Winning the battle against sepsis: The first theranostic EAA & Toraymyxin

Transcription

1 Third quarter report 2010 Winning the battle against sepsis: The first theranostic EAA & Toraymyxin

2 Spectral Third Quarter Letter to Shareholders Dear Shareholders, Subsequent to quarter-end, in October, we enrolled the first patients in our pivotal Phase III trial for Toraymyxin - a major achievement for Spectral and a key milestone in our US strategy to commercialize this unique treatment for severe sepsis and septic shock. Toraymyxin is a therapeutic hemoperfusion device that removes over 90% of circulating endotoxin from the bloodstream, resulting in a significant reduction in mortality. Treatment is directed by the Company s Endotoxin Activity Assay (EAA ), the only FDA cleared diagnostic for the measurement of endotoxin. Over 250,000 patients in the United States develop severe sepsis or septic shock each year. Our activities during the last quarter were focused on the qualification, training and activation of sites for the clinical trial. To ensure a well-executed trial, the selection and qualification process for sites has been highly detailed and aimed at including sites that have extensive experience in clinical trials as well as an appropriate patient population for our trial. We remain on track for all 15 trial sites to be enrolling patients within the next three months. The EUPHRATES trial is the first trial where a theranostic approach has been used as inclusion criteria. Theranostics, the combination of a diagnostic that directs the use of a targeted therapy, is a powerful approach to medicine. In the EUPHRATES trial, our EAA will be used to measure the level of endotoxin in the bloodstream of a patient with severe sepsis or septic shock, and thereby determine whether the Toraymyxin column has the potential to be a beneficial treatment. The trial is expected to enroll approximately 360 patients and will have a primary endpoint of 28 day mortality. We expect that an interim analysis of data will take place by the end of 2011 or early While the EUPHRATES trial remains our priority, we also continue to be active in outreach to both the scientific and investment communities. We recently presented at the American Association for Clinical Chemistry, as well as the 5th Annual Western Canadian Kidney Research Symposium. We also continued our activities with the investment community, highlighted in early September by our presentation at the Rodman & Renshaw 12 th Annual Healthcare Conference in New York. This investorfocused conference was attended by more than 3,500 participants over three days and provided an excellent forum for new investors to become aware of Spectral, our Phase III pivotal trial and our theranostics strategy. I would like to thank the shareholders for your continuing support of Spectral and I look forward to updating you on our progress next quarter. Sincerely, Dr. Paul Walker President & CEO

3 MANAGEMENT S DISCUSSION & ANALYSIS (in thousands of Canadian dollars) This Management s Discussion and Analysis ( MD&A ) for the nine months ended September 30, 2010 has been prepared to help investors understand the financial performance of the Company in the broader context of the Company s strategic direction, the risks and opportunities as understood by management, and the key success factors that are relevant to the Company s performance. Management has prepared this document in conjunction with its broader responsibilities for the accuracy and reliability of the financial statements, as well as the development and maintenance of appropriate information systems and internal controls to ensure that the financial information is complete and reliable. The Finance and Audit Committee of the Board of Directors has reviewed this document and all other publicly reported financial information for integrity, usefulness, reliability and consistency. The following discussion should be read in conjunction with the financial statements for the years ended December 31, 2009 and December 31, This discussion contains certain forward-looking statements based on current expectations. The words expect, intend, anticipate, and similar expressions generally identify forward-looking statements. These forward-looking statements entail various risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements. DISCLOSURE CONTROLS AND INTERNAL CONTROLS The Company s management maintains a system of disclosure controls and procedures to provide reasonable assurance that material information is made known, and has designed internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Generally Accepted Accounting Principles ( GAAP ). Management continually evaluates the effectiveness of its disclosure controls and procedures and has concluded that such processes are operating effectively. There has been no change during the Company s most recent interim period in the internal controls over financial reporting. Dr. Paul M. Walker, Chief Executive Office, and Mr. Anthony Businskas, Chief Financial Officer, in accordance with Multilateral Instrument , have also both certified that: They have reviewed the financial statements and this MD&A ( the Filings ); Based on their knowledge, these Filings do not contain any untrue fact or omit a material fact; The Filings present fairly the financial position, results of the operations and cash flows of the Company;

