




The
useful life for the refinery under U.S. GAAP is the same as that disclosed under
Canadian GAAP.





(2)
            Indirect
      participation interest





As
disclosed in note 19 in the consolidated financial statements, the Company
entered into an indirect participation interest agreement in exchange for
proceeds of $125,000,000.  Under Canadian GAAP, this amount was apportioned
between non financial liabilities and equity.  Under U.S. GAAP, the
Company has not bifurcated the amount between liability and equity as the
Company has opted to utilize the scope exception under SFAS 133 Para 10(f) for
‘derivatives that serve as impediments to sales accounting’.





As
explained in note 19, during the year ended December 31, 2008, two of the
investors’ with a combined 5.225% interest in the eight well drilling program
waived their right to convert their IPI percentage into 696,667 common shares.
These waivers have resulted in conveyance being triggered on this portion of the
IPI agreement for the year ended December 31, 2008.  As the initial
IPI proceeds were not bifurcated under U.S. GAAP, the total conveyance proceeds
available for the conveyed interest is $11,938,979 (higher by $1,405,548 from
the CGAAP balance), the amounts offset against oil and gas properties is
$6,158,895 (higher by $360,548 from CGAAP balance), and the gain recognised in
the statement of operations is $5,780,084 (higher by $1,045,000 from CGAAP
balance).





(3)
            Preference
      shares





As
disclosed in Note 22 in the consolidated financial statements, 517,777
preference shares were issued to an investor in November 2007 for
$15,000,000.





Under
Canadian GAAP, the preference shares were assessed based on the rights attached
to those shares and Management valued the equity and liability component of the
instrument using the residual value basis.





As the
Preference share agreement has contractual redemption provisions under
‘Fundamental change’ section mainly relating to listing requirements,
shareholding etc, under U.S. GAAP, the preference shares needs to be classified
under temporary equity classification in accordance with ASR
268.  Transaction costs amounting to $750,000 have been deducted from
the total proceeds of $15,000,000.  Under Canadian GAAP the
transaction costs attributable to the liability component was
expensed.





In
addition to the above, the 5% dividend paid for the twelve month period
amounting to $418,526 has been included within long term borrowing costs within
Canadian GAAP, but has been treated as a reduction to retained earnings under
U.S. GAAP.





During
the year ended December 31, 2008 the entire preference shares issued of 517,777
shares were converted into common shares.





(4)
            8%
      subordinated debentures





As
disclosed in Note 23 in the consolidated financial statements, on May 13, 2008,
the Company completed the issue of $95,000,000 unsecured 8% subordinated
convertible debentures with a maturity of five years. Under Canadian GAAP, these
debentures were assessed based on the rights attached to the instrument and
Management valued the equity and liability component of the instrument using the
residual value basis.




Consolidated
Financial Statements   INTEROIL
CORPORATION     51








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Under
U.S. GAAP, Management assessed the debentures following the guidance under FAS
133 to decide whether the embedded conversion option needs to be bifurcated and
disclosed separately.  The embedded conversion option did not satisfy
the condition of embedded derivatives that requires separation due to the scope
exception under FAS 133 Para 11(a) as the option is indexed to the Company’s own
stock and would have been classified in Shareholder’s equity if it had been
separated.





As FAS
133 bifurcation is not applicable, the provisions of EITF 00-27 requires that
the instrument be assessed for any ‘Beneficial Conversion Features (‘BCF’)’
included in the instrument, which should be separated using the intrinsic value
method as noted in EITF 98-5. Based on the guidance, the BCF has been valued at
$8,821,320 which will be separate and classified separately under equity as
Contributed Surplus.  After separation, the liability component would
be accreted over the life of the debentures, being 5 years until May 2013. If
the conversion occurs prior to the stated redemption date, the entire
unamortized value related to the converted portion would be immediately
recognized in the Statement of operations as an ordinary interest
expense.





The
accretion expense of the liability component for the period ending December 31,
2008 was $1,569,709 (accretion expense under US GAAP is less due to the higher
liability component of the instrument).





In
addition to the above, deferred financing costs are offset against the
respective liabilities under Canadian GAAP; however, the same is disclosed as a
separate item on the face of the balance sheet under US GAAP. As at December 31,
2008, there was $144,478 of deferred finance costs which were not amortized in
relation to the 8% convertible debentures.





