SolarAttic, Inc.

AUDITED FINANCIAL STATEMENTS

Independent Auditors' Report on the Financial Statements F-2

Balance sheets F-3

Statements of operations F-4

Statements of stockholders' equity F-5

Statements of cash flows F-6

Notes to financial statements F-8

To the Board of Directors and Stockholders
SolarAttic, Inc.
Elk River, Minnesota

We have audited the accompanying balance sheets of SolarAttic, Inc. as of December 31, 1996 and 1997, and the related statements of operations, stockholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits 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 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 SolarAttic, Inc. as of December 31, 1996 and 1997, and the results of its operations and its cash flows for the years then ended, in conformity with generally accepted accounting principles.

Plymouth, Minnesota January 15, 1998

---

---

---

Note 1 Nature of Business and Significant Accounting Principles

Nature of operations:

SolarAttic, Inc. (the Company), a Minnesota corporation, was formed on August 11, 1986 and was in the development stage through December 31, 1996. The year 1997 is the first year during which it is considered an operating company. Sales are currently throughout the continental United States. However, markets for the Company's technology and products are international in nature.

Basis of financial statement presentation and accounting estimates:

The accompanying financial statements are presented in accordance with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could vary from those estimates.

Cash equivalent policy and cash flows:

For purposes of reporting cash flows, cash and equivalents is comprised of bank checking accounts.

Inventories:

Inventories are valued at the lower of cost (first-in, first-out method) or market. Inventory is comprised primarily of raw materials.

Furniture and equipment:

Furniture and equipment is recorded at cost, less accumulated depreciation. Depreciation is provided on a straight-line basis over the estimated useful life of three to seven years.

Patent:

The Company has capitalized costs related to acquiring a patent, which are being amortized using the straight-line method over 9.5 years. All other patent costs are expensed as incurred.

Customer list:

The Company has capitalized costs related to acquiring a customer list which are being amortized using the straight-line method over 7 years.

Other liabilities:

The Company has credit cards payable which are backed by the personal guarantee of an officer.

Research and development:

Research and development costs are charged to operations as incurred and totaled $7,817 and $1,853 for 1996 and 1997, respectively.

Stock based compensation:

In 1995, the Financial Accounting Standards Board issued SFAS No. 123, Accounting for Stock-Based Compensation. As permitted by this Standard, the Company will continue to measure compensation cost using the intrinsic value-based method of accounting prescribed by the Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.

Prepaid stock issuance costs:

The Company has recorded prepaid stock issuance costs for legal and other expenses incurred in connection with its SCOR (small corporate offering registration) stock offering. These SCOR costs will be deducted from the proceeds of the SCOR stock issuance.

Income taxes:

The Company has adopted FASB Statement No. 109, Accounting for Income Taxes, which requires an asset and liability approach to financial accounting and reporting for income taxes. Under the asset and liability method, deferred tax assets are recognized for deductible temporary differences and operating loss or tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the amounts of assets and liabilities recorded for income tax and financial reporting purposes. Deferred tax assets are reduced by a valuation allowance when management determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Note 2 Related Party Transactions

Interest expense for related parties was $4,939 in 1996 and $11,659 in 1997.

Amounts due from officer are unsecured, non interest bearing and mature December 31, 1999. Due from officer is scheduled for monthly repayment at the rate of 1/20th of Mr. Palmer's salary when Mr. Palmer starts to receive a salary.

The Company rented office and warehouse facilities from an officer of the Company on a month-to-month basis in 1996 and the first four months in 1997. In addition, the Company paid certain real estate taxes and repairs. Total occupancy related expense was $10,432 in 1996 and $2,354 in 1997.

Note 3 Stockholders' Equity

Stock option plan:

The Company has reserved 1,000,000 shares of common stock for issuance under an incentive stock option plan established in 1986. Under the plan, options are granted at prices determined by the Board of Directors. It is the Company's policy to not grant any options at a price less than the current market or sales price. No options have been granted as of December 31, 1997. The incentive stock option plan matures in 2001.