4 They have designed such disclosure controls and procedures, or caused them to be designed under their supervision, to provide reasonable assurance that (a) material information relating to the Company is made known to them by others within the Company, particularly during the period in which the interim filings are being prepared; and (b) information required to be disclosed by the Company in its annual filings, interim filings or other reports filed or submitted by it under securities legislation is recorded, processed, summarized and reported within the time periods specified in securities legislation. This document and the related financial statements can also be viewed on the Company s website at and at The Company s Annual Information Form is also available on these websites.

5 CRITICAL ACCOUNTING POLICIES The Company s accounting policies are described in the notes to the Audited Financial Statements for the years ended December 31, 2009 and December 31, In addition to accounting policies, the assets, liabilities, revenues and expensed reported in Spectral s financial statements, depend to varying degrees on estimates and judgments made by management. These judgemental areas are similar for most businesses in this industry and should not expose the shareholders to unusual or unexpected trends. The estimates and judgments are based on historical experience and may reflect certain assumptions about the future that are believed to be reasonable. Although these estimates and assumptions are re-evaluated on an ongoing basis, the factors upon which these estimates and assumptions are based, as well as actual results, may differ materially. INTERNATIONAL FINANCIAL REPORTING STANDARDS In February 2008, the CICA announced that Canadian GAAP for publicly accountable enterprises will be replaced by International Financial Reporting Standards ( IFRS ) for fiscal years beginning on or after January 1, Accordingly, the conversion from Canadian GAAP to IFRS will be applicable to the Company s reporting for the first quarter of 2011, for which the current and comparative information will be prepared under IFRS. The Company has determined that the transition to IFRS will not have a material impact on its financial results, internal control over financial reporting, disclosure controls and procedures and business activities. As part of its IFRS implementation plan, the Company continues to review the impact on its disclosure controls and procedures and internal control over financial reporting. The Company has established an IFRS changeover plan consisting of three phases. Diagnostic review phase- consisted of a high level impact assessment to identify key areas of changes. This was completed in 2009 and the results of the review were presented to the Board of Directors. Impact analysis, evaluation and design phase- develop policy alternatives, draft financial statement content and determine changes to existing accounting policies, information systems and business processes. This was completed in the third quarter of Implementation and review phase implement and approve changes to accounting policies, information systems, business processes and training programs, develop IFRS compliant financial statements and obtain audit committee approval. The Company is currently in this phase of the IFRS changeover plan.

6 The following table summarizes the key elements of the Company s plan for transitioning to IFRS and the progress made against each activity: IFRS Impact Area Key Activities Current Status Accounting policies and procedures Identify differences between Canadian GAAP and IFRS accounting policies that impact the Company Selection of IFRS 1 accounting policy choices Analyze and select ongoing policies where alternative are permitted Accounting policy alternatives have been analyzed and recommendations made for the majority of key accounting policy decisions. These accounting policy decisions were preliminarily approved by senior management in Q and will be reviewed by the audit committee in Q Financial statement presentation Prepare financial statements and note disclosure in compliance with IFRS Quantify the effects of converting to IFRS Prepare first-time adoption reconciliations required under IFRS 1 Financial statement format has been completed for the first interim period in 2011 Note disclosure format and content has been completed for the first interim period in 2011 The effects of the conversion have been quantified First-time adoption reconciliations are in process and will be completed with the first annual financial statement prepared under IFRS in 2011

