LKAI LKA Gold Incorporated (CE)

Notes to the Unaudited Consolidated Financial Statements

September 30, 2017

NOTE 1 -      ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

LKA Gold Incorporated ("LKA" or the "Company") is currently engaged in efforts to expand mine production and continues to seek additional investment opportunities.

The accompanying unaudited consolidated financial statements have been prepared by LKA pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted in accordance with such rules and regulations. The information furnished in the interim consolidated financial statements include normal recurring adjustments and reflects all adjustments, which, in the opinion of management, are necessary for a fair presentation of such financial statements. Although management believes the disclosures and information presented are adequate to make the information not misleading, it is suggested that these interim consolidated financial statements be read in conjunction with LKA's most recent audited financial statements. Operating results for the nine months ended September 30, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

NOTE 2 -      RELATED PARTY TRANSACTIONS

Related Party Debt – Office Space

LKA pays a company owned by an officer and shareholder $1,500 per month for office rent and expenses. The affiliated company (Abraham & Co., Inc. a FINRA member and registered investment advisor) also executes LKA's securities transactions and manages its investment portfolio. During the nine months ended September 30, 2017, Abraham & Co., Inc. agreed to exchange $25,500 in outstanding accounts payable for 56,818 shares of LKA common stock valued at the market price on the grant date and recognized $25,500 in accounts payable extinguishment and $10,863 in expense related to market discount. LKA owed Abraham & Co. $19,305 and $31,500 as of September 30, 2017 and December 31, 2016, respectively.

Related Party Debt – Notes, Accounts and Wages Payable

At September 30, 2017 and December 31, 2016, LKA owes $0 and $5,500, respectively, for short-term operating capital notes payable to LKA's President, Kye Abraham.  During the nine months ended September 30, 2017, LKA borrowed an additional $1,100 and repaid the entire $6,600.

At September 30, 2017 and December 31, 2016, LKA owes $36 and $8,595, respectively, for purchases made on the personal credit card of LKA's President, Kye Abraham.  

During the nine months ended September 30, 2017, LKA's President, Kye Abraham agreed to convert $150,000 in accrued unpaid salary into a convertible debenture. At September 30, 2017 and December 31, 2016, LKA owed Kye Abraham $75,757 and $163,257 in unpaid salary, respectively.

Convertible Debentures

On September 29, 2015, LKA issued two convertible debentures (Convertible Debentures), each in the amount of $125,000, or a total of $250,000 to members of the Koski family, the Company's largest shareholders. Principal on the Convertible Debentures is due September 29, 2018. Interest accrues at 7.5% per annum and interest is due on a semi-annual basis. The Convertible Debentures are convertible at any time into shares of LKA common stock at $0.50 per share.

On March 15, 2017, LKA issued a convertible debenture in the amount of $150,000 to members of the Koski family, the Company's largest shareholders. Principal on the Convertible Debenture is due March 15, 2021. The Convertible Debenture accrues interest at 7.5% and is convertible at any time into shares of LKA common stock at $0.50 per share. Interest is due on a semi-annual basis and LKA is required to retain a reserve amount of the proceeds to pay the first two semi-annual interest payments, which, if the Convertible Debentures are converted within one year, will be paid to the Convertible Debenture holders. As such, LKA has designated $11,250 as restricted cash at September 30, 2017.

On March 17, 2017, LKA issued a convertible debenture in the amount of $150,000 to its President and Chairman, Kye Abraham in exchange for $150,000 in accrued and unpaid wages. Principal on the Convertible Debenture is due March 17, 2021. The Convertible Debenture accrues interest at 7.5% and is convertible at any time into shares of LKA common stock at $0.50 per share. Interest is due on a semi-annual basis and LKA is required to retain a reserve amount of the proceeds to pay the first two semi-annual interest payments, which, if the Convertible Debentures are converted within one year, will be paid to the Convertible Debenture holders. As such, LKA has designated $11,250 as restricted cash at September 30, 2017.

On March 31, 2017, LKA issued a convertible debenture in the amount of $50,000 to an entity controlled by LKA's President and Chairman, Kye Abraham. Principal on the Convertible Debenture is due June 30, 2021. The Convertible Debenture accrues interest at 7.5% and is convertible at any time into shares of LKA common stock at $0.50 per share. Interest is due on a semi-annual basis and LKA is required to retain a reserve amount of the proceeds to pay the first two semi-annual interest payments, which, if the Convertible Debentures are converted within one year, will be paid to the Convertible Debenture holders. As such, LKA has designated $3,750 as restricted cash at September 30, 2017.