Stock options:

Certain stockholders are able to purchase additional stock with stock options from options granted which are considered associated with compensation issues under reporting requirements. At December 31, 1997, there were 950,000 options outstanding and exercisable. Of this total, 200,000 options are exercisable at 20¢ per share expiring December 31, 1998; 250,000 options are exercisable at 30¢ per share expiring December 31, 1998; 400,000 shares are exercisable at 40¢ per share expiring December 31, 2000; and, 100,000 options are exercisable at $1.00 per share expiring December 31, 2003. These options were granted outside of the stock option plan. During 1996, options to purchase 400,000 shares were granted at an exercise price of 40¢ per share. During 1997, options to purchase 100,000 shares were granted at an exercise price of $1.00 per share. No option shares expired, were canceled or exercised in 1996 and 1997.

Stock warrants:

Certain stockholders are able to purchase additional stock with stock warrants attached to common stock issued. At December 31, 1997, there were 685,993 warrants outstanding and exercisable. Of this total, 645,993 warrants are exercisable at 20¢ per share expiring December 31, 1998. The remaining 40,000 warrants are exercisable at 30¢ per share expiring December 31, 1998. No warrants were granted in 1996 and 1997. 32,210 shares were exercised in 1996 at 20¢ per share and 130,000 shares were exercised in 1997 at 20¢ per share.

Common shares issued as consideration:

Common shares have been issued periodically for patents, inventory, consulting services, rent and customer lists. The amount assigned to each transaction is based upon contractual agreements.

Stock based compensation:

The Company applies APB Opinion No. 25 in accounting for its stock incentive plans. Accordingly, no compensation cost has been recognized for options granted. There are no charges or credits to expense with respect to the granting or exercise of options since the options were issued with exercise prices at or exceeding fair market value on their respective dates of grant. However, using an option pricing model to determine the fair value of the options and considering the expected option life, anticipation of no dividends, and the risk-free interest rate, determining compensation cost for stock-based compensation plans consistent with SFAS 123 would not have had a material impact on reported net income of the Company.

Note 4 Income Taxes

The Company recorded no provision for income tax expense for the periods ended December 31, 1996 and 1997.

A valuation allowance has been established for the deferred tax asset because management determined it is more likely than not that the deferred tax asset will not be realized. The Company's valuation allowance increased $63,800 from December 31, 1996 to December 31, 1997, due to net operating losses incurred during 1997. At December 31, 1997, for income tax purposes, the Company had federal and state net operating loss carry forwards of approximately $592,000 available that expire through the year 2012.

Note 5 Commitments and Contingencies

Warranty:

The materials assembled by the Company generally carry warranties provided by the manufacturers against product failure. In addition, the Company provides a warranty of its assembled product workmanship. Management has determined that no warranty reserve was necessary as of December 31, 1996 and 1997.

Note 6 Performance Stock Option Agreement

On June 25, 1997, the Company signed a distribution agreement for the exclusive distribution of the Company's pool heater. As part of the agreement, the Company granted the distributor a performance option clause with the following terms: If, prior to September 30, 1998, the distributor sells 100 of the Company's swimming pool heaters, SolarAttic will grant an option in the Company's common stock of 300,000 shares exercisable at $1.65 per share through September 30, 2003. If the distributor sells 500 swimming pool heaters prior to this same date, the option shall be for a total of 600,000 shares exercisable at $1.65 per share and expiring on September 30, 2003. If the distributor fails to sell 100 units, there shall be no options. There are no extensions or other provisions to this agreement. Prior to this time there was no affiliation between the distributor, its principals and the Company or the Company's employees, officers or directors.

Note 7 Operating Leases

In April of 1997, the Company began leasing space under a non-cancelable operating lease expiring April 15, 1999. Under this agreement, the Company issued 124,110 shares of common stock totaling $49,644. This was recorded as prepaid rent expense and is being amortized to rent expense over the lease term. In addition to the common stock, the Company makes a monthly cash payment for rent.

Rent expense totaled $0 and $23,852 for the years ended December 31, 1996 and 1997.

--- End of Audit Report ---

Due to limitations in html translations, the exact format of the auditor's report is not preserved.
The exact report is downloadable as an Acrobat Portable Document File (PDF).  The PDF file provides an exact replication of the auditors's report.

CLICK HERE TO DOWNLOAD AUDIT REPORT
IN ACROBAT PDF FORMAT