7 Information technology and data systems Internal control over financial reporting ( ICFR )/Disclosure controls and procedures ( DC&P ) Training and communication Business activities Identify changes required to financial systems and implement solutions Determine and implement processes for capturing financial information under Canadian GAAP and IFRS in 2010 for comparative information Determine and implement processes for all changes to policies and procedures identified Design and implement internal controls over the IFRS changeover process Education of management and Audit Committee External communication regarding IFRS status Identify impact of changeover on contractual arrangements and employee compensation plans Completed no changes required, financial software upgraded to the most current version Completed financial reporting system generates all requisite information and thereby satisfies reporting for 2010 and on a go forward basis for 2011 The assessment is done as changes in accounting policies and financial statement preparation are identified Key individuals involved in the changeover process have been trained Included in 2009, year-end MD&A and quarterly MD&A s in 2010 Review of contracts and compensation plans has been completed and there is no impact New contracts entered into will accommodate IFRS changes Substantially all of the differences identified between IFRS and Canadian GAAP have now been quantified. While many of the differences will not have a significant impact on the Company s reported results and financial position, some adjustments will be required as a result of IFRS accounting principles and provisions for first-time adoption. These adjustments are outlined in the following sections.

8 Most adjustments required on transition to IFRS will be made retrospectively against opening deficit as of the date of the first comparative balance sheet presented based on standards applicable at that time. Transitional adjustments relating to those standards where comparative figures are not required to be restated will only be made as of the first day of the year of adoption. First-Time Adoption of IFRS First-Time Adoption of International Financial Reporting Standards ( IFRS 1 ) provides entities adopting IFRS for the first time with a number of optional exemptions and mandatory exceptions, in certain areas, to the general requirement for full retrospective application of IFRS. The most significant IFRS 1 exemptions that are expected to apply to the Company upon adoption are summarized in the following table: Areas of IFRS Share-Based Payments Summary of exemption available Choices: The Company may elect not to apply IFRS 2, Share-Based Payments, to equity instruments granted on or before November 7, 2002 or which vested before the Company s date of transition to IFRS. Policy selection: The Company will elect not to apply the IFRS 2 to equity instruments granted on or before November 7, 2002 or which vested before the company s date of transition to IFRS. Expected transition impact: Not quantified. Expected future impact: Not quantified. Expected areas of significance The key areas where the Company expects accounting policies may differ and where accounting policy decisions are necessary that may impact the Company s financial statements are set out in the following table. Note that this does not include the transition policy choices made under IFRS 1, as described above. Accounting Policy Area Impairment of Assets Impact of Policy Adoption Choices: There are no policy choices available under IFRS. Differences from existing Canadian GAAP: If an indication of impairment exists under Canadian GAAP, the asset s carrying value is compared to the asset s undiscounted cash flows. If the undiscounted cash flows are less than the carrying value, the asset is impaired by an amount equal to the difference between the discounted cash flows and the carrying value. Under IFRS, the asset s carrying value is compared to the asset s discounted cash flows. If the discounted cash flows are less than the carrying value, the asset is impaired by an amount equal to the difference between the discounted cash flows and

9 the carrying value. This may potentially result in more write-downs where carrying values of assets were previously supported under Canadian GAAP on an undiscounted cash flow basis, but could not be supported on a discounted cash flow basis. However, the analytical reporting level under IFRS is higher, which could potentially result in fewer impairments. In addition, IFRS allows the reversal of impairment write-downs, which is prohibited under Canadian GAAP. Expected transition impact: The Company completed an impairment review of its assets on January 1, 2010 and concluded that its assets were not impaired in accordance with IFRS. Expected future impact: Dependent upon future circumstances.

10 Accounting Policy Area Property, plant and Equipment Inventories Financial instruments Impact of Policy Adoption Choices: Either historical cost model or a revaluation model can be used to value property, plant and equipment. Policy selection: The Company has chosen the historical cost method. Differences from existing Canadian GAAP: Under IFRS, where part of an item of property, plant and equipment has a cost that is significant in relation to the cost of the item as a whole, it must be depreciated separately from the remainder of the item. Canadian GAAP is similar in this respect; however it has often not been applied to the same extent due to practicality and/or materiality. Expected transition impact: The Company has reviewed its assets to determine if there are any significant components that need to be depreciated separately. There is no impact. Expected future impact: Dependant on future circumstances. Choices: Either the first-in first-out (FIFO) or the weighted average method can be used to value inventories. Policy selection: The weighted average method will be used to value inventories. Differences from existing Canadian GAAP: None Expected transition impact: None. Expected future impact: None. Choices: Trade date or settlement date can be used. Policy selection: The Company will recognize purchases and sales of financial assets at the trade date. Differences from Canadian GAAP: None. Expected transition impact: None. Expected future impact: None.