If any event of default occurs, the interest rate increases to 15% per annum and the conversion rate shall be decreased to $0.25 per share. As a result of the potential variable conversion rate, the conversion option embedded in this instrument is classified as a liability in accordance with Accounting Series Codification Topic 815, "Derivatives and Hedging" (ASC 815) on the date of issuance and during the nine months ended September 30, 2017, LKA recognized debt discounts totaling $350,000. During the nine months ended September 30, 2017 and 2016, LKA recognized $60,295 and $1,383 of interest expense from the amortization of the debt discounts, respectively.

LKA incurred $12,500 in debt issuance costs on the convertible debenture issuances in September 2015. The debt issuance costs are being amortized over the three year term of the convertible debenture. During the nine months ended September 30, 2017 and 2016, LKA recognized $4,515 and $3,125 of interest expense from the amortization of debt issuance costs, respectively.

Convertible debenture holders were notified November 6, 2017 that the current bi-annual interest payments in the amount of $22,499 would be delayed while the Company is working on new financing arrangements. During November 2017, all related party convertible debenture holders agreed to defer the semi-annual past due payment until the next scheduled payment in 2018.

NOTE 3 -     CONVERTIBLE DEBENTURES

During October 2015, LKA issued a 7.5% Convertible Debenture for $50,000 in cash. The Convertible Debenture accrues interest at 7.5% per annum due in semi-annual payments, is unsecured, due in three years from the date of issuance and is convertible into shares of LKA common stock at any time at the option of the holder at a rate of $0.50 per share.

During April 2016, LKA issued two $50,000 Convertible Debentures for $100,000 in cash.  The Convertible Debentures accrue interest at 7.5% per annum due in semi-annual payments, are unsecured, due in three years from the dates of issuance and are convertible into shares of LKA common stock at any time at the option of the holder at a rate of $0.50 per share. Interest is due in semi-annual payments.

On April 26, 2017, LKA issued a convertible debenture in the amount of $50,000 for cash. Principal on the Convertible Debenture is due April 26, 2021. The Convertible Debenture accrues interest at 7.5% and is convertible at any time into shares of LKA common stock at $0.50 per share. Interest is due on a semi-annual basis and LKA is required to retain a reserve amount of the proceeds to pay the first two semi-annual interest payments, which, if the Convertible Debentures are converted within one year, will be paid to the Convertible Debenture holders. As such, LKA has designated $3,750 as restricted cash at September 30, 2017.

If any event of default occurs, the interest rate increases to 15% per annum and the conversion rate shall be decreased to $0.25 per share. As a result of the potential variable conversion rate, the conversion option embedded in this instrument is classified as a liability in accordance with ASC 815 and LKA recognized a debt discount of $199,369 on all the above mentioned Convertible Debentures. During the nine months ended September 30, 2017 and 2016, LKA recognized 8,659 and $3,107 of interest expense from the amortization of the debt discount.

LKA incurred $12,500 in debt issuance costs on the convertible debenture issuance. The debt issuance costs are being amortized over the three year term of the convertible debenture. During the nine months ended September 30, 2017 and 2016, LKA recognized $623 and $10,625 of interest expense from the amortization of debt issuance costs.

Convertible debenture holders were notified November 6, 2017 that the current bi-annual interest payments in the amount of $7,500 would be delayed while the Company is working on new financing arrangements. During November 2017, the Caldera Partners Limited Partnership, a related party entity, agreed to extend a financing arrangement with LKA for the purpose paying off this past due interest and the amounts were subsequently paid in full by LKA on November 17, 2017.

NOTE 4 -      DERIVATIVE LIABILITY

LKA analyzed the conversion options embedded in the convertible notes payable and convertible notes payable related party for derivative accounting consideration under ASC 815 and determined that the instruments embedded in the above referenced Convertible Notes should be classified as liabilities and recorded at fair value due to the potentially variable conversion prices.  

 

The fair value of the conversion options for Convertible Debentures issued during the nine months ended September 30, 2017 was determined to be $609,812 as of the issuance date using a Black-Scholes option-pricing model.   Upon the date of issuance of the Convertible Notes, $400,000 was recorded as debt discount and $209,812 was recorded as day one loss on derivative liability.  During the nine months ended September 30, 2017 , $494,995 of gain was recorded on mark-to-market of the conversion options, respectively.

