Archangel Diamond Corporation -127 #8802

Consolidated Financial Statements

ARCHANGEL DIAMOND CORPORATION

Years ended December 31, 2007 and 2006

(Expressed in United States Dollars)

Deloitte & Touche LLP Brookfield Place 181 Bay Street Suite 1400 Toronto ON M5J 2V1 Canada Tel: 416-601-6150 Fax: 416-601-6151 www.deloitte.ca

Auditors’ Report To the Shareholders of Archangel Diamond Corporation We have audited the consolidated balance sheets of Archangel Diamond Corporation as at December 31, 2007 and 2006 and the consolidated statements of operations and deficit and comprehensive loss, shareholders’ (deficiency) equity, and cash flows for the years then ended. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Corporation as at December 31, 2007 and 2006 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. As disclosed in Note 4, the consolidated financial statements as at December 31, 2006 and for the year then ended have been restated. We therefore withdraw our previous audit report dated March 30, 2007.

Chartered Accountants Licensed Public Accountants Toronto, Ontario April 9, 2008, except for note 11 which is as of April 28, 2008

“Deloitte & Touche LLP”

ARCHANGEL DIAMOND CORPORATION Table of Contents December 31, 2007

Page

Consolidated Balance Sheets 1

Consolidated Statements of Operations and Deficit and Comprehensive Loss 2

Consolidated Statements of Cash Flows 3

Consolidated Statements of Shareholders’ (Deficiency) Equity 4

Notes to the Financial Statements 5 - 21

ARCHANGEL DIAMOND CORPORATIONConsolidated Balance SheetsAs at December 31, 2007 and 2006(Expressed in United States Dollars)

2007 2006ASSETS (Restated - Note 4)

CURRENTCash and cash equivalents 868,607$ 2,991,485$ Accounts receivable 59,280 6,046 Prepaid deposit 113,669 196,312

1,041,556 3,193,843

RESTRICTED DEPOSIT 50,439 - MINERAL PROPERTY (Note 5) 1 1

1,091,996 3,193,844

PROPERTY, PLANT AND EQUIPMENT 49,474 49,474 ACCUMULATED AMORTIZATION (49,474) (49,474)

- - 1,091,996$ 3,193,844$

LIABILITIES

CURRENTAccounts payable and accrued liabilities 2,327,954$ 840,652$

NON CURRENTLoan payable to related party (Note 9) 1,000,000 -

3,327,954 840,652

CONTINUING OPERATIONS (Note 2)

CONTINGENCIES (Note 10)

SHAREHOLDERS' (DEFICIENCY) EQUITY

SHARE CAPITAL (Note 6) 42,824,484 41,856,904

CONTRIBUTED SURPLUS - 443,321

ACCUMULATED OTHER COMPREHENSIVE INCOME - -

DEFICIT (45,060,442) (39,947,033) (2,235,958) 2,353,192 1,091,996$ 3,193,844$

APPROVED BY THE BOARD

/s/ Robert Shirriff /s/ Tom Beardmore-Gray

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ARCHANGEL DIAMOND CORPORATIONConsolidated Statements of Operations and Deficit and Comprehensive LossYears ended December 31, 2007 and 2006(Expressed in United States Dollars)

2007 2006(Restated - Note 4)

ADMINISTRATION COSTSAccounting and audit fees 47,712$ 28,153$ Bank charges and interest 5,133 2,968 Consulting 564,720 - Directors' fees 36,500 36,500 Foreign exchange (loss) gain (9,208) 5,012 Investor relations 14,717 2,708 Legal 149,888 73,883 Listing fees 11,709 25,123 Loan interest 2,511 80,045 Office and administration 59,166 53,158 Printing and shareholder information 7,976 - Telephone 1,177 765 Transfer agent 11,853 14,838 Travel 127,295 32,293

1,031,149 355,446

MINERAL PROPERTY COSTSContract services and salaries 30,000 30,000 Legal 3,979,690 1,724,915 Russian office administration 129,710 124,390

4,139,400 1,879,305

INTEREST INCOME (57,140) (75,287)