11 Accounting Policy Area Revenue recognition Impact of Policy Adoption i.instrumentation Choices: There are no policy choices under IFRS. Differences from existing Canadian GAAP: Under IFRS instrumentation provided to customers where all the risks and benefits of ownership are transferred at the time of shipment is recorded as revenue and the cost is expensed in the same period. Under Canadian GAAP, the net cost is recorded as commercial instruments and written off over the same period as the related customer contract. Expected transition impact: Quantified, not significant. Expected future impact: Not significant. ii.access fees and milestone payments Choices: There are no policy choices under IFRS. Differences from existing Canadian GAAP: Under IFRS milestone payments received for a license with no further performance obligation to the Company are recognized as income when they are receivable under the terms of the contract and receipt is probable. Under Canadian GAAP access fees and milestone payments are recorded as deferred revenue and taken into income over the term of the license or the remaining life of the related patent, whichever is shorter. Expected transition impact: Quantified, not significant. Expected future impact: Not significant. Statement of Cash Flows Statement of loss and comprehensive loss Choices: Either the direct or indirect method may be presented. Interest paid or received can be presented as either operating or financing activities. Policy selection: The Company will use the indirect method. Differences from Canadian GAAP: None. Expected transition impact: None. Expected future impact: None. Choices: Either the by function or by nature method may be presented. Policy selection: The Company will use the by nature method. Expenditures related to the EUPHRATES clinical trial will be disclosed in a

12 note to the financial statements according to function. Differences from Canadian GAAP: None. Expected transition impact: None. Expected future impact: None. The above list and related comments should not be regarded as a complete list of changes that will result from the transition to IFRS. It is intended to highlight those areas that are considered to be the most significant. Until the Company has prepared a full set of annual financial statement under IFRS, it will not be able to determine or precisely quantify all of the impacts that will result from converting to IFRS. Furthermore, the standards are in a constant state of transition and refinement. The ultimate differences between GAAP and IFRS cannot be completely determined at this time. All potential changes are monitored and evaluated and will be adopted as required. OPERATIONS The Company s primary focus continues to be the U.S. commercialization of Toraymyxin as an effective treatment for severe sepsis. On February 26, 2010, the Company received final approval of its Investigation Device Exemption ( IDE ) from the U.S. FDA, which now permits the Company to conduct a pivotal trial for Toraymyxin in the United States. On March 2, 2010, the Company completed a private placement financing for aggregate gross proceeds of 19,500. Net proceeds from the financing, after related costs, were 17,608. Approximately 15,900 of these funds have been invested in low risk guaranteed investment certificates and money market investment funds. In April, 2010, the Company began implementation of its EUPHRATES (Evaluating the Use of Polymyxin B Hemoperfusion in a Randomized controlled trial of adults Treated for Endotoxemia and Septic shock) trial in the United States comparing standard of care versus Toraymyxin plus standard of care. Activities during the third quarter consisted of site evaluation, qualification, and physical set up. All sites are projected to be fully operational by the first quarter of The estimated length of the trial is 24 to 30 months after all sites are operational, with an interim analysis planned at the midpoint of the trial. The trial is expected to enroll approximately 360 patients at 15 sites throughout the U.S., with 28 day mortality being the primary end point. In October, 2010, the Company announced the initiation of the EURPHRATES trial. The Cooper Health System, in Camden, New Jersey, which also acts as the coordinating centre for the trial, has been screening patients using the FDA approved protocol for inclusion and exclusion criteria. After determining the suitability of the protocol, patients are now being enrolled in the trial.