During
the year ended December 31, 2008, debenture holders exercised their conversion
rights for $16,025,000 resulting in issue of 641,000 common shares of the
Company.  As at December 31, 2008, of the 3,800,000 convertible
debentures issued, 3,159,000 (December 2007 – nil), were
outstanding.





Under
U.S. GAAP, a portion of the placement fees and BCF accretion are expensed
immediately on conversion.  The additional financing expense
recognized under U.S. GAAP due to the conversion of the debentures during the
year ended December 31, 2008 was $2,780,274.





(5)
            Investment in LNG
      Project/Deferred gain on contributions to LNG
    Project





As
disclosed in Note 14 in the consolidated financial statements, a Shareholders
Agreement was signed on July 30, 2007 which converted PNG LNG Inc. and its
subsidiaries into a joint venture project from being a subsidiary of
InterOil.  Under Canadian GAAP, joint ventures are proportionately
consolidated into the Company’s consolidated financials based on the
shareholding in the joint venture.





Applying
the guidance under APB 18, a corporate joint venture has to be equity accounted
under U.S. GAAP. InterOil has also followed the guidance under SAB Topic 5H
wherein a gain on contributions to the joint venture is not recognised, however,
a gain is recognised as a result of a change in economic interest.





InterOil
will account for the joint venture using equity accounted method.  In
addition to the gain or loss recognised as part of the operations, InterOil will
also recognise any difference between the Investment carried in its balance
sheet and the underlying equity in net assets of the joint venture in the
statement of operations and the investment balance will increase/decrease in
line with this difference.





The
adjustments to reflect the reversal of proportionately consolidated balances and
take-up of equity accounted balances have been summarised below. Given below is
the Midstream – liquefaction consolidated balance sheet and statement of
operations under Canadian GAAP and U.S. GAAP.  The statement of
operations incorporates results for the year ended December 31, 2008. PNG LNG
Inc. was a subsidiary of InterOil until the date of the Shareholder’s Agreement
and has been proportionately consolidated subsequent to that date.




Consolidated
Financial Statements   INTEROIL
CORPORATION     52








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Midstream - liquefaction
                                    
                                    
                                    
                                    
                                    GAAPConsolidated Balance Sheet
                                    
                                    Canadian GAAP
                                    
                                    
                                    Adjustments
                                    
                                    
                                    US GAAPCash
      and cash equivalents
                                    
                                    
                                    4,919,448
                                    
                                    
                                    
                                    (4,919,348
                                    )
                                    
                                    
                                    100Cash
      restricted
                                    
                                    
                                    61,074
                                    
                                    
                                    
                                    (61,074
                                    )
                                    
                                    
                                    -Other
      assets
                                    
                                    
                                    21,710
                                    
                                    
                                    
                                    (21,710
                                    )
                                    
                                    
                                    -Prepaid
      expenses
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Current
      assets
                                    
                                    
                                    5,002,232
                                    
                                    
                                    
                                    (5,002,132
                                    )
                                    
                                    
                                    100Investment
      in PNG LNG Inc.
                                    
                                    
                                    -
                                    
                                    
                                    
                                    6,610,480
                                    
                                    
                                    
                                    6,610,480Plant
      and equipment
                                    
                                    
                                    2,273,619
                                    
                                    
                                    
                                    (2,273,619
                                    )
                                    
                                    
                                    -Total
      assets
                                    
                                    
                                    7,275,851
                                    
                                    
                                    
                                    (665,271
                                    )
                                    
                                    
                                    6,610,580Accounts
      payable and accrued liabilities
                                    
                                    
                                    687,327
                                    
                                    
                                    
                                    (687,327
                                    )
                                    
                                    
                                    -Intercompany
      payables
                                    
                                    
                                    3,498,042
                                    
                                    
                                    
                                    21,056
                                    
                                    
                                    
                                    3,519,098Current
      liabilities
                                    
                                    
                                    4,185,369
                                    
                                    
                                    
                                    (666,271
                                    )
                                    
                                    
                                    3,519,098Deferred
      gain on contributions to LNG project
                                    
                                    
                                    17,497,110
                                    
                                    
                                    
                                    (17,497,110
                                    )
                                    
