DAYBREAK OIL & GAS, INC. - Quarter Report: 2009 May (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Commission File Number: 000-50107

DAYBREAK OIL AND GAS, INC.

(Exact name of registrant as specified in its charter)

(509) 232-7674

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  þ Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ¨  No¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨Yes þNo

At July 13, 2009 the registrant had 46,979,899 outstanding shares of $0.001 par value common stock.

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TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

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Balance Sheets at May 31, 2009 and February 28, 2009 (Unaudited)

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Statements of Operations for the Three Months Ended May 31, 2009 and 2008, and

from March 1, 2005 (Date of Inception of Exploration Stage) to May 31, 2009 (Unaudited)

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Statements of Changes in Stockholders’ Equity (Unaudited)

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Statements of Cash Flows for the Three Months Ended May 31, 2009 and 2008, and

from March 1, 2005 (Date of Inception of Exploration Stage) to May 31, 2009 (Unaudited)

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Notes to Unaudited Financial Statements

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Item 2 – Management Discussion and Analysis of Financial Condition and Results of Operations

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Item 3 – Quantitative and Qualitative Disclosures about Market Risk

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Item 4 – Controls and Procedures

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PART II - OTHER INFORMATION

Item 1 – Legal Proceedings

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Item 1A – Risk Factors

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Item 6 - Exhibits

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SIGNATURES

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PART I

FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

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

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

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

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

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

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

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DAYBREAK OIL AND GAS, INC.

NOTES TO FINANCIAL STATEMENTS - Unaudited

NOTE 1 — ORGANIZATION AND BASIS OF PRESENTATION

Organization

Originally incorporated as Daybreak Uranium, Inc. under the laws of the State of Washington on March 11, 1955, the Company was organized to explore for, acquire, and develop mineral properties in the Western United States.  During 2005, management of the Company decided to enter the oil and gas exploration industry.  On October 25, 2005, the shareholders approved a name change to Daybreak Oil and Gas, Inc., (the “Company” or “Daybreak”) to better reflect the business of the Company.

All of the Company’s oil and gas production is sold under contracts which are market-sensitive. Accordingly, the Company’s financial condition, results of operations, and capital resources are highly dependent upon prevailing market prices of, and demand for, oil and natural gas.  These commodity prices are subject to wide fluctuations and market uncertainties due to a variety of factors that are beyond the control of the Company.  These factors include the level of global demand for petroleum products, foreign supply of oil and gas, the establishment of and compliance with production quotas by oil-exporting countries, the relative strength of the U.S. dollar, weather conditions, the price and availability of alternative fuels, and overall economic conditions, both foreign and domestic.

Basis of Presentation

The accompanying unaudited interim financial statements and notes for the Company have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q for quarterly reports under Section 13 or 15 (d) of the Securities Exchange Act of 1934 (the “Exchange Act”).  Accordingly, they do not include all of the information and footnotes disclosures normally required by accounting principles generally accepted in the United States of America for complete financial statements.  

In the opinion of management, all adjustments considered necessary for a fair presentation have been included and such adjustments are of a normal recurring nature.  Operating results for the three months ended May 31, 2009 are not necessarily indicative of the results that may be expected for the fiscal year ending February 28, 2010.

These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual report on Form 10-K for the year ended February 28, 2009.

Exploration Stage Company

On March 1, 2005 (the inception date), the Company commenced oil and gas exploration and development activities. As of May 31, 2009, the Company has not achieved sustainable positive cash flow from its oil and gas operations.  Accordingly, the Company’s activities have been accounted for as those of an “Exploration Stage Enterprise” as set forth in SFAS No. 7, “Accounting for Development Stage Entities” (“SFAS No. 7”).  Among the disclosures required by SFAS No. 7 are that the Company’s financial statements be identified as those of an exploration stage company. In addition, the statements of operations, stockholders’ equity and cash flows are required to disclose all activity since the Company’s date of inception.

The Company will continue to prepare its financial statements and related disclosures in accordance with SFAS No. 7 until such time as the Company’s oil and gas properties have generated significant and sustainable revenues.

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Use of Estimates

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions.  These estimates and assumptions may affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period.  Actual results could differ materially from those estimates. The accounting policies most affected by management’s estimates and assumptions are as follows:

·

The reliance on estimates of proved reserves to compute the provision for depreciation, depletion and amortization and to determine the amount of any impairment of proved properties;

·

The valuation of unproved acreage and proved oil and gas properties to determine the amount of any impairment of oil and gas properties;

·

Judgment regarding the productive status of in-progress exploratory wells to determine the amount of any provision for abandonment; and

·

Estimates regarding abandonment obligations.

Reclassifications

Certain reclassifications have been made to conform the prior period’s financial information to the current period’s presentation.  These reclassifications had no effect on previously reported net loss or accumulated deficit.

