<PAGE>
 
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549
                            
--------------------------------------------------------------------------------
                                   FORM 10-K
(MARK ONE)

           [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
                                        
         [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
--------------------------------------------------------------------------------
                        COMMISSION FILE NUMBER 0-23634
                                   KFX INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

          DELAWARE                                              84-1079971
(STATE OR OTHER JURISDICTION OF                              (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION)                            IDENTIFICATION NUMBER)
                                        
             1999 BROADWAY, SUITE 3200, DENVER, COLORADO USA  80202
                    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

                                 (303) 293-2992
              (REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE)

          Securities registered pursuant to Section 12(b) of the Act:

================================================================================
        TITLE OF EACH CLASS           NAME OF EXCHANGE ON WHICH REGISTERED
        -------------------           ------------------------------------
    Common Stock, $.001 par value             American Stock Exchange
================================================================================

       Securities registered pursuant to Section 12(g) of the Act:  None

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the proceeding 12 months, and (2) has been subject to such filing requirements
for the past 90 days.  Yes [ X ]  No [   ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will no be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [   ]

As of March 24, 1998, the aggregate market value of the Registrant's common
stock held by non-affiliates of the Registrant was approximately $32,995,000.
At March 24, 1998, 23,926,040 shares of common stock of the Registrant were
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:  Portions of the Registrant's definitive
Proxy Statement for the Annual Meeting of Shareholders to be held on June 18,
1998 are incorporated by reference into Part III.
<PAGE>
 
                                   KFX INC.

                            FORM 10-K ANNUAL REPORT
                     FOR THE YEAR ENDED DECEMBER 31, 1997

                               TABLE OF CONTENTS

                                                                                
<TABLE>
<CAPTION>
                                                                                            PAGE NO.
                                                                                            --------
                                                 PART I
 
<S>         <C>                                                                               <C>
Item 1.     Business........................................................................     1
Item 2.     Properties......................................................................    12
Item 3.     Legal Proceedings...............................................................    13
Item 4.     Submission of Matters to a Vote of Security Holders.............................    13
                                                                                               
                                                PART II                                        
                                                                                               
Item 5.     Market for Common Stock and Related Stockholder Matters.........................    14
Item 6.     Selected Financial Data.........................................................    15
Item 7.     Management's Discussion and Analysis of Financial Condition and                    
            Results of Operations...........................................................    16
Item 8.     Financial Statements and Supplemental Data......................................    20
Item 9.     Changes in and Disagreements with Accountants on Accounting                        
            And Financial Disclosures.......................................................    20
                                                                                               
                                                PART III                                       
                                                                                               
Item 10.    Directors and Executive Officers of the Registrant..............................    21
Item 11.    Executive Compensation..........................................................    21
Item 12.    Security Ownership of Certain Beneficial Owners and Management..................    21
Item 13.    Certain Relationships and Related Transactions..................................    21
                                                                                               
                                                PART IV                                        
                                                                                               
Item 14.    Exhibits, Financial Statement Schedules and Reports on Form 8-K.................    22
                                                                                               
            SIGNATURES......................................................................    25
</TABLE>
<PAGE>
 
                                    PART I
                                        
ITEM 1.  BUSINESS

GENERAL

     KFX Inc. (the "Company"), a Delaware corporation, is a provider of
responsible energy solution technologies that enhance energy value and clean the
environment. The Company's primary enterprise is the business of licensing and
commercializing a technology that enhances the combustion characteristics of
coal and other carbonaceous solid fuels (the "K-Fuel Technology"). The K-Fuel
Technology uses heat and pressure to physically and chemically transform high-
moisture, low-energy per pound coal and other organic feedstocks into a lower-
moisture, high-energy solid fuel ("K-Fuel").

CERTAIN RECENT DEVELOPMENTS

     Pegasus Technologies, Ltd.

     On March 23, 1998, the Company acquired a 60 percent interest in Pegasus
Technologies, Ltd., an Ohio limited liability company formed in August 1996
("Pegasus"), for $2,200,000, comprised of cash payments totaling $1,600,000 and
promissory notes totaling $600,000. Additionally, the Company has agreed to
provide Pegasus $1,400,000 in working capital guarantees secured through lines
of credit or other financing sources mutually acceptable to the Company and
Pegasus.

     Pegasus has developed and is commercializing a neural network (i.e.,
artificial intelligence) software technology that optimizes the combustion
performance of coal-fired electric utility boilers. Pegasus' software product,
known as NeuSIGHT, provides two primary benefits: improved combustion
performance and reduction in nitrogen oxide ("NOx") emissions.  NeuSIGHT
dynamically models in real-time the operating conditions of boiler operations
and makes recommendations and changes to operating variables that result in
improved boiler heat-rate performance, thereby reducing coal fuel costs.  This
combustion optimization process also results in significant reductions in NOx.
NOx is a primary component of ground-level smog and the U.S. Environmental
Protection Agency ("EPA") has proposed regulations that would significantly
reduce the amount of NOx emissions currently allowed for certain U.S. electric
utilities (see "K-Fuel  Domestic Market").

     Charco Redondo, LLC

     In December 1997, the Company purchased a 12.6 percent interest in Charco
Redondo, LLC, a Texas limited liability company ("Charco") in consideration for
its commitment to contribute $540,000 to Charco as working capital.  Funding
under this commitment began in January 1998 and to date the Company has
contributed $404,000 to Charco.

     Charco was formed to develop and complete a project intended to demonstrate
the effectiveness of Synthetic Energy Corporation's ("Synthetic") patented
process which uses mining techniques in connection with superheated steam and
moderate pressure to extract crude oil that otherwise cannot be extracted by
conventional production techniques.  The technology licensed by Charco is based
on a patent held by John A. Masek (the "Masek Technology").   Charco has an
exclusive sublicense to use the Masek Technology in a four-county area of Texas
(the "AMI"), which is believed to have reservoirs containing approximately 1
billion barrels of crude oil which would be appropriate targets for application
of the Masek Technology.  The pilot project (the "Charco Pilot Project") is
being conducted on a mineral lease covering approximately 1800 acres in southern
Texas.  If the Charco Pilot Project is successful, Charco intends to complete
development of the lease, which contains an estimated 23 million barrels of
crude oil.  The Company's interest in the profits and losses of Charco is 12.6
percent, other than in the Charco Pilot Project phase, for which it is
approximately 19 percent.  There are no assurances that the Charco Pilot Project
will be successful.

                                       1
<PAGE>
 
     The Company also entered into an option agreement with Synthetic with
respect to the use of the Masek Technology outside the AMI. The option agreement
provides that the Company and Synthetic will form a joint venture to be owned
55% by the Company and 45% by Synthetic.  Upon exercise of the option the
Company will have to pay $2.0 million to Synthetic, of which a total of $50,000
was paid upon execution of the option agreement.  The Company is not committed
to pay any additional amounts to Synthetic under the option agreement until
certain performance milestones of the Charco Pilot Project are met.

     Activated Carbon

     In January 1998, the Company completed an initial feasibility study to
construct an activated carbon facility at the same site as the previously
proposed K-Fuel Partners II Project (as defined herein), adjacent to the KFP
Facility (as defined herein).  The activated carbon facility, as proposed, would
be operated in conjunction with the KFP Facility and would utilize coal fines
and other process off-streams from the KFP Facility to reduce raw material and
operating costs substantially below those of similar free-standing activated
carbon production facilities.  Permitting for the proposed activated carbon
facility is presently underway.  Activated carbon can be made from coal or
various biowaste materials and is used in various industrial liquid and vapor-
phase treatment and purification processes, and can also be used in certain soil
remediation and mining applications.

     In order to commence construction of an activated carbon facility,
contracts for engineering and construction, commitments for sale of the product,
financing commitments, and environmental and other permits must be secured. The
Company anticipates that one or more joint venture partners may be required to
assist the Company in constructing the activated carbon facility. To date there
are no definitive agreements with respect to an activated carbon plant, and the
Company is not able to predict if or when an activated carbon plant will be
constructed.

     Debenture Offering

     In August 1997, the Company completed the offer and sale (the "Debenture
Offering") of $17 million principal amount of the Company's 6% unsecured
convertible debentures due 2002 (the "Debentures"). The Debentures were sold
without registration under the Securities Act of 1933, as amended (the
"Securities Act") in reliance on the exemption from registration provided by
Regulation S under the Securities Act. The Debentures were offered, sold and
delivered only to non-United States persons outside of the United States, its
territories and possessions.

     The aggregate underwriting discounts and commissions paid to the placement
agents in conjunction with the sale of the Debentures was $1,190,000 (7% of the
principal amount thereof).  The Company also issued to the placement agents
and/or their designees, warrants (the "Placement Agents' Warrants") to purchase
453,333 shares of the Company's $.001 par value common stock (the "Common
Stock") with an exercise price of $5.00 per share.

     The Debentures are convertible into shares of Common Stock at the option of
the holder of the Debentures at any time prior to maturity (unless previously
redeemed or repurchased by the Company), into that whole number of shares
determined by dividing (a) the principal amount of Debentures to be converted by
(b) the Conversion Price (as defined herein), subject to adjustment in certain
circumstances.

     The initial Conversion Price is $3.75 per share and such price will be
reset on November 1, 1999 (the "Reset Conversion Date"). On and after the Reset
Conversion Date, the Conversion Price will be the product obtained by
multiplying (i) the Stock Price Factor (as defined below), by (ii) 90%. However,
the Conversion Price may not be less than $3.65 (the "Floor"), other than as the
result of the operation of customary antidilution adjustments set forth in the
indenture entered into between the Company and First Bank National Association,
as trustee dated as of July 25, 1997 (the "Indenture"); provided, however,
notwithstanding the foregoing, if the exercise price of the warrant issued to
TCK (as defined herein) to purchase 7,750,000 shares of Common Stock is reduced,
then the Floor will be adjusted downward on a dollar-for-dollar basis. "Stock
Price Factor" means the average American Stock Exchange ("AMEX") closing

                                       2
<PAGE>
 
sale price per share (or, if the Company is listed or quoted on a U.S. exchange
other than AMEX, the average closing price on such exchange) for the 15 trading
days immediately preceding the Reset Conversion Date.

K-FUEL

     The K-Fuel Technology is comprised of three groups, or Series, of patents.
The Series "A" and Series "B" Technology patents are based on hot gas and steam
heat-transfer mediums, respectively. The Series "C" Technology is based on a
nitrogen heat-transfer medium. The principal difference between the Series "A"
and "B" Technologies and the Series "C" Technology is that Series "C" is based
on a more simplified design with respect to the manufacturing equipment and
facilities, resulting in lower capital costs. The Company anticipates that the
Series "C" Technology will be primarily used for coal fuel product manufacturing
facilities. The Series "A" and "B" Technologies can also be used for coal fuel
product facilities, but the Company expects to also use them for renewable
resource (e.g., bagasse, municipal solid waste, sludge and wood waste) fuel
product manufacturing facilities. The Series "A" and "B" Technology patents were
developed by Edward Koppelman and assigned to the Company under a research and
development contract (the "R&D Contract") with the Company. The Company
purchased the initial Series "C" Technology patent directly from Mr. Koppelman
at a later date after completion of the R&D Contract. The Company is currently
focusing all of its commercialization efforts on the development of projects for
the manufacture of coal fuel product using the Series "C" Technology. To date,
one commercial-scale K-Fuel manufacturing facility has been constructed and has
begun operations. See "Current K-Fuel Projects - KFX Fuel Partners."

     In the Series "C" process, raw coal is crushed and screened before it is
introduced into a steel alloy processing vessel that is then pressurized and
heated indirectly using vertical tube heat exchangers.  Nitrogen, serving as an
inert, non-oxidizing heat-transfer medium, is admitted to the tube side of the
processing vessel at a pressure of approximately 125 pounds per square inch
("psi").  After the nitrogen is inserted, it picks up heat from the walls of the
tube and gradually expands to approximately 800 psi.  Water is released from the
coal during this expansion period.  When the temperature in the tubes reaches in
excess of 520 degrees Fahrenheit, any water remaining in the coal turns to steam
and continues to process the raw coal.  When the temperature of the coal reaches
approximately 650 to 740 degrees Fahrenheit, the process is complete.  The
process takes 30 to 40 minutes to complete from initial loading of the raw coal
into the processing vessels to final discharge of finished K-Fuel product.

     The principal benefit of the K-Fuel Technology in the United States is that
the fuel produced from the process can allow electric power producers,
manufacturers and other large-scale users of coal to meet the clean air
standards imposed by the Clean Air Act, as amended by the Clean Air Act
Amendments of 1990 (the "CAAA").  The principal benefit of the K-Fuel Technology
in foreign markets is that low-rank indigenous coal reserves can be upgraded to
provide a more cost effective and less environmentally damaging fuel source for
power producers, manufacturers and households, either in internal markets or for
export.

Domestic Market

     The CAAA is the primary stimulus for the developing United States market
for beneficiated clean coal fuel products. Specifically, Title IV of the CAAA
addresses acid rain, which is largely caused by airborne sulfur dioxide ("SO2")
particulates emitted from coal-fired power plants and other industrial
facilities. The K-Fuel Technology addresses this problem by producing a coal
fuel product that has SO2 emissions significantly below the levels required by
the CAAA (the level of reduction can vary with the chemical composition of the
coal feedstock).

     Title IV of the CAAA specifies a two-phase implementation schedule that
primarily targets electric utility companies with annual generating capacities
in excess of 25 megawatts ("MW").  Phase I implementation began on January 1,
1995, and affected 110 large, high-emission generating plants in 21 states
(primarily in the industrial midwest).  The emissions limit for these plants
during Phase I is 2.5 lbs. SO2 per million Btu ("MMBtu") of heat output.  Phase
II will begin in the year 2000 and will affect over 

                                       3
<PAGE>
 
1,400 electrical generating plants and other industrial users of coal. The
effective SO2 emission rate limitation under Phase II will be reduced to 1.2
lbs. SO2 per MMBtu. When using Wyoming Powder River Basin ("PRB") coal as
feedstock material, the K-Fuel Technology produces a fuel product that has a SO2
emission rate of approximately 0.7 to 1.0 lbs. SO2 per MMBtu.

     The Company's United States marketing emphasis is directed primarily at
electric utility companies and industrial coal users located in the industrial
midwest states.  The combustion characteristics of cyclone furnace boilers, a
common boiler type of midwestern utilities originally designed to burn high-
sulfur midwestern coal, are particularly well-suited to the K-Fuel product
manufactured from PRB coal.  As reported by the U.S. Department of Energy, the
total domestic market for coal fuel is approximately 1 billion tons per year
("TPY"), of which the majority of the tonnage (in excess of 80 percent) is used
by electric utility companies.  Coal-fired electricity generation currently
accounts for approximately 55 percent of the nation's total electricity supply.
The Company has estimated, based on published utility coal consumption data and
responses to Phase I and Phase II requirements of the CAAA, that a market of
approximately 100 to 150 million TPY of clean coal fuel products will develop
between the year 2000 and  2010.  This anticipated market assumes that
regulations passed under the CAAA remain in force.  Any amendments to the CAAA
that reduce the specified limits on industrial SO2 emissions could negatively
impact the potential size of the market and the domestic growth prospects of the
Company.  In addition to the electric utility industry, the Company intends to
market the K-Fuel product to manufacturers and other industrial coal users that
are either subject to the SO2 provisions of the CAAA or that desire to improve
their fuel combustion performance.  Fuel combustion performance is becoming more
important to electric utilities because of the need to cut costs and become more
efficient in an increasingly competitive market environment.
 
     The K-Fuel Technology can also produce lower NOx emissions (when using PRB
coal as the feedstock) as compared to typical eastern coals.  Laboratory tests
have indicated that such reductions can be up to approximately 50 percent.  NOx
is a primary component in ground-level smog and is also a contributor to acid
rain.  In October 1997, the EPA proposed new NOx emission guidelines for 22
midwestern and southern states and the District of Columbia that would
significantly reduce current allowed levels of NOx (in some states by up to
approximately 40 percent).  Electric utility power plants are the likely targets
to reduce NOx as the overall cost to achieve the reduction levels is thought to
be less than reduction initiatives aimed at the automobile and manufacturing
industries.  In February 1998, the U.S. Court of Appeals for the District of
Columbia rejected a legal challenge by the electric utility industry, upholding
certain 1996 regulations under the CAAA with respect to NOx control standards.
The court held that the standards were achievable and that the EPA had the
technical and legal authority to mandate such standards.

Foreign Markets

     The international coal market is approximately four times the size of the
United States market. The Company's objective is to concentrate on markets where
there is either a significant need for more energy efficient and environmentally
responsible fuel products, or where abundant coal reserves can be utilized in
conjunction with the K-Fuel Technology to develop a value-added export product.
The Company is currently focusing its international commercialization efforts in
Indonesia and Turkey.  See "Current K-Fuel Projects."

Strategic Relationships

     The Company believes that it can maximize it's chances for long-term
success in the development of the K-Fuel Technology, both domestically and
internationally, by means of strategic relationships with mature, well-
positioned companies already operating in the Company's intended markets, or
that have a value-added technology or service that complements the K-Fuel
Technology. To that end, the Company has successfully negotiated and entered
into separate strategic relationships with Thermo Ecotek Corporation and
Kennecott Energy and Coal Company.