                                    
                                    -Total
      non-current liabilities
                                    
                                    
                                    17,497,110
                                    
                                    
                                    
                                    (17,497,110
                                    )
                                    
                                    
                                    -Share
      capital
                                    
                                    
                                    1
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1Accumulated
      deficit
                                    
                                    
                                    (14,406,629
                                    )
                                    
                                    
                                    17,498,110
                                    
                                    
                                    
                                    3,091,481Shareholders'
      Equity
                                    
                                    
                                    (14,406,628
                                    )
                                    
                                    
                                    17,498,110
                                    
                                    
                                    
                                    3,091,482Total
      liabilities and Shareholders' equity
                                    
                                    
                                    7,275,851
                                    
                                    
                                    
                                    (665,271
                                    )
                                    
                                    
                                    6,610,580Midstream
      - liquefaction
                                    
                                    
                                    
                                    
                                    
                                    GAAPConsolidated Statement of
      Operation
                                    
                                    Canadian GAAP
                                    
                                    
                                    Adjustments
                                    
                                    
                                    US GAAPInterest
      income
                                    
                                    
                                    90,757
                                    
                                    
                                    
                                    (90,757
                                    )
                                    
                                    
                                    -Total
      revenues
                                    
                                    
                                    90,757
                                    
                                    
                                    
                                    (90,757
                                    )
                                    
                                    
                                    -Office
      and Administrative expenses
                                    
                                    
                                    3,213,034
                                    
                                    
                                    
                                    (2,873,563
                                    )
                                    
                                    
                                    339,471Depreciation
                                    
                                    
                                    69,142
                                    
                                    
                                    
                                    (69,142
                                    )
                                    
                                    
                                    -Professional
      fees
                                    
                                    
                                    3,809,329
                                    
                                    
                                    
                                    (3,831,000
                                    )
                                    
                                    
                                    (21,671
                                    )Borrowing
      costs
                                    
                                    
                                    240,782
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    240,782Exchange
      (Gain) loss
                                    
                                    
                                    559,793
                                    
                                    
                                    
                                    (559,793
                                    )
                                    
                                    
                                    -Loss
      on proportionate consolidation of PNG LNG Inc
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Gain
      on equity accounted investment
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,047,795
                                    )
                                    
                                    
                                    (1,047,795
                                    )Income
      taxes
                                    
                                    
                                    110,037
                                    
                                    
                                    
                                    (110,037
                                    )
                                    
                                    
                                    -Total
      expenses
                                    
                                    
                                    8,002,117
                                    
                                    
                                    
                                    (8,491,330
                                    )
                                    
                                    
                                    (489,213
                                    )Net
      gain/(loss)
                                    
                                    
                                    (7,911,360
                                    )
                                    
                                    
                                    8,400,573
                                    
                                    
                                    
                                    489,213





(6)
            Deferred Financing
      costs





Deferred
financial costs are offset against the respective liabilities under Canadian
GAAP; however, the same is disclosed as a separate item on the face of the
balance sheet under US GAAP in accordance with guidance under APB
21.





(7)
            Income
      tax effect of adjustments





The
income tax effect of U.S. GAAP adjustments was a reduction to the future tax
asset of $2,671,594 (year ended December 31, 2007 - $3,403,154) for the year
ended December 31, 2008 due to a decrease in the loss carry-forwards. A
corresponding decrease in the valuation allowance was recorded.





(8)
            Non
      controlling interest





The
non-controlling interest movements are the result of the U.S. GAAP adjustments
relating to the midstream operations described in point 1 above.




Consolidated
Financial Statements   INTEROIL
CORPORATION     53








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Recent
Accounting Pronouncements





Fair
value measurements





In
September 2006, the FASB issued FAS 157 which defines fair value, establishes a
framework for measuring fair value in U.S. GAAP, and expands disclosures about
fair value measurements.  The standard is effective for fiscal years
beginning after November 15, 2007 and all interim periods within those fiscal
years.  The Company has complied with the disclosure requirements
under this standard for the year ended December 31, 2008.





Fair
Value Option for Financial Assets and Financial Liabilities





In
February 2007, the FASB issued FAS 159 which permits entities to choose to
measure many financial instruments and certain other items at fair
value.  The objective is to improve financial reporting by providing
entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions.  This Statement is expected to
expand the use of fair value measurement, which is consistent with the Board’s
long-term measurement objectives for accounting for financial
instruments.  This Statement is effective as of the beginning of an
entity’s first fiscal year beginning after November 15, 2007.  This
standard does not have any material impact on the financial statements of the
Company.