LOSS BEFORE INCOME TAXES 5,113,409 2,159,464

INCOME TAXES - -

NET LOSS AND OTHER COMPREHENSIVE LOSS FOR THE YEAR 5,113,409 2,159,464

DEFICIT, BEGINNING OF YEAR 39,947,033 37,787,569

DEFICIT, END OF YEAR 45,060,442$ 39,947,033$

Basic and diluted loss per share (0.06)$ (0.03)$ Weighted average number of shares outstanding - basic and diluted 84,769,779 80,332,561

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ARCHANGEL DIAMOND CORPORATIONConsolidated Statements of Cash FlowsYears ended December 31, 2007 and 2006(Expressed in United States Dollars)


NET INFLOW/(OUTFLOW) OF CASH RELATED TO THE FOLLOWING ACTIVITIES

OPERATING Net loss for the year (5,113,409)$ (2,159,464)$

Changes in non-cash working capital itemsAccounts receivable (53,234) (4,461) Prepaid deposit 82,643 (196,312) Accounts payable and accrued liabilities 1,487,302 714,479

(3,596,698) (1,645,758)

INVESTINGRestricted deposit (50,439) -

(50,439) -

FINANCING Loan from related party 1,000,000 (2,512,075) Issuance of shares, net of issuance costs 524,259 6,939,891

1,524,259 4,427,816

(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (2,122,878) 2,782,058

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 2,991,485 209,427 CASH AND CASH EQUIVALENTS, END OF YEAR 868,607$ 2,991,485$

CASH AND CASH EQUIVALENTS ARE COMPRISED OF:Cash 868,607$ 691,485$ Cash equivalents - 2,300,000

868,607$ 2,991,485$

SUPPLEMENTARY INFORMATIONInterest received 57,140$ 74,361$ Interest paid 679$ 80,045$ Income taxes paid - -

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ARCHANGEL DIAMOND CORPORATIONConsolidated Statements of Shareholders' (Deficiency) EquityYears ended December 31, 2007

(Expressed in United States Dollars)

Contributed Accumulated OtherShares Amount Surplus Comprehensive Income Deficit Total

Balance, December 31, 2006 (Restated - Note 4) 83,110,327$ 41,856,904$ 443,321$ -$ (39,947,033)$ 2,353,192$

Net loss and comprehensive loss for the year - - - - (5,113,409) (5,113,409)

Exercise of options 1,900,000 967,580 (443,321) - - 524,259

Balance, December 31, 2007 85,010,327$ 42,824,484$ -$ -$ (45,060,442)$ (2,235,958)$

Common shares

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ARCHANGEL DIAMOND CORPORATION Notes to Consolidated Financial Statements December 31, 2007 and 2006 (Expressed in United States Dollars, unless otherwise stated)

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1. GENERAL

The Corporation was incorporated on July 3, 1987 under the laws of British Columbia and continued under the Business Corporations Act of the Yukon Territory on September 16, 1996. The Corporation’s principal business activities are the exploration for, and development of, natural resource properties.

2. CONTINUING OPERATIONS

The Corporation is engaged in diamond exploration in Russia. The Corporation’s mineral property is subject to disputes (Note 5) and the Russian corporation which holds the mineral property licence has refused to transfer the licence to an incorporated joint venture that is 40% owned by the Corporation. The disputes are subject to legal proceedings in the United States and Sweden. If the Corporation receives favourable decisions in respect of legal proceedings or arbitration, the ability to enforce judgments or arbitration awards in Russia could be affected by the evolving Russian legal, political and regulatory system.

To date, the Corporation has not generated revenue from its principal business activities and has relied on related party loans and equity financings to meet its obligations. The ability of the Corporation to continue as a going concern is dependent on the ultimate confirmation of the Corporation’s interest in the underlying mineral claims, the discovery of economically recoverable reserves, the continued financial support of the controlling shareholder, the ability of the Corporation to obtain necessary financing to complete exploration and, ultimately, development and future profitable production. The Corporation’s major shareholder, Cencan S.A., extended an unsecured loan in the amount of $4.5 million late in 2007 in order to ensure that the Corporation has sufficient funds to meets its anticipated expenditures for the foreseeable future including consulting, legal, administrative and compliance expenses. If the going concern assumption was not appropriate, the Corporation may not be able to realize its assets and satisfy its liabilities in the normal course of business.