NOTE 2 — GOING CONCERN

Financial Condition

The Company’s financial statements for the three months ended May 31, 2009 have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities in the normal course of business.  The Company has incurred net losses since inception and has accumulated a deficit during the exploration stage of $19,063,418, which raises substantial doubt about the Company’s ability to continue as a going concern.

Management Plans to Continue as a Going Concern

Implementation of plans to enhance the Company’s ability to continue as a going concern are underway.  On May 1, 2009, the Company signed an Exchange Option Agreement with a third party, which gave that third party the option to purchase a 25% working interest in the East Slopes project for $512,500 and commits to a payment in an amount equal to $700,000 to be payable out of production from (a) 25% of the net revenue from the Sunday #1 and Bear #1 wells and (b) 50% of the net revenue from all future wells.  The third party will also assign the Company a 25% working interest in 14,100 acres in Kern County, California that is immediately north of the Company’s East Slopes project area.  This sale was completed on June 11, 2009 with an effective date of May 1, 2009.  The Company continues to own its original 25% working interest in the project and plans to expand its developmental drilling program at a rate that is compatible with its cash flows.  

On April 29, 2009, the Company signed an agreement to sell its interest in the East Gilbertown Field to a third party for $50,000 and other considerations.  The closing date for this sale will occur upon receiving final regulatory approval from the State of Alabama.  After this sale is complete, the Company will recover $250,000 in cash collateral that the Company had to post to secure an operator bond in Alabama.  In addition, the Company plans to secure additional debt or equity funding, if necessary.

The Company’s financial statements as of May 31, 2009 do not include any adjustments that might result from the inability to implement or execute its plans to improve its ability to continue as a going concern.

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NOTE 3 — RECENT ACCOUNTING PRONOUNCEMENTS

In April 2009, the FASB issued FSP No. FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FAS 157-4”) to amend SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).  FAS 157-4 provides additional guidance for estimating fair value in accordance with SFAS 157 when the volume and level of activity for an asset or liability has significantly decreased.  In addition, FAS 157-4 includes guidance on identifying circumstances that indicate a transaction is not orderly.  FAS 157-4 is effective for interim and annual reporting periods ending after June 15, 2009.  The Company is currently assessing the impact, if any, that the adoption of this pronouncement will have on the Company’s operating results, financial position or cash flows.

In June 2008, FASB ratified EITF No. 07-05, “Determining Whether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s Own Stock” (“EITF 07-05”).  EITF 07-05 provides that an entity should use a two-step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions.  EITF 07-05 became effective March 1, 2009, and the Company has determined that the adoption of this pronouncement did not have an impact on the Company’s operating results, financial position or cash flows.

In December 2008, the Securities and Exchange Commission (the “SEC”) released Final Rule, “Modernization of Oil and Gas Reporting.”  The new disclosure requirements include provisions that permit the use of new technologies to determine proved reserves if those technologies have been demonstrated empirically to lead to reliable conclusions about reserve volumes.  The new requirements also will allow companies to disclose their probable and possible reserves to investors.  In addition, the new disclosure requirements require that companies 1) report the independence and qualifications of its reserves preparer or auditor, 2) file reports when a third party is relied upon to prepare reserves estimates or conduct a reserves audit, 3) report oil and gas reserves using an average price based upon the prior 12-month period rather than year-end prices.  The new disclosure requirements are effective for financial statements for fiscal years ending on or after December 31, 2009.  Early adoption is not permitted.  The Company is currently assessing the impact, if any, that the adoption of the pronouncement will have on the Company’s operating results, financial position or cash flows.  

In May 2008, the FASB issued SFAS No. 162 “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), which identifies a consistent framework for selecting accounting principles to be used in preparing financial statements for nongovernmental entities that are presented in conformity with United States generally accepted accounting principles (“GAAP”).  The current GAAP hierarchy was criticized due to its complexity, ranking position of FASB Statements of Financial Accounting Concepts and the fact that is directed at auditors rather than entities.  SFAS 162 will be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU Section 11 “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.”  The FASB does not expect that SFAS 162 will have a change in current practice, and the Company does not believe that SFAS 162 will have an impact on operating results, financial position or cash flows.  

NOTE 4 — CONCENTRATION OF CREDIT RISK

Substantially all of the Company’s accounts receivable result from natural gas and crude oil sales or joint interest billings to third parties in the oil and gas industry.  This concentration of customers and joint interest owners may impact the Company’s overall credit risk as these entities could be affected by similar changes in economic conditions as well as other related factors.  Accounts receivable are generally not collateralized.  

At each of the Company’s three producing projects, there is only one buyer for the purchase of oil or gas production.  At May 31, 2009, three customers represented 100% of crude oil and natural gas sales receivable from all projects in aggregate.