                                       4
<PAGE>
 
     Thermo Ecotek Corporation.  In August 1995, the Company entered into a
Stock Purchase Agreement (the "Stock Purchase Agreement"), with Thermo Ecotek
Corporation ("TCK"), a Massachusetts company engaged primarily in non-utility
electric power generation using environmentally responsible technologies. Under
the Stock Purchase Agreement, in 1995 TCK purchased 3 million shares of Common
Stock for $6 million, or approximately 14 percent of the outstanding Common
Stock as of December 31, 1996, and in 1997 purchased an additional 1.25 million
shares of Common Stock for $2.5 million, increasing its ownership to
approximately 18 percent of the outstanding Common Stock. As part of the
transaction TCK was also granted (i) a warrant ("Warrant A") to purchase an
additional 7,750,000 shares of Common Stock (subject to certain adjustments) at
an exercise price of $3.65 per share, exercisable on January 1, 2000 and
expiring July 1, 2001; and (ii) a warrant ("Warrant B"), that gives it the right
to purchase the number of shares of Common Stock (at the then prevailing market
price) that, when added to all shares owned by TCK on the exercise date,
including any shares acquired by the exercise of Warrant A, would be sufficient
to give TCK 51 percent of the outstanding Common Stock, on a fully diluted
basis. Warrant B has the same exercise and termination dates as Warrant A. In
August 1995, the Company and TCK entered into a separate agreement to construct
and operate a 500,000 TPY commercial-scale K-Fuel production facility. See
"Current K-Fuel Projects - KFX Fuel Partners."

     Kennecott Energy and Coal Company.  In April 1996, the Company entered into
a joint venture agreement (the "Kennecott Agreement") with Kennecott Alternative
Fuels, Inc. ("KAFI"), a wholly-owned subsidiary of Kennecott Energy and Coal
Company ("KECC"). The joint venture, a Delaware limited liability company named
K-Fuel, L.L.C. ("K-Fuel LLC"), will be the vehicle for further technical
advancement and the commercialization of business opportunities arising out of
the K-Fuel Technology, including research and development, sublicensing,
marketing and consulting, but not including the construction of facilities to
produce K-Fuel products on a commercial basis ("Commercial Projects").
Commercial Projects will be constructed by separate entities in which KAFI, the
Company or both will have an equity interest and which will be granted a
sublicense from K-Fuel LLC for the K-Fuel Technology.

     Initially, the Company has a 51 percent interest in K-Fuel LLC and KAFI has
a 49 percent interest. Certain research and development and amortization
expenses are allocated 100 percent to KAFI. At such time as entities in which
KAFI has an equity interest have placed into service Commercial Projects with a
collective design capacity equal to or in excess of 3 million TPY of K-Fuel
product, KAFI will have a 51 percent interest in K-Fuel LLC and the Company will
have a 49 percent interest. In addition to a fee of $1 million paid to the
Company in 1996 to enter into the K-Fuel LLC joint venture, and subject to
certain conditions, KAFI has agreed to pay to K-Fuel LLC such amounts as may be
necessary for all research and development costs incurred by K-Fuel LLC, up to
$4 million (the "Initial Work Plan"). During 1997 and 1996, KAFI funded such
research and development costs totaling approximately $879,000 and $1,440,000,
respectively.

     In the event that KAFI has not as of December 31, 2001 approved for
construction Commercial Projects in which KAFI will have an equity interest
having a design capacity equal to 1 million TPY of K-Fuel product, then the
Company may purchase KAFI's interest in K-Fuel LLC for a purchase price equal to
(a) 100 percent of the aggregate amount expended on third party costs, and (b)
75 percent of the aggregate amount charged for internal KAFI or KECC costs
incurred for the Initial Work Plan or any subsequent research and development
plan, plus a reasonable return on capital percentage.

     In connection with the Kennecott Agreement, the Company granted K-Fuel LLC
an exclusive, worldwide, fully-paid, royalty-free right and license (including
the right to grant sublicenses) to and under the K-Fuel Technology, except to
the extent that it pertains to the beneficiation or restructuring of coal or
coal related feedstocks covered under the HFC License (as defined below)  (the
"KFX License"). In addition, Heartland Fuels Corporation, an 85 percent-owned
subsidiary of the Company, granted K-Fuel LLC an exclusive, worldwide, fully-
paid, royalty-free right and license (including the right to grant sublicenses)
to and under the Series "A" and Series "B" K-Fuel Technology, as it pertains to
the beneficiation or restructuring of coal or coal-related feedstocks (the "HFC
License"). Both the KFX License and the HFC License specify minimum terms and
provisions for any sublicenses granted by K-Fuel LLC to third parties.

                                       5
<PAGE>
 
     With respect to future Commercial Projects to be licensed by K-Fuel LLC,
the Company is entitled to a one-time license fee based on the annual designed
capacity of each project, to be paid one-half at the time the license is
granted, with the remaining one-half paid over a period of three years beginning
when the project begins commercial operations. The Company will also receive a
production royalty, to be paid each calendar quarter, depending on certain
levels of the projects' selling price per ton of coal product. Additionally, the
Company will be entitled to an additional payment based on a percentage of the
excess of (1) annual cash revenue from each project, over (2) annual pre-tax
cash operating costs of each project plus an annual capital charge ("Bonus
Royalty") related to each project. The Kennecott Agreement provides that KAFI
will fund 100 percent of the capital requirements for each Commercial Project
that it elects to participate in, provided however that the Company retains the
option to fund and invest up to 50 percent of the capital requirements for any
Commercial Project. As of December 31, 1997, there were no commitments to
construct any Commercial Projects.
 
Current K-Fuel Projects

     KFX Fuel Partners.   In August 1995, the Company and TCK, acting through
wholly-owned subsidiaries KFX Wyoming, Inc. ("KFX Wyoming", 100 percent owned by
the Company) and Eco Fuels, Inc. (100 percent owned by TCK), formed KFX Fuel
Partners, L.P. ("KFP"), a Delaware limited partnership, and began construction
of a 500,000 TPY K-Fuel coal production facility (the "KFP Facility") near
Gillette, Wyoming using the Company's Series "C" K-Fuel Technology.  The Company
has a 5 percent interest in KFP, with the remaining 95 percent held by TCK.  TCK
is the managing general partner for KFP and makes all day-to-day operating
decisions.  The KFP Facility must be "placed in service" by June 30, 1998, to
qualify for certain federal tax credits on its output.

     The KFP Facility was substantially completed in December 1996.  TCK has
continued to refine and optimize operations at the KFP Facility, conducting
extensive testing and producing commercially salable K-Fuel product.  Although
the KFP Facility has operated and produced commercially salable product, certain
difficulties have been encountered in attempting to achieve optimal and
sustained operations.  Certain problems previously encountered, including a
December 1996 industrial fire at the facility and certain construction problems,
including issues relating to the flow of materials within the KFP Facility and
the design and operation of certain pressure-release equipment, have been
resolved.  Currently, certain operational problems relating to tar residue
build-up within the system during production are being experienced.  TCK is
actively exploring solutions to this problem.   Because the technology being
developed at the KFP Facility is new and untested, no assurance can be given
that other difficulties will not arise or that these problems can be corrected
and optimal and sustained performance can be achieved.  The Company does not
believe its share of such additional costs to bring the KFP Facility to optimal
operating performance, if incurred, will be material.

     In addition to its 5 percent ownership of KFP, the Company will receive a
production royalty of 3 percent of the gross sales of KFP, payable quarterly.
See "Patents, Licenses and Royalty Agreements." The Company, in conjunction with
K-Fuel LLC, is also performing certain marketing activities for KFP.  The terms
of any compensation for those activities are being negotiated by the parties.

     KFP has signed a Fuel Supply Agreement (the "FSA") with Ohio Valley
Electric Corporation ("OVEC"), a subsidiary of American Electric Power, Inc.
("AEP"), whereby KFP will supply K-Fuel to OVEC upon the satisfactory completion
of the test burn procedure described in the FSA. The term of the FSA will
commence upon the commencement of commercial operations of the KFP Project and
will continue until December 31, 1999 (the "Original Term"). The term may be
extended, at the option of OVEC, for a period of up to 120 months (the "Initial
Extended Term"), and may be extended further, at the option of OVEC, for a
period up to 60 months beyond the Initial Extended Term. KFP's initial shipment
of K-Fuel product to OVEC is expected to occur in the third quarter of 1998.
Total tonnage as per the FSA over the Original Term is 500,000 tons. See
"Patents, Licenses and Royalty Agreements." KFP has scheduled a 15-ton
combustion test at Southern Research Birmingham for the second quarter of 1998.
KFP is presently purchasing its raw coal feedstock on a spot market basis from a
neighboring coal mine,
                                       6
<PAGE>
 
and is negotiating for a long-term coal purchase contract to commence when
startup operations have been completed.

     The KFP Facility qualifies for a tax credit available under Section 29 of
the United States Internal Revenue Code entitled "Credit for Producing Fuel From
a Nonconventional Source" ("Section 29"). Section 29, which was originally
adopted in 1980, provides a tax credit to the producer of fuel from alternative
sources. The credit is equal to $3.00 in 1979 dollars for each barrel equivalent
of crude oil ("OBE"), which is defined as 5.8 million Btu. In 1996 dollars, the
phase out of the credit begins as the reference price of oil (the average price
of oil for the year as announced by the Secretary of the Treasury) exceeds
$46.62 per barrel and is fully phased out if the reference price exceeds $58.52.
For 1996 the reference price was $18.48 per barrel. Section 29 applies to
qualified fuels which are produced in a facility placed in service before July
1, 1998 pursuant to a binding written contract in effect before January 1, 1997,
and which are sold after December 1992 and before January 2008. Calculated in
1996 dollars, the tax credit is currently valued at $25.45 per ton of the K-Fuel
product (assuming a K-Fuel Btu content of 12,400 Btu per pound). The credit per
OBE and the phase-out prices for oil are adjusted annually for inflation. If the
KFP Facility is not deemed to be placed in service by July 1, 1998, thereby
qualifying for the Section 29 tax credit, the return on investment on the KFP
Facility will be materially adversely affected.
 
     Other than alternative minimum tax provisions, generally there is no
provision for carrybacks or carryovers in the event the taxpayer cannot use the
entire alternative fuel production credit available for the taxable year.  There
are also no recapture provisions which apply to this credit.  The Company is
currently unable to directly utilize any Section 29 tax credits derived from its
5 percent ownership of KFP because of its cumulative net operating loss
carryforward.

      K-Fuel LLC.   Phase 1 of the Initial Work Plan was completed in 1997, with
emphasis on  product reactivity and dusting and development of a new processing
vessel design.  Phase 2 of the Initial Work Plan, consisting of construction of
a small demonstration plant based on a new processing vessel design, will be
considered after test burn results from the KFP Facility have been evaluated.
KAFI will fund 100 percent of the remaining Phase 2 research and development
program of K-Fuel LLC, up to $4 million.  The Company expects that the total
costs of the Initial Work Plan will not exceed $4 million.

      KFX Fuel Partners II.  In December 1996, the Company formed KFX Fuel
Partners II, L.P. ("KFP II"), a Delaware limited partnership, in connection with
an anticipated 635,000 TPY K-Fuel plant project ("KFP II Project") to be
constructed on a site adjacent to the existing KFP Project near Gillette,
Wyoming.  The KFP II Project was terminated in the fourth quarter of 1997
because of the uncertainty regarding the KFP Facility and the Section 29 tax
credit placed-in-service date (July 1, 1998) becoming unrealistic given the
construction lead times necessary for the KFP II Project.  The Company now is
seeking a permit to use the site for its proposed activated carbon facility.
Other pre-construction engineering activities related to the KFP II Project (and
a related project considered in 1997 to add a fifth processing vessel to the KFP
Facility) have been modified for the proposed activated carbon facility.   See
"Activated Carbon."

      Indonesia.   In September 1995, KFX Indonesia, a joint venture between the
Company and RCD Development, a Maryland partnership ("RCD"), entered into a
Memorandum of Understanding with PT Tambang Batubara Bukit Asam ("PTBA"), an
Indonesian state-owned coal-mining company, to jointly undertake a feasibility
study on the commercialization of the K-Fuel Technology in Indonesia using
PTBA's high-moisture coal as feedstock.  KAFI, through its interest in K-Fuel
LLC, subsequently  participated in the feasibility study.  In 1996, KFX
Indonesia, KAFI and PTBA completed the feasibility study and  identified a
potential K-Fuel project on the southern portion of the Indonesian island of
Sumatra ("Indonesia Project").   The proposed Indonesia Project is an
approximately 1.5 million metric ton-per-year ("MTPY") facility, with an
estimated development and construction cost of approximately $160 million,
including approximately $21 million to develop an existing coal reserve of PTBA
estimated at approximately 180 million metric tons.  In 1998, KFX Indonesia,
KAFI and PTBA expect to keep current detailed engineering studies of the
proposed mining and K-Fuel plant sites to keep abreast of the viability of the
Indonesia Project.  The costs needed to maintain these studies are expected to
be paid by KAFI and PTBA.  Furthermore, the Company expects to have no direct
financial ownership in the initial Indonesia 

                                       7
<PAGE>
 
Project other than license fees, royalties and Bonus Royalty. The funding for
the Indonesia Project, other than the feasibility study costs incurred in 1996,
is expected to be funded 100 percent by KAFI and PTBA. Feasibility study costs
incurred in 1997 for the Indonesia Project were not material. It is possible
that PTBA will participate in the Indonesia Project only as a supplier of raw
coal feedstock, rather than being the coal supplier and a partner in the
Indonesia Project. Also, with the Company's consent, KAFI may transfer its
rights in the Indonesia Project to one or more international affiliates. There
are no assurances that the Indonesia Project or other possible future projects
in Indonesia will be constructed.

     In January 1997, the Company and K-Fuel LLC entered into an amended
agreement with RCD regarding certain future performance fees related to a
successful Indonesia K-Fuel project. In the event that the Company and/or K-Fuel
LLC construct or license an Indonesia K-Fuel project utilizing at least 25
percent raw coal feedstock supplied by PTBA, RCD would be entitled to a fee of
$2.00 per U.S. short ton (2,000 lbs.) for the first 1.5 million tons of
installed capacity, and a fee of $1.33 per ton for the second 1.5 million tons
of installed capacity. The fees RCD derives from individual K-Fuel projects in
Indonesia supplied by PTBA coal are not expected to impact the license fees or
royalties the Company would separately receive under its license agreement with
K-Fuel LLC.

     Development of the Indonesia Project in 1997 suffered from the overall
economic and political problems experienced by Indonesia and other Asian
countries beginning in mid-1997. Further development of the Indonesian Project
(other than periodic assessment of Indonesian coal trade and overall economic
conditions) has been limited pending completion of the product test burns from
the KFP Facility and the return to a more stable economic and political
environment in Indonesia.  The Company is not able to determine when such
conditions will materialize to allow the Indonesia Project to commence
construction.

     Turkey.  In June 1996, the Company entered into a non-binding memorandum of
understanding with Soma Komur Isletmerleri A.S. ("SOMA"), a Turkish private 
coal-mining company, to cooperate in the development of a proposed 500,000 TPY
K-Fuel project in the Soma Basin coal-mining region in western Turkey ("Turkey
Project"). The intended use of K-Fuel from the Turkey Project would be for
household heating markets in the urban areas of Izmir and Bursa.

     The Company is presently conducting pelletizing and test burns of raw
Turkish coal.  The test burns are being conducted in a domestic-use combustion
chamber received from SOMA.  After completion of these initial tests, shipment
of larger quantities of pelletized fuel product to Turkey for further testing is
planned.

     To date there are no definitive agreements with respect to a Turkey K-Fuel
production facility, and the Company is not able to predict if or when a K-Fuel
production facility will be constructed in Turkey.

PATENTS, LICENSES AND ROYALTY AGREEMENTS

     The Company has patents or patent applications for the K-Fuel Technology
registered in the United States and 46 foreign countries, including all major
industrialized countries that either have significant reserves of high-moisture
lignite or subbituminous coal, or that are readily accessible to such reserves
via large-scale transportation infrastructure (primarily ocean barge vessels).
Included in the pending patent applications are inventions developed by the
Company as well as seven improvement patent applications assigned to the Company
as a result of the K-Fuel LLC research activities.

     The only licenses the Company has granted to the K-Fuel Technology are to
the KFP Facility (Series "C"), K-Fuel LLC ("Series C"), and Heartland Fuels
Corporation ("HFC") (Series "A" and "B"). The Company owns 85 percent of the
common stock of HFC, and as a condition of the Kennecott Agreement, the Company
caused HFC to grant to K-Fuel LLC an exclusive sublicense to the Series "A" and
"B" Technologies.

     In connection with the KFP Project, the Company and OVEC entered into a
Fuel Option Agreement (the "OVEC Fuel Option Agreement") in 1995 whereby, in the
event OVEC exercises its option to extend the Original Term of the FSA for the
full 120-month period of the Initial Extended Term, 

                                       8
<PAGE>
 
OVEC will have the right to designate, and, if designated, the obligation to
provide, at the Company's expense, one or more sites suitable for the location
of plants for the processing of K-Fuel. Upon the Company's determination at the
time of each such designation that the plant will be commercially viable, the
Company or an affiliate thereof, and OVEC and/or Indiana Kentucky Corporation, a
subsidiary of AEP, shall promptly thereafter negotiate in good faith and enter
into a purchase agreement whereby OVEC will purchase the K-Fuel produced by any
such plant built by the Company on terms and conditions substantially similar to
those in the FSA. In the event the Company decides not to proceed with the
construction of such plant, the Company is obligated to grant OVEC a non-
exclusive license for the Series "C" Technology to enable OVEC to proceed with
the development and construction of such plant, and OVEC is required to pay the
Company a royalty of $0.65 per ton on any fuel produced at such plant.
Additionally, the Company entered into a Fuel Option Agreement with Indiana
Michigan Power Company ("I&M"), a subsidiary of AEP, dated August 17, 1995 (the
"I&M Fuel Option Agreement") which provides that under certain circumstances I&M
shall have the same rights as OVEC pursuant to the OVEC Fuel Option Agreement.

     A predecessor entity of the Company acquired the Series "A" and "B"
Technologies from Edward Koppelman and other investors (the "Koppelman Group")
in 1984 for $10 million in cash and a royalty agreement of $90 million.  In June
1996, the Company entered into a royalty amendment agreement with Edward
Koppelman, the inventor of the K-Fuel Technology.  Prior to the agreement, Mr.
Koppelman was entitled to a royalty of 2 percent on the gross sales value of K-
Fuel product produced by any entity, including any product produced by the
Company.  As a result of the agreement, Mr. Koppelman's royalty is now 25
percent of the Company's worldwide royalty and license fee revenue, computed
after the State of Wyoming royalty (discussed below).  The royalty to Mr.
Koppelman will cease when the cumulative payments to him reach the sum of
approximately $75,222,000. As consideration for the royalty amendment agreement,
the Company paid Mr. Koppelman $300,000 cash and issued a promissory note for
$200,000. See Note 7 to the consolidated financial statements.  The $500,000
prepaid royalty will be amortized based on the difference between what royalty
payments to Mr. Koppelman would have been on the original royalty agreement and
the amended royalty agreement reached in 1996.  Also as part of the royalty
agreement, Mr. Koppelman indemnified the Company for any claims made by the
Koppelman Group.  Mr. Koppelman is now deceased and all his rights and
obligations as discussed above are held by his estate.

     The following table summarizes the Company's royalty obligations to various
third parties based on licensing and royalty revenues received by the Company
and the geographic source of the revenues:

<TABLE>
<CAPTION>
  Royalty Obligation        UNITED STATES        INTERNATIONAL          EXPIRATION DATE OR MAXIMUM AMOUNT
-----------------------------------------------------------------------------------------------------------------
<S>                         <C>                 <C>                     <C>
Estate of Edward            25 Percent/(1)/       25 Percent            $75,222,000
 Koppelman
 
State of Wyoming            12 Percent/(2)/       NA - None             $5,000,000/(2)/
 
Fort Union Ltd.             20 Percent/(3)/     Canada, Mexico          Earlier of cumulative royalties paid of
                                                                        $1,500,000 or September 15, 2015

Ohio Valley Electric        0.5 Percent/(4)/      NA  None              None
</TABLE>

    /(1)/  Computed after the State of Wyoming's royalty, and applies to both
           license fees and royalties.

    /(2)/  The royalty percentage decreases to 6 percent when $5,000,000 has
           been paid. There is no expiration date or maximum amount on the
           remaining 6 percent, and applies to both license fees and royalties.

    /(3)/  Applies to royalties only and is also applicable to any production in
           Canada or Mexico.

    /(4)/  Applies to royalties only and does not include the plant constructed
           in 1996 by KFP or any future plants constructed under the OVEC Fuel
           Option Agreement.

                                       9
<PAGE>
 
GOVERNMENT AND ENVIRONMENTAL REGULATION

K-Fuel

     In the United States, the K-Fuel product is not expected to be subject to
significant amounts of local, state or federal regulation with respect to its
transportation and distribution.  However, any future United States production
plants will require numerous permits, approvals and certificates from
appropriate federal, state and local governmental agencies before construction
of each facility can begin, and will be subject to periodic maintenance and
review requirements once facilities begin production.  Typically, most
permitting requirements are governed by state laws, but the EPA has the
authority to overrule state permitting decisions.  The following types of
permits are typically required for commercial production facilities: (a) air
quality, (b) wastewater discharge, (c) land use, and (d) hazardous waste
treatment, storage and disposal.  KFP has in place all permits for the operation
of the KFP Facility, and the Company expects no difficulties in obtaining the
necessary permits for the activated carbon facility (formerly the KFP II
Project), although no assurances can be given that such permits will be granted.
The K-Fuel Technology process generates only waste gas, waste discharge water,
and a small amount of fuel liquid as by-products of the process.  The KFP
Facility has, as will all future production facilities, waste gas and water
treatment facilities to properly treat and dispose of the waste by-products.

     The Company currently has an operating permit in the name of KFX Wyoming,
issued by the Land Quality Division of the Wyoming Department of Environmental
Quality ("DEQ"), that encompasses all of the operating activities of the KFP
Facility, the previously proposed KFP II Project, and the Company's mine
property adjacent to the KFP Facility (see "ITEM 2 - PROPERTIES").  The
operating permit issued by DEQ governs the current day-to-day operating
activities of both KFP and KFX Wyoming with respect to the permitted area, as
well as the future reclamation obligations to return the project site to its
original condition.  Each year, the permit is reviewed by DEQ for compliance
with specified operating procedures and the appropriateness of the estimated
future reclamation costs for the project site.  The 1998 annual permit review
was submitted to DEQ in December 1997 and is expected to be approved by DEQ no
later than May 1998.  The total reclamation obligations of KFP, KFP II and KFX
Wyoming are currently estimated at approximately $3,791,000, including certain
contingency amounts required under Wyoming law.  Upon approval of the 1998
operating permit by DEQ, KFX Wyoming and KFP will each be required to provide
reclamation bonds as collateral to the DEQ for the estimated reclamation
obligations.  The future reclamation obligation of KFX Wyoming as submitted in
the 1998 annual permit review is approximately $1,166,000. The Company expects
that there will be no significant additional reclamation requirements in 1998.
 
     Future international K-Fuel production plants will also be subject to
various permitting and operational regulations specific to each country.
Generally, environmental permitting and operating regulations in the countries
the Company has targeted for international development (i.e., Indonesia and
Turkey) are not as stringent as those in the United States.

Charco Redondo, LLC

     The operations of Charco are regulated to the extent of environmental
permitting by various state and local governmental authorities and by the Mine
Safety and Health Administration ("MSHA") to the extent of its mining activities
to excavate subsurface production rooms.  To the best of the Company's
knowledge, Charco is currently in compliance with all such governmental
regulations.

Pegasus Technologies, Ltd.

     The operations of Pegasus are not significantly impacted by governmental
regulation with respect to its development of the NeuSIGHT software product.
However, the market acceptance of the NeuSIGHT software is significantly
impacted by the various issues surrounding the current trend to de-regulate the
domestic electric utility industry.  Currently, those industry trends are
positively impacting Pegasus as the NeuSIGHT software can significantly reduce
utility fuel costs and NOx emissions, thereby benefiting electric utilities in
a de-regulated scenario that favors low-cost operations.

                                       10
<PAGE>
 
COMPETITION

K-Fuel

     To the Company's knowledge, there are currently no competitors producing
significant commercial quantities of beneficiated clean coal fuel products
either in the United States or in international markets.  However, there are
other clean coal technology ("CCT") companies, primarily in the United States,
that are developing fuel combustion and product technologies that would reduce
emission pollutants and/or increase the heating value of coal feedstock fuel
sources.  Many of these CCT competitors have greater financial, technical and
operational resources than the Company.

     ENCOAL, a joint venture of SGI International, Inc. and Ziegler Coal
Holdings, has a demonstration facility in the PRB that is currently capable of
producing approximately 100,000 TPY of Process Derived Fuel ("PDF"), a solid,
low-sulfur fuel product for use in utility boilers that has a heating content of
approximately 11,500 Btu per pound. The ENCOAL process also produces a liquid
fuel product known as Coal Derived Liquid ("CDL"). ENCOAL has reported
completion of its  demonstration project conducted in participation with the U.
S. Department of Energy and has idled its demonstration plant.  ENCOAL has
further indicated that it is presently developing commercialization options for
its technology.

     Rosebud-Syncoal, a joint venture of Montana Power and an affiliate of
Northern States Power, has a demonstration facility at Montana Power's Rosebud
coal mine near Colstrip, Montana. The Syncoal facility is currently capable of
producing approximately 300,000 TPY of beneficiated coal that has a heating
content of approximately 11,800 Btu per pound.

     In the United States market, the Company must also compete with other
naturally low-sulfur coals.  Also, sulfur dioxide emission credits ("emission
credits") allow non-compliance users of higher sulfur coal to bundle coal
purchases with these emission credits to meet the CAAA requirements.  Because of
an over-compliance situation that has developed in Phase I of the CAAA, there is
currently an abundant supply of emission credits in the U.S. market.  However,
Phase II implementation of the CAAA beginning in January 2000 is expected to
result in a decreasing availability of emission credits.  Additionally, existing
supplies of naturally low-sulfur coal are continually being depleted.

     The Company is not able to predict the impact that competing coal
beneficiation technologies, the availability and pricing of low-sulfur coal
reserves, or the availability and pricing of emission credits will have on the
future competitive position of the Company. The Company believes that its
current competitive advantage is its expectation of having the KFP Facility
fully operational in 1998 to prove the K-Fuel Technology in the early stages of
a developing worldwide market that is expected to grow significantly in the
future.

Pegasus Technologies, Ltd.

     Pegasus' primary competitors are Pavillion Corporation and its Process
Insights system and Electric Power Research Institute ("EPRI") and its GNOCIS
system.  Other information technology companies are currently developing and
marketing software systems to compete with Pegasus' NeuSIGHT system, including
Praxis Engineering, Aspen Technologies, and NeuCO (a joint venture between
Commonwealth Energy Systems and Charles River Associates).  Many of these
potential competitors to Pegasus may have financial, technical and operational
resources greater than those of Pegasus.

     Pegasus' current competitive advantage is that it is the only neural
network software company yet to achieve closed-loop supervisory control of
utility combustion systems with automatic retraining and optimization of the
neural network database. None of Pegasus' competitors, to the best of its
knowledge, have yet achieved this level of technical performance on coal-fired
utility boilers.

                                       11
<PAGE>
 
RESEARCH AND DEVELOPMENT

     In 1997 and 1996, the Company incurred approximately $1,251,000 and
$1,198,000, respectively, in research and development ("R&D") expenses
(including demonstration plant and laboratory operating expenses) to further
refine and develop the K-Fuel Technology process.  Substantially all of the
Company's R&D expenses in 1997 and 1996 have been to test the design and
operating characteristics of planned production facilities (e.g., product
loading and handling requirements, storage and transportation characteristics,
etc.).  The Company will continue to operate its Gillette, Wyoming demonstration
facility in 1998 in a supporting role to K-Fuel LLC and KFP.  See "ITEM 2 -
PROPERTIES."

EMPLOYEES

     The Company currently has 12 full-time employees who work in the areas of
marketing, finance and administration, and research and development.  The
Company considers its relations with all employees to be excellent.

     Pegasus Technologies, Ltd. currently has 11 full-time employees who work in
the areas of software development, implementation, finance and administration.

ITEM 2.  PROPERTIES

     For its principal executive offices, the Company has leased approximately
5,900 square feet of office space for a period of five years ending September
30, 2000 located at 1999 Broadway, Suite 3200, Denver, Colorado 80202.  The base
rent under the lease is $6,783 per month; the Company is also obligated to pay,
as additional rent, allocable operating costs.  The Company has a right of
refusal on additional adjacent office space, and has the option to renew the
lease for one additional five-year term.

     The Company has leased approximately 2,500 square feet of office space for
a period of five years ending June 30, 1998 located at 901 North Stuart Street,
Suite 750, Arlington, Virginia 22203. The base rent under the lease is
approximately $4,452 per month, with escalations of 3 percent for each
subsequent year of the lease term. The Company is also obligated to pay, as
additional rent, allocable operating costs. The Company has the option to renew
the lease for one additional five-year term.

     The Company, through its KFX Technology, Inc. ("KFXT") subsidiary, owns a
demonstration plant and leases from KFP (on a rent-free basis) a research and
development laboratory adjacent to the KFP Facility (the "Gillette Facility").
The Gillette Facility is located on approximately 80 acres of land, inside the
rail loop of Fort Union Mine, in Campbell County, Wyoming, approximately 5 miles
northeast of Gillette, Wyoming.  The Gillette Facility is comprised of three
buildings totaling approximately 7,100 square feet.

     In 1995, the Company acquired the Fort Union Mine ("Pit 1"), which consists
of approximately 1,002 acres of surface and coal lands located northeast of
Gillette, Campbell County, Wyoming, and a coal loadout facility located on a
railroad loop connecting to the Burlington Northern Railroad. Recoverable coal
lying within Pit 1 is approximately 1.3 million tons. In 1997, the Company
transferred ownership of approximately 348 acres of surface land and the coal
loadout facilities to KFP.

                                       12
<PAGE>
 
ITEM 3.  LEGAL PROCEEDINGS

     In November 1995, the Company filed a lawsuit against Fru-Con Construction
Corporation and Fru-Con Engineering, Inc. (collectively, "Fru-Con") in the
Wyoming State Court, 6th Judicial District.  The action has been removed to the
United States District Court for the District of Wyoming ("Court").  The
Company's lawsuit requests that the court enter a judgement that Fru-Con has no
interest or claim in or against the Company or any of the Company's property or
interests, or that Fru-Con is barred from such claims.  Fru-Con had asserted
claims for approximately $1.8 million for engineering services and an interest
in K-Fuel plants built in North America by virtue of contractual arrangements
with a limited partnership sponsored by corporations in which a predecessor
entity to the Company had a partnership interest.  Because the work done by Fru-
Con was for a limited partnership in which the Company's predecessor entity was
not a partner, and because payment for the work performed by Fru-Con was
contingent upon successful project financing which never materialized, as well
as for other legal and factual reasons, the Company believes that Fru-Con has no
valid rights or claims against the Company.  On May 20, 1997, the Court granted
the Company's Motion for Summary Judgment on all claims.  Fru-Con has appealed
to the 10th Circuit Court of Appeals.  The Company believes that the ultimate
resolution of this action will not have a material adverse impact on the
Company's financial position or results of operations.

     On March 9, 1998, Fidelity and Deposit of Maryland, as subrogee of Walsh
Construction Company, a division of Guy F. Atkinson Company, filed a
construction lien against KFP with respect to the construction of the KFP
Facility in the amount of approximately $5.9 million.  It is not possible at
this time to evaluate the merits of the claim or the range of potential loss.
However, the Company believes that the ultimate resolution of this  action will
not have a material adverse impact on the Company's financial position or
results of operations.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     No matters were submitted to a vote of security holders during the fourth
quarter of 1997.

                                       13
<PAGE>
 
                                    PART II

ITEM 5.  MARKET FOR COMMON STOCK AND RELATED STOCKHOLDER MATTERS

     Beginning January 30, 1996, the Common Stock was traded on the American
Stock Exchange (under the trading symbol "KFX"). From January 1 to January 29,
1996, the Common Stock traded on the NASDAQ SmallCap Market (under the trading
symbol "KFXI"). The following table presents the reported high and low bid
prices for the Common Stock on the NASDAQ SmallCap Market and the reported sales
prices on the American Stock Exchange for the two-year period ended December 31,
1997. With respect to NASDAQ SmallCap Market prices, the bid prices reflect
interdealer quotations, without retail markup, markdown or commission, and do
not necessarily represent actual transactions.

<TABLE>
<CAPTION>
     YEAR        PERIOD             HIGH         LOW    
     -------------------------------------------------- 
     <S>    <C>                   <C>           <C>     
     1997   First Quarter         $5 3/4        $3 7/8  
            Second Quarter         4 1/2         3 1/4  
            Third Quarter          4 1/16        2 5/8  
            Fourth Quarter         3 13/16       2 7/16 
                                                        
     1996   First Quarter          5 11/16       3 7/8  
            Second Quarter         8 1/2         5 1/8  
            Third Quarter          7 1/2         5 1/2  
            Fourth Quarter         7 7/16        4 7/8   
</TABLE>
                                        
     As of March 24, 1998, the Company had 225 holders of record of the Common
Stock.  This does not include holdings in street or nominee names.  On March 24,
1998, the closing price of the Common Stock on the American Stock Exchange was
$3 3/8 per share.

     The Company has never paid cash dividends and does not anticipate paying
dividends in the foreseeable future.  The Company is also restricted from paying
dividends pursuant to the terms of the Indenture.  In addition, pursuant to the
Stock Purchase Agreement, so long as TCK, together with its affiliates, own at
least 1,000,000 shares of Common Stock and either of the warrants are
outstanding, the Company may not declare or pay any dividends on the Common
Stock other than dividends payable solely in shares of Common Stock.  See "ITEM
1 - BUSINESS - Strategic Relationships - Thermo Ecotek Corporation."

                                       14
<PAGE>
 
ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                         1997             1996             1995              1994                1993
                                  ----------------------------------------------------------------------------------------
<S>                               <C>               <C>              <C>              <C>                <C> 
STATEMENT OF OPERATIONS
 DATA FOR THE YEAR
 ENDED DECEMBER 31:
 Total revenues and
  other income ................       $ 1,735,176      $ 1,767,567      $   379,322        $   452,775        $  2,239,730
 Interest and other income ....           650,353          171,269          124,959             88,188             544,565
 Loss before income taxes
  and extraordinary item .......       (5,095,160)      (5,628,541)      (8,795,929)        (6,119,677)         (3,528,698)
 Net income (loss) .............       (5,095,160)      (5,628,541)      (6,228,720)         2,349,126          (3,528,698)
 Basic and diluted net income
  (loss) per share ............              (.21)            (.25)            (.33)               .14                (.23)
 Average shares
  outstanding ..................       23,820,000       22,458,000       18,578,000         16,621,000          15,472,000
 
BALANCE SHEET DATA
 AT DECEMBER 31:
 Current assets ................      $14,461,198      $ 1,957,005      $ 4,680,784        $   449,895        $  5,736,853
 Working capital (deficit) ....        12,565,373         (166,521)       2,253,682         (6,940,882)        (14,863,745)
 Total assets ..................       29,057,706       14,923,567       18,611,493         11,630,896          18,009,849
 Long-term debt ...............        17,500,000        1,110,000        1,399,851            650,000             280,000
 Stockholders' equity (deficit)         8,495,881       10,524,041       13,752,528          3,590,119          (2,870,749)
</TABLE>
                                                                                

                                       15
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS
 
     This 10-K filing contains, in addition to historical information, forward-
looking statements that include risks and uncertainties.  The Company's actual
results may differ materially from those anticipated in these forward-looking
statements.  Factors that might cause such a difference include those discussed
below, as well as general economic and business conditions, regulatory changes,
competition, the acceptance of new product offerings and other factors discussed
elsewhere in this 10-K.  The Company undertakes no obligation to release
publicly any revisions to these forward-looking statements that may be made to
reflect events or circumstances after the date hereof or to reflect the
occurrence of anticipated or unanticipated events.

OVERVIEW

     Excluding the joint venture fee of $1 million in 1996, to date the Company
has not generated any other material revenues from the licensing of the K-Fuel
Technology to third party licensees or the direct manufacturing of K-Fuel. All
revenues other than the joint venture fee in 1996 have been derived from
ancillary sources not directly related to the Company's efforts to commercialize
the K-Fuel Technology. Net losses before extraordinary items and income taxes
were approximately $5.1 million, $5.6 million, and $8.8 million in 1997, 1996
and 1995, respectively. The KFP Facility is the only commercial-scale K-Fuel
production facility constructed to date. Until the Company successfully
negotiates additional third-party licensing and royalty agreements,
independently constructs and operates additional commercial-scale K-Fuel
production facilities, or successfully enters into other lines of environmental
and/or energy technology businesses, net operating losses will continue. The
royalties and profit interests to be derived from the Company's 5 percent
ownership interest in the KFP Facility will not be sufficient to meet all of the
operating and debt service needs of the Company based on current and future
anticipated operating plans and budgets. Until such time as the Company has in
place sufficient additional commercial-scale K-Fuel production facilities
(either owned independently or through joint venture entities similar to the KFP
Facility) or has successfully entered into other lines of environmental and/or
energy technology businesses to generate positive cash flow from operations, the
Company will be dependent on additional debt and/or equity financing. The
Company has recently made investments in environmental and energy technologies
not directly related to the K-Fuel Technology that may provide a more rapid
economic return than the K-Fuel Technology (see "ITEM 1 - BUSINESS Certain
Recent Developments"). There are no assurances that any of these investments
will produce an acceptable economic return, if at all.

     Additionally, any equity participation that the Company negotiates for
future commercial-scale K-Fuel production facilities prior to January 2000 (or
later, depending on whether TCK exercises Warrant "A") will have to be financed
by sources other than the Stock Purchase Agreement with TCK.   See "ITEM 1 -
BUSINESS - Strategic Relationships - Thermo Ecotek Corporation."

     The Company expects that most or all of its financing needs in 1998 with
respect to day-to-day operations and debt service requirements will be satisfied
by the proceeds of the Debenture Offering.  See Note 10 to the consolidated
financial statements.

RESULTS OF OPERATIONS

Year Ended December 31, 1997 vs. Year Ended December 31, 1996

     The Company had a net loss of approximately $5,095,000 in 1997 compared to
a net loss of approximately $5,629,000 in 1996. The decrease of approximately
$534,000 is attributable to a decrease in revenue of approximately $32,000 in
1997 as compared to 1996, and a decrease in expenses of approximately $566,000
in 1997 as compared to 1996.

     Revenues decreased slightly from 1996 to 1997 due to several factors: 1) a
one-time joint venture fee of $1,000,000 received in 1996 which was not repeated
in 1997; 2) an increase in contract revenues of $489,000 from the increased
level of technical subcontract work the Company performed for KFP, and 3) 

                                       16
<PAGE>
 
an increase in interest and other income of $479,000 as a result of overall
higher cash balances resulting from the Debenture Offering, and certain payable
write-offs. The Company will perform additional technical subcontract work for
KFP through the second quarter of 1998, although the dollar amount of such work
in not currently determinable. The decrease in technical subcontract work
performed for K-Fuel LLC in 1997 was expected given the planned schedule and
timing of the K-Fuel LLC Initial Work Plan.

     Expenses decreased by approximately $566,000 in 1997 as compared to 1996.
The components of the overall decrease in expenses are summarized as follows
(all figures are approximate):

<TABLE>
<S>                                                                             <C>
Decrease in marketing, general and administrative expenses....................   $ 569,000
Write-down of mine property and reclamation costs                      
   Incurred in 1996...........................................................     701,000
Increase in depreciation and amortization expense.............................    (108,000)
Increase in research and development / laboratory operating expenses..........     (52,000)
Increase in equity loss of unconsolidated affiliates..........................    (182,000)
Increase in interest expense..................................................    (362,000)
                                                                                 ---------
      Net decrease in expenses................................................   $ 566,000
                                                                                 =========
</TABLE>

     Marketing, general and administrative expenses decreased by approximately
$569,000 in 1997 compared to 1996 primarily as a result of (1) personnel
reductions in 1997 which decreased salaries and wages by approximately $220,000;
(2) an overall decrease in professional fees in 1997 by approximately $487,000;
and (3) reduction of travel expenses in 1997 by approximately $100,000. These
decreases were partially offset by an overall increase in other general and
administrative expenses in 1997 of approximately $238,000.

     The decrease in salaries and wages in 1997 is attributable to the Company
implementing a personnel reduction program in which the total number of
employees of the Company was reduced from 17 in 1996 to 12 in 1997 (reduction of
3 executive positions and 2 administrative positions). Professional fees
decreased in 1997 primarily due to $340,000 of legal expenses related to the K-
Fuel, LLC joint venture agreement incurred in 1996. The increase in general and
administrative expenses is primarily due to (1) a one-time charge of $163,000 to
write-off previously capitalized project development expenses associated with
the previously planned KFP II Project; (2) approximately $100,000 of internal
costs associated with the Debenture Offering and permitting costs related to the
Company's coal mining property adjacent to the KFP Facility; offset by a one-
time payment of a $50,000 listing fee with the American Stock Exchange incurred
only in 1996.

     The mine property and reclamation costs write-down of $701,000 relating to
the Company's coal mine located near Gillette, Wyoming was a one-time expense
incurred only in 1996. No additional material write-downs are expected in 1998.
In addition, the Company does not expect to incur any additional material
reclamation costs in 1998.

     The increase in depreciation and amortization expense in 1997 is primarily
attributable to the Company's re-evaluation of the depreciable useful lives of
certain demonstration plant and laboratory equipment located in Gillette,
Wyoming (approximately $216,000), the amortization of Debenture Offering costs
beginning in August 1997 (approximately $205,000), offset by the amortization of
a consulting contract in 1996 of approximately $281,000.

     The increase in research and development and laboratory expenses is
attributable to increased efforts associated with overall project developments
activities, with particular emphasis on the activated carbon program, the
proposed projects in Indonesia and Turkey, and the start-up of the KFP Facility.
The Company will continue to perform such services for these projects in 1998,
although the amount and scope of such work is not currently determinable.

     The increase in equity loss of unconsolidated affiliates relates to losses
the Company recognized for its 51 percent share of the marketing, general and
administrative expenses of K-Fuel LLC for a full year 

                                       17
<PAGE>
 
in 1997 versus a partial year in 1996. The Company will continue marketing
efforts through K-Fuel LLC, and as the KFP Facility becomes fully operational,
these expenses are expected to increase in 1998.

     The increase in interest expense is attributable to the Debenture Offering
completed in July 1997 which has resulted in monthly interest of $85,000
beginning in August 1997.  The Company incurred $425,000 of interest expense
related to this debt in 1997.  This was partially offset by overall lower levels
of other debt in 1997.

Year Ended December 31, 1996 vs. Year Ended December 31, 1995

     The Company had a net loss before income tax benefits and extraordinary
item of approximately $5,629,000 in 1996 as compared to a loss of approximately
$8,796,000 in 1995. The decrease of approximately $3,167,000 is attributable to
an increase in revenue of approximately $1,388,000 in 1996 as compared to 1995,
and a decrease in expenses of approximately $1,779,000 in 1996 as compared to
1995. In 1996, the Company had no debt extinguishment gains and related income
tax benefits, as compared to such gains in 1995 totaling approximately
$2,567,000. Including such gains in 1995, overall net loss decreased from
approximately $6,229,000 in 1995 to approximately $5,629,000 in 1996.

     Revenues increased in 1996 because of the one-time joint venture fee of
$1,000,000, as well as approximately $360,000 in technical subcontract work the
Company performed for K-Fuel LLC beginning in mid-1996. As the K-Fuel LLC joint
venture commenced in 1996, there were no comparable figures in 1995.

     Expenses decreased by approximately $1,779,000 in 1996 as compared to 1995.
The components of the overall decrease in expenses are summarized as follows
(all figures are approximate):
 
<TABLE>
<S>                                                                        <C>
Decrease in marketing, general and administrative expenses...............      $  899,000
One-time litigation charge and performance fee in 1995...................       1,760,000
Decrease in interest expense.............................................         493,000
Increase in depreciation and amortization expense........................        (204,000)
Increase in equity loss of unconsolidated affiliates.....................         (86,000)
Increase in research & development / laboratory operating expenses ....          (382,000)
Write-down of mine property and reclamation costs                         
     incurred in 1996....................................................        (701,000)
                                                                               ----------
          Net decrease in expenses.......................................      $1,779,000
                                                                               ==========
</TABLE>
                                                                                
     Marketing, general and administrative expenses decreased approximately
$899,000 in 1996 as compared to 1995 primarily as a result of (1) an overall
decrease in professional services fees in 1996 of approximately $859,000 and (2)
a decrease in board of director compensation expense in 1996 of approximately
$178,000.  This decrease was partially offset by an overall increase in payroll
and general administrative expenses in 1996 totaling approximately $138,000.

     The decrease in professional services fees in 1996 is generally
attributable to certain stock-based compensation agreements incurred only in
1995 relating to certain marketing and public relations activities.  However,
legal fees increased by approximately $177,000 in 1996 to a total of
approximately $693,000, of which approximately $340,000 was specifically
attributable to the K-Fuel LLC joint venture agreement in 1996 and for which no
further significant legal expense is expected in 1997.  The decrease in board of
director compensation in 1996 is attributable to a change of compensation policy
beginning in 1996. The increase in payroll and general and administrative
expenses in 1996 is attributable to the hiring of two executive employees in
1996 and the Company doubling its Denver, Colorado headquarters office space in
the fourth quarter 1995.
 
     The litigation settlement ($800,000) and success fees relating to the
closing of the KFP Project ($960,000) were one-time expenses incurred in 1995
only.

                                       18
<PAGE>
 
     The decrease in interest expense in 1996 is attributable to the significant
decrease in outstanding debt in 1996 as compared to 1995. Total debt outstanding
has decreased to $1,225,000 at December 31, 1996 from approximately $1,614,000
at December 31, 1995, and from approximately $4,835,000 at December 31, 1994.

     The increase in depreciation and amortization expense in 1996 is
attributable to the full year of amortization of the Series "C" patents acquired
in the third quarter of 1995 and the depreciation of certain property and
equipment additions in 1996 at the Company's demonstration and laboratory
facility.

     The increase in equity loss of unconsolidated affiliates is due to the
first year in which the Company recognized losses for its 51 percent share of
the marketing, general and administrative expenses of K-Fuel LLC.
 
     The increase in research and development and laboratory operating expenses
in 1996 is attributable to the K-Fuel LLC technical subcontract services
performed in 1996 only.

     The write-down of mine property and reclamation costs incurred in 1996 are
attributable to the Company's mining property near Gillette, Wyoming. This
property was acquired by the Company in 1995 and was related to its
participation in the KFP Project. The Company had intended to sell this
property. However, in 1996 the Company determined that it would not sell the
property but would retain it to hold the mining property as a reserve coal
supply for the KFP Project to protect against any raw coal feedstock
disruptions. Also in 1996, the Company reassessed the value of this asset and
wrote-down the value of the property to its current estimated value.
Additionally, the Company increased its reclamation reserve related to the
property by approximately $134,000 in 1996 because of more accurate reclamation
studies performed in 1996 and certain regulatory changes enacted by the State of
Wyoming.

LIQUIDITY AND CAPITAL RESOURCES

     Working capital increased from a deficit of approximately $167,000 at
December 31, 1996 to a surplus of approximately $12,565,000 at December 31,
1997. The increase is primarily attributable to $2.5 million in proceeds from
the sale of Common Stock to TCK in January 1997 and approximately $15.1 million
in net proceeds from the Debenture Offering.

     The Company expects no additional stock purchases by TCK in 1998 or 1999.
Under the terms of the Stock Purchase Agreement, the next possible investment by
TCK is not until a period of time beginning in January 2000 and expiring in July
2001. There are no assurances that TCK will make any investments in the Company
at that time. Additionally, the Stock Purchase Agreement prohibits the Company
from issuing shares of Common Stock to other investors unless at least 90
percent of the proceeds from such stock issuances are used to invest in K-Fuel
production facilities. Furthermore, in the event of any stock issuances by the
Company, TCK's Warrant "A" may be subject to certain adjustments that increase
the number of shares available to TCK under Warrant "A." See "ITEM 1 - 
BUSINESS - Strategic Relationships - Thermo Ecotek Corporation."

     The Company may be required to seek additional debt and / or equity
financing as early as the second or third quarter of 1999 for general operating
purposes or for capital investments. Factors that may reduce or eliminate the
need for additional financing in 1999 are as follows: (1) license fees from
proposed K-Fuel projects in Indonesia and Turkey; (2) cash flow distributions
from the Company's 60 percent ownership of Pegasus; (3) cash flow distributions
from Charco; and (4) a sale of all or a portion of the Company's 5 percent
ownership interest in KFP.

     The Company expects no material net operating revenues from its ownership
interest in KFP in the foreseeable future. Additionally, the Company's net
production royalties (after fulfilling related royalty obligations) once the KFP
Facility reaches full production is projected to be less than $200,000 per year.
The Section 29 tax credit available for the KFP production of K-Fuel at full
capacity could result in an opportunity to sell the Company's interest to TCK or
other third parties; the Company intends to try to retain its production royalty
following any such sale. The value, amount or possibility of any such sale
                                       19
<PAGE>
 
will not be determinable until KFP reaches its full productive capacity,
currently expected to be in the third or fourth quarter of 1998.
 
     Should the Company be required to seek any additional debt or equity
financing, the ability of the Company to do so may be affected by an existing
agreement with TCK and by the terms of the Indenture.  With respect to TCK, the
Company must obtain TCK's consent to sell any Common Stock or to incur any
indebtedness other than indebtedness that is secured only by the assets of a
particular project and is non-recourse to the Company and its subsidiaries.
With respect to the Indenture, the Company may only incur unsecured indebtedness
of up to $8.0 million (of which approximately $1.4 million was outstanding as of
March 24, 1998) and indebtedness secured only by the assets of a particular
project and is non-recourse to the Company and its subsidiaries.

     There are no assurances that any of these potential funding sources will
materialize, and the Company does not currently have any commitments with
respect to any such funding sources. If such events do not materialize, the
Company may be forced to seek debt and / or equity financing on terms and
conditions that may not be favorable to the Company, if available at all.
 
YEAR 2000 COMPLIANCE

     Like many other companies, the Company is aware of the problems associated
with "The Year 2000 Issue." This issue centers on certain computer systems being
unable to recognize the year 2000 as a valid date or may interpret a date in the
format of "00" as the year 1900 rather than the year 2000. This system issue
creates risk for the Company from unforeseen problems in its own computer
systems and from third parties with which the Company deals. Such failures of
the Company and/or third parties' computer systems could potentially have a
material impact on the Company's ability to conduct its business. Based on
interviews with and publications from those vendors supplying the Company's
current business information systems, management believes those systems to be
date compliant such that they will not pose a significant risk to the Company's
future business operations. Future version upgrades to these systems and/or new
acquisitions will be subjected to Year 2000 date compliance as selection,
acceptance, and installation criteria.

     During 1998, the Company will assess any impact the Year 2000 issue may
have on other systems that support the Company's operation. These can include,
but are not limited to, supplier systems, shipper systems, environmental control
systems, manufacturing equipment, building security systems, etc. The Company
will evaluate appropriate courses of corrective action if any are needed outside
of routine maintenance or currently planned projects.

     The Company has made an initial assessment of the Year 2000 issue and
related potential effects on the Company's operations, and has determined that
it will not have a material effect on its financial position or results of
operations.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

     The consolidated financial statements and notes thereto included in this
item are indexed on page F-1 "Index to Consolidated Financial Statements."

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURES

     There were no changes in or significant disagreements with the Company's
independent accountants in 1997.

                                       20
<PAGE>
 
                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS

ITEM 11.  EXECUTIVE COMPENSATION

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by items 10 through 13 is set forth under the
captions "Election of Directors," "Executive Officers," "Executive
Compensation," "Stock Ownership," and "Related Party Transactions" in the
Company's definitive proxy statement to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of
1934, as amended, not later than 120 days after the close of the Company's
fiscal year on December 31, 1997, and is incorporated by reference as if set
forth in full.

                                       21
<PAGE>
 
                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(1)  EXHIBITS LIST

     The following exhibits are filed herewith or are incorporated by reference
to exhibits previously filed with the Securities and Exchange Commission. The
Company shall furnish copies of exhibits for a reasonable fee (covering the
expense of furnishing copies) upon written request.

<TABLE>
<CAPTION>
EXHIBIT NO.                                    DESCRIPTION                               PAGE NUMBER
----------------------------------------------------------------------------------------------------
<S>               <C>                                                                   <C>
3.1 /(1)/         Restated Certificate of Incorporation of the Company                        -
3.2 /(1)/         Certificate of Amendment to Certificate of Incorporation of                 -
                    the Company                                                             
3.3 /(5)/         Second Amended and Restated Bylaws of the Company                           -
4.1 /(5)/         Sample Common Stock Certificate                                             -
4.2*              Indenture dated July 25, 1997 by and between the Company and                -
                    Colorado National Bank                                                  
10.1 /(1)/        Amendments to Agreements between Theodore Venners,                          -
                    S.A. Wilson, Koppelman Fuel Development Company, and                    
                    the Koppelman Group dated December 29, 1992                             
10.2 /(1)/        Assignment of U.S. Patents by K-Fuel Limited Partnership to the             -
                    Company dated July 23, 1993                                             
10.3 /(1)/        Assignment of U.S. Trademark Registration by K-Fuel Limited                 -
                    Partnership to the Company dated July 23, 1993                          
10.4 /(1)/        Royalty Agreement dated December 29, 1992 between the Company               -
                    and the Koppelman Group                                                 
10.5 /(1)/        Agreement dated December 19, 1991 among K-Fuel Partnership,                 -
                    Edward Koppelman, K-Fuel Limited Partnership and KSA Inc.               
10.6 /(1)/        Atlantic Partners License dated April 15, 1992 between K-Fuel               -
                    Limited Partnership and Atlantic Partners                               
10.7 /(1)/        Lease Agreement dated June 24, 1993 between Equitable Life                  -
                    Assurance Society of the United States and the Company                  
10.8 /(5)/        Fourth Amendment to Office Lease dated August 17, 1995 between              -
                    1999 Broadway Partnership and the Company                               
10.9 /(1)/        Restricted Stock Plan for Directors and Selected Officers dated             -
                    December 16, 1993                                                       
10.10 /(4)/       Restricted Stock Plan for Selected Independent Contractors dated            -
                    February 16, 1994                                                       
10.11 /(1)/       Stock Option Plan dated December 16, 1993                                   -
10.12 /(1)/       Settlement Agreement dated December 14, 1992                                -
10.13 /(1)/       Stock Exchange Agreement Dated December 14, 1992                            -
10.14 /(1)/       Stipulation and Agreement dated February 28, 1994 between Energy            -
                    Brothers Technology, Inc., State of Wyoming, the Company,               
                    Theodore Venners, Edward Koppelman and Energy                           
                    Brothers Holding, Inc.                                                  
10.15 /(4)/       Internal Revenue Service Private Letter ruling dated March 20, 1995         -
10.16 /(4)/       Extension of Stock Forfeiture Agreement between Theodore Venners            -
                    and Rudolph G. Swenson; Joyce M. Goldman; David Bretzlauf;              
                    Joseph M. Butler; R.C. Whitner; Hillari Koppelman; Thomas D.            
                    Smart and Susan M. Thevenet; Charles F. Vance                           
10.17 /(2)/       Stock Purchase Agreement dated August 18, 1995 between the                  -
                    Company and Thermo Ecotek Corporation                                   
</TABLE>
 
                                       22
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT NO.                                    DESCRIPTION                               PAGE NUMBER
----------------------------------------------------------------------------------------------------
<S>               <C>                                                                   <C>
10.18 /(2)/       Stock Purchase Warrants dated August 18, 1995 between the                   -
                    Company and Thermo Ecotek Corporation                                    
10.19 /(2)/       Stockholders' Voting and Co-Sale Agreement dated August 18, 1995            -
                    among the Company, Thermo Ecotek Corporation and                         
                    Theodore Venners.                                                        
10.20 /(2)/       Registration Rights Agreement dated August 18, 1995 between the             -
                    Company and Thermo Ecotek Corporation                                    
10.21 /(3)/       Limited Partnership Agreement of KFX Fuel Partners, L.P.                    -
                    dated August 18, 1995                                                    
10.22 /(3)/       Letter Agreement dated August 18, 1995 between Eco Fuels, Inc.              -
                    and KFX Wyoming, Inc. regarding the Management, Operations               
                    and Maintenance Agreement                                                
10.23 /(3)/       Gross Royalty Share Agreement dated August 17, 1995 between                 -
                    the Company and Fort Union, Ltd.                                         
10.24 /(3)/       Indemnity Agreement dated August 18, 1995 between the Company               -
                    and Thermo Ecotek Corporation                                            
10.25 /(3)/       Letter of Agreement dated August 15, 1995 between the Company               -
                    and Edward Koppelman                                                     
10.26 /(3)/       Assignment dated August 29, 1995 executed by Edward Koppelman               -
                    in favor of the Company                                                  
10.27 /(3)/       Promissory Note dated August 25, 1995 executed by the Company               -
                    in favor of Edward Koppelman                                             
10.28 /(3)/       Patent and Technology License dated August 17, 1995 between                 -
                    Edward Koppelman and KFX Fuel Partners, L.P.                             
10.29 /(3)        Notice of Termination dated August 16, 1995 between Edward                  -
                    Koppelman and Energy Brothers Holding, Inc.                              
10.30 /(5)/       Letter Agreement dated February 28, 1995 between RCD                        -
                    Development and the Company                                              
10.31 /(6)/       Limited Liability Company Agreement of K-Fuel, L.L.C.                       -
                    dated April 19, 1996                                                     
10.32 /(6)        Pledge Agreement executed by Theodore Venners in favor of                   -
                    Kennecott Energy and Coal Company dated April 19, 1996                   
10.33 /(6)/       Letter Agreement between Theodore Venners and Kennecott                     -
                    Energy and Coal Company dated April 22, 1996                             
10.34 /(6)/       Amended and Restated Heartland License Agreement between                    -
                    Heartland Fuels Corporation and the Company dated                        
                    April 19, 1996                                                           
10.35 /(7)/       Royalty Amendment Agreement dated June 3, 1996 between the                  -
                    Company, Edward Koppelman and Theodore Venners                           
10.36 /(7)/       Promissory Note to Edward Koppelman dated June 3, 1996                      -
10.37 /(8)/       Design-Build Agreement between the Company and Yanke Energy              
                    dated December 30, 1996                                                   -
10.38 /(8)/       Amendment to Agreement between the Company and                           
                    RCD Development dated January 16, 1997                                    -
10.39 /(*)/       Purchase Agreement dated March 23,  1998 among the Company and              -
                    Pegasus Technologies, Ltd. and the Lucier Group and The Radl Group       
10.40 /(*)/       Amended and Restated Operating Agreement of Pegasus Technologies            -
                    dated March 23, 1998                                                     
21.1 /(*)/        Subsidiaries                                                               26
23.1 /(*)/        Consent of Independent Accountants                                         27
27.1 /(*)/        Financial Data Schedule                                                     -
</TABLE>
____________________

                                      23
<PAGE>
 
<TABLE>
<S>      <C>
/(*)/    Filed herewith.
/(1)/    Document previously filed with the U.S. Securities and Exchange Commission on March 1, 1994
           as an exhibit to the Company's Form 10-SB and incorporated herein by reference.
/(2)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Current Report on Form 8-K dated August 18, 1995 and incorporated herein
           by reference.
/(3)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Registration Statement on Form SB-2 (File No. 33-97418) and incorporated
           herein by reference.
/(4)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Registration Statement on Form SB-2 (File No. 33-90128) and incorporated
           herein by reference.
/(5)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Annual Report on Form 10-KSB, as amended, for the year ended December
           31, 1995 and incorporated herein by reference.
/(6)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Current Report on Form 8-K dated April 19, 1996 and incorporated herein
           by reference.
/(7)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996
           and incorporated herein by reference.
/(8)/    Document previously filed with the U.S. Securities and Exchange Commission with the
           Company's Annual Report on Form 10-K for the year ended December 31, 1996
           and incorporated herein by reference.
</TABLE>

(2)  FINANCIAL STATEMENT SCHEDULES
 
     NA - None.

(3)  REPORTS ON FORM 8-K

     No reports on Form 8-K were filed by the Registrant during the quarter
     ended December 31, 1997.

                                      24
<PAGE>
 
                                   SIGNATURES

     PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

                                   KFX INC.

<TABLE>
<S>                                                     <C>
Date:  March 24, 1998                                    By:  /s/ Theodore Venners
                                                              ------------------------------------------------
                                                              Theodore Venners
                                                              Chairman of the Board of Directors
                                                              President and Chief Executive Officer
</TABLE>

     PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.

<TABLE>
<S>                                                     <C>
Date:  March 24, 1998                                    By:  /s/ Jeffrey A. Hansen
                                                              ------------------------------------------------
                                                              Jeffrey A. Hansen
                                                              Chief Financial Officer
 
Date:  March 24, 1998                                    By:  /s/ Rudolph G. Swenson
                                                              ------------------------------------------------
                                                              Rudy G. Swenson
                                                              Secretary and Treasurer
 
Date:  March 24, 1998                                    By:  /s/ Vincent N. Cook
                                                              ------------------------------------------------
                                                              Vincent N. Cook
                                                              Director
 
Date:  March 24, 1998                                    By:  /s/ Brian D. Holt
                                                              ------------------------------------------------
                                                              Brian D. Holt
                                                              Director
 
Date:  March 24, 1998                                    By:  /s/ Peter G. Martin
                                                              ------------------------------------------------
                                                              Peter G. Martin
                                                              Director
 
Date:  March 24, 1998                                    By:  /s/ Jack C. Pester
                                                              ------------------------------------------------
                                                              Jack C. Pester
                                                              Director
 
Date:  March 24, 1998                                    By:  /s/ Stanley G. Tate
                                                              ------------------------------------------------
                                                              Stanley G. Tate
                                                              Director
</TABLE>

                                      25
<PAGE>
 
                          SUBSIDIARIES - EXHIBIT 21.1


<TABLE>
<CAPTION>
                                      ADDRESS OF PRINCIPAL        STATE OF INCORPORATION       PERCENTAGE
SUBSIDIARY                              PLACE OF BUSINESS             OR ORGANIZATION           OWNERSHIP
------------------------------------------------------------------------------------------------------------
<S>                               <C>                            <C>                        <C>
KFX Technology, Inc.              3574 Garner Lake Road                   Wyoming                     99.8  %
                                  Gillette, Wyoming  82716
 
KFX Wyoming, Inc.                 1999 Broadway                           Wyoming                    100.0  %
                                  Suite 3200
                                  Denver, CO  80202
 
Atlantic Partners L.L.C. /(*)/    1999 Broadway                          Colorado                     83.0  %
                                  Suite 3200
                                  Denver, CO  80202
 
Heartland Fuels Corporation /(*)/ 1999 Broadway                          Wisconsin                    85.0  %
                                  Suite 3200
                                  Denver, CO  80202
 
K-Fuel L.L.C.                     1999 Broadway                          Delaware                     51.0  %
                                  Suite 3200
                                  Denver, CO  80202
 
KFX Fuel Partners II, L.P. /(*)/  1999 Broadway                          Delaware                    100.0  %
                                  Suite 3200
                                  Denver, CO  80202
 
KFX Bohemia, s.r.o. /(*)/         1999 Broadway                       Czech Republic                  100.0 %
                                  Suite 3200
                                  Denver, CO  80202
 
KSA Partnership /(*)/             1999 Broadway                          Delaware                      67.0 %
                                  Suite 3200
                                  Denver, CO  80202
 
Pegasus Technologies, Ltd.        1100 Mentor Avenue                       Ohio                        60.0 %
                                  Painesville, OH  44077
</TABLE>

/(*)/   Entity is substantially inactive with no significant assets or revenues.

                                       26
<PAGE>
 
               CONSENT OF INDEPENDENT ACCOUNTANTS - EXHIBIT 23.1
                                        
We hereby consent to the incorporation by reference in the Prospectuses
constituting part of the Registration Statement on Form S-3 (No. 333-4298), the
Registration Statement on Form S-3 (No. 333-28129) and the Registration
Statement on Form S-8 (No. 333-9873) of KFX Inc. of our report dated March 31,
1998 appearing on page F-2 of this Form 10-K.

PRICE WATERHOUSE LLP

Denver, Colorado
April 10, 1998

                                       27
<PAGE>
 
                                    KFX INC.

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
<S>                                                                        <C> 
Report of Independent Accountants                                                  F-2
Consolidated Balance Sheets..........................................              F-3
Consolidated Statements of Operations................................              F-4
Consolidated Statements of Stockholders' Equity......................              F-5
Consolidated Statements of Cash Flows................................       F-6 to F-7
Notes to Consolidated Financial Statements...........................      F-8 to F-22
</TABLE>
                                                                                

                                      F-1
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS


To the Board of Directors and
     Stockholders of KFX Inc:

     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity and of
cash flows present fairly, in all material respects, the financial position of
KFX Inc. and its subsidiaries at December 31, 1997 and 1996, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles. 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 these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, 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 the opinion expressed
above.

PRICE WATERHOUSE LLP

Denver, Colorado
March 31, 1998

                                      F-2
<PAGE>
 
                                    KFX INC.

                          CONSOLIDATED BALANCE SHEETS
<TABLE>                             
<CAPTION> 
                                                                                        DECEMBER 31,         
                                                                             ----------------------------------
                                                                                   1997                1996
                                ASSETS                                        ------------        -------------
                                ------
<S>                                                                      <C>                 <C>
Current:
  Cash and cash equivalents............................................       $ 14,078,773        $   1,403,625
  Accounts receivable..................................................            220,729              447,230
  Accrued interest.....................................................             52,000                  -- 
  Prepaid expenses.....................................................            109,696              106,150
                                                                              ------------        -------------
     Total current assets..............................................         14,461,198            1,957,005
                                                                              ------------        -------------
Property, plant and equipment, net of accumulated depreciation.........          4,458,305            5,458,801
Patents, net of accumulated amortization...............................          3,087,853            3,662,894
Investment in and advances to KFX Fuel Partners, L.P...................          3,787,138            2,792,304
Investment in K-Fuel, L.L.C............................................            224,016              157,180
Debt issue costs, net of accumulated amortization......................          2,230,565                    -
Prepaid royalty........................................................            500,000              500,000
Other assets...........................................................            308,631              395,383
                                                                              ------------        -------------
                                                                              $ 29,057,706        $  14,923,567
                                                                              ============        =============
             LIABILITIES AND STOCKHOLDERS' EQUITY
             ------------------------------------
Current:
  Accounts payable.....................................................       $    363,881        $   1,041,800
  Accrued expenses.....................................................            190,001              166,651
  Due to related parties...............................................            557,522              707,756
  Interest payable.....................................................            504,421               92,319
  Current maturities of long-term debt.................................            280,000              115,000
                                                                              ------------        -------------
     Total current liabilities.........................................          1,895,825            2,123,526
                                                                              ------------        -------------
Long-term debt, less current maturities................................            500,000            1,110,000
Convertible debentures.................................................         17,000,000                    -
Mine reclamation liability.............................................          1,166,000            1,166,000
                                                                              ------------        -------------
     Total liabilities.................................................         20,561,825            4,399,526
                                                                              ------------        -------------
 
Commitments and contingencies (Notes 2,4,5,7,14,16)
 
Stockholders' equity:
  Preferred stock, $.001 par value, 20,000,000 shares authorized;
     none issued.......................................................                --                   --
  Common stock, $.001 par value, 80,000,000 shares authorized;
     23,926,040 and 22,676,040 shares issued and outstanding...........             23,926               22,676
  Additional paid-in capital...........................................         47,758,843           44,693,093
  Accumulated deficit..................................................        (39,286,888)        ( 34,191,728)
                                                                              ------------        -------------
     Total stockholders' equity........................................          8,495,881           10,524,041
                                                                              ------------        -------------
                                                                              $ 29,057,706        $  14,923,567
                                                                              ============        =============
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-3
<PAGE>
 