3. SIGNIFICANT ACCOUNTING POLICIES

These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. Specific policies are as follows:

Basis of presentation

These consolidated financial statements include the accounts of the Corporation, its wholly owned subsidiary and its interest in the incorporated joint venture. All intercompany balances and transactions have been eliminated on consolidation.

Cash equivalents

Cash equivalents are comprised of highly liquid term deposits having original terms to maturity of 90 days or less when purchased.


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3. SIGNIFICANT ACCOUNTING POLICIES (continued)

Mineral property and deferred exploration costs

Expenditures to acquire mineral properties and incur exploration costs are capitalized pending the determination and production of commercially recoverable reserves. Administration costs are expensed in the year that they are incurred.

Management periodically reviews the carrying value of its investments in mineral leases and properties with internal and external mining related professionals. A decision to abandon, reduce or expand a specific project is based upon many factors including general and specific assessments of exploration results to date and mineral reserves, anticipated future mineral prices, the anticipated costs of developing and operating a producing mine, the expiration term, if any, of leased mineral properties and the general likelihood that the Corporation will continue exploration. The Corporation does not set a pre-determined holding period for properties with unproven reserves. However, properties that have not demonstrated suitable mineral concentrations at the conclusion of each phase of an exploration program are re-evaluated to determine if future exploration is warranted and carrying values are appropriate.

If there has been a delay in exploration activity that extends beyond three years, the Corporation writes off any exploration or acquisition costs related to that property unless persuasive evidence exists to the contrary.

If an area of interest is abandoned, it is determined that its carrying value cannot be supported by future production or sale or significant uncertainty exists as to access and operations, the related costs are charged against operations in the year of abandonment or determination of impairment in value. The amounts recorded as mineral leases and properties and deferred exploration costs represent costs to date less write-downs and do not necessarily reflect present or future values.

Share capital

The Corporation records proceeds from share issuances net of issue costs. Shares issued for other than cash consideration are valued at the quoted price on the TSX Venture Exchange on the date the agreement to issue the shares was reached.

Stock based compensation

The Corporation has a stock option plan as approved by its shareholders (see Note 6).

The Corporation uses the fair value method to account for stock options granted to employees and directors. Under the fair value method, the Corporation recognizes estimated compensation expense related to stock options over the vesting period of options granted, and an offsetting increase to contributed surplus. Upon exercise of these stock options, amounts are transferred from contributed surplus to share capital.

Future income taxes

The Corporation uses the asset and liability method of accounting for income taxes. Under the asset and liability method, future income tax assets and liabilities are determined based on differences


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between the financial statement carrying values and their respective income tax basis (temporary differences) and loss carryforwards. Future income tax assets and liabilities are measured using the enacted or substantively enacted tax rates expected to be in effect when the temporary differences are likely to reverse. The effect on future income tax assets and liabilities of a change in tax rates is included in operations in the period in which the change is substantively enacted. The amount of future income tax assets recognized is limited to the amount that is more likely than not to be realized.

Foreign currency transactions

These financial statements are presented in United States dollars, the Corporation’s functional currency. Transactions and amounts denominated in other currencies have been translated into United States dollars as follows:

(i) monetary items at the rate of exchange prevailing at the balance sheet date; and

(ii) non-monetary and revenue and expense items at the rate of exchange prevailing at the time of the transactions.

Any gains or losses arising thereon are charged to operations.

Use of estimates

The preparation of financial statements in conformity with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The significant area requiring the use of management estimates relates to the assessment of recoverability of the Corporation’s mineral property and deferred exploration costs and reclamation obligations. Actual results could differ from those estimates.

Financial instruments and comprehensive income

The Corporation has adopted the recommendations of the Canadian Institute of Chartered Accountants (“CICA”) Handbook Section 1530, Comprehensive Income; Section 3855, Financial Instruments – Recognition and Measurement; Section 3861, Financial Instruments – Disclosure and Presentation; Section 3865, Hedges; and Section 3251, Equity. These sections apply to fiscal years beginning on or after October 1, 2006 and provide standards for recognition, measurement, disclosure and presentation of financial assets, financial liabilities and non-financial derivatives, and describe when and how hedge accounting may be applied. Section 1530 provides standards for the reporting and presentation of comprehensive income, which represents the change in equity from transactions and other events and circumstances from non-owner sources. Other Comprehensive Income is defined by revenues, expenses, gains and losses that are recognized in comprehensive income, but excluded from net income, in conformity with generally accepted accounting principles. On adoption of these new standards, the Corporation did not identify any items that would result in comprehensive income. The principal changes in accounting for financial instruments due to the adoption of these accounting standards are described below.