13 Toraymyxin is marketed in Japan and Europe and has been used to treat more than 80,000 sepsis patients safely and effectively. Spectral s EAA can identify patients that will benefit from Toraymyxin and monitor the effects of the treatment. This combination of the EAA diagnostic and the Toraymyxin therapeutic has been utilized by clinicians in Europe since November 2007 and has demonstrated the potential to lead to a significant reduction in mortality. The market opportunity for Spectral is large, as the combined diagnostic and therapeutic product is expected to fulfill a major unmet need for the approximately 250,000 patients who develop severe sepsis or septic shock in the U.S. each year. Over half of these patients have highly elevated levels of endotoxin. SALES Third quarter sales of 722 in 2010 were 93 lower than sales of 815 for the same period in Sales for the nine months ended September 30, 2010 were 2,148 compared to 2,433 in the first half of EAA diagnostic sales and royalty revenues from the Company s proprietary Troponin I products were slightly lower than in the prior year. The lower sales in 2010, compared to 2009, were due primarily to the foreign exchange impact of a strengthening Canadian dollar versus the U.S. and Euro currencies. GROSS MARGIN AND EXPENSES The Company continues to maintain a low cost operating structure, resulting in a gross margin of approximately 79%. While operating expenses that support the existing commercial business have not increased materially, the Company is starting to incur significant expenditures with respect to the implementation of its U.S. pivotal trial. Selling, general and administrative expenses in the quarter of 850 were 143 higher than selling, general and administrative expenses of 707 for the same period as in Selling, general and administrative expenses were 2,511 for the nine months ended September 30, 2010, compared to 2,261 in the prior year. The 250 year to date increase is related to expanded commercialization activities for Toraymyxin and EAA. Clinical trial costs in the quarter were 595, compared to 41 in the third quarter of For the nine months ended September 30, 2010, clinical trial costs were 1,563, compared to 304 for the same period in Clinical trial costs that were incurred in 2009 and through the first quarter of 2010 were primarily related to consulting costs associated with the IDE approval. Commencing April 2010 these costs consist mainly of clinical site start ups, CRO costs and ongoing trial expenses. The 250 of service fees in the third quarter (750 year to date) was paid to Medwell Capital ( Medwell ) formerly BioMS Medical Corp., pursuant to a three year, 3,000 contract that became effective January 1, Under the terms of this contract, Medwell provides consulting services and resources to Spectral, as required, to assist the Company in the regulatory and commercialization process for Toraymyxin.

14 Foreign exchange loss of 35 arises from the collection of second quarter accounts receivable at a lower currency conversion rate than that at which the receivables were recorded. The Canadian dollar continues to fluctuate in value during the first nine months of 2010 in comparison to the U.S. and Euro currencies. Stock based compensation expense of 792 for the nine months ended September 30, 2010 reflects 1,800,000 of stock options granted to directors, officers and employees of the Company, as approved by shareholders, on closing of the private placement financing. There were 365,000 stock options granted during the same period in Other net investment income for the nine months ended September 30, 2010 is 28 compared to a net investment loss of 34 for the same period in The prior period loss was due to a write down of the Company s bond portfolio, which was sold at the end of FINANCING On March 2, 2010, the Company completed a private placement financing whereby the Company issued 48,750,000 Units of the Company (the Units ), at a price of 0.40 per Unit, to a group of investors for aggregate gross proceeds of 19,500. Each Unit consists of one common share of the Company ( Common Share ) and one half of one Common Share purchase warrant (each whole Common Share purchase warrant, a Warrant ) entitling the holder thereof to acquire one Common Share at a price of 0.60 per Common Share for a period of four years from Closing. In connection with the Financing, and as partial consideration for services performed, at Closing, the Company also issued broker warrants to Desjardins Securities Inc., who acted as agent for the Financing, which will entitle them to acquire 1,462,500 Common Shares at an exercise price of 0.40 per Common Share, and a further 731,250 Common Shares at an exercise price of 0.60 per Common Share, in each case, for a period of four years from Closing. The Company has also issued 2,890,625 Common Shares to GrowthWorks Canadian Fund Ltd., at a deemed price of 0.40 per Common Share as full repayment and final settlement of a non-interest bearing, unsecured convertible promissory note in the principal amount of 1,156 dated June 19, BALANCE SHEET, FINANCIAL CONDITION AND LIQUIDITY Cash of 16,353 as at September 30, 2010 (December 31, ,944) increased by 13,409. This increase is attributable to the following cash utilization: Net proceeds of financing 17, 608 Operating losses (3,104) Working capital (446) Payment of Toraymyxin license fee (502)