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In accordance with the provisions of SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information,” a table disclosing the total amount of revenues from any single customer that exceeds 10% of total revenues follows:

NOTE 5 — ASSETS HELD FOR SALE

On June 11, 2009, the Company closed on the sale of a 25% working interest in its California (East Slopes) project to a third party.  Consequently, the related working interest amounts is presented as Assets held for sale in the balance sheet as of May 31, 2009. The excess of the net book value over the selling price ($287,701) was recorded as impairment loss in accordance with SFAS 144.   

NOTE 6 — OIL AND GAS PROPERTIES

Oil and gas properties at May 31, 2009 and February 28, 2009 consisted of the following:

NOTE 7 — ACCOUNTS PAYABLE

During January 2009, the Company was notified by its non-Chevron working interest partners, including the project operator, that they could no longer financially continue in the East Slopes Project in California.  As a result, these partners defaulted on a portion of the financial obligation of their respective working interests for the drilling and completion costs of the four earning wells program and Daybreak assumed an additional 25% working interest in the project.  On March 1, 2009, the Company became the operator for both of the California project areas. Additionally, the Company then assumed the defaulting partners approximate $1.5 million liability from the drilling and completion costs associated with the East Slopes Project four earning wells program.  The Company subsequently sold the 25% working interest on June 11, 2009 (see also Notes 2 and 5).

NOTE 8 — DISCONTINUED OPERATIONS

The Company finalized the disposal of two oil and gas properties during the year ended February 28, 2009.  The properties disposed of were the Tuscaloosa Project in Louisiana and the Saxet Deep Field in Texas.  

On April 29, 2009, the Company signed an agreement to sell its interest in the East Gilbertown Field to a third party for $50,000 and other considerations.  The sale closing is awaiting final regulatory approval from the State of Alabama.   

The following tables present the revenues and expenses related to the above projects for the three months ended May 31, 2009 and May 31, 2008, and from inception through May 31, 2009.  Prior period income statement amounts applicable to the above projects have been reclassified and included under Income (loss) from discontinued operations.

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NOTE 9 — SERIES A CONVERTIBLE PREFERRED STOCK

The Company has designated 2,400,000 shares of the authorized 10,000,000 preferred shares as Series A Convertible Preferred Stock (“Series A Stock”), with a $0.001 par value.  The Series A Stock can be converted by the shareholder at any time into three shares of the Company’s common stock.  As of May 31, 2009, there have been 339,300 shares of Series A Stock converted by 22 shareholders into 1,017,900 shares of the Company’s common stock.

NOTE 10 — SERIES A CONVERTIBLE PREFERRED STOCK DIVIDEND

A component of the Series A Stock is a 6% annual cumulative dividend based on the original purchase price of the shares.  The dividends may be paid in cash or common stock at the discretion of the Company. Accumulations of annual dividends do not bear interest and are not payable until a dividend is declared by the Company.  Dividends are earned until the Series A Stock is converted to common stock.   

The table below details the cumulative dividends for each fiscal year since issuance and the interim three months of the current fiscal year:

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NOTE 11 — WARRANTS

Warrants outstanding and exercisable as of May 31, 2009 are:

For the three months ended May 31, 2009, no warrants were issued or exercised. As of May 31, 2009 and February 28, 2009, there were 13,306,893 warrants issued and outstanding.  The intrinsic value of all warrants at May 31, 2009 was $-0-.

NOTE 12 — RESTRICTED STOCK and RESTRICTED STOCK UNIT PLAN

On April 6, 2009, the Board of Directors (the “Board”) of Daybreak approved the 2009 Restricted Stock and Restricted Stock Unit Plan (the “2009 Plan”) allowing the executive officers, directors, consultants and employees of the Company and its affiliates to be eligible to receive restricted stock and restricted stock units awards.  Subject to adjustment, the total number of shares of the Company’s Common Stock that will be available for the grant of Awards under the 2009 Plan may not exceed 4,000,000 shares; provided, that, for purposes of this limitation, any stock subject to an Award that is forfeited in accordance with the provisions of the Plan will again become available for issuance under the Plan. 

On April 6, 2009, the compensation committee of the board of directors approved awards of restricted shares of common stock of the Company to James F. Westmoreland, President and Chief Executive Officer of the Company and Timothy R. Lindsey, former interim President and Chief Executive Officer of the Company of 500,000 each (the “Restricted Shares”).  The Restricted Shares were granted pursuant to the 2009 Plan and vest over three years at a rate of 33 1/3% each year.

On April 6, 2009, the compensation committee of the board of directors approved awards of restricted shares of common stock of the Company to five non-employee directors.  A total of 900,000 Restricted Shares were granted pursuant to the 2009 Plan and vest in three annual increments or upon the retirement of the Director from the Board.

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NOTE 13 — INCOME TAXES

Reconciliation between actual tax expense (benefit) and income taxes computed by applying the U.S. federal income tax rate and state income tax rates to income from continuing operations before income taxes is as follows:

Tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred liabilities are presented below: