The Company’s estimates of proved reserves are made using available geological and reservoir data as well as production performance data. These estimates, made by the Company’s engineers, are reviewed annually and revised, either upward or downward, as warranted by additional data. Revisions are necessary due to changes in, among other things, reservoir performance, prices, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner.
 

Properties and Equipment. The Company uses the full cost method of accounting for exploration and development activities as defined by the SEC. Under this method of accounting, the costs of unsuccessful, as well as successful, exploration and development activities are capitalized as properties and equipment. This includes any internal costs that are directly related to exploration and development activities but does not include any costs related to production, general corporate overhead or similar activities. Gain or loss on the sale or other disposition of oil and gas properties is not recognized, unless the gain or loss would significantly alter the relationship between capitalized costs and proved reserves of oil and natural gas attributable to a country. The application of the full cost method of accounting for oil and gas properties generally results in higher capitalized costs and higher DD&A rates compared to the successful efforts method of accounting for oil and gas properties.

OFF-BALANCE SHEET ARRANGEMENTS

We do no have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to our investors.

RECENT ACCOUNTING PRONOUNCEMENTS

Effective January 1, 2006, we adopted the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when quantifying Misstatements in Current Year Financial Statements” ("SAB 108”). SAB 108 requires companies to evaluate the materiality of identified unadjusted errors on each financial statement and related financial statement disclosure using both the rollover approach and the iron curtain approach. The rollover approach quantifies misstatements based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origin. Financial statements would require adjustment when either approach results in quantifying a misstatement that is material. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. The adoption of SAB 108 did not have a material impact on our consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instruments. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment to FASB Statement No. 140” (“SFAS 156”). SFAS 156 requires that all separately recognized servicing rights be initially measured at fair value, if practicable. In addition, this statement permits an entity to choose between two measurement methods (amortization method or fair value measurement method) for each class of separately recognized servicing assets and liabilities. This new accounting standard is effective January 1, 2007. We do not expect the adoption of SFAS 156 to have an impact on our results of operations or financial condition.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This Interpretation provides that the tax effects from an uncertain tax position can be recognized in the Company’s financial statements, only if the position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.
 

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In September 2006, FASB issued Statement 157, “Fair Value measurements”. This statement defines fair value and establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”). More precisely, this statement sets forth a standard definition of fair value as it applies to assets or liabilities, the principal market (or most advantageous market) for determining fair value (price), the market participants, inputs and the application of the derived fair value to those assets and liabilities. The effective date of this pronouncement is for all full fiscal and interim periods beginning after November 15, 2007. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.

 

In September 2006, FASB issued Statement 158, “Employers’ Accounting for Defined Benefit Pension and other Postretirement Plans, which amend FASB Statements No. 87, 88, 106 and 132(R)”. This statement requires employers to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its financial statements and to recognize changes in that funded status in the year in which the changes occur. The effective date for the Company would be for any full fiscal years ending after December 15, 2006. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.

 

 

ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The financial statements are attached to this Annual Report on Form 10-KSB as Appendix A. The report of Company’s Independent Auditor appears at Page F-1 through F-2 hereof, the Financial Statements of the Company appear at Page F-3 through F-24 hereof.

 
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

 

Not applicable.

 

ITEM 8A. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures 

As required by Rule 13a-15 under the Exchange Act, as of the end of the period covered by this annual report, being December 31, 2006, we evaluated the effectiveness of the design and operation of (i) our disclosure controls and procedures (“Disclosure Controls”), and (ii) our internal control over financial reporting (“Internal Controls”). This evaluation (“Evaluation”) was performed by our Chief Executive Officer and our Chief Financial Officer in consultation with our accounting personnel.

Based upon the Evaluation, our CEO and CFO have concluded that as of the end of the period covered by this report, our Disclosure Controls are effective to ensure that material information relating to us is made known to management, including the CEO and CFO, and that our Internal Controls are effective.. Additionally, there has been no change in our Internal Controls that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to affect, our Internal Controls.

 

ITEM 8B. OTHER INFORMATION

 

None
 

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PART III

 

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

 

The following table sets forth the names, ages and positions of our directors and executive officers:

Name	Age	Position
Wang Hong Jun	35	President and Chairman of the Board
Wei Guo Ping	39	Director
Yu Li Guo	34	Director
Zhang Yang	25	Chief Financial Officer
Jiang Chao	27	Secretary

 

Each Director will hold office until the next annual meeting of stockholders and until his successor has been elected and qualified.

 

WANG HONG JUN has served as Chairman and President of the Company since May 2004, following completion of the share exchange transaction with Hong Xiang. From 1985 to 1987, Mr. Wang was a Researcher for Tai Quin Petroleum Institute at Jilin Province, specializing in petroleum exploration and production matters. From 1989 to 1992, he was a researcher at the State Economy Faculty of Jilin University. From 1992 to 2003, Mr. Wang worked for Jilin Oil Field and Drilling Company as an Executive with the responsibility of overseeing operations and coordinating various projects.

 

WEI GUO PING has served as a Director of the Company since May 2004, following completion of the share exchange transaction with Hong Xiang. From April 1991 to March 1997, Mr. Wei was the Executive Officer for the Government Office of Heilongjiang Province where he was responsible for evaluation and approval of business projects. From March 1997 to March 2002, he was General Manager of Shui Tak Chemical Company Limited and was responsible for handling day-to-day operations and strategic planning. Mr. Wei received a bachelor degree from the Heilongjiang Petrochemical Institute.

 

ZHANG YANG has served as Chief Financial Officer of the Company since January 1, 2006. Mr. Zhang was previously employed by Gloria International Hotel Group, from October 2004 through October 2005, as controller of the Harbin Gloria Inn, where he gained experience devising fund plans, overseeing budget management, and realizing financial operation objectives. Mr. Zhang received a degree from London College of International Business Study and also a degree in accounting from London South Bank University. Mr. Zhang is a member under the Association of Chartered Certified Accountants (ACCA).

JIANG CHAO has served as Secretary of the Company since January 1, 2006. Mr. Jiang was previously employed by Songzai International Holding Group, Inc., a Nevada corporation engaged in the coal mining business in the People’s Republic of China, where he served as assistant to the president from 2004 through 2005, and assisted executives with daily management operations. He received degrees from Heilongjiang University (Harbin, China) and University of Bradford (Bradford, UK), and a master degree in International Business Management from University of Surrey (London, UK).

YU LI GUO has served as Director of the Company since June 2004. In 2003, Mr Yu was elected a director of Harbin Hong Xiang Petroleum Services Limited, a wholly-owned subsidiary of the Registrant. From 2000 to 2003, Mr. Yu was employed by Jilin Yong Ji Wan Tong Tong Xun Hang as General Manager. Prior, Mr. Yu was employed by the Department of Industrial & Commercial Bank of China as Vice Manager of Human Resources from 1997 to 2000. Mr. Yu received a bachelor degree in International Finance from Jilin Financial College.

There are no family relationships, or other arrangements or understandings between or among any of the directors, executive officers or other person pursuant to which such person was selected to serve as a director or officer.
 

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Involvement in Certain Legal Proceedings

 

Our directors, executive officers and control persons have not been involved in any of the following events during the past five years:

 

1.     any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time;

 

2.     any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses);

 

3.     being subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; or

 

4.     being found by a court of competent jurisdiction (in a civil action), the Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated.

 

 

Our Board of Directors has determined that it does not have a member that qualifies as an “financial expert” as defined in Item 401(e) of Regulation S-B, and is “independent” as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934, as amended.

 

We believe that the members of our Board of Directors are collectively capable of analyzing and evaluating our financial statements and understanding internal controls and procedures for financial reporting. In addition, we believe that retaining an independent director who would qualify as an “audit committee financial expert” would be overly costly and burdensome and is not warranted in our circumstances given the early stages of our development and the fact that we have not generated significant revenues to date.

 

Corporate Governance Matters

Audit Committee. The Board of Directors has not yet established an audit committee, and the functions of the audit committee are currently performed by our Chief Financial Officer, with assistance by expert independent accounting personnel and oversight by the entire board of directors. We are not currently subject to any law, rule or regulation requiring that we establish or maintain an audit committee. We may establish an audit committee in the future if the board determines it to be advisable or we are otherwise required to do so by applicable law, rule or regulation.

Board of Directors Independence. Our Board of Directors consists of three members. We are not currently subject to any law, rule or regulation requiring that all or any portion of our board of directors include ”independent” directors. None of the members of the board of directors is “independent” as defined under the rules of the NASDAQ Stock Market.

Audit Committee Financial Expert. Our Board of Directors has determined that it does not have a member that qualifies as an “audit committee financial expert” as defined in Item 401(e) of Regulation S-B, and is “independent” as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934, as amended.

We believe that the members of our Board of Directors are collectively capable of analyzing and evaluating our financial statements and understanding internal controls and procedures for financial reporting. In addition, we believe that retaining an independent director who would qualify as an “audit committee financial expert” would be overly costly and burdensome and is not warranted in our circumstances given the early stages of our development and the fact that we have not generated revenues to date. Code of Ethics. A Code of Business Conduct and Ethics is a written standard designed to deter wrongdoing and to promote (a) honest and ethical conduct, (b) full, fair, accurate, timely and understandable disclosure in regulatory filings and public statements, (c) compliance with applicable laws, rules and regulations, (d) the prompt reporting violation of the code and

 

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 (e) accountability for adherence to the Code. We are not currently subject to any law, rule or regulation requiring that we adopt a Code of Ethics, however, we have adopted a code of ethics that applies to our principal executive officer, chief financial officer, principal accounting officer or controller, or persons performing similar functions. Such code of ethics will be provided to any person without charge, upon request, a copy of such code of ethics by sending such request to us at our principal office.