15 Other (net) (147) 13,409 Management believes it has sufficient cash to fund its U.S. pivotal trial and its existing commercial operations, and to successfully implement its strategy of bringing a combined diagnostic/therapeutic treatment for severe sepsis to the U.S. market. OUTLOOK The Company will continue to operate pursuant to its existing commercial arrangements for EAA and for its proprietary biological reagents in Revenues are anticipated to be relatively consistent with 2009 levels. Selling, general and administrative expenses are also expected to remain consistent year over year, while clinical trial costs will increase as new sites are initiated and patients are enrolled. The Company s strategic focus will be on achieving the site initiation and patient enrolment targets for the Toraymyxin trial, leading to its successful completion, and on the continuing commercialization of the Toraymyxin therapeutic in the U.S. market. The U.S. market opportunity for this product is estimated to be in excess of 1 billion.

16 Spectral Diagnostics Inc. Balance Sheets - unaudited As at September 30, 2010 and December 31, 2009 (in thousands of dollars) Assets Current assets Cash and cash equivalents 16,353 2,944 Accounts receivable Inventories Prepaid expenses ,455 3,893 Property, plant and equipment Commercial instruments Purchased technology and trademarks (note 5) Liabilities 18,671 5,032 Current liabilities Accounts payable and accrued liabilities 784 1,077 Current portion of convertible notes payable (note 6) 1,319 2,336 2,103 3,413 Deferred revenue ,260 3,667 Shareholders Equity Common shares (note 6) 21,281 2,524 Other equity 6,586 5,794 Deficit (11,456) (6,953) 16,411 1,365 18,671 5,032

17 Spectral Diagnostics Inc. Statements of Operations, Comprehensive Loss and Deficit - unaudited For the nine months ended September 30, 2010 and 2009 (in thousands of dollars, except share and per share data) 3 Months Ended September 30 9 Months Ended September Sales ,148 2,433 Cost of sales Gross margin ,691 1,851 Operating expenses Selling, general and administrative ,511 2,261 Clinical trial , Service fees (note 9) Amortization Foreign exchange loss Stock-based compensation Research and product development, net of tax credits , ,154 3,228 Loss before the following (1,301) (416) (4,463) (1,377) Interest on convertible notes payable (24) (41) (83) (123) Other net investment income (loss) (34) Loss and comprehensive loss for the period (1,290) (429) (4,503) (1,534) Deficit - Beginning of period (10,166) (5,294) (6,953) (4,189) Deficit - End of period (11,456) (5,723) (11,456) (5,723) Basic and diluted loss per common share (0.02) (0.01) (0.07) (0.06) Weighted average number of common shares outstanding 75,844,484 24,118,424 64,281,721 24,118,424

18 Spectral Diagnostics Inc. Statements of Cash Flows unaudited For the nine months ended September 30, 2010 and 2009 (in thousands of dollars) Cash provided by (used in) 3 Months Ended 9 Months Ended September 30 September Operating activities Loss and comprehensive loss for the period (1,290) (429) (4,503) (1,534) Items not affecting cash Amortization Amortization of commercial instruments included in cost of sales Stock-based compensation expense Interest on convertible notes payable Unrealized loss on short-term investments Changes in non-cash working capital (note 7) 150 (54) (1,546) (93) (951) (233) (4,650) (838) Financing activities Proceeds on issue of private placement (note 6) ,608 - Proceeds on exercise of stock options Settlement of convertible notes payable (note 6) - - 1, Investing activities Purchase of property, plant and equipment (6) (31) (61) (85) Purchase of commercial instruments (11) (7) (38) (32) Purchase of technology and trademarks (note 5) - - (502) - Decrease in short-term investments - 2,945-3,909 Decrease in deferred revenue (32) (43) (97) (129) (49) 2,864 (698) 3,663 Increase (decrease) in cash and cash equivalents during the period (983) 2,631 13,409 2,825 Cash and cash equivalents - Beginning of period 17, , Cash and cash equivalents - End of period 16,353 3,122 16,353 3,122 Non cash working capital and financing activities Decrease in current portion of convertible notes payable - - (1,100) - Settlement of convertible notes payable - - 1,100 -