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Section 3855, Financial Instruments – Recognition and Measurement and Section 3861, Financial Instruments – Disclosure and Presentation Under the new standards, all financial assets are classified as held for trading, held-to-maturity Investments, loans and receivables or available-for-sale categories. Also, all financial liabilities must be classified as held for trading or other financial liabilities. All financial instruments are initially recorded on the balance sheet at fair value. After initial recognition, the financial instruments should be measured at their fair values, except for held-to-maturity investments, loans and receivables and other financial liabilities, which should be measured at amortized cost. Classification of financial instruments The following is a summary that the Corporation has elected to apply to each of its significant categories of financial instruments outstanding as at January 1, 2007:

Cash and cash equivalents Held for trading Restricted deposits Held for trading Accounts receivable Loans and receivables Accounts payable and accrued liabilities Other financial liabilities Related party loan Other financial liabilities

Held for trading Held for trading financial assets are financial assets typically acquired for resale prior to maturity. They are measured at fair value on the balance sheet, with realized and unrealized gains and losses reported in operations. Available-for-sale Available-for-sale financial assets are carried at fair value with unrealized gains and losses included in other comprehensive income until the financial asset is derecognized and any cumulative gain or loss is then recognized in operations or until an impairment is recognized. Loans and receivables Loans and receivables are non-derivative financial assets resulting from the delivery of cash or other assets by a lender to a borrower in return for a promise to pay on a specified date or dates, or on demand, usually with interest other than debt securities and loans and receivables that the entity, upon initial recognition, designates as held for trading or as available-for sale. Loans and receivables are accounted for at amortized cost. Other liabilities Financial liabilities are classified as “other liabilities”. Other liabilities are initially recognized at fair value and are subsequently measured at amortized cost using the effective interest method. Transaction costs Transaction costs with respect to instruments not classified as held-for-trading are recognized as an adjustment to the cost of the underlying instruments and are recognized and amortized using the effective interest method. Application of this accounting policy did not have a material impact on the financial position or results of operations as at or for the year ended December 31, 2007.


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Effective interest method The Corporation uses the effective interest method of amortization for transaction costs or deferred financing charges, fees, premiums, discounts earned or incurred for financial instruments. Determination of fair value The fair value of a financial instrument is the amount of consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act. The following methods and assumptions have been used to estimate the fair value of the Corporation’s various financial instruments. Future accounting pronouncements The CICA has issued new accounting standards, the following of which are applicable to the Corporation: Section 3862, Financial Instruments – Disclosures. This standard describes the required disclosures related to the significance of financial instruments on the Corporation’s financial position and performance and the nature and extent of risks arising for financial instruments to which the Corporation is exposed and how the Corporation manages those risks. This standard complements the principles of recognition, measurement, and presentation of financial instruments of Section 3855, Financial Instruments – Recognition and Measurement, Section 3863, Financial Instruments – Presentation and Section 3865, Hedges. The Corporation does not expect the adoption of this standard will have a significant impact on the consolidated financial statements. This standard will be effective for the Corporation as of January 1, 2008. Section 3863, Financial Instruments – Presentation. This section establishes standards for presentation of financial instruments and non-financial derivatives. It replaces standards of Section 3861, Financial Instruments – Disclosure and Presentation. The Corporation does not expect the adoption of this standard will have a significant impact on the consolidated financial statements. This standard will be effective for the Corporation as of January 1, 2008.