Nominating Committee. We have not yet established a nominating committee. Our board of directors, sitting as a board, performs the role of a nominating committee. We are not currently subject to any law, rule or regulation requiring that we establish a nominating committee.

Compensation Committee. We have not yet established a compensation committee. Our board of directors, sitting as a board, performs the role of a compensation committee. We are not currently subject to any law, rule or regulation requiring that we establish a compensation committee.

At this stage of our development, we have elected not to expend our limited financial resources to implement these measures. It is possible that if we were to adopt some or all of the corporate governance measures described in this section, shareholders would benefit from somewhat greater assurances that internal corporate decisions were being made pursuant to objective criteria, by disinterested directors and that policies had been implemented to define responsible conduct.

 

COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT OF 1934

 

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires our executive officers and directors and persons who own more than 10% of a registered class of our equity securities to file with the Securities and Exchange Commission initial statements of beneficial ownership, reports of changes in ownership and annual reports concerning their ownership of our common stock and other equity securities, on Forms 3, 4 and 5 respectively. Executive officers, directors and greater than 10% shareholders are required by the Securities and Exchange Commission regulations to furnish our company with copies of all Section 16(a) reports they file.

 

To the best of our knowledge, all executive officers, directors and greater than 10% shareholders filed the required reports in a timely manner.

 

ITEM 10. EXECUTIVE COMPENSATION.

 

The table below sets forth information concerning compensation paid to the chief executive officer and two of our most highly compensated officers of the Company. None of the Company’s other executive officers currently serving as such had annual compensation exceeded $100,000 (U.S.) in the last fiscal year.

 

Summary Compensation Table

 

 

Name and Principal Position		Year			Salary ($)			Bonus ($)			Stock Awards ($)			Option Awards ($)			Non-Equity Incentive Plan Compensation ($)			Nonqualified Deferred Compensation Earnings ($)			All Other Compensation ($)			Total ($)
(a)		(b)			(c)			(d)			(e)			(f)			(g)			(h)			(i)			(j)
Wang Hong Jun, President, and Chairman of the Board,			2006			RMB23,426		$	0		$	0		$	0			0		$	0		$	0			RMB23,426
Zhang Yang, Chief Financial Officer			2006			RMB24,000			0			0			0			0			0			0			RMB24,000
Jiang Chao			2006			0			0			0			0			0			0			0		$	0

 

(1) All compensation is paid in RMB. The amounts in the foregoing table have been converted to U.S. dollars at the conversion rate of 0.1281 U.S. dollars to one RMB.

 

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No deferred compensation or long-term incentive plan awards were issued or granted to the Company’s officers and directors at the fiscal year end, December 31, 2006. No employee, director, or executive officer has been granted any option or stock appreciation rights, options awards and stock awards, accordingly, no tables relating to such items have been included within this Item.

 

Directors Compensation

 

The non-employee directors received compensation in cash in connection with their service on the Board of Directors during the years ended December 31, 2006. Yu Li Guo and Wei Guo Ping each received RMB 36,000 during 2006. Wang Hong Jun did not receive any compensation for his service on the Board during 2006. The only compensation received by Wang Hong Jun was his salary disclosed above.

 

DIRECTOR COMPENSATION TABLE

 

Name	Fees Earned or Paid in Cash ($)	StockAwards ($)	Options Awards ($)	Non-Equity Incentive Plan Compensation ($)	Nonqualified Deferred Compensation Earnings ($)	All Other Compensation ($)	Total ($)
Wang Hong Jun	$0	0	0	0	0	0	RMB0
Wei Guo Ping	RMB 36,000						RMB36,000
Yu Li Guo	RMB 36,000	0	0	0	0	0	RMB36,000

 

(1) All compensation is paid in RMB. The amounts in the foregoing table have been converted to U.S. dollars at the conversion rate of 0.1281 U.S. dollars to one RMB.

 

Employment Contracts and Termination of Employment and Change-In-Control Arrangements

 

There are no employment contracts, compensatory plans or arrangements, including payments to be received from the Company, with respect to any director or executive officer of the Company which would in any way result in payments to any such person because of his resignation, retirement or other termination of employment with the Company, any change in control of the Company, or a change in the person’s responsibilities following a change in control of the Company.

 

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

 

The following tables set forth information as of April 10, 2007 regarding the beneficial ownership of stock by (a) each stockholder who is known by the Company to own beneficially in excess of 5% of the Company’s outstanding stock; (b) each director; (c) the Company’s chief executive officer; and (v) the executive officers and directors as a group. Except as otherwise indicated, all persons listed below have (i) sole voting power and investment power with respect to their shares of common stock (the only class of outstanding stock), except to the extent that authority is shared by spouses under applicable law, and (ii) record and beneficial ownership with respect to their shares of stock. The percentage of beneficial ownership is based upon 19,224,080 shares of common stock outstanding, as of April 10, 2007.
 

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Security Ownership Of Certain Beneficial Owners, Directors And Executive Officers In
Common Stock

 

 

NAME AND ADDRESS OF BENEFICIAL OWNER(1)	AMOUNT OF BENEFICIAL OWNERSHIP	PERCENT OF CLASS OF STOCK OUTSTANDING
Officers and Directors
Wang Hong Jun	6,732,000	35.02%
Zhang Yang	0	0.0%
Wei Guo Ping	2,000	0.01%
Yu Li Guo	0	0.00%
Jiang Chao	0	0.0%
All Officers and Directors as a Group (five persons)	6,734,000	35.03%
5% Beneficial Owners
N/A

 

(1)

Unless otherwise indicated, the address of the following stockholders is 20337 Rimview Place, Walnut, California, 91789.

 

(2)

Security ownership information for beneficial owners is taken from statements filed with the Securities and Exchange Commission pursuant to information made known by the Company. There are no shares issuable to any beneficial owner, director or executive officer pursuant to stock options that are/or will become exercisable within 60 days of April 10, 2007.

 

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

 

During the last two fiscal years, we have not entered into any material transactions or series of transactions that would be considered material in which any officer, director or beneficial owner of 5% or more of any class of our capital stock, or any immediate family member of any of the preceding persons, had a direct or indirect material interest. There are transactions presently proposed, except as follows:

 

a)

In 2006, Yu Qiao owed the Company $256,623 which is interest-free and repayable on demand.

 

b)

In 2006 and 2005, the Company owed Ms. Ju Guizhi, mother of Wang Hong Jung, the president of the Company, $3,262,917 and $1,418,814 respectively for advances without fixed repayment terms. Imputed interest expense is charged at 6% per annum on the amount due.

 

c)

In 2006 and 2005, the Company owed Wang Hong Jung, the Company’s president, $1,656,935 and $1,106,363 respectively for short-term advances. Imputed interest expense is charged at 6% per annum on the amount due.

 

d)

On April 3, 2006, the Company issued 700,000 shares of common stock to Li Hong Jun, a shareholder of the Company, for consulting services. The stock was valued at the closing price on the date of grant of $0.31 per share, yielding an aggregate value of $217,000.

 

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ITEM 13. EXHIBITS

 

Exhibit No.	Description
2.2	Distribution Agreement between Draco Holding Corporation and Jump’n Jax, dated April 30, 2004, is incorporated herein by reference from Registrant’s Current Report on Form 8-K filed with the SEC on May 14, 2004.
2.3	Agreement for Share Exchange dated as of March 29, 2004, by and among Draco Holding Corp., Hong Xiang Petroleum International Holdings, Ltd., and the shareholders of Hong Xiang is incorporated herein by reference from Registrant’s Current Report on Form 8-K filed with the SEC on March 30, 2004.
3.1	Articles of Incorporation is incorporated herein by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 28, 2001.
3.2	By-laws is incorporated herein by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 28, 2001.
3.2	Certificate of Amendments to Articles of Incorporation is incorporated herein by reference from Registrant’s Information Statement on Form 14C filed with the SEC on May 26, 2004.
4.1	2006 Stock Option/Stock Issuance Plan is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on February 27, 2006.
10.3	Consulting Agreement between Mark Anthony and Registrant is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on September 2, 2004.
10.3	Consulting Agreement between Anna Herbst and Registrant is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on October 27, 2004.
10.4	Consulting Agreement between Howard Scala and Registrant is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on September 2, 2004.
10.4	Consulting Agreement between Michelle P. Suppes and Registrant is incorporated herein by reference from Registrant’s Report on Form S-8 filed with the SEC on October 27, 2004.
10.5	Consulting Agreement between Frank Pioppi and Registrant is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on October 27, 2004.
10.6	Consulting Agreement between Cosmo F. Pioppi and Registrant is incorporated herein by reference from Registrant’s Registration Statement on Form S-8 filed with the SEC on October 27, 2004.
10.7	Loan Contract between Song Yuan City Yu Qiao Qian’an Hong Xiang Oil and Gas Development Limited Company and Song Yuan City Wu Lan Da Jie Cheng Shi Xin Yong She is incorporated herein by reference from Registrant’s Quarterly Report on Form 10-QSB filed with the SEC on November 23, 2005. (Translated from the original Mandarin)

10.8	Loan Contract between Song Yuan City Yu Qiao Qian’an Hong Xiang Oil and Gas Development Limited Company and Song Yuan City Wu Lan Da Jie Cheng Shi Xin Yong She is incorporated herein by reference from Registrant’s Quarterly Report on Form 10-QSB filed with the SEC on November 23, 2005. (Translated from the original Mandarin)
10.9	Warranty Deed between Lien holder: Song Yuan City Wu Lan Da Jie Cheng Shi Xin Yong She and Mortgager: Wang Hongjun, Sun Jishuang is incorporated herein by reference from Registrant’s Quarterly Report on Form 10-QSB filed with the SEC on November 23, 2005. (Translated from the original Mandarin)

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10.10	Guarantee Contract between Creditor: Song Yuan City Wu Lan Da Jie Cheng Shi Xin Yong She and Assurer: Songyuan City Hongxiang Petroleum Technical Services Co., Ltd is incorporated herein by reference from Registrant’s Quarterly Report on Form 10-QSB filed with the SEC on November 23, 2005. (Translated from the original Mandarin)
10.11	Qian-112 Oilfield Cooperative Development Contract among PetroChina Oil and Gas Company Limited, Jilin Oil Field Branch Company; Song Yuan City Yu Qiao Oil and Gas Development Company Limited, dated as of May 28, 2003 is incorporated by reference from Registrant’s annual report on Form 10-KSB filed with the SEC on April 17, 2006.
10.12	Joint Venture Agreement among the Registrant, Ms. Ju GuiZhi and Mr. Wang Hongjun, to form a joint venture limited liability company in China, to be named Song Yuan North East Petroleum Technical Service Co., Ltd is incorporated herein by reference from Registrant’s Current Report on Form 8-K filed with the SEC on July 28, 2006.
10.13	Equity Transfer Agreement by and among LongDe Oil & Gas Development Co. Ltd and Song Yuan North East Petroleum Technical Service Co., Ltd. dated June 1, 2005 is incorporated by reference from Registrant’s Current Report on Form 8-K filed with the SEC on December 28, 2006.
10.14	Hetingbao 301 Oilfield Cooperative Development Contract among PetroChina Oil and Gas Company Limited and Chang Ling LongDe Oil and Gas Development Company Limited dated as of May 28, 2003.
10.15	Agreement for the Purchase and Sale of Stock among Song Yuan North East Petroleum Technical Service Co., Ltd., China North East Petroleum Holdings, Limited, Ju Guizhi, Ping Wu Wang, Meng Xiangyun, dated January 26, 2007 is incorporated by reference from Registrant’s Current Report on Form 8-K filed with the SEC on January 29, 2007.
10.16	Trust Agreement between Ping Wu Wang and Song Yuan North East Petroleum Technical Service Co., Ltd. is incorporated by reference from Registrant’s Current Report on Form 8-K filed with the SEC on January 29, 2007.
10.17	Trust Agreement between Meng Xiangyun and Song Yuan North East Petroleum Technical Service Co., Ltd. is incorporated by reference from Registrant’s Current Report on Form 8-K filed with the SEC on January 29, 2007.
10.18	Cooperative Development Contract among PetroChina Oil and Gas Company Limited, Jilin Oil Field Branch Company and Song Yuan City Yu Qiao Oil and Gas Development Company Limited dated as May 28, 2003 to develop Qian 112 Oilfield, Da 34 Oilfield and Gu 31 Oilfied.

  

14.1	Code of Ethics of China North East Petroleum Holdings, Ltd. is incorporated herein by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on May 18, 2005.

23.2	Consent of R.A. Lenser & Associates
31.1	Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer
31.2	Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer
32.1	Certification by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification by the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.

Jimmy C.H. Cheung & Co., Certified Public Accountants, is our independent auditors engaged to examine our financial statements for the fiscal years ended December 31, 2005 and December 31, 2006. The following table shows the fees that we paid or accrued for the audit and other services provided by Jimmy C.H. Cheung & Co. for the fiscal years ended December 31, 2006 and December 31, 2005.

 

	Years Ended December 31
	2006	2005
Audit Fees	69,000	50,500
Audit-Related Fees	-	-
Tax Fees	-	-
Other Fees	-	-

 

Audit Fees

This category includes the audit of our annual financial statements, review of financial statements included in our annual and quarterly reports and services that are normally provided by the independent auditors in connection with engagements for those fiscal years. This category also includes advice on audit and accounting matters that arose during, or as a result of, the audit or the review of interim financial statements.

Audit-Related Fees

This category consists of assurance and related services by the independent auditors that are reasonably related to the performance of the audit or review of our financial statements and are not reported above under “Audit Fees”. The services for the fees disclosed under this category include services relating to our registration statement and consultation regarding our correspondence with the SEC.

Tax Fees

This category consists of professional services rendered for tax compliance and tax advice.

All Other Fees

This category consists of fees for other miscellaneous items.

 

 

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, China North East Petroleum Holdings, Limited has duly caused this annual report on Form 10-KSB to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Date: April 16, 2007

 

CHINA NORTH EAST PETROLEUM HOLDINGS, LIMITED

By: /s/ Hong Jun Wang

Wang Hong Jun

Chairman of the Board and President

 

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.

 

Name	Title	Date
/s/ Wang Hong Jun	Chairman of the Board and President	April 16, 2007
Wang Hong Jun	(Principal Executive Officer)
/s/Wei Guo Ping	Director	April 16, 2007
Wei Guo Ping
/s/ Yu Li Guo	Director	April 16, 2007
Yu Li Guo
/s/ Zhang Yang	Chief Financial Officer, Treasurer	April 16, 2007
Zhang Yang	(Principal Accounting and Financial Officer)

 

 

 

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APPENDIX A

 

FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firms, together with consolidated financial statements for the Company and subsidiary, including:

a.

Consolidated balance sheet as of December 31, 2006

 

b.

Consolidated statements of operations and comprehensive loss for the years ended December 31, 2006 and 2005

 

c.

Consolidated statements of changes in stockholders’ equity for the years ended December 31, 2006 and 2005

 

d.

Consolidated statements of cash flows for the years ended December 31, 2006 and 2005

 

e.

Notes to consolidated financial statements for the years ended December 31, 2006 and 2005

 

 

 

 

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006

 

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED AND SUBSIDIARIES

CONTENTS  

PAGES	F-1	REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS
PAGE	F-2	CONSOLIDATED BALANCE SHEET AS OF DECEMBER 31, 2006 AND 2005
PAGE	F-3	CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
PAGE	F-4	CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
PAGE	F-5	CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
PAGES	F-6-F-24	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005

 

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	Jimmy C.H. Cheung & Co		Registered with the Public Company Accounting Oversight Board
	Certified Public Accountants (A member of Kreston International)

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors of:

China North East Petroleum Holdings Limited

 

 

We have audited the accompanying consolidated balance sheets of China North East Petroleum Holdings Limited and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of operations and comprehensive income, stockholders’ equity and cash flows for the years ended December 31, 2006 and 2005. 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 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits of the financial statements provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of China North East Petroleum Holdings Limited and subsidiaries as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the years ended December 31, 2006 and 2005, in conformity with accounting principles generally accepted in the United States of America.

 

 

JIMMY C.H. CHEUNG & CO

Certified Public Accountants

 

 

Hong Kong

 

Date: February 10, 2007

 

 

 

1607 Dominion Centre, 43 Queen’s Road East, Wanchai, Hong Kong Tel: (852) 25295500 Fax: (852) 28651067 Email: jchc@krestoninternational.com.hk Website: http://www.jimmycheungco.com

 

F-1

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2006 AND 2005

ASSETS
					Restated
		2006			2005
CURRENT ASSETS
Cash and cash equivalents	$	8,307		$	203,349
Accounts receivable from a non-operating interest owner		256,623			350,577
Accounts receivable from a third party		20,831			55,871
Other receivables and prepaid expenses		66,148			91,270
Value added tax recoverable		11,573			28,207
Total Current Assets		363,482			729,274
PROPERTY AND EQUIPMENT
Oil and gas properties, net		9,716,559			5,166,391
Fixed assets, net		606,138			317,686
Oil and gas properties under construction		5,682,384			-
Total Property and Equipment		16,005,081			5,484,077
TOTAL ASSETS	$	16,368,563		$	6,213,351
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable	$	7,442,423		$	592,676
Other payables and accrued liabilities		764,942			1,002,722
Due to related parties		55,835			-
Notes payable		128,062			371,747
Other loans payable		25,612			43,371
Income tax payable		84,099			616,785
Due to a stockholder		1,656,935			1,106,363
Total Current Liabilities		10,157,908			3,733,664
LONG-TERM LIABILITIES
Due to a related party		3,262,917			1,418,814
Notes payable		256,125			-
Total Long-term Liabilities		3,519,042			1,418,814
TOTAL LIABILITIES		13,676,950			5,152,478
COMMITMENTS AND CONTINGENCIES		-			-
MINORITY INTERESTS		127,743			122,826
STOCKHOLDERS' EQUITY
Common stock ($0.001 par value, 150,000,000 shares authorized,
19,224,080 shares issued and outstanding as of
December 31, 2006; 18,274,080 shares issued and
outstanding as of December 31, 2005)		19,224			18,274
Additional paid-in capital		2,004,018			1,409,334
Deferred stock compensation		(135,625	)		-
Retained earnings (deficit)
Unappropriated		295,811			(487,695	)
Appropriated		221,072			78,965
Accumulated other comprehensive income (loss)		159,370			(80,831	)
Total Stockholders' Equity		2,563,870			938,047
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	16,368,563		$	6,213,351

The accompanying notes are an integral part of these financial statements

F-2

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE INCOME (LOSS)
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005

					Restated
		2006			2005
NET SALES	$	2,661,485		$	1,550,236
COST OF SALES
Production costs		408,310			304,804
Management fee		18,678			28,244
Depreciation - oil and gas properties		235,837			110,178
Gain on disposal of oil and gas properties		-			(1,455	)
Total Cost of Sales		662,825			441,771
GROSS PROFIT		1,998,660			1,108,465
OPERATING EXPENSES
General and administrative expenses		439,743			190,579
Professional fees		164,577			155,227
Consulting fees		81,375			948,000
Depreciation - fixed assets		75,440			44,743
Total Operating Expenses		761,135			1,338,549
INCOME (LOSS) FROM OPERATIONS		1,237,525			(230,084	)
OTHER INCOME (EXPENSES)
Other expense		(672	)		(575	)
Other income		8,909			86
Interest expense		(346,909	)		(156,848	)
Interest income		329			556
Total Other Expenses, net		(338,343	)		(156,781	)
NET INCOME (LOSS) BEFORE TAXES AND MINORITY
INTERESTS		899,182			(386,865	)
Income tax benefits (expenses)		31,348			(267,997	)
Minority interests		(4,917	)		(1,826	)
NET INCOME (LOSS)		925,613			(656,688	)
OTHER COMPREHENSIVE INCOME (LOSS)
Foreign currency translation gain (loss)		240,201			(80,831	)
COMPREHENSIVE INCOME (LOSS)	$	1,165,814		$	(737,519	)
Net income (loss) per share-basic and diluted	$	0.05		$	(0.04	)
Weighted average number of shares outstanding during the year-
basic and diluted		19,003,806			18,377,038
The accompanying notes are an integral part of these financial statement

F-3

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005 (RESTATED)
	Common stock					Additional		Deferred			Unappropriated			Appropriated	Accumulated other
	Number of					paid-in		stock			retained			retained	comprehensive
	shares		Amount			capital		compensation			earnings (deficit)			earnings	income (loss)				Total
Restated balance at December 31, 2004
(business combination under common control)	20,089,080	$	20,089		$	316,928	$	-		$	237,508		$	10,450	$	-		$	584,975
Issuance of common stock for services	750,000		750			809,250		-			-			-		-			810,000
Issuance of common stock for services	150,000		150			137,850		-			-			-		-			138,000
Cancellation of stock capital	(2,715,000	)	(2,715	)		2,715		-			-			-		-			-
Net loss for the year	-		-			-		-			(656,688	)		-		-			(656,688	)
Foreign currency translation loss	-		-			-		-			-			-		(80,831	)		(80,831	)
Imputed interest expenses on advances from
a stockholder and related parties	-		-			142,591		-			-			-		-			142,591
Transfer from retained earnings (deficit) to
statutory and staff welfare reserves	-		-			-		-			(68,515	)		68,515		-			-
Restated balance at December 31, 2005	18,274,080		18,274			1,409,334		-			(487,695	)		78,965		(80,831	)		938,047
Issuance of common stock for services	250,000		250			87,250		-			-			-		-			87,500
Issuance of common stock for services	700,000		700			216,300		(135,625	)		-			-		-			81,375
Net income for the year	-		-			-		-			925,613			-		-			925,613
Foreign currency translation gain	-		-			-		-			-			-		240,201			240,201
Imputed interest expenses on advances from
a stockholder and related parties	-		-			291,134		-			-			-		-			291,134
Transfer from retained earnings to
statutory and staff welfare reserves	-		-			-		-			(142,107	)		142,107		-			-
Balance at December 31, 2006	19,224,080	$	19,224		$	2,004,018	$	(135,625	)	$	295,811		$	221,072	$	159,370		$	2,563,870
The accompanying notes are an integral part of these financial statements

F-4

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES
     CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005

					Restated
		2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	925,613		$	(656,688	)
Adjusted to reconcile net income (loss) to cash provided by
operating activities:
Depreciation of oil and gas properties		235,837			110,089
Depreciation of fixed assets		75,440			44,949
Minority interests		4,917			1,826
Stocks issued for services		109,148			948,000
Imputed interest expenses		291,134			142,591
Gain on disposal of oil and gas properties		-			(1,455	)
Changes in operating assets and liabilities
(Increase) decrease in:
Accounts receivable from a non-operating interest owner		93,954			(350,577	)
Accounts receivable from a third party		35,040			(40,059	)
Other receivables and prepaid expenses		25,122			(65,152	)
Value added tax recoverable		16,634			(28,207	)
Increase (decrease) in:
Accounts payable		6,849,747			183,272
Other payables and accrued liabilities		(178,053	)		414,871
Income tax payable		(532,686	)		272,827
Net cash provided by operating activities		7,951,847			976,287
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of oil and gas properties		(4,502,198	)		(487,764	)
Purchase of fixed assets		(349,881	)		(116,498	)
Additions to oil and gas properties under construction		(5,682,384	)		-
Proceeds on disposal of oil and gas properties		-			182,005
Cash outflow from acquisition of LongDe (Note 3)		-			(118,344	)
Net cash used in investing activities		(10,534,463	)		(540,601	)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from the issuance of notes payable		12,440			371,747
(Decrease) increase in other loans payable		(17,759	)		43,371
Capital contribution from minority stockholders		-			121,000
Increase (decrease) in amount due to a stockholder		550,572			(1,250,166	)
Increase in amounts due to related parties		1,899,938			1,527,510
Decrease in amount due to a non-operating interest owner		-			(965,755	)
Net cash provided by (used in) financing activities		2,445,191			(152,293	)
EFFECT OF EXCHANGE RATE ON CASH		(57,617	)		(80,831	)
NET (DECREASE) INCREASE IN CASH AND CASH
EQUIVALENTS		(195,042	)		202,562
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		203,349			787
CASH AND CASH EQUIVALENTS AT END OF YEAR	$	8,307		$	203,349
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income tax expenses	$	509,972		$	5,694
Interest expenses	$	46,756		$	14,257

SUPPLEMENTAL DISCLOSURE OF NON-CASH OPERATING ACTIVITIES:
During 2006, the Company issued 250,000 shares of common stock valued at $87,500 for legal services.

During 2006, the Company issued 700,000 shares of common stock valued at $217,000 for consulting services.
 

The accompanying notes are an integral part of these financial statements
 

F-5

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION

 

(A)	Organization

 

China North East Petroleum Holdings Limited (“North East Petroleum”) is a US listed company which was incorporated in Nevada on August 20, 1999 under the name of Draco Holding Corporation (“Draco”). Draco was authorized to issue 20,000,000 shares of common stock of $0.001 par value per share.

Hong Xiang Petroleum Group Limited (“Hong Xiang Petroleum Group”) was incorporated in the British Virgin Islands (“BVI”) on August 28, 2003 as an investment holding company.

On December 5, 2003, Song Yuan City Hong Xiang Petroleum Technical Services Co., Ltd. (“Hong Xiang Technical”) was incorporated in the People’s Republic of China (“PRC”) as a limited liability company with a registered capital of $484,000. Hong Xiang Technical provides technical advisory services to oil and gas exploration companies in the PRC.

 

During 2004, Hong Xiang Petroleum Group acquired a 100% ownership of Hong Xiang Technical.

 

During 2004, Hong Xiang Technical acquired a 100% interest in Song Yuan City Yu Qiao Qianan Hong Xiang Oil and Gas Development Co., Ltd. (“Hong Xiang Oil Development”), a limited liability company incorporated on April 1, 2003 in the PRC with a registered capital of $604,800. Hong Xiang Oil Development is engaged in the exploration and production of crude oil in the Jilin Oil Region, Jilin of the PRC.

 

In December 2002, the Company entered into a Co-operative Exploration Contract with a non-operating interest owner in respect of the development rights to the proven reserves in the Qian’an Oil Field Zone 112 (Qian’an 112) in Jilin Oil Region for 20 years (the “Contract Period”). The non-operating interest owner obtained the rights through a Co-operative Exploration Contract with Jilin Office, PetroChina Group (“PetroChina”) and is entitled to a management fee 2% on the net sales.

 

In accordance with the Co-operative Exploration Contract, the Company was responsible for providing working capital and developing Qian’an 112. Production from Qian’an 112 is shared in the following manner:-

           

	Contract period	For PetroChina		For the Company
	First 10 years, commencing January 3, 2002	20%		80%
	Remaining 10 years	40%		60%

 

On March 29, 2004, Draco executed a Plan of Exchange (“the Agreement”) with all of the stockholders of Hong Xiang Petroleum Group pursuant to which Draco would issue 18,700,000 shares of its common stock in exchange for 100% of the outstanding shares of Hong Xiang Petroleum Group.

 

 

 

F-6

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The transaction contemplated by the Agreement was consummated on April 30, 2004 and has been accounted for as a reverse acquisition under the purchase method of accounting since the stockholders of Hong Xiang Petroleum Group obtained control of the consolidated entity (“North East Petroleum”). Accordingly, the merger of North East Petroleum and Hong Xiang Petroleum Group has been recorded as a recapitalization by Hong Xiang Petroleum Group, with Hong Xiang Petroleum Group being treated as the continuing entity. The financial statements have been prepared as if the reorganization had occurred retroactively.
 

Accordingly, the financial statements include the following:

 

a)

The balance sheet consists of the net assets of the acquirer at historical cost and the net assets of the acquiree at historical cost; and

 

b)

The statements of operations include the operations of the acquirer for the years presented and the operations of the acquiree from the date of the merger.

 

F-7

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(A)	Organization (Continued)

 

On June 28, 2004, the Articles of Incorporation of Draco were amended to change the Company’s name to China North East Petroleum Holdings Limited and to increase its authorized shares of common stock from 20,000,000 to 50,000,000. On August 11, 2005, the Company’s Articles of Incorporation were amended again to increase the Company’s authorized shares of common stock from 50,000,000 shares to 150,000,000 shares.

 

On July 26, 2006, the Company entered into a Joint Venture Agreement (the “JV Agreement”) with a principal stockholder and a related party, hereafter referred to as the “Related Parties,” to acquire oil and gas properties for the exploration of crude oil in the PRC. Pursuant to the JV Agreement, the Company and the Related Parties are obligated to contribute $1 million and $121,000, respectively, to the registered capital of Song Yuan North East Petroleum Technical Service Co., Ltd. (“Song Yuan Technical”), and the Company and the Related Parties will each share 90% and 10% respectively of the equity and profit interests of Song Yuan Technical. On September 26, 2006, the Company made a capital contribution of $490,000 to Song Yuan Technical and has an outstanding capital contribution of $510,000 as of December 31, 2006. Song Yuan Technical was incorporated on May 27, 2005 as a limited liability company in the PRC with a registered capital of $121,000. All the registered capital was fully paid in cash by the Related Parties. On October 8, 2006, Song Yuan Technical was approved as a sino-foreign equity joint venture and the registered capital was increased to $1,121,000. As both companies are under common management, this joint venture arrangement has been accounted for as a reorganization of entities under common control and the financial statements have been prepared as if the reorganization had occurred retroactively. (see note 2)

 

On June 1, 2005, Song Yuan Technical acquired from third parties 100% equity interest of LongDe Oil & Gas Development Co. Ltd. (“LongDe”) (see note 3). LongDe was incorporated on May 6, 2003 as a limited liability company in the PRC with a registered capital of $120,773. LongDe is a party to a 20 year Co-operative Exploration Contract with PetroChina pursuant to which LongDe has the right to explore, develop and extract crude oil at Hetingbao Oilfield 301 Area in the PRC. Pursuant to the Co-operative Exploration Contract, PetroChina is entitled to 20 % of LongDe’s output for the first ten years and 40% of LongDe’s output thereafter until the end of the Co-operative Exploration Contract.

 

North East Petroleum, Hong Xiang Petroleum Group, Hong Xiang Technical, Hong Xiang Oil Development, Song Yuan Technical and LongDe are hereafter referred to as (“the Company”).

 

(B)

Principles of consolidation

 

The accompanying consolidated financial statements include the financial statements of North East Petroleum and its wholly owned subsidiaries, Hong Xiang Petroleum Group, Hong Xiang Technical and Hong Xiang Oil Development and 90% equity interest owned subsidiaries, Song Yuan Technical and LongDe. The minority interests represent the minority shareholders’ 10% share of the results of Song Yuan Technical and LongDe. All significant inter-company accounts and transactions have been eliminated in consolidation.

 

(C)

Use of estimates

 

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant assumptions are for estimated reserves of oil and gas. Oil and gas reserve estimates are developed from information provided by the Company to R.A. Lenser and Associates, Inc. of Houston, Texas for the years ended December 31, 2006 and 2005, respectively. In 2006, management’s estimate of its proved reserves was revised downward from 1,752,986 to about 1,468,871 barrels of oil. This revision was based on the decline trend established by the application of appropriate decline curves, Iso-ultimate recovery curves, or other performance relationships for depletion-type reservoirs. While reserves are not reflected on the Company’s Consolidated Balance Sheets, the revision in estimate has affected the depreciation expense associated with its oil and gas properties which is calculated on the basis of proved reserves. The change was accounted for as a revision in an estimate, and the effect on net income was approximately $48,417.

F-8

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(D)

Cash and cash equivalents

 

For purpose of the statements of cash flows, cash and cash equivalents include cash on hand and demand deposits with a bank with a maturity of less than three months.

 

(E)

Accounts receivable

 

The Company extends unsecured credit to its customers in the ordinary course of business but mitigates the associated risks by performing credit checks and actively pursuing past due accounts. An allowance for doubtful accounts is established and recorded based on managements’ assessment of the credit history with the customer and current relationships with them.

 

 As of December 31, 2006 and 2005, the Company considers all its accounts receivable to be collectible and no provision for doubtful accounts has been made in the financial statements.

 

(F)

Oil and gas properties

 

The Company follows the full cost method of accounting for oil and gas properties. Accordingly, all costs associated with the acquisition of development rights, and the development of oil reserves, including direct related overhead costs, are capitalized.
 

Depreciation, depletion and amortization of capitalized costs, excluding unproved properties, are based on the unit-of-production methods based on proved reserves. Investments in unproved properties and major development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs. If the results of an assessment indicate that the properties are impaired, the amount of the impairment is added to the capitalized costs to be amortized.

 

In addition, the capitalized costs are subject to a “ceiling test”, which basically limits such costs to the aggregate of the “estimated present value”, discounted at a 10-percent interest rate of future net revenues from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties.

 

Sales of portion of development rights and other proved and unproved properties are accounted for as adjustments to capitalized costs with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas, in which case the gain or loss is recognized as income.

 

Abandonment of oil and gas properties other than the development rights are accounted for as adjustments of capitalized costs with no loss recognized.

 

(G)

Fixed assets

 

Fixed assets are stated at cost, less accumulated depreciation. Expenditures for additions, major renewals and betterments are capitalized and expenditures for maintenance and repairs are charged to expense as incurred.

 

Depreciation is provided on a straight-line basis, less estimated residual value over the assets’ estimated useful lives. The estimated useful lives are as follows:

 

	Buildings	20 Years
	Furniture, fixtures and equipment	5 Years
	Motor vehicles	5 Years

F-9

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(H)

Long-lived assets

 

The Company accounts for long-lived assets under the Statements of Financial Accounting Standards (“SFAS”) Nos. 142 and 144 “Accounting for Goodwill and Other Intangible Assets” and “Accounting for Impairment or Disposal of Long-Lived Assets” (“SFAS No. 142 and 144”). In accordance with SFAS No. 142 and 144, long-lived assets held and used by the Company are reviewed for impairment annually in the fourth quarter or more frequently if events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. For purposes of evaluating the recoverability of long-lived assets, when undiscounted future cash flows will not be sufficient to recover an asset’s carrying amount, the asset is written down to its fair value. The long-lived assets of the Company, which are subject to evaluation, consist primarily of oil and gas properties. For the years ended December 31, 2006 and 2005, the Company has not recognized any allowances for impairment.

 

(I)

Fair value of financial instruments

SFAS No. 107, “Disclosure About Fair Value of Financial Instruments,” requires certain disclosures regarding the fair value of financial instruments. Fair value of financial instruments is made at a specific point in time, based on relevant information about financial markets and specific financial instruments. As these estimates are subjective in nature, involving uncertainties and matters of significant judgment, they cannot be determined with precision. Changes in assumptions can significantly affect estimated fair values.

 

The carrying value of cash and cash equivalents, accounts receivable (trade and others), accounts payable (trade and related party), accrued liabilities, notes payable and other loans payable approximate their fair values because of the short-term nature of these instruments. The management of the Company is of the opinion that the Company is not exposed to significant interest or credit risks arising from these financial instruments.

The Company’s major operation is in the PRC, which may give rise to significant foreign currency risks from fluctuations and the degree of volatility of foreign exchange rates between the United States dollars (“US$”) and the Chinese Renminbi (“RMB”). On July 21, 2005, the PRC allowed the RMB to fluctuate ending its decade-old valuation peg to the US$. The new RMB rate reflects an approximately 2% increase in value against the US$. Historically, the PRC government has benchmarked the RMB exchange ratio against the US$, thereby mitigating the associated foreign currency exchange rate fluctuation risk. The Company does not believe that its foreign currency exchange rate fluctuation risk is significant, especially if the PRC government continues to benchmark the RMB against the US$.

(J)

Revenue recognition

 

The Company recognizes revenue upon the delivery of its share of crude oil extracted to PetroChina at which time title passes to the Sub-Owner; there are no uncertainties regarding customer acceptance; persuasive evidence of an arrangement exists; the sales price is fixed and determinable; and collectability is deemed probable.

 

(K)

Management fee

In connection with the arrangement of production activities, the Company pays a management fee of 2 percent on sales to the non-operating interest owner, which is charged to income as incurred.

 

The management fee expense for 2006 and 2005 was $18,678 and $28,244 respectively.
 

F-10

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(L)

Income taxes

 

The Company accounts for income taxes under the SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). Under SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date.

 

(M)

Foreign currency translation

 

Except for North East Petroleum and Hong Xiang Petroleum Group, which maintain their accounting records in their functional currency in US$, all other subsidiaries of the Company maintain their accounting records in their functional currency in RMB.

 

Foreign currency transactions during the year are translated to their functional currencies at the approximate rates of exchange on the dates of transactions. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the approximate rates of exchange at that date. No-monetary assets and liabilities are translated at the rates of exchange prevailing at the time the asset or liability was acquired. Exchange gains or losses are recorded in the statement of operations.