                                    KFX INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
                                                                              YEAR ENDED DECEMBER 31,           
                                                                 -------------------------------------------------
                                                                    1997                1996              1995
                                                                 -----------        -----------        -----------
<S>                                                              <C>                <C>                <C>
Joint venture fee.......................................         $       --         $ 1,000,000        $       -- 
Contract revenue........................................           1,084,823            596,298            254,363
Interest and other income...............................             650,353            171,269            124,959
                                                                 -----------        -----------        -----------
  Total revenue and other income........................           1,735,176          1,767,567            379,322
                                                                 -----------        -----------        -----------
Marketing, general and administrative expenses..........           2,795,121          3,364,574          4,264,034
Performance fees related to investment in                                                         
  KFX Fuel Partners, L.P................................                 --                 --             960,000
Litigation settlement...................................                 --                 --             800,000
Research and development................................             493,723            465,166            444,329
Demonstration plant and laboratory operations...........             756,969            733,268            371,921
Write-down of mine property and reclamation costs.......                 --             700,500                -- 
Equity in loss of unconsolidated affiliates.............             267,977             86,572                -- 
Depreciation and amortization...........................           1,969,561          1,861,164          1,657,385
Interest expense........................................             546,985            184,864            677,582
                                                                 -----------        -----------        -----------
  Total expenses........................................           6,830,336          7,396,108          9,175,251
                                                                 -----------        -----------        -----------
Loss before income taxes and extraordinary item.........          (5,095,160)        (5,628,541)        (8,795,929)
Income tax benefit......................................                 --                 --             872,851
                                                                 -----------        -----------        -----------
Loss before extraordinary item..........................          (5,095,160)        (5,628,541)        (7,923,078)
Extraordinary item:                                                                               
  Gain from debt extinguishment, net of income taxes                                              
     of $872,851........................................                 --                 --           1,694,358
                                                                 -----------        -----------        -----------
  Net loss..............................................         $(5,095,160)       $(5,628,541)       $(6,228,720)
                                                                 ===========        ===========        ===========
Basic and diluted net income (loss) per common share:                                             
  Before income taxes and extraordinary item............               $(.21)             $(.25)             $(.47)
  Income tax benefit and extraordinary item.............                 --                 --                 .14
                                                                 -----------        -----------        -----------
  Net loss..............................................               $(.21)             $(.25)             $(.33)
                                                                 ===========        ===========        ===========
Weighted average common shares outstanding:                       23,820,000         22,458,000         18,578,000
                                                                 ===========        ===========        ===========
</TABLE>
                                                                                



  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-4
<PAGE>
 
                                    KFX INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


                                        
<TABLE>
<CAPTION>
                                                                               
                                                  COMMON STOCK          ADDITIONAL                     
                                             ----------------------      PAID-IN       ACCUMULATED 
                                              SHARES        AMOUNT       CAPITAL         DEFICIT
                                            ----------     --------    ------------   -------------     
<S>                                      <C>              <C>              <C>                 <C>
Balance, December 31, 1994.............     16,789,192     $16,789     $25,907,797    $(22,334,467)
                                                                                  
Stock issued for cash..................      4,377,365       4,377      10,092,498
Stock issued for promissory notes                                                 
  and accrued interest payable.........        374,727         375       1,580,348                   
Stock issued for services and board                                                                  
  of director fees.....................        233,090         233       1,146,298                   
Stock options and warrants issued                                                                    
  for services.........................            --          --          840,000                   
Stock issued for litigation settlement.         10,000          10          49,990                   
Stock of director and officer exchanged                                                              
  for litigation settlement............            --          --          750,000                   
Stock issued to acquire controlling                                                                  
  Interest in Heartland Fuels Corp.....        375,000         375       1,874,625                   
Discount on issuance of promissory                                                                   
  notes converted to common stock......            --          --           52,000                   
Net loss...............................            --          --              --       (6,228,720)    
                                            ----------     -------     -----------    ------------     
Balance, December 31, 1995.............     22,159,374      22,159      42,293,556     (28,563,187)
                                                                                  
Stock issued for cash..................        382,000         382       1,449,498                   
Stock issued for services and board                                                                  
  of director fees.....................        134,666         135         650,039                   
Warrants issued for services...........            --          --          300,000                   
Net loss...............................            --          --              --       (5,628,541)   
                                            ----------     -------     -----------    ------------     
Balance, December 31, 1996.............     22,676,040      22,676      44,693,093     (34,191,728)     
                                                                                                      
Stock issued for cash..................      1,250,000       1,250       2,498,750                    
Warrants issued in connection with                                                                    
  Placement of convertible debentures..            --          --          567,000                    
Net loss...............................            --          --              --       (5,095,160)   
                                            ----------     -------     -----------    ------------     
Balance, December 31, 1997.............     23,926,040     $23,926     $47,758,843    $(39,286,888)   
                                            ==========     =======     ===========    ============     
</TABLE>
                                                                                



  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-5
<PAGE>
 
                                    KFX INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                        

                            
<TABLE>
<CAPTION>
                                                                         YEAR ENDED DECEMBER 31,
                                                               ------------------------------------------
                                                                   1997            1996           1995
                                                               -----------     -----------    -----------
<S>                                                            <C>             <C>           <C>
OPERATING ACTIVITIES:                                                                      
  Net loss..............................................       $(5,095,160)   $(5,628,541)   $(6,228,720)
  Adjustments to reconcile net loss to cash                                               
     Used in operating activities:                                                        
      Income tax benefit and extraordinary item.........               --             --      (2,567,209)
      Depreciation and amortization.....................         1,969,561      1,861,164      1,657,385
      Write-down of mine property and                                                     
       reclamation costs................................               --         700,500            -- 
      Amortization of discount on notes payable.........               --             --         273,000
      Equity in loss of unconsolidated affiliates.......           267,977         86,572            -- 
      Common stock issued for services..................               --             --         713,919
      Stock options and warrants issued for services....               --         237,500        840,000
      Common stock issued by the Company and a                                            
       director and officer to settle litigation........               --             --         800,000
      Promissory notes exchanged for services...........               --             --          30,000
      Other, net........................................           (16,197)           --        (105,794)
  Changes in operating assets and liabilities:                                            
      Accounts receivable and prepaid expenses..........          (155,332)      (669,687)        62,918
      Interest receivable...............................           (52,000)           --             -- 
      Trade and related party payables..................          (590,715)       569,925        120,685
      Accrued interest and other liabilities............           435,452        (28,886)       720,797
      Prepaid royalty...................................               --        (300,000)           -- 
      Other.............................................           (95,281)       (37,431)           -- 
                                                               -----------    -----------    -----------
Cash used in operating activities.......................        (3,331,695)    (3,208,884)    (3,683,019)
                                                               -----------    -----------    -----------
INVESTING ACTIVITIES:                                                                     
  Reclamation deposit...................................               --       1,503,032     (1,503,032)
  Patents acquisition and pending patent applications...           (59,260)       (35,918)    (1,092,652)
  Investments in K-Fuel, L.L.C..........................          (334,813)      (243,752)           -- 
  Investments in KFX Fuel Partners, L.P.................          (733,120)           --        (107,114)
  Acquisition of Heartland Fuels Corporation stock......               --             --        (100,000)
  Purchases of property and equipment...................           (16,175)      (211,700)       (70,656)
  Other.................................................           (36,224)      (130,221)        (8,180)
                                                               -----------    -----------    -----------
Cash provided by (used in) investing activities.........        (1,179,592)       881,441     (2,881,634)
                                                               -----------    -----------    -----------
FINANCING ACTIVITIES:                                                                     
  Net proceeds from sale of common stock................         2,500,000      1,449,880     10,096,875
  Proceeds from issuance of notes/debentures............        17,000,000            --       1,490,000
  Debenture placement fees..............................        (1,868,565)           --             -- 
  Payments on promissory notes..........................          (445,000)      (588,851)    (2,231,447)
                                                               -----------    -----------    -----------
Cash provided by financing activities...................        17,186,435        861,029      9,355,428
                                                               -----------    -----------    -----------
                                                                                          
Increase (decrease) in cash and cash equivalents........        12,675,148     (1,466,414)     2,790,775
Cash and cash equivalents, beginning of period..........         1,403,625      2,870,039         79,264
                                                               -----------    -----------    -----------
Cash and cash equivalents, end of period................       $14,078,773    $ 1,403,625    $ 2,870,039
                                                               ===========    ===========    ===========
</TABLE>
                                                                                

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-6
<PAGE>
 
                                    KFX INC.

              CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED)


                                
<TABLE>
<CAPTION>
                                                                 YEARS ENDED DECEMBER 31, 
                                                            ---------------------------------- 
                                                              1997         1996         1995
                                                            --------     --------     --------
<S>                                                         <C>          <C>          <C> 
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                   
  Cash paid for interest ...............................    $134,605     $157,404     $297,821
</TABLE>

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

See Notes 2,3,4,7,9,10, 11, 12 and 13.






  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-7
<PAGE>
 
                                    KFX INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                        
NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     The consolidated financial statements include the accounts of KFX Inc.
("KFX" or the "Company"), its wholly-owned subsidiary, KFX Wyoming, Inc.
("KFXW"), and its majority-owned subsidiaries, KFX Technology, Inc. ("KFXT",
formerly Energy Brothers Technology, Inc.), Atlantic Partners, Ltd. ("APL"), and
Heartland Fuels Corporation ("HFC").  The Company's 67 percent interest in KSA
Partnership ("KSA"), its 51 percent interest in K-Fuel, L.L.C. ("K-Fuel LLC"),
and its 5 percent interest in KFX Fuel Partners, L.P. ("KFP") are accounted for
as equity investments as the Company does not have the authority or ability to
independently control or manage these entities. All significant intercompany
transactions have been eliminated in consolidation.

     The Company holds patents to the K-Fuel Technology which enhances the
combustion characteristics of coal and other carbonaceous fuels.  The Company
intends to generate revenue by licensing the K-Fuel Technology to third party
operators or by the direct ownership and management of K-Fuel production
facilities.

CASH AND CASH EQUIVALENTS

     The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents. At December
31, 1997, cash and cash equivalents included commercial paper and money market
accounts of $14,068,510. Such amounts are carried at cost which at December 31,
1997 approximates fair market value.

PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment is recorded at cost. Expenditures that extend
the useful lives of assets are capitalized. Repairs and maintenance that do not
extend the useful lives of the assets are expensed as incurred. Depreciation
expense is computed using the straight-line method over the following estimated
useful lives:

                 Plant, machinery and equipment    7-15 years
                 Office furniture and equipment    3-5  years

PATENTS

     The Company holds patents to the Series "A", "B" and "C" K-Fuel Technology.
The costs of obtaining new patents are capitalized; costs of defending and
maintaining patents are expensed as incurred. Patents are amortized over the
lives of the respective patents of 17 to 20 years for domestic patents and 5 to
20 years for foreign patents.

DEFERRED FINANCING COSTS

     The Company has capitalized issuance costs related to the convertible
debentures.  These costs are amortized over the life of the debentures using the
straight-line method, the results of which are not materially different than
using the effective interest method because of the short life of the debentures.

RESEARCH AND DEVELOPMENT COSTS

     Research and development costs are expensed as incurred.

                                      F-8
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

STOCK BASED COMPENSATION

     The Company periodically grants stock options to certain executive
officers, non-employee directors and other key employees under two employee
stock option plans the Amended and Restated Stock Option Plan and the 1996 Stock
Option and Incentive Plan. Under these plans, stock options are accounted for in
accordance with Accounting Principles Board Opinion No. 25 "Accounting for Stock
Issued to Employees" ("APB25").

INCOME (LOSS) PER SHARE

     In 1997, the Financial Account Standards Board ("FASB") issued Statement
No. 128, "Earnings per Share" (FASB 128). FASB 128 replaced the calculation of
primary and fully diluted earnings per share with basic and diluted earnings per
share. Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previous concept of fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented to conform to the Statement 128 requirements. The effects of options,
warrants, and convertible securities have not been considered for the years
ended December 31, 1997, 1996 and 1995 because the result would be anti-
dilutive.

ESTIMATES

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenue and expenses during the periods
presented.  Significant estimates have been made by management with respect to
the realizability of the Company's property, plant and equipment, patents,
equity investments, prepaid royalty, mine reclamation liability, and the
possible outcome of outstanding litigation.  Actual results could differ from
these estimates, making it possible that a change in these estimates could occur
in the near term.  See Notes 2,3,4,7,12, and 14 for additional information with
respect to these estimates.

RECLASSIFICATIONS

     Certain reclassifications have been made to the 1996 and 1995 financial
statements to conform to the current year presentation.

RECENT ACCOUNTING PRONOUNCEMENTS

     In June 1997, the FASB issued Statement No. 131 "Disclosures about Segments
of an Enterprise and Related Information" ("FASB 131"), which requires publicly-
held companies to report financial and descriptive information about its
operating segments in financial statements issued to shareholders for interim
and annual periods. The Statement also requires additional disclosures with
respect to products and services, geographical areas of operations, and major
customers. FASB 131 is effective for fiscal years beginning after December 15,
1997 and requires restatement of earlier periods presented. Such adoption is not
expected to have a material effect on the Company's financial position or
results of operation.

                                      F-9
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


NOTE 2.  PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment consisted of the following:

                                  
<TABLE>
<CAPTION> 
                                                        December 31, 
                                                -----------------------------
                                                   1997              1996
                                                -----------       ----------- 
<S>                                             <C>                <C>
Demonstration plant..........................   $10,854,375       $10,854,375
Mine property................................       465,500           465,500
Laboratory equipment.........................        53,880            51,307
Buildings....................................        90,781            90,781
Office and computer equipment................       192,589           178,988
                                                -----------       -----------
                                                 11,657,125        11,640,951
Less accumulated depreciation................    (7,198,820)       (6,182,150)
                                                -----------       -----------
                                                $ 4,458,305       $ 5,458,801
                                                ===========       ===========
</TABLE>
                                                                                
     Depreciation expense was $1,016,670 and $837,945 in 1997 and 1996,
respectively.  In August 1995, the Company contributed laboratory equipment,
buildings and other equipment with a net book value of $410,645 to KFP. See Note
4.

     In order to facilitate the development of the production facility discussed
in Note 4, in August 1995 the Company acquired certain coal mining and surface
properties near Gillette, Wyoming from Fort Union, Ltd. ("Fort Union").  Such
properties include approximately 1.3 million tons of coal reserves which will be
depleted using the units of production method, if and when mined.  The
consideration paid for the properties is in the form of a royalty share
agreement whereby the Company is required to pay Fort Union an amount equal to
20 percent of the royalty income received by the Company from all North American
applications of the K-Fuel process until the earlier of such time as (1) Fort
Union has received royalty share payments in the amount of $1,500,000, or (2)
September 15, 2015.  Additionally, the Company was required to assume Fort
Union's reclamation liabilities related to the acquired properties.

     The mine reclamation liability of $1,166,000 at December 31, 1997
represents the estimated cost to the Company to reclaim the property in
compliance with minimum standards established by the State of Wyoming and
various governmental agencies. In connection with obtaining a permit to conduct
mining and reclamation operations, the Company has entered into a bond agreement
to ensure payment of reclamation costs.

     When acquired, it was the Company's intent to sell this coal mining
property. However, in 1996 the Company determined that it would not sell it;
rather, it would be retained for purposes of a reserve supply of coal to be used
in the KFP production facility if ever needed. In 1996, the Company also
reassessed the value of this asset in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-
Lived Assets and for Long-Lived Assets to be Disposed Of," and wrote down its
investment in mining property to an estimated fair market value of $465,500. The
charge of $566,512 is reflected in the results of operations of the Company for
the year ended December 31, 1996.

                                      F-10
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


NOTE 3.  PATENTS

     Patents consisted of the following:
                                  
<TABLE>
<CAPTION>
                                                           DECEMBER 31, 
                                                   ---------------------------
                                                       1997            1996
                                                   -----------     -----------
<S>                                                <C>             <C>
Series "A" and "B" patents.....................    $ 8,800,000     $ 8,800,000
Series "C" patents.............................      1,335,134       1,335,134
Foreign patents - granted......................        212,922         212,922
Domestic and foreign patents - pending.........        182,589         123,329
Other..........................................            --           18,725
                                                   -----------     -----------
                                                    10,530,645      10,490,110
Less accumulated amortization..................     (7,442,792)     (6,827,216)
                                                   -----------     -----------
                                                   $ 3,087,853     $ 3,662,894
                                                   ===========     ===========
</TABLE>
                                                                                
     Patents amortization expense, including abandoned patents, was $637,765 and
$646,607 in 1997 and 1996, respectively.  The Series "C" patents were acquired
in August 1995 by the payment of $1,000,000 and the issuance of a $335,134
promissory note what was paid in 1996.  Additionally, $18,725 of fully amortized
organizational costs ("Other") were written off in 1997.  There was $3,464 of
amortization expense related to these organization costs in 1997.

NOTE 4.  INVESTMENT IN KFX FUEL PARTNERS, L.P.