Business
combinations





In
December 2007, the FASB issued FAS 141 (revised 2007) to improve the relevance,
representational faithfulness, and comparability of the information that a
reporting entity provides in its financial reports about a business combination
and its effects.  This Statement applies prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  This will have no impact unless the Company undertakes a
business combination subsequent to adoption of this standard.





Non-controlling
interests in consolidated financial statements





In
December 2007, the FASB issued FAS 160.  The objective of this
Statement is to improve the relevance, comparability, and transparency of the
financial information that a reporting entity provides in its consolidated
financial statements by establishing accounting and reporting standards. It
clarifies that a noncontrolling interest in a subsidiary is an ownership
interest in the consolidated entity that should be reported as equity in the
consolidated financial statements.  This Statement changes the way the
consolidated income statement is presented. It requires consolidated net income
to be reported at amounts that include the amounts attributable to both the
parent and the noncontrolling interest.  It also requires disclosure,
on the face of the consolidated statement of income, of the amounts of
consolidated net income attributable to the parent and to the noncontrolling
interest.  Previously, net income attributable to the noncontrolling
interest generally was reported as an expense or other deduction in arriving at
consolidated net income.  This Statement applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after December
15, 2008.  This will have no impact unless the Company undertakes a
business combination involving a non-controlling interest subsequent to adoption
of this standard.





Disclosures
about derivative instruments and hedging activities





In March
2008, the FASB issued FAS 161.  This statement requires enhanced
disclosures about an entity’s derivative and hedging activities and thereby
improves the transparency of financial reporting.  Entities are
required to provide enhanced disclosures about how and why an entity uses
derivative instruments, how derivative instruments and related hedged items are
accounted for under Statement 133 and its related interpretations, and how
derivative instruments and related hedged items affect an entity’s financial
position, financial performance, and cash flows.  The statement
requires that objectives for using derivative instruments be disclosed in terms
of underlying risk and accounting designation.  This disclosure better
conveys the purpose of derivative use in terms of the risk that the entity is
intending to manage.  Disclosing the fair values of derivative
instruments and their gains and losses in a tabular format should provide a more
complete picture of the location in an entity’s financial statements of both the
derivative positions existing at period end and the effect of using derivatives
during the reporting period.  Disclosing information about
credit-risk-related contingent features should provide information on the
potential effect on an entity’s liquidity from using
derivatives.  This statement is effective for financial statements
issued for fiscal years and interim periods beginning after November 15,
2008.  The Company does not expect that the application of FAS 161
will have a material impact on the financial statements.




Consolidated
Financial Statements   INTEROIL
CORPORATION     54








InterOil
      Corporation
              Notes
      to Consolidated Financial Statements
              (Expressed
      in United States dollars)





29.
            Reconciliation
      to generally accepted accounting principles in the United States
      (cont’d)





Hierarchy
of generally accepted accounting principles





In May
2008, the FASB issued FAS 162.  This statement identifies the sources
of accounting principles and the framework for selecting the principles to be
used in the preparation of financial statements by nongovernmental entities that
are presented in accordance with the US GAAP.  This statement is
effective 60 days following the SEC’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles.  The SEC
approved the amendments on September 16, 2008.  The Company does not
expect that the application of FAS 161 will have a material impact on the
financial statements.





Accounting
for financial guarantee insurance contracts





In May
2008, the FASB issued FAS 163 which clarifies how FAS 60 applies to financial
guarantee insurance contracts, including the recognition and measurement to be
used to account for premium revenue and claim liabilities.  The
statement requires recognition of a claim liability prior to an event of default
when there is evidence that credit deterioration has occurred in an insured
financial obligation.  The statement also required expanded
disclosures about financial guarantee insurance contracts.  This
statement is effective for years beginning after December 15, 2008 and interim
periods within those years, except for certain disclosure requirements which are
effective for the first period (including interim periods) beginning after May
23, 2008.  The Company does not expect that the application of FAS 163
will have any impact on the financial statements.




Consolidated
Financial Statements   INTEROIL
CORPORATION     55