19 Spectral Diagnostics Inc. Notes to Financial Statements unaudited September 30, 2010 and 2009 (in thousands of dollars) 1 Nature of operations Spectral Diagnostics Inc. (Spectral or the Company) was incorporated on July 29, 1991 in Ontario, Canada. The Company is strategically focused on the development and commercialization of a treatment for severe sepsis utilizing its Endotoxin Activity Assay (EAA ) diagnostic and the Toraymyxin therapeutic. A US pivotal clinical trial for Toraymyxin (the EUPHRATES trial) is scheduled to be implemented in fifteen sites by the end of All costs related to this regulatory approval process are being charged to income as clinical trial costs. Current revenues are derived primarily from the sale of the Company s EAA diagnostic and of certain proprietary biochemicals and related royalties highlighted by its single chain Troponin I products. 2 Accounting policies The accompanying unaudited financial statements of the Company have been prepared by management in accordance with Canadian generally accepted accounting principles (GAAP) on a basis consistent with those followed in the most recent audited financial statements, except as noted below. These unaudited interim financial statements do not include all the disclosure required by GAAP for annual financial statements. Accordingly, these unaudited interim financial statements should be read in conjunction with the audited annual financial statements of the Company for the years ended December 31, 2009 and Adoption of new accounting policies a) In January 2006, the CICA Accounting Standards Board (AcSB) adopted a strategic plan for the direction of accounting standards in Canada. As part of that plan, the AcSB confirmed in February 2008 that International Financial Reporting Standards (IFRS) will replace Canadian GAAP over a transition period, which will end in 2011, when IFRS will be fully adopted for profit-oriented, publicly accountable enterprises. The Company will be required to report its results in accordance with IFRS commencing on January 1, 2011, with appropriate comparative IFRS financial information for The Company has completed all stages of the changeover plan and has determined that its internal control, accounting and reporting systems will satisfy the financial and disclosure requirements imposed by the adoption of this new standard. The Company has determined that the transition to IFRS will not have a material impact on its financial results, internal control over financial reporting, disclosure controls and procedures and business activities. As part of its IFRS implementation plan, the Company continues to review the impact on its disclosure controls and procedures and internal control over financial reporting.

20 Spectral Diagnostics Inc. Notes to Financial Statements unaudited September 30, 2010 and 2009 (in thousands of dollars) 4 Risk Management a) Financial risk management In the normal course of business, the Company is exposed to a number of financial risks that can affect its operating performance. These risks are: credit risk, liquidity risk and market risk. The Company's overall risk management program and prudent business practices seek to minimize any potential adverse affects on the Company's financial performance. (i) Credit Risk Cash The Company places its cash with Canadian Schedule I banks. Cash equivalents Cash equivalents consist of a 180 day non redeemable GIC s and a premium money market account. All investments are placed with Canadian Schedule I banks and the money market investment account can be converted to cash on demand. Both investments provide a nominal rate of return, which is commensurate with a low investment risk. Accounts receivable The Company sells its products to distribution partners in major markets. The credit risk associated with the accounts receivable pursuant to these agreements is evaluated during initial negotiations and on an ongoing basis. There have been no events of default under these agreements. As of September 30, 2010, no material accounts receivable balances were considered impaired or past due. (ii) Liquidity Risk The Company has no long term debt that requires repayment in cash. The convertible notes payable (face value 1,344) are non-interest bearing and are due on December 31, They may be repaid in cash or common shares at the option of the Company. Accounts payable and accrued liabilities are settled in the regular course of business based on negotiated terms with trade suppliers and will be paid in less than one year. The carrying values of these balances approximate their fair values.