 

The financial statements of the subsidiaries whose functional currencies are RMB are translated into US$ using the closing rate method. The balance sheet items are translated into US$ using the exchange rates at the respective balance sheet dates. The capital and various reserves are translated at historical exchange rates prevailing at the time of the transactions while income and expenses items are translated at the average exchange rate for the year. All exchange differences are recorded within equity. A translation gain of $240,201 was recorded for the year ended December 31, 2006 and a translation loss of $80,831 was recorded for the year ended December 31, 2005.

 

(N)

Comprehensive income (loss)

 

The foreign currency translation gain or loss resulting from the translation of the financial statements expressed in RMB to US$ is reported as other comprehensive income (loss) in the statements of operations and stockholders’ equity. Comprehensive income (loss) for the years ended December 31, 2006 and 2005 was income of $240,201 and loss of $80,831 respectively.

 

(O)

Earnings per share

 

Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common stocks outstanding during the year. Diluted income per share is computed similar to basic income per share except that the denominator is increased to include the number of additional common stocks that would have been outstanding if the potential common stocks had been issued and if the additional common stocks were diluted. There were no potentially dilutive securities for 2006 and 2005.

 

(P)

Segments

 

The Company operates in only one segment. Thereafter segment disclosure is not presented.
 

 F-11

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(Q)

Environmental costs

 

The PRC has adopted extensive environmental laws and regulations that affect the operations of the oil and gas industry. The outcome of environmental liabilities under proposed or future environmental legislation cannot be reasonably estimated at present, and could be material. Under existing legislation, however, the management believes that there are no probable liabilities that will have a material adverse effect on the financial position of the Company.

 

(R)

Asset retirement obligations

 

The Company adopts the provisions of SFAS No. 143, Accounting for Asset Retirement Obligations. This Statement generally applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset. SFAS No. 143 requires the Company to recognize the fair value of asset retirement obligations in the financial statements by capitalizing that cost as a part of the cost of the related asset. With regard to the Company, asset retirement obligations primarily relate to the abandonment of oil producing facilities. The Company did not incur and does not anticipate to incur any material dismantlement, restoration and abandonment costs given the nature of its producing activities and the current PRC regulations surrounding such activities.

 

(S)

Recent accounting pronouncements

 

Effective January 1, 2006, we adopted the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires companies to evaluate the materiality of identified unadjusted errors on each financial statement and related financial statement disclosure using both the rollover approach and the iron curtain approach. The rollover approach quantifies misstatements based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatement’s year(s) of origin. Financial statements would require adjustment when either approach results in quantifying a misstatement that is material. Correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. The adoption of SAB 108 did not have a material impact on our consolidated financial statements.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instruments. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position

 

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment to FASB Statement No. 140” (“SFAS 156”). SFAS 156 requires that all separately recognized servicing rights be initially measured at fair value, if practicable. In addition, this statement permits an entity to choose between two measurement methods (amortization method or fair value measurement method) for each class of separately recognized servicing assets and liabilities. This new accounting standard is effective January 1, 2007. We do not expect the adoption of SFAS 156 to have an impact on our results of operations or financial condition.
 

 F-12

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

1.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION (CONTINUED)

 

(S)

Recent accounting pronouncements (Continued)

 

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This Interpretation provides that the tax effects from an uncertain tax position can be recognized in the Company’s financial statements, only if the position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.

 

In September 2006, FASB issued Statement 157, “Fair Value measurements”. This statement defines fair value and establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”). More precisely, this statement sets forth a standard definition of fair value as it applies to assets or liabilities, the principal market (or most advantageous market) for determining fair value (price), the market participants, inputs and the application of the derived fair value to those assets and liabilities. The effective date of this pronouncement is for all full fiscal and interim periods beginning after November 15, 2007. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.

 

In September 2006, FASB issued Statement 158, “Employers’ Accounting for Defined Benefit Pension and other Postretirement Plans, which amend FASB Statements No. 87, 88, 106 and 132(R)”. This statement requires employers to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its financial statements and to recognize changes in that funded status in the year in which the changes occur. The effective date for the Company would be for any full fiscal years ending after December 15, 2006. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position.

 

2.	BUSINESS COMBINATIONS BETWEEN ENTITIES UNDER COMMON CONTROL

 

The Company entered into a Joint Venture Agreement, dated June 26, 2006, with a related party and a principal stockholder of the Company to acquire oil and gas properties for the exploration of crude oil in the PRC through a limited liability company wholly owned by the related party and principal stockholder, Song Yuan Technical. Pursuant to the Joint Venture Agreement, Song Yuan Technical applied for registration with the PRC Government as a sino-foreign equity joint venture on October 8, 2006 with an increase in registered capital from $121,000 to $1,121,000; the increase of $1,000,000 to be contributed by the Company. Under the Joint Venture Agreement, the Company will share 90% of the equity and profit interests of Song Yuan Technical with the remaining 10% shared by the related party and principal stockholder. As of October 8, 2006, Song Yuan Technical has become a 90% owned subsidiary of the Company.

 

This transaction was accounted for as a reorganization of entities under common control. Accordingly, the operations of Song Yuan Technical for the years ended December 31, 2006 and 2005 were included in the consolidated financial statements as if the transactions had occurred at the beginning of the first period presented, each account stated at its historical cost. In this regard, the prior year’s financial statements and financial information have been restated to combine the previously separate entities to furnish comparative information. The results of the restatement were to increase the total assets, total liabilities and additional paid-in capital as of December 31, 2005 by $1,054,747, $792,251 and $4,375 respectively, and to decrease the net loss for the year ended December 31, 2005 by $13,363.

 

F-13

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

3.	BUSINESS COMBINATION

 

On June 1, 2005, Song Yuan Technical acquired all of the registered capital of LongDe from third parties for a total consideration of $120,773 in cash. LongDe is a party to a 20 year Co-operative Exploration Contract with PetroChina pursuant to which LongDe has the right to explore, develop and extract crude oil at Hetingbao Oilfield 301 Area in the PRC. Pursuant to the Co-operative Exploration Contract, PetroChina is entitled to 20 % of LongDe’s output for the first ten years and 40% of LongDe’s output thereafter to the end of the Co-operative Exploration Contract.

 

The preliminary allocation of the net assets acquired is as follows:

	Cash and cash equivalents	$	2,429
	Accounts receivable		15,812
	Other receivables and prepaid expenses		3,063
	Due from stockholders		108,696
	Total current assets		130,000
	Oil and gas properties and fixed assets, net		367,544
	Intangible mining right		13,445
	Total assets		510,989
	Less: Accounts payable and accrued liabilities		(388,217	)
	Other taxes payable		(1,999	)
	Total purchase price	$	120,773

 

Analysis of the net outflow of cash and cash equivalents in respect of the business combination is as follows:

 

	Cash consideration paid	$	120,773
	Less: cash and cash equivalents acquired		(2,429	)
	Net cash outflow	$	118,344

 

The acquisition of LongDe was accounted for as a purchase under SFAS No. 141, Business Combinations. Accordingly, the operating results of LongDe have been included in the consolidated statements of operation and comprehensive income after the effective date of the acquisition of June 1, 2005.

 

The following table reflects the unaudited pro forma combined results of operations for the year ended December 31, 2005, assuming the acquisition had occurred at the beginning of 2005.

 

	Revenues	$	1,587,807
	Net loss	$	(653,515	)
	Net loss per share
	basic and diluted	$	(0.04	)

F-14

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

4.	OIL AND GAS PROPERTIES

 

The following is a summary of oil and gas properties at December 31, 2006 and 2005:

 

			2006		2005
	Oil and gas properties, proven reserves	$	10,359,232	$	5,544,501
	Intangible mining right		13,445		13,445
	Less: accumulated depreciation		656,118		391,555
	Oil and gas properties, net	$	9,716,559	$	5,166,391

Depreciation expense for the years ended December 31, 2006 and 2005 was $235,837 and $110,178 respectively.

 

5.	ACCOUNTS RECEIVABLE FROM A NON-OPERATING INTEREST OWNER

 

Pursuant to a 20-year exclusive Exploration Contract among PetroChina, a non-operating interest owner Yu Qiao and the Company, the Company has the right to explore, develop (including well logging, drill-stem testing and core sampling) and pump crude oil at Qian’an 112 in Jilin Province, PRC. Pursuant to the Co-operative Exploration Contract, PetroChina is entitled to 20% of the output in the first ten years and 40% of the output thereafter until the end of the Co-operative Exploration Contract; and Yu Qiao is entitled to 2% of the output as a management fee for managing the process of oil production. The Company sells all of its current oil production to PetroChina. Pursuant to the terms of the Co-operative Exploration Contract, all payments by PetroChina for sales of the Company’s crude oil are paid to Yu Qiao, who forwards the payment to the Company after deducting its management fee. No allowance for doubtful accounts has been recorded as of December 31, 2006 as the debt owed by Yu Qiao has been subsequently settled.

 

On January 26, 2007, Song Yuan Technical entered into an agreement with the stockholders of Yu Qiao to acquire 100% of the equity interests of Yu Qiao for a total consideration of $3,100,000 by the issuance of 10,000,000 shares of the Company’s common stock, having a value of $3,100,000.

 

 

6.	ACCOUNTS RECEIVABLE FROM A THIRD PARTY

 

Accounts receivable from a third party at December 31, 2006 and 2005 consisted of the following:

 

					Restated
			2006		2005
	Accounts receivable from PetroChina	$	20,831	$	55,871
	Less: allowance for doubtful accounts		-		-
	Accounts receivable, net	$	20,831	$	55,871

 

As of December 31, 2006 and 2005, the Company considered all accounts receivable collectable and has not recorded a provision for doubtful accounts.