The following table summarizes the derivative liabilities included in the consolidated balance sheets at September 30, 2017 and December 31, 2016:

The Company valued its derivatives liabilities using the Black-Scholes option-pricing model.  Assumptions used during the nine months ended September 30, 2017 include (1) risk-free interest rates of between 1.31% and 1.93%, (2) lives of between 1.01 and 4.06 years, (3) expected volatility between 214% - 446%, (4) zero expected dividends, (5) conversion prices as set forth in the related instruments, and (6) the common stock price of the underlying share on the valuation dates.

 

NOTE 5-       FAIR VALUE OF FINANCIAL INSTRUMENTS  

ASC 820, "Fair Value Measurements" (ASC 820) and ASC 825, "Financial Instruments" (ASC 825) , requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. It establishes a fair value hierarchy based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. It prioritizes the inputs into three levels that may be used to measure fair value:

Level 1 - Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.

Level 2 - Level 2 applies to assets or liabilities for which there are inputs other than quoted prices that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.

Level 3 - Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.

The carrying values of cash, accounts payable, and accrued liabilities approximate fair value. Pursuant to ASC 820 and 825, the fair value of cash is determined based on "Level 1" inputs, which consist of quoted prices in active markets for identical assets. The recorded values of all other financial instruments approximate their current fair values because of their nature and respective maturity dates or durations.

The following table sets forth by level within the fair value hierarchy the Company's financial assets and liabilities that are measured at fair value on a recurring basis at September 30, 2017 and December 31, 2016:

NOTE 5 -      NOTIFICATION OF POSSIBLE ENVIRONMENTAL REMEDIATION

In 2002 the Federal Bureau of Land Management (the "BLM") advised LKA of its desire to extend to the Ute-Ulay Property certain environmental clean-up ("remediation") activities that it is conducting on neighboring properties that LKA does not own.  The BLM commissioned and obtained three engineering evaluation and cost analysis ("EE/CA") studies/reports on the Ute-Ulay and the neighboring public lands in 2002-2006.  These EE/CA studies analyzed the current environmental state of the Ute-Ulay property and other properties in the area.  The studies identified a large volume of mine tailings and metals loading of shallow ground water, with elevated levels of arsenic, cadmium and lead being present.  The BLM's most recent study, "Value Engineering Study on the Ute Ulay Mine/Mill Site – Final Report" dated January 5, 2006, projected the costs of remediation and property stabilization on the Ute-Ulay property to be approximately $2.1 million.  Based upon discussions with Hinsdale County, Colorado officials, Colorado Department of Public Health & Environment Ute-Ulay project supervisor, the Federal Environmental Protection Agency's (the "EPA") regional manager, and legal counsel, the actual costs associated with this effort are expected to be approximately $1.2 million; substantially below previous BLM estimates.  Under the federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), the EPA may either require a property owner to perform the necessary cleanup or the agencies may perform the work and seek recovery of costs against the property owner and previous owners.  While it cannot be determined with absolute certainty until the project is completed, LKA's status as a " de minimis" participant and the fact that remediation activities are focused on property located largely outside of LKA's permitted operating area, LKA management expects this project will have a negligible impact on the LKA's financial condition.  Accordingly, pursuant to Generally Accepted Accounting Principles, and all discussions with the above named agencies to date, LKA management believes it is unlikely there will be a material impact to its financial statements and no liability for this project has been recorded as of September 30, 2017. Actual completion of remediation work at the site was completed in late 2013 by the EPA. The EPA has not yet issued its notice of final determination.

NOTE 6 -     WASTEWATER DISCHARGE LIABILITY

During the fourth quarter of 2014, LKA received a Notice of Violation (NOV) from the Colorado Department of Health and Environment (CDPHE) for failure to meet certain requirements of the Company's wastewater discharge permit. During 2016, the Company undertook all corrective actions specified in the NOV, under CDPHE oversight, and believes it is in compliance with the terms of its permit. Additional work is going to be required to modify and upgrade the mine's water treatment process in 2017 to meet regulatory requirements and bring LKA back into compliance with its discharge permit requirements. Until this work is completed to the satisfaction of CDPHE, the Company is considered to be in a "non-compliance" status with the terms of its discharge permit and additional penalties could be assessed beyond those described (anticipated) above.  It is currently expected that discussions with the CDPHE will be concluded by the end of 2017 and that any financial penalty assessed and any further corrective actions will not likely cost less than $75,000 but not more than $150,000. If LKA is unsuccessful is achieving full compliance with permit requirements, it may be subject to additional penalties or revocation of its discharge permit. As a result, LKA has accrued a liability of $120,416 and $75,000 as of September 30, 2017 and December 31, 2016, respectively, as there is no better estimate of the amount of loss within this range. During the nine months ended September 30, 2017, due to an increase in estimated costs to meet proposed corrective actions, LKA increase the accrual by $75,000. During the nine months ended September 30, 2017, LKA spent approximately $29,584 in remediation expenses and the liability balance is $120,416 at September 30, 2017.