21 Spectral Diagnostics Inc. Notes to Financial Statements unaudited September 30, 2010 and 2009 (in thousands of dollars) (iii) Market Risk Currency risk The majority of the Company's revenue is denominated in US dollars and Euros. At September 30, 2010, cash and cash equivalents included US341. Accounts receivable included a total of US447 and 25. Accounts payable and accrued liabilities included a total of US273 dollars and l. There is no active hedging program currently in place due to the relatively short time frame for settlement of theses balances. A 10% change in the US/Canadian or Euro/Canadian exchange rates on the September 30, 2010 amounts would impact earnings by 26. Interest rate risk The Company has minimal exposure to fluctuations in interest rates. The convertible notes payable are non interest bearing. b) Capital Risk Management The Company's primary objective, when managing capital, is to maintain appropriate levels of cash and short term investments for working capital and operating purposes, as well as funding commercialization of its core products. Capital includes shareholders' equity and the convertible notes payable. 4 Purchased technology and trademarks On April 21, 2010, the Company paid 502 to a third party pursuant to the terms of a license agreement granting Spectral the exclusive development and commercial rights in the US for Toraymyxin. This amount will be amortized over the remaining term of the license commencing on the date of US regulatory approval, unless there is a permanent impairment in value, in which case it will be written off. The remaining 234 balance of purchased technology and trademarks is related to EAA and will be completely amortized by the end of the first quarter of Financing On March 2, 2010, the Company completed a private placement financing, whereby the Company issued 48,750,000 Units of the Company (the Units), at a price of 0.40 per Unit, to a group of investors for aggregate gross proceeds of 19,500. The Company received net proceeds of 17,608. Each Unit consists of one common share of the Company (common share) and one half of one common share purchase warrant (each whole common share purchase warrant) entitling the holder thereof to acquire one common share at a price of 0.60 per common share for a period of four years from closing. In connection with the financing, and as partial consideration for services performed, the Company also issued broker warrants to Desjardins Securities Inc., which acted as agent for the financing, which will entitle it to

22 Spectral Diagnostics Inc. Notes to Financial Statements unaudited September 30, 2010 and 2009 (in thousands of dollars) acquire 1,462,500 common shares at an exercise price of 0.40 per common share, and a further 731,250 common shares at an exercise price of 0.60 per common share, in each case, for a period of four years from closing. The Company has also issued 2,890,625 common shares to GrowthWorks Canadian Fund Ltd., at a deemed price of 0.40 per common share as full repayment and final settlement of a non-interest bearing, unsecured convertible promissory note in the principal amount of 1,156, dated June 19, Supplemental cash flow information 9 Months Ended September Months Ended September Changes in non-cash working capital relating to operating activities Accounts receivable Inventories (128) (4) Prepaid expenses (40) (26) Accounts payable and accrued liabilities (293) (235) Current portion of convertible notes payable (note 6) (1,100) 8 Segmented information a) Sales by geographic location (1,546) (93) 9 Months Ended September Months Ended September United States 1,449 1,750 Europe Asia and other b) Sales to major customers 2,148 2,433 The Company derives a significant portion of its revenues from four customers, representing 49% ( %); 11% ( %); 11 %( %); 10 %( %) of total sales respectively.

23 Spectral Diagnostics Inc. Notes to Financial Statements unaudited September 30, 2010 and 2009 (in thousands of dollars) 9 Related party transactions The Company has entered into a services agreement with Medwell Capital ( Medwell ), formerly BioMS Medical Corp., which entity owns approximately 40% of the outstanding common shares of Spectral. The services agreement is for the provision of various consulting services to assist the Company in its commercialization activities. Under the terms of the agreement, Medwell is paid 1,000 per annum, plus applicable expenses, over three years effective January 1, As at September 30, 2010, the amount owing to Medwell was 99 and was paid in the subsequent period. 10 Comparative figures Certain comparative figures have been reclassified to conform to the financial statement presentation adopted in the current year.