 

F-15

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

7.	FIXED ASSETS

 

					Restated
			2006		2005
	Buildings	$	206,032	$	154,817
	Furniture, fixtures and equipment		101,520		88,927
	Motor vehicles		476,944		170,067
			784,496		413,811
	Less: accumulated depreciation		178,358		96,125
	Fixed assets, net	$	606,138	$	317,686

 

Depreciation expense for the years ended December 31, 2006 and 2005 was $75,440 and $44,743 respectively.

 

8.	OTHER RECEIVABLES AND PREPAID EXPENSES

 

Other receivables and prepaid expenses at December 31, 2006 and 2005 consist of the following:
 

					Restated
			2006		2005
	Other receivables	$	49,275	$	67,798
	Other prepaid expenses		16,873		23,472
		$	66,148	$	91,270

 

 

9.	OTHER PAYABLES AND ACCRUED LIABILITIES

 

Other payables and accrued liabilities at December 31, 2006 and 2005 consist of the following:

 

					Restated
			2006		2005
	Other payables	$	543,202	$	766,618
	Accrued professional fees		152,204		164,727
	Other accrued liabilities		69,536		71,377
		$	764,942	$	1,002,722

 

F-16

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

10.	NOTES PAYABLE

 

Notes payable at December 31, 2006 and 2005 consist of the following:

					Restated
			2006		2005
	Note payable to a bank, interest rate of 10.44%
	per annum, guaranteed by a subsidiary,
	due January 2006 and fully repaid in May 2006	$	-	$	123,916
	Note payable to a bank, interest rate of 10.60%
	per annum, guaranteed by a subsidiary,
	due June 2007		128,062		-
	Note payable to a bank, interest rate of 11.16%
	per annum, secured by a property owned
	by a stockholder, due July 2006 and
	extended to July 2008		256,125		247,831
			384,187		371,747
	Less: current maturities		128,062		371,747
	Long-term portion	$	256,125	$	-

Interest expense paid for the years ended December 31, 2006 and 2005 was $43,541 and $13,867 respectively. 

 

11.	OTHER LOANS PAYABLE

 

The Company has two outstanding short-term loans in the amount of $12,806 and $12,806, which were borrowed from third parties in October 2005 without fixed repayment terms. Interest is charged at 36% per annum.

 

Interest expense for the years ended December 31, 2006 and 2005 was $10,712 and $390 respectively.

 

During the year, the Company borrowed a short term interest free loan of $125,000 from a third party which was fully repaid in October 2006. Imputed interest expense on this loan for the year ended December 31, 2006 was $1,879.

 

 

12.	COMMITMENTS AND CONTINGENCIES

 

(A)

Employee benefits

 

The full time employees of Hong Xiang Oil Development and LongDe are entitled to employee benefits including medical care, welfare subsidies, unemployment insurance and pension benefits through a Chinese government mandated multi-employer defined contribution plan. The Company is required to accrue for those benefits based on certain percentages of the employees’ salaries and make contributions to the plans out of the amounts accrued for medical and pension benefits. The total provision and contributions made for such employee benefits for the years ended December 31, 2006 and 2005 was $13,693 and $7,364, respectively. The Chinese government is responsible for the medical benefits and the pension liability to be paid to these employees.

 

F-17

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

12.	COMMITMENTS AND CONTINGENCIES (CONTINUED)

 

(B)

Commitments

The Company leases office spaces from a stockholder and land spaces from a third party under two operating leases which expire on June 30, 2015 and September 20, 2023 at annual rental of $12,294 and $160 respectively.

 

As at December 31, 2006, the Company has outstanding commitments with respect to the above non-cancelable operating leases, which are due as follows:

	2007	$	12,454
	2008		12,454
	2009		12,454
	2010		12,454
	Thereafter		57,355
		$	107,171

(C)

Capital commitments

According to the amended Articles of Association of Song Yuan Technical, the Company has to fulfill registered capital contribution of $1 million. As of December 31, 2006, the Company has fulfilled $490,000 of the registered capital requirement and has outstanding capital contributions of $510,000.

 

13.	STOCKHOLDERS’ EQUITY

 

(A)

Stock issuances

 

On March 6, 2006, the Company issued 250,000 shares of common stock for legal services. The stock was valued at the closing price on the date of grant of $0.35 per share, yielding an aggregate fair value of $87,500. The Company recognized expense of $27,773 during the year ended December 31, 2006 and applied the balance of $59,727 against accrued liabilities.

 

On April 3, 2006, the Company issued 700,000 shares of common stock to a consultant for consulting services for a period of two years. The stock was valued at the closing price on the date of grant of $0.31 per share, yielding an aggregate value of $217,000. The Company recognized expense of $81,375 during the year ended December 31, 2006 and recorded deferred stock compensation of $135,625 as of December 31, 2006 for these services.

 

On April 3, 2006, the Company issued 1,550,000 shares of common stock to a consultant for consulting services. These shares were subsequently returned to the Company upon the cancellation by mutual consent of the consulting agreement in August 2006.

 

(B)

Appropriated retained earnings

 

The Company’s PRC subsidiaries are required to make appropriations to reserve funds, comprising the statutory surplus reserve, statutory public welfare fund and discretionary surplus reserve, based on the after-tax net income determined in accordance with the laws and regulations of the PRC. Prior to January 1, 2006 the appropriation to the statutory surplus reserve should be at least 10% of the after tax net income determined in accordance with the laws and regulations of the PRC until the reserve is equal to 50% of the entities’ registered capital. Appropriations to the statutory public welfare fund are at 5% to 10% of the after tax net income determined by the Board of Directors. Effective January 1, 2006, the Company is only required to contribute to one statutory reserve fund at 10 percent of net income after tax per annum, such contributions not to exceed 50 percent of the respective companies’ registered capital.

 

F-18

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

13.	STOCKHOLDERS’ EQUITY (CONTINUED)

 

(B)

Appropriated retained earnings (Continued)

 

The statutory reserve funds are restricted for use to set off against prior period losses, expansion of production and operation or for the increase in the registered capital of the Company. The statutory public welfare fund is restricted for use in capital expenditures for the collective welfare of employees. These reserves are not transferable to the Company in the form of cash dividends, loans or advances. These reserves are therefore not available for distribution except in liquidation.

 

During 2006 and 2005, the Company appropriated $142,107 and $68,515 respectively to the reserves funds based on its net income in accordance with the laws and regulations of the PRC.

 

14.	RELATED PARTY TRANSACTIONS

 

a)

In 2006, the non-operating interest owner controlled by a related party owed the Company $256,623 which is interest-free and repayable on demand.

 

b)

In 2006 and 2005, the Company owed a related party $3,262,917 and $1,418,814 respectively for advances without fixed repayment terms. Imputed interest expense is charged at 6% per annum on the amount due.

 

c)

In 2006, the Company owed a related party $12,806 for short-term advances. Imputed interest expense is charged at 6% per annum on the amount due.

 

d)

In 2006, the Company owed a related party $43,029 for short-term advances. Interest is charged at 24% per annum.

 

e)

In 2006 and 2005, the Company owed a stockholder $1,656,935 and $1,106,363 respectively for short-term advances. Imputed interest expense is charged at 6% per annum on the amount due.

 

f)

Total interest expenses payable to a stockholder and related parties amounted to $290,777 and $142,591 for the years ended December 31, 2006 and 2005 respectively.

 

g)

The Company paid a stockholder $12,027 and $9,000 for leased office spaces for the years ended December 31, 2006 and 2005 respectively.

 

h)

In 2005, the Company issued 550,000 shares of common stock to a consultant for consulting services provided. The consultant was subsequently appointed a director of the Company. The stock was valued at the closing price on the date of grant, or at $1.08 per share, yielding an aggregate fair value of $594,000.

 

i)

On April 3, 2006, the Company issued 700,000 shares of common stock to a related party for consulting services. The stock was valued at the closing price on the date of grant of $0.31 per share, yielding an aggregate value of $217,000.

 

F-19

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

15.	INCOME TAX

 

It is management’s intention to reinvest all the income attributable to the Company earned by its operations outside the US. Accordingly, no US corporate income taxes are provided for in these financial statements.

 

The Company is subject to income taxes on an entity basis on income arising in or derived from the tax jurisdiction in which each entity is domiciled.

 

North East Petroleum was incorporated in the United States and has incurred net operating loss as for income tax purposes for 2006 and 2005.

 

North East Petroleum has net operating loss carry forwards for income taxes amounting to approximately $1,629,000 as at December 31, 2006 which may be available to reduce future years’ taxable income. These carry forwards, will expire, if not utilized, commencing in 2024. Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses. Accordingly, a full deferred tax asset valuation allowance has been provided and no deferred tax asset benefit has been recorded. The valuation allowances at December 31, 2006 and December 31, 2005 were $553,815 and $461,763 respectively. The net change in the valuation allowance was an increase of $92,052.

 

Hong Xiang Petroleum Group was incorporated in the British Virgin Islands (the “BVI”) and income earned is not subject to income tax.

 

Hong Xiang Technical, Hong Xiang Oil Development, Song Yuan Technical and LongDe were incorporated in the PRC and are subject to PRC income tax which is computed according to the relevant laws and regulations in the PRC. The applicable tax rate has been 33% and no tax benefit is expected from the tax credits in the future.