     In August 1995, the Company acquired a 5 percent general and limited
partnership interest in KFP. The remaining 95 percent general and limited
partnership interest in KFP is held by Thermo Ecotek Corporation ("TCK"). In
September 1995, KFP began construction of a 500,000 tons-per-year K-Fuel
production facility near Gillette, Wyoming. At December 31, 1997, total
construction costs of the facility were approximately $55 million, and were
funded entirely by TCK. As part of its investment in 1995, the Company
contributed to KFP certain assets from its demonstration facility near Gillette,
Wyoming with a book value of approximately $411,000, and certain permitting and
engineering costs incurred by the Company totaling approximately $620,000.
Additionally, as a condition of acquiring the 5 percent interest in KFP, in
August 1995 the Company acquired an additional 80 percent interest in HFC in
exchange for 375,000 shares of the Company's common stock valued at $1,875,000,
a cash payment of $100,000, and a promissory note of $150,000 due in February
1996. HFC's only asset is a license to the Company's Series "A" and "B" K-Fuel
technology. Prior to the HFC transaction, the Company held a 5 percent interest
in HFC and was indebted to HFC in the amount of approximately $364,000. The
total consideration paid for the HFC interest, less the indebtedness of the
Company to HFC, was also recorded as part of the Company's investment in KFP.

     At December 31, 1996, the Company had $261,714 in accounts receivable due
from KFP for certain construction and start-up costs. These receivables were
included in the "Investment in KFx Fuel Partners, L.P." at December 31, 1997.

     In addition to its 5 percent interest in KFP, the Company will receive a
royalty of 3 percent of the net sales of the KFP facility.  The Company also
performed $395,679 of technical services for KFP in 1997, these amounts are
included in contract revenues for the period.
 

                                      F-11
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     The KFP facility has encountered several problems delaying the achievement
of optimal commercial operations including (1) a fire on December 24, 1996 which
destroyed one of two oil heating systems that provide the main processing
structure (comprised of four processing vessels) with heat transfer fluid (with
substantially all repair costs anticipated to be reimbursable by KFP insurance
proceeds), (2) construction problems relating to the flow of materials within
the facility, and (3) design and operation of certain pressure-release
equipment.  KFP is actively exploring solutions to these problems with
anticipated optimal commercial operations to begin in the third or fourth
quarter of 1998.  However, because the technology being developed at the
facility is new and untested, no assurance can be given regarding specific
timing and production levels, or that KFP will be able to correct these problems
and be in full commercial operations in the second quarter of 1998, if at all.

     KFP had construction in progress of approximately $55,419,000 and
$44,736,000 and current liabilities of approximately $2,623,000 and $1,893,000
at December 31, 1997 and 1996, respectively.  For the years ended December 31,
1997 and 1996, KFP generated no revenues and had no net income.  This was a
result of all of KFP's efforts being directed towards start-up of the facility
discussed above.

NOTE 5.  THERMO ECOTEK CORPORATION STOCK PURCHASE AGREEMENT

     In August 1995, the Company and TCK entered into a stock purchase agreement
(the "Stock Purchase Agreement") whereby TCK acquired 1,500,000 shares of the
Company's common stock for $3 million, and the right to purchase up to an
additional 2,750,000 shares of the Company's common stock at the same price per
share.  In December 1995, TCK purchased an additional 1,500,000 shares for $3
million.  Additionally, TCK purchased the remaining 1,250,000 shares of common
stock in January 1997 for $2.5 million, increasing its ownership in the Company
from approximately 14 percent  to approximately 18 percent.

     In addition, as part of the Stock Purchase Agreement, the Company issued
two common stock purchase warrants to TCK. The first warrant ("Warrant A") is
for 7,750,000 shares of common stock of the Company at an exercise price of
$3.65 per share (subject to certain adjustments), and is exercisable, in whole
or in part, commencing on January 1, 2000 and expiring on July 31, 2001. The
second warrant ("Warrant B") gives TCK the right to purchase the number of
shares of common stock that, when added to the shares owned by TCK on the
exercise date or which TCK has the right to acquire 60 days after the exercise
date, would be sufficient to give TCK ownership of 51 percent of the outstanding
shares of common stock of the Company, on a fully diluted basis, on the exercise
date. Warrant B is exercisable, in whole or in part, commencing on January 1,
2000 and expiring on July 31, 2001, provided, however, that Warrant B may not be
exercised unless TCK has fully exercised Warrant A. The exercise price of
Warrant B will be the average daily closing price of the common stock for the 40
trading days immediately preceding the exercise date.

NOTE 6.  INVESTMENT IN K-FUEL, L.L.C.

     In April 1996, the Company and Kennecott Alternative Fuels, Inc. ("KAFI"),
a wholly-owned subsidiary of Kennecott Energy and Coal Company ("KECC"), formed
K-Fuel LLC. Pursuant to the Limited Liability Company Agreement (the
"Agreement"), K-Fuel LLC is intended to be the vehicle for further technical
advancement and the commercialization of business opportunities arising out of
the K-Fuel Technology, including research and development, sublicensing,
marketing and consulting, but not including any actual construction of plants or
facilities to produce K-Fuel products on a commercial basis ("Commercial
Projects"). Commercial Projects will be constructed by separate entities in
which KAFI, the Company or both will have an equity interest and which will
receive a sublicense from K-Fuel LLC for the K-Fuel Technology.

                                      F-12
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     Initially, the Company has a 51 percent interest in K-Fuel LLC and KAFI has
a 49 percent interest, except to the extent of certain research and development
and amortization expenses, which by written agreement are allocated 100 percent
to KAFI. At such time as entities in which KAFI has an equity interest have
placed into service Commercial Projects with a collective design capacity equal
to or in excess of 3 million tons of K-Fuel product per annum, KAFI will have a
51 percent interest in K-Fuel LLC and the Company will have a 49 percent
interest. A fee of $1,000,000 was paid to the Company in consideration for the
Company entering into the Agreement, and has been recorded by the Company as
joint venture fee revenue in 1996. Subject to certain conditions, KAFI has also
agreed to make additional capital contributions to K-Fuel LLC in such amounts as
may be necessary for all research and development costs incurred by K-Fuel LLC,
up to $4,000,000. KAFI funded such research and development costs totaling
approximately $879,000 and $1,440,000 in 1997 and 1996, respectfully, and an
additional $327,000 and $371,000, for certain administrative, marketing and
project development activities in the United States and Indonesia for the same
periods. The Company contributed $334,000 and $386,000 to K-Fuel LLC in 1997 and
1996, respectively, for certain administrative, marketing and project
development activities in the United States and Indonesia. As of December 31,
1997, K-Fuel LLC was not committed to fund or construct any Commercial Projects.

     The activities and financial results of K-Fuel LLC are accounted for by the
Company using the equity method, rather than consolidated, as the Company does
not have the authority to independently control K-Fuel LLC. The Company
recognized an expense of $267,977 and $86,572 for its equity share of the
marketing, general and administrative expenses of K-Fuel LLC for 1997 and 1996,
respectively. The Company's investment in K-Fuel LLC at December 31, 1997 was
approximately $224,000.

     In connection with the Agreement, the Company granted K-Fuel LLC an
exclusive, worldwide, fully-paid, royalty-free right and license (including the
right to grant sublicenses) to and under the K-Fuel Technology, except to the
extent that it pertains to the beneficiation or restructuring of coal or coal
related feedstocks covered under the HFC License (as defined below) (the "KFX
License"). In addition, Heartland Fuels Corporation, an 85 percent owned
subsidiary of the Company, granted K-Fuel LLC an exclusive, worldwide, fully-
paid, royalty-free right and license (including the right to grant sublicenses)
to and under the Series "A" and Series "B" K-Fuel Technology, as it pertains to
the beneficiation or restructuring of coal or coal related feedstocks (the "HFC
License"). Both the KFX License and the HFC License specify minimum terms and
provisions for any sublicenses granted by K-Fuel LLC to third parties.

NOTE 7.  PREPAID ROYALTY

     In June 1996, the Company entered into a royalty amendment agreement with
Edward Koppelman, the inventor of the K-Fuel Technology.  Prior to the
agreement, Mr. Koppelman was entitled to a royalty of 2 percent on the gross
sales value of K-Fuel product produced by any entity, including any product
produced by the Company.  As a result of the agreement, Mr. Koppelman's royalty
is now 25 percent of the Company's worldwide royalty and license fee revenue,
computed after a State of Wyoming royalty.  The royalty to Mr. Koppelman will
cease when the cumulative payments to him reach the sum of approximately
$75,222,000.  Mr. Koppelman is now deceased and all royalty obligations are held
by his estate.

     As consideration for the royalty amendment agreement, the Company paid Mr.
Koppelman $300,000 cash and issued a promissory note for $200,000. See Note 9.
The $500,000 prepaid royalty will be amortized based on the difference between
what royalty payments to Mr. Koppelman would have been on the original royalty
agreement and the amended royalty agreement reached in 1996.

                                      F-13
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

NOTE 8.  DUE TO RELATED PARTIES

     Due to related parties consisted of the following:
<TABLE>
<CAPTION>
                                                                         DECEMBER 31, 
                                                                  ------------------------
                                                                     1997           1996
                                                                  --------        -------- 
<S>                                                               <C>             <C>
Due to board of directors, payable in cash....................    $    --         $ 27,800
Due to officers of the Company, payable in cash...............      15,062         113,708
Due to KSA Partnership, payable in cash.......................     286,958         286,958
Due to K-Fuel, L.L.C., payable in cash........................     244,665         250,000
Due to other related parties, payable in cash.................      10,837          29,290
                                                                  --------        --------
  Total related party liabilities.............................    $557,522        $707,756
                                                                  ========        ========
</TABLE>
                                                                                
     During 1997, the Company wrote off $237,438 in trade and related party 
payables.

NOTE 9.  LONG-TERM DEBT

     Long-term debt consisted of the following

<TABLE>
<CAPTION>
                                                                              DECEMBER 31,
                                                                       -------------------------
                                                                          1997           1996
                                                                       ---------      ----------  
<S>                                                                    <C>            <C>   
Unsecured promissory note, interest at 6.5 percent and payable                      
  annually, no principal payments due until maturity                                
  in February 1999................................................     $ 500,000      $  650,000
Unsecured promissory note, interest at 8.0 percent, quarterly                       
  principal and interest payments of $10,000 beginning in                           
  January 1996 until October 1998, when any remaining                               
  principal balance is due........................................       280,000         300,000
Unsecured promissory note to related party, interest at prime rate                  
  plus 2 percent, interest payable quarterly beginning in                           
  December 1995, principal payable in semi-annual installments                      
  of $50,000 beginning in December 1995 until September 1997                        
  Paid in January 1997............................................           --          100,000
Unsecured promissory note, interest at prime rate (8.25 percent                     
  at December 31, 1996) and payable annually, no principal                          
  payments due until maturity in June 1998, paid in August 1997              --          175,000
                                                                       ---------      ----------  
                                                                         780,000       1,225,000
Less current maturities...........................................      (280,000)       (115,000)
                                                                       ---------      ----------
                                                                       $ 500,000      $1,110,000
                                                                       =========      ==========
</TABLE>
                                                                               
     Scheduled maturities of long-term debt at December 31, 1997 are as follows:
$280,000 in 1998, and $500,000 in 1999.
 
     The promissory note of $175,000 at December 31, 1996 was issued as part of
a royalty amendment agreement. See Note 7.

     In July 1995, the Company completed a debt settlement agreement whereby
promissory notes and accrued interest obligations totaling $2,867,209, including
accrued interest of $940,209 at December 31, 1994, were extinguished for cash
payments totaling $300,000.

                                      F-14
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

NOTE 10.  CONVERTIBLE DEBENTURES

     On July 31, 1997, the Company completed a private placement of unsecured
convertible debentures (the "Debentures") totaling $17.0 million. The Debentures
mature in July 2002, and have an annual interest rate of 6.0 percent, payable
semi-annually on January 31 and July 31, commencing on January 31, 1998. The
Debentures are initially convertible into shares of the Company's common stock
at a conversion price of $3.75 per share, beginning on October 30, 1997. On
November 1, 1999, the conversion price will change to be 90 percent of the
average closing price of the Company's common stock (on the American Stock
Exchange or other exchange, if applicable) for the 15 days immediately preceding
November 1, 1999. The conversion price on November 1, 1999 cannot be less than
$3.65 per share, subject to certain adjustments.
 
     The Debentures were offered, sold and delivered only to non-United States
persons outside of the United States pursuant to Regulation S of the Securities
Act of 1933, as amended.  Application has been made to list the Debentures on
the Luxembourg Stock Exchange.
 
     In connection with the sale of the Debentures, the Company issued to the
placement agents warrants to purchase 453,333 shares of common stock to the
placement agents. See Note 11.

     The net cash proceeds from the sale of the Debentures (approximately $15.1
million) will be used for continued project development efforts for proposed K-
Fuel projects in Indonesia and Turkey, continued project development efforts for
a proposed activated carbon production facility, acquisitions of strategic
businesses or partners capable of enhancing the development of the Company, and
for general corporate purposes.

NOTE 11.  STOCKHOLDERS' EQUITY

     During 1997, the Company issued 1,250,000 shares of common stock for
$2,500,000 as part of the Stock Purchase Agreement. See Note 5.
 
     In connection with the sale of the Debentures, the Company issued to the
placement agents warrants to purchase 453,333 shares of common stock at an
exercise price of $5.00 per share, expiring in July 2002. The warrants were
valued at $567,000 using the Black-Scholes option-pricing model and are included
in the total debenture offering costs (before 1997 amortization of $205,000) of
$2,435,565.

     During 1996, the Company issued 382,000 shares of common stock for net cash
proceeds of $1,449,880, resulting from the exercise of outstanding common stock
purchase warrants issued prior to 1996.

     During 1996, the Company issued (1) 93,240 shares of common stock and
warrants to purchase 200,000 shares of common stock in exchange for professional
service fee obligations totaling $740,394, of which $502,894 was accrued at
December 31, 1995, and (2) 41,426 shares of common stock in exchange for 1995
board of director fees totaling $209,780 which were accrued at December 31,
1995. The warrants are exercisable for $4.00 per share and expire 100,000 each
in November and December 1999.

     During 1995, the Company also issued (1) 192,778 shares of common stock for
professional service obligations totaling $979,216, of which $265,297 was
accrued at December 31, 1994, and (2) 40,312 shares of common stock in exchange
for 1994 board of director fees totaling $167,315 which were accrued at December
31, 1994.

                                      F-15
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     During 1995, the Company issued 374,727 shares of common stock in exchange
for promissory notes and accrued interest obligation totaling $1,580,723.
 
     In May 1995, the Company reached a settlement agreement regarding a legal
claim brought against the Company and a director and officer of the Company in
1994. As part of the settlement agreement, the Company issued 10,000 shares of
common stock valued at $50,000, and a director and officer of the Company
transferred in January 1996 150,000 shares of common stock held by him which was
valued at $750,000. The 1995 consolidated statement of operations includes an
aggregate $800,000 non-cash charge related to this litigation settlement, and
includes the value of the common stock transferred by the director and officer
of the Company as he acted on behalf of the Company.

     In August 1995 and related to a sale of common stock by the Company, the
Company issued a common stock purchase warrant to purchase 50,000 shares of
common stock at $4.00 per share, expiring in August 1997.

     In August 1995, the Company issued 375,000 shares of common stock to
acquire an 80 percent interest in HFC. See Note 4.

NOTE 12.  STOCK OPTION PLANS

     The Company has two employee stock option plans - the Amended and Restated
Stock Option Plan (the "1992 Plan"), and the 1996 Stock Option and Incentive
Plan (the "1996 Plan").

     The 1992 Plan provides for the award to executive officers (including
officers who are also directors), non-employee directors and other key employees
of the Company of either non-qualified stock options ("NSO") or incentive stock
options ("ISO"), as defined in Section 422 of the United States Internal Revenue
Code.  Stock options, either NSO or ISO, granted under the 1992 Plan vest 20
percent on the date of grant, with an additional 20 percent vesting on each
anniversary date of the grant until fully vested, unless other terms of vesting
are specified by the Compensation Committee of the Board of Directors (the
"Committee").  Additionally, the Committee can accelerate the vesting of an
outstanding option at its sole discretion, and is required to accelerate the
vesting of all outstanding options outstanding under the 1992 Plan in the event
of a change in control of the Company, which is defined as (1) when any person
(as such term is defined in Sections 13(d) and 14(d) of the Securities Exchange
Act of 1934) becomes the beneficial owner of 15 percent or more of the total
number of shares of common stock then outstanding; (2) the Board of Directors or
shareholders approve the sale of all or substantially all of the assets of the
Company or any merger with or into the Company; or (3) the Company declares a
cash dividend in an amount in excess of 10 percent of the then fair market value
of the outstanding shares of common stock.  All stock options granted under the
1992 Plan expire ten years from the date of grant.  The Company has reserved
1,000,000 shares of common stock for issuance under the 1992 Plan.  As a result
of TCK's investment in the Company on January 31, 1997, increasing its ownership
in the Company to in excess of 15 percent, all options issued under the 1992
Plan became fully vested on that date.

                                      F-16
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     The 1996 Plan provides for the award to executive officers, non-employee
directors and other key employees and consultants of the Company of only non-
qualified stock options. Stock options granted under the 1996 Plan vest 20
percent on the first anniversary date of the grant, and an additional 20 percent
each anniversary date thereafter until fully vested. The Committee has similar
authority to accelerate the vesting of any outstanding option as with the 1992
Plan, except there are no specific change in control vesting requirements in the
1996 Plan. All stock options granted under the 1996 Plan expire seven years from
the date of grant. The Company has reserved 1,500,000 shares of common stock for
issuance under the 1996 Plan.