NOTE 7 -     MINE EXPLORATION AND OPTION AGREEMENT

On July 9, 2015, LKA entered into an Exploration Agreement & Option (Agreement) with Kinross Gold U.S.A., Inc. for the purpose of expanding its Golden Wonder Mine exploration beyond LKA's active workings. The Agreement, amongst its other provisions, granted Kinross a five-year exclusive right to explore, and if successful, develop any mineral resource(s) containing 50,000 or more ounces of gold on LKA's properties above and adjacent to the Golden Wonder Mine. On or about September 20, 2017, Kinross gave LKA notice of termination of the Agreement.

NOTE 8 -      COMMON STOCK

During February 2017, Abraham & Co., Inc. agreed to exchange $25,500 in outstanding accounts payable for 56,818 shares of LKA common stock valued at the market price on the grant date and recognized $25,500 in accounts payable extinguishment and $10,863 in expense related to market discount.

During June 2017, LKA issued 18,913 shares of common stock for services valued at the market price on the grant date of $10,782, or $0.57 per share.

During July 2017, LKA commenced a limited private Offering to sell to certain accredited investors, "Units" priced at $0.48 each, with a minimum investment of $10,000 and additional investment in increments of $5,000. Each Unit consists of one share of LKA Gold common stock and a "Warrant" to purchase an additional LKA Gold share of common at $0.60 for a period of two years from date of original subscription.

During July 2017, LKA issued 20,834 shares of common stock and warrants to purchase an additional 20,834 shares of common stock at an exercise price $0.60 per share for cash of $10,000.

NOTE 9 -      GOING CONCERN

LKA's consolidated financial statements are prepared using Generally Accepted Accounting Principles applicable to a going concern that contemplates the realization of assets and liquidation of liabilities in the normal course of business.  However, LKA has recently accumulated significant losses,   has a working capital deficit and has negative cash flows from operations, which raise substantial doubt about its ability to continue as a going concern.  Management's plans with respect to alleviating the adverse financial conditions that caused management to express substantial doubt about the LKA's ability to continue as a going concern are as follows:

During the third quarter of 2015, LKA shifted its focus from exploratory mining to prepare for another surface and/or underground drilling program. The new program will be designed to locate new high-grade structures near or within the Carve-Out Area defined by the exploration agreement between LKA and Kinross. Until additional high-grade targets are located, LKA has suspended exploratory mining operations. Accordingly, cash flow from gold sales is not expected until exploratory mining is resumed. The exploration program, which began in November 2008, has involved extensive sampling/assaying for the purpose of identifying possible new production zones within the mine. During this evaluation period, sampling and analysis of exposed veins yielded encouraging results and some precious metals revenues. While encouraging, no conclusion can be drawn at this time about the commercial viability of the mine and LKA continues to evaluate potential merger, joint venture or lease agreements for the property.

In order to support continued operation of the mine, LKA completed a $200,000 capital funding raise in March 2017, an additional $50,000 in April 2017 and during July 2017, entered into a limited private offering of its common stock to sell to certain accredited investors, "Units" priced at $0.48 each with a minimum investment of $10,000 with additional investment in increments of $5,000. Each Unit consists of one share of LKA Gold common stock and a "Warrant" to purchase an additional LKA Gold share of common at $.60 (exercise price) for a period of two years from date of original subscription. During September, in conjunction with the termination of the Kinross exploration agreement, LKA terminated the limited private offering (see Note 7). 

There can be no assurance that LKA will be able to achieve its business plans, raise any more required capital or secure the financing necessary to achieve its current operating plan.  The ability of LKA to continue as a going concern is dependent upon its ability to successfully accomplish the plan described in the preceding paragraph and eventually attain profitable operations. The accompanying consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.