 

The income tax (benefits) expenses for 2006 and 2005 are summarized as follows:

 

	PRC Income Tax		2006			2005
	Current year (benefits) expenses	$	(31,348	)	$	249,245

 

 

16.	CONCENTRATIONS AND RISKS

 

During 2006 and 2005, 100% of the Company’s assets were located in the PRC and 100% of the Company’s revenues were derived from one customer located in the PRC. The regulations governing oil and gas producing corporations in the PRC prohibits the sale of crude oil to other customers except PetroChina.

 

F-20

 

---

CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

 

17.	SUBSEQUENT EVENTS

 

(A)

Acquisition of the non-operating interest owner

 

On January 26, 2007, Song Yuan Technical entered into an agreement with the stockholders of Yu Qiao to acquire 100% of the equity interest of Yu Qiao. In consideration for the acquisition, the Company will issue to the stockholders of Yu Qiao an aggregate of 10,000,000 shares of the Company’s common stock having a fair value of $3,100,000 based on the preceding 30-day average of the high bid and the low ask price for the Company’s common stock as quoted on the Over-the-Counter Bulletin Board as of the date of the closing of the transaction.

 

(B)

Termination of subsidiaries

 

In March 2007, the Company consummated the closure of its wholly owned subsidiaries, Hong Xiang Technical and Hong Xiang Oil Development. Hong Xiang Oil Development, a wholly owned subsidiary of Hong Xiang Technical, leases the rights to explore, develop and extract oil in Qian’an 112 from Yu Qiao which holds a 20-year exclusive Cooperative Exploration Contract with PetroChina for the rights to explore, develop and extract oil in Qian’an 112. (see note 1)

 

On January 26, 2007, the Company’s 90% owned subsidiary, Song Yuan Technical acquired 100% of the equity interests of Yu Qiao from the stockholders of Yu Qiao. As a result of the acquisition, the lease agreement became unnecessary, as the Company became, effectively, both the lessor and lessee under the lease agreement pertaining to Qian’an 112 and may now exploit the rights under the Exploration Contract through Yu Qiao. The Board of the Company therefore determined that Hong Xiang Technical and Hong Xiang Oil Development, are no longer necessary elements of its corporate structure and has consequently approved that such companies shall be liquidated and dissolved.

 

The Company does not expect to incur any material costs in connection with the dissolution of Hong Xiang Technical and Hong Xiang Oil Development nor does the Company expect the dissolution of Hong Xiang Technical and Hong Xiang Oil will have a significant financial impact on the Company’s operations or financial condition as all the assets, liabilities, retained profit and operations of Hong Xiang Oil Development will be transferred to Yu Qiao upon Yu Qiao becoming a subsidiary of the Company.

 

18.	SUPPLEMENTAL OIL AND GAS DISCLOSURES (UNAUDITED)

 

The accompanying table presents information concerning the Company’s crude oil producing activities as required by SFAS No. 69, Disclosures about Oil and Gas Producing Activities.

 

A.

Capitalized costs relating to oil and gas producing activities are as follows:

 

						Restated
			2006			2005
	Proved crude oil properties	$	10,359,232		$	5,544,501
	Intangible mining right		13,445			13,445
	Accumulated depreciation, depletion and amortization		(656,118	)		(391,555	)
	Net capitalized costs	$	9,716,559		$	5,166,391

 

B.

Cost incurred in oil and gas property acquisitions, exploration and development activities are as follows:

 

					Restated
			2006		2005
	Property acquisition costs (net of costs of properties sold)
	Proved reserves	$	1,906,524	$	878,143
	Property development costs	$	8,452,708	$	4,666,358

F-21

---

 
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

18.	SUPPLEMENTAL OIL AND GAS DISCLOSURES (UNAUDITED) (CONTINUED)

 

C.

The results of operations for oil and gas producing activities are as follows:

 

						Restated
			2006			2005
	Net sales	$	2,661,485		$	1,550,236
	Production costs		(408,310	)		(304,804	)
	Management fee		(18,678	)		(28,244	)
	Depreciation, depletion and amortization		(311,277	)		(154,921	)
	General and administrative expenses		(439,743	)		(190,579	)
	Income tax benefits (expenses)		31,348			(267,997	)
	Results of operations from oil and gas producing
	(excluding corporate overhead and financing costs)	$	1,514,825		$	603,691

 

D.

Estimated quantities of proved oil and gas reserves

 

The following schedule estimates proved crude oil reserves attributable to the Company. Proved reserves are estimated quantities of oil which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are those which are expected to be recovered through existing wells with existing equipment and operating methods. Reserves are stated in barrels of oil (Bbls). Geological and engineering estimates of proved oil and natural gas reserves at one point in time are highly interpretive, inherently imprecise and subject to ongoing revisions that may be substantial in amount. Although every reasonable effort is made to ensure that the reserve estimates reported represent the most accurate assessments possible, these estimates are by their nature generally less precise than other estimates presented in connection with financial statement disclosures.

 

		Bbls
	Proved oil reserves
	Balance at December 31, 2003	1,885,878
	Discoveries and extensions	-
	Revisions of previous estimates	(36,059	)
	Production	(42,054	)
	Balance at December 31, 2004	1,807,765
	Discoveries and extensions	-
	Revisions of previous estimates	(24,303	)
	Production	(30,476	)
	Balance at December 31, 2005	1,752,986
	Discoveries and extensions	-
	Revisions of previous estimates	(246,235	)
	Production	(37,880	)
	Balance at December 31, 2006	1,468,871
	Proved developed producing
	reserves at December 31, 2006	394,006
	Proved developed producing
	reserves at December 31, 2005	313,828

The following schedule presents the standardized measure of estimated discounted future net cash flows from the Company’s proved developed reserves for the years ended December 31, 2006 and 2005. Estimated future cash flows were based on independent reserves evaluation from R.A. Lenser and Associates, Inc. for the years ended December 31, 2006 and 2005, respectively. Because the standardized measure of future net cash flows was prepared using the prevailing economic conditions existing at December 31, 2006 and 2005, it should be emphasized that such conditions continually change. Accordingly, such information should not serve as a basis in making any judgment on the potential value of the Company’s recoverable reserves or in estimating future results of operations.

 

F-22

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

18.	SUPPLEMENTAL OIL AND GAS DISCLOSURES (UNAUDITED) (CONTINUED)

 

D.

Estimated quantities of proved oil and gas reserves (Continued)

 

Estimated future net cash flows represent an estimate of future net revenues from the production of proved reserves using current sales prices, along with estimates of the operating costs, production taxes and future development and abandonment costs (less salvage value) necessary to produce such reserves. The average prices per barrel used at December 31, 2006 were $72.58 for Hong Xiang Oil Development and $69.70 for LongDe and those at December 31, 2005 were $55.00 for both Hong Xiang Oil Development and for LongDe. No deduction has been made for depreciation, depletion or any indirect costs such as general corporate overhead or interest expense.

 

Operating costs and production taxes are estimated based on current costs with respect to producing gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions.

 

Income tax expense is computed based on applying the appropriate statutory tax rate to the excess of future cash inflows less future production and development costs over the current tax basis of the properties involved, less applicable carry forwards, for both regular and alternative minimum tax.

 

The future net revenue information assumes no escalation of costs or prices, except for gas sales made under terms of contracts which include fixed and determinable escalation. Future costs and prices could significantly vary from current amounts and, accordingly, revisions in the future could be significant.

 

Standardized measures of discounted future net cash flows relating to proved oil and gas reserves at December 31, 2006 and 2005 is as follows:

 

						Restated
			2006			2005
	Future cash inflows	$	104,761,912		$	96,414,240
	Future production costs and taxes		(25,711,029	)		(29,632,261	)
	Future development costs		(7,180,000	)		(9,840,000	)
	Future income tax expense		(20,365,341	)		(17,298,263	)
	Future net cash flows		51,505,542			39,643,716
	Discount at 10% for timing of cash flows		(29,048,577	)		(23,232,085	)
	Standardized measure of discounted future net cash
	related to proved reserves	$	22,456,965		$	16,411,631

Of the Company’s total proved reserves as of December 31, 2006 and 2005, 27% and 18% respectively were classified as proved developed producing. All of the Company’s reserves are located in the PRC.

 

F-23

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CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED

AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006 AND 2005

 

18.	SUPPLEMENTAL OIL AND GAS DISCLOSURES (UNAUDITED) (CONTINUED)

 

D.

Estimated quantities of proved oil and gas reserves (Continued)

 

The following table sets forth the changes in the standardized measure of discounted future net cash flows from proved reserves for December 31, 2006 and 2005.

 

						Restated
			2006			2005
	Balance, beginning of year	$	16,411,631		$	10,499,973
	Purchase of minerals in place		4,502,198			479,009
	Sale of minerals in place		-			(182,005	)
	Sales and transfers of oil and gas produced, net
	of production costs		(2,236,185	)		(1,235,899	)
	Changes in prices and production costs		27,865,205			21,803,869
	Revision of quantity estimates		(13,360,105	)		(971,354	)
	Changes in estimated future development
	and acquisition costs		(1,842,198	)		(296,998	)
	Net changes in income taxes		(3,067,089	)		(6,373,622	)
	Accretion of discount		(5,816,492	)		(7,311,342	)
	Standardized measure, end of year	$	22,456,965		$	16,411,631

 

 

F-24

 

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