     The following table summarizes the Company's stock option activity for the
three-year period ending December 31, 1997:

<TABLE>
<CAPTION>
                                                                                              EXERCISABLE
                                                                                       -----------------------------
                                                                          WEIGHTED       NUMBER OF         WEIGHTED
                        NUMBER OF        NUMBER OF                        AVERAGE         SHARES           AVERAGE
                         SHARES,          SHARES,                          PRICE        EXERCISABLE      OPTION PRICE
                        1992 PLAN        1996 PLAN          TOTAL        PER SHARE      AT 12-31-97       PER SHARE
                    ------------------------------------------------------------------------------------------------
<S>                   <C>             <C>             <C>            <C>           <C>              <C>
Balance, 12-31-94           630,000             --         630,000          $5.02          165,000           $5.38
 Granted............        370,000             --         370,000           5.19          187,000            5.26
 Cancelled..........       (350,000)            --        (350,000)
                          ---------                      ---------
Balance, 12-31-95           650,000             --         650,000
 Granted............        350,000         525,500        875,500           6.46          455,100            5.61
 Cancelled..........        (30,000)            --         (30,000)
                          ---------       ---------      ---------
Balance, 12-31-96           970,000         525,500      1,495,500
 Granted............            --          735,000        735,000           3.81          170,000            3.90
 Cancelled..........       (268,000)       (120,000)      (388,000)
                          ---------       ---------      ---------                         -------           -----
Balance, 12-31-97...        702,000       1,140,500      1,842,500                         977,100           $5.21
                                                                                           =======           =====
Remaining shares
 Authorized.........        298,000         359,500        657,500
                          ---------       ---------      ---------
Total authorized....      1,000,000       1,500,000      2,500,000
                          =========       =========      =========
</TABLE>

     The range of exercise prices for stock options granted under the 1992 Plan
and the 1996 Plan are as follows: 1995 - $5.13 to $5.64 per share; 1996 -$5.09
to $7.43 per share; 1997 - $3.75 to $4.28 per share. All stock options granted
under the 1992 Plan and the 1996 Plan in 1995, 1996 and 1997 were at exercise
prices that were not below the fair market value of the Company's common stock
on the date of grant.

     In 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation."  This new standard defines a fair value approach of accounting
for employee stock options or similar equity instruments.  As permitted under
SFAS No. 123, the Company has elected to continue measuring compensation expense
under Accounting Principles Board ("APB") No. 25, which uses an intrinsic value
approach to measuring compensation expense, i.e., compensation expense is
generally recognized only when the exercise price of an employee stock option or
similar equity instrument is below the fair market value of the underlying
common stock on the date of grant.  The following table summarizes the pro forma
effects on net loss for the two most recent fiscal years as if the Company had
elected to implement SFAS No. 123:

                                      F-17
<PAGE>
 
                                   KFX INC.

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

<TABLE>
<CAPTION>
                                                                  YEAR ENDED DECEMBER 31,
                                                   --------------------------------------------------------
                                                       1997                  1996                  1995
                                                   --------------------------------------------------------
<S>                                               <C>                   <C>                   <C>
Net loss - as reported..........................    $(5,095,160)          $(5,628,541)          $(6,228,720)
Net loss  pro forma.............................    $(7,959,467)          $(6,320,601)          $(6,689,280)
Net loss per share - as reported................    $      (.21)          $      (.25)          $      (.33)
Net loss per share - pro forma..................    $      (.33)          $      (.28)          $      (.36)
</TABLE>

     The fair value of options granted under the 1992 Plan and the 1996 Plan
were estimated using the Black-Scholes option pricing model. The following table
summarizes the assumptions used for valuing each grant:

<TABLE>
<CAPTION>
                                                  EXPECTED LIFE       EXPECTED
                                  NUMBER OF         OF OPTION         DIVIDEND         RISK-FREE        VOLATILITY
                                   SHARES            (YEARS)            YIELD        INTEREST RATE      PERCENTAGE
                                  --------------------------------------------------------------------------------
 
<S>                               <C>              <C>                 <C>            <C>                <C>
Granted in 1995..........          320,000             10                  NA            7.31  %          47.7  %
Granted in 1995..........           50,000              5                  NA            6.88  %          47.7  %
                                   -------                    
 Total 1995..............          370,000                    
                                   =======                    
                                                              
Granted in 1996..........          350,000              7                  NA            6.33  %          54.5  %
Granted in 1996..........          455,000              7                  NA            6.90  %          55.0  %
Granted in 1996..........           50,000              7                  NA            6.89  %          54.9  %
Granted in 1996..........           20,500              7                  NA            6.25  %          53.5  %
                                   -------
 Total 1996..............          875,500
                                   =======

Granted in 1997..........           35,000              7                  NA            6.41  %          50.6  %
Granted in 1997..........           50,000              7                  NA            6.39  %          50.4  %
Granted in 1997..........          525,000              7                  NA            6.55  %          50.4  %
Granted in 1997..........          120,000              5                  NA            6.22  %          50.4  % 
                                   -------
 Total 1997..............          730,000
                                   =======
</TABLE>

     In addition to the 1992 Plan and the 1996 Plan, the Company has issued
non-qualified stock options related to various compensation agreements with
consultants and former employees of the Company.  The following table summarizes
the terms of such grants as of December 31, 1997:


<TABLE>
<CAPTION>
                                                                                           EXERCISABLE
                                                                                  ------------------------------
                                                                  WEIGHTED         NUMBER OF          WEIGHTED
                                                                  AVERAGE            SHARES           AVERAGE
                                               NUMBER OF        OPTION PRICE      EXERCISABLE       OPTION PRICE
                                                SHARES           PER SHARE        AT 12-31-97        PER SHARE
                                              ------------------------------------------------------------------
<S>                                           <C>              <C>               <C>               <C>
Granted in 1993........................           90,000             $9.00            90,000             $9.00
Granted in 1995........................          630,000             $3.20           630,000              3.20
Granted in 1996........................          150,000             $5.00           150,000              5.00
Granted in 1997........................          150,000             $5.00               --                --
                                               ---------                             -------
Outstanding at December 31, 1997.......        1,020,000                             870,000
                                                                                     =======
Shares authorized and remaining
 to be granted in 1998.................          150,000             $5.00
                                               ---------
Total granted and authorized...........        1,170,000
                                               =========
</TABLE>

                                      F-18
<PAGE>
 
                                   KFX INC.

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

     The grant of options for 150,000 shares in 1996 is included in the pro
forma effects of SFAS No. 123 for the years ended December 31, 1996. Relating to
the grant of options for 630,000 shares in 1995, the Company recorded non-cash
charges totaling $840,000 in the year ended December 31, 1995, including a
charge of $190,000 resulting from the cancellation of options for 350,000 shares
and the granting of options for 130,000 shares, of which options for 120,000
shares were repriced from the original option price of $4.63 per share to $4.13
per share.

     See Note 5 regarding the option of TCK to acquire up to 7,750,000 shares of
the Company's common stock beginning in January 2000.

NOTE 13.  WARRANTS TO PURCHASE COMMON STOCK

     Associated with various financing transactions and professional services
agreements, the Company has issued transferable warrants to purchase common
stock. The following table summarizes the outstanding warrants as of December
31, 1997, all of which are fully exercisable as of that date:

<TABLE>
<CAPTION>
                                      TYPE OF            NUMBER OF        EXERCISE PRICE
                                    TRANSACTION           SHARES            PER SHARE          EXPIRATION DATE
                                   ---------------------------------------------------------------------------
<S>                                <C>                  <C>                <C>              <C>
Granted in 1995...........             Services             55,000               $4.00          August 2, 1998
Granted in 1995...........            Financing             25,000               $4.00          August 2, 1998
Granted in 1995...........            Financing             50,000               $4.38          August 2, 1998
Granted in 1996...........             Services            100,000               $4.00        November 5, 1999
Granted in 1996...........             Services            100,000               $4.00       December 15, 1999
Granted in 1997...........             Services            453,333               $3.75           July 31, 2002
                                                           -------
                                                           783,333
                                                           =======
</TABLE>

     Related to the issuance of the warrants in 1996 for services, the Company
recorded non-cash charges of $237,500 and $62,500 in 1996 and 1995,
respectively, for the difference between the fair market value per share of the
Company's common stock and the warrant price on the date of the issuance.
Warrants granted in 1997 related to the placement of the Convertible Debentures.
See Note 10.

NOTE 14.  COMMITMENTS AND CONTINGENT LIABILITIES

     The Company is obligated for noncancelable operating leases with initial
terms exceeding one year relating to office space and certain equipment and
vehicle leases. The lease agreements require future minimum lease payments as
follows:

      YEAR ENDING DECEMBER 31,             Amount Payable
      ------------------------             --------------
                1998                           $154,865
                1999                            116,990
                2000                             70,147
                2001                              6,426
             Thereafter                           2,142
                                               --------
                                               $350,570
                                               ========
                                                                                
Rent expense in 1997, 1996, and 1995 was $182,005, $226,025, and $146,436,
respectively.

                                     F-19
<PAGE>
 
                                   KFX INC.

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


     Pursuant to a Pledge Agreement dated April 19, 1996 between an officer and
director of the Company and KECC, the same officer and director pledged to KECC
500,000 shares of his ownership of the Company's common stock in the event KECC
suffers any loss related to possible losses from the purchase and sale of
product pursuant to a fuel purchase option between KECC and KFP dated April 19,
1996.

     As part of the restructured bond agreement with the State of Wyoming in
1994, Energy Brothers Holding, Inc., an affiliate of the Company and an officer
and director of the Company executed a promissory note to the State of Wyoming
for $819,000, with annual interest at 6 percent. The Company has agreed to
indemnify both Energy Brothers Holding, Inc. and the officer and director of the
Company to the extent that payments are made to the State of Wyoming under the
agreement.

     The Company is contingently liable to Ohio Valley Electric Corporation
("OVEC") for an overriding royalty of 0.5 percent to OVEC on the gross revenues
generated by the sale of fuel produced from any production plant (other than the
current facility being constructed by KFP) located in the United States in which
the feedstock is coal and which uses the Company's proprietary Series "C" K-Fuel
technology to produce fuel. See Note 4.

     The Company is contingently liable to Fort Union for 20 percent of the
Company's North American royalty proceeds. This obligation expires upon the
earlier of (1) the cumulative payment to Fort Union of $1.5 million, or (2)
September 15, 2015.

     Pursuant to an Indemnity Agreement dated August 18, 1995 between the
Company and TCK, the parties agreed, among other things, that (i) neither party,
nor any affiliate thereof may build, construct or operate, or have any interest
in a plant or facility, except as contemplated by the OVEC Fuel Option Agreement
and the I&M Fuel Option Agreement that would compete, directly or indirectly,
with the Project until the earlier of (a) five years after the date the KFP
Project commences commercial operation, (b) the date on which KFP has entered
into contracts for the sale of a minimum of 70 percent of the output of the KFP
Project for a term of at least five years, and (c) the date on which the
combined KFP interests of the Company and TCK total less than 50.1 percent;
provided, however, that such limitation shall not apply to the operations or
activities of the parties with respect to international (excluding Canada and
Mexico) business ventures and activities; and (ii) the Company shall guarantee
any loan created pursuant to the Partnership Agreement relating to a capital
call for the license to mine coal. An officer and director of the Company has
pledged 225,000 shares of his ownership of the Company's common stock to
guarantee any obligations of the Company arising from the Indemnity Agreement.

     In November 1995, the Company filed a lawsuit against Fru-Con Construction
Corporation and Fru-Con Engineering, Inc. (collectively, "Fru-Con") in the
Wyoming State Court, 6th Judicial District. The action has been removed to the
United States District Court for the District of Wyoming. The Company's lawsuit
requests that the court enter a judgement that Fru-Con has no interest or claim
in or against the Company or any of the Company's property or interests, or that
Fru-Con is barred from such claims. Fru-Con had asserted claims for
approximately $1.8 million for engineering services and an interest in K-Fuel
plants built in North America by virtue of contractual arrangements with a
limited partnership sponsored by corporations in which a predecessor entity to
the Company had a partnership interest. Because the work done by Fru-Con was for
a limited partnership in which the Company's predecessor entity was not a
partner, and because payment for the work performed by Fru-Con was contingent
upon successful project financing which never materialized, as well as for other
legal and factual reasons, the Company believes that Fru-Con has no valid rights
or claims against the Company. On May 20, 1997, the Court granted the Company's
Motion for Summary Judgment on all claims. Fru-Con has appealed to the 10th
Circuit Court of Appeals. The Company believes that the ultimate resolution of
this action will not have a material adverse impact on the Company's financial
position or results of operations.

                                     F-20
<PAGE>
 
                                    KFX INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
 
     On March 9, 1998, Fidelity and Deposit of Maryland, as subrogee of Walsh
Construction Company, a division of Guy F. Atkinson Company, filed a
construction lien against KFP with respect to the construction of the KFP
Facility in the amount of approximately $5.9 million.  It is not possible at
this time to evaluate the merits of the claim or the range of potential loss.
However, the Company believes that the ultimate resolution of this  action will
not have a material adverse impact on the Company's financial position or
results of operations.
 
NOTE 15.  INCOME TAXES

     All of the Company's operations are currently domestic, with income taxable
at the federal statutory rate of 34 percent. The tax benefit recorded in 1995 of
$872,851 related to the utilization of current year losses to offset taxes on
the extraordinary gains from debt extinguishment. Deferred tax assets
(liabilities) were comprised of the following:

<TABLE>
<CAPTION>
                                                                  1997               1996
                                                              -----------        -----------
<S>                                                           <C>                <C>
Gross deferred tax assets:                                                  
  Loss carryforwards....................................      $ 7,500,419        $ 6,220,807
  Depreciation and amortization.........................          447,315            152,906
  Deferred compensation.................................          496,258            508,498
  Other.................................................          108,592            116,892
                                                              -----------        -----------
     Gross deferred tax assets..........................        8,552,584          6,999,103
     Deferred tax assets valuation allowance............       (8,552,584)        (6,999,103)
                                                              -----------        -----------
       Net deferred tax assets..........................                0                  0
Gross deferred tax liabilities..........................              --                 --
                                                              -----------        -----------
                                                              $         0        $         0
                                                              ===========        ===========
</TABLE>
                                                                                
     No net deferred tax asset has been recorded for loss carryforwards or other
deferred tax assets because it is currently more likely than not that such
benefits will not be realized. The change in the valuation allowance for the
current year reflects the changes in the above items. The Company's loss
carryforwards of approximately $ 22,060,000 expire in various amounts through
2012.

     The Company's total provision for income taxes in 1997, 1996 and 1995 were
different from the amount expected by applying the statutory federal income tax
rate to the net loss from operations and the extraordinary item. The approximate
differences are as follows:

<TABLE>
<CAPTION>
                                                             1997                1996               1995
                                                          -----------         -----------        ----------- 
<S>                                                       <C>                 <C>                <C>
Expected tax on extraordinary item...............         $       --          $       --         $   873,000
Expected tax benefit on loss before income                                                
  Taxes and extraordinary item...................          (1,732,000)         (1,914,000)        (2,991,000)
                                                          -----------         -----------        ----------- 
     Total expected tax provision (benefit)......          (1,732,000)         (1,914,000)        (2,118,000)
Non-deductible items.............................              27,000             142,000            716,000
Increase (decrease) in valuation allowance.......           1,553,000           1,515,000          1,633,000
Other............................................             152,000             257,000           (231,000)
                                                          -----------         -----------        -----------
  Total tax provision............................         $         0         $         0        $         0
                                                          ===========         ===========        ===========
</TABLE>
                                                                                
NOTE 16.  SUBSEQUENT EVENTS

     In January 1998, the Company converted $170,000 of current accounts
payables related to general corporate legal services into a promissory note.
Interest accrues at six percent per annum with quarterly

                                      F-21
<PAGE>
 
                                   KFX INC.

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

interest payments beginning on March 31, 1998 and quarterly principal payments
beginning on March 31, 1999.  Any unpaid principal and interest is due on
December 31, 2001.

     In January 1998, the Company began funding its 12.6 percent interest in
Charco Redondo, LLC, a Texas limited liability company to construct a pilot
phase tertiary crude oil recovery facility that uses heat and pressure to
extract crude oil from shallow reservoir structures.  The Company's funding
commitment for the pilot phase is $540,000 which is expected to be completed by
the second half of 1998.

     On March 23, 1998, the Company acquired a 60% interest in Pegasus
Technologies, LLC ("Pegasus), an Ohio limited liability company that sells a
computer software product that enhances combustion optimization in coal-fired
electric utility power plants. The acquisition consisted of a cash payment of
$1,600,000 and a $600,000 four-year promissory note. The terms of the note
include annual principal payments of $150,000 each anniversary date of the note
until fully paid in March 2002, and interest at 5.0 percent per annum. In
addition, the Company agreed to provide Pegasus $1,400,000 in working capital
guarantees secured through lines of credit or other financing sources mutually
acceptable to the Company and Pegasus.

                                      F-22