Section 1535, Capital Disclosures. This section establishes standards for disclosing information about an entity’s capital and how it is managed to enable users of financial statements to evaluate the entity’s objectives, policies and procedures for managing capital. The Corporation does not expect the adoption of this standard will have a significant impact on the consolidated financial statements. This standard will be effective for the Corporation as of January 1, 2008. Section 1400 – General Standards of Financial Statement Presentation. This section was amended June 2007 to include guidance on an entity’s ability to continue as a going concern. The revised standards are effective for all fiscal periods commencing on or after January 1, 2008. The revised standard explicitly requires management to assess and disclose the entity’s ability to continue as a going concern.


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International Financial Reporting Standards On February 13, 2008, the Accounting Standards Board (AcSB) of the Canadian Institute of Chartered Accountants confirmed the mandatory International Financial Reporting Standards (IFRS) changeover date for Canadian profit-oriented publicly accountable entities (PAEs). This means that PAEs will be required to prepare financial statements in accordance with IFRS for interim and annual financial statements for fiscal years beginning on or after January 1, 2011. It is premature to currently assess the impact initiative, if any, of the Canadian IFRS initiative on the Corporation.

4. RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

During 2007, the Corporation identified an error in its 2006 audited financial statements in respect of the underaccrual of certain legal expenditures. As a result, the corporation has restated its legal expenses and accounts payable and accrued liabilities for the year ended December 31, 2006 to correct this error. The impact of this correction on the originally reported balances for the 2006 fiscal year are as follows:

As Originally Reported Adjustment As Restated

Accounts payable and accrued liabilites 534,297$ 306,355$ 840,652$ Administrative costs - Legal 62,656$ 11,227$ 73,883$ Mineral properties - Legal 1,429,787$ 295,128$ 1,724,915$ Deficit - beginning of the year 37,787,569$ -$ 37,787,569$ Net and comprehensive loss for the year 1,853,109$ 306,355$ 2,159,464$ Deficit - end of year 39,640,678$ 306,355$ 39,947,033$ Basic and diluted loss per share 0.02$ 0.01$ 0.03$

5. MINERAL PROPERTY

The Corporation’s mineral property consists of the following:

2007 2006

Verkhotina, Arkhangel'sk, RussiaDeferred mineral property costs 1$ 1$

On October 12, 1993, the Corporation acquired rights to acquire an interest in the Verkhotina area mineral licence in Russia.

On December 30, 1993, a 25-year licence for the exploration and mining of diamonds (the “Licence”) for an approximately 400-square kilometer area located northwest of Arkhangel’sk, Russia (the “Verkhotina Area”) was granted to a Russian enterprise, Arkhangelskgeoldobycha (“AGD”) (formerly Arkhangel’sk Geologia Enterprises). Pursuant to the Verkhotina Diamond


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5. MINERAL PROPERTY (continued)

Venture Agreement (the “VDV Agreement”) dated November 24, 1993 (as amended) with AGD, the Corporation acquired the right to a 40% interest in, and 40% of any profits from, the Verkhotina Area.

The VDV Agreement requires the Corporation to fund all exploration and evaluation costs, the costs of completing feasibility studies on the Verkhotina Area, the funding of all agreed upon expenses associated with the registration and maintenance of the Licence, and all Licence fees, bonuses and payments for geological information until such time as the decision is made to place the Verkhotina Area into commercial production. Under the VDV Agreement, if a feasibility study were to recommend commencement of commercial production, the parties further agreed to establish a Russian joint stock company (the “Stock Company”), of which the Corporation would own a 40% interest. AGD agreed to grant to the Stock Company sole and exclusive rights within the Verkhotina Area for the conducting of development and mining as determined as a result of the feasibility study. The parties would contribute through the Stock Company to all expenditures incurred in relation to the Verkhotina Project in proportion to their respective interests in the Stock Company. At the time of formation of the Stock Company, the prior expenditures of each of the parties were to be reflected in the initial contributed capital. For this purpose, the past expenditures of AGD were estimated to be approximately US$20 million, subject to such expenditures being substantiated and verified by independent audit. All profits derived from commercial mining are to be distributed between the parties in proportion to their shareholding interest in the Stock Company.

Should the Corporation withdraw from the VDV Agreement, the Corporation will be required to reassign its interest to AGD without compensation. Should the Corporation breach its financial obligations under the VDV Agreement, AGD has a right to withdraw from the VDV Agreement.

In January 1994, the Corporation and AGD agreed to set up a Russian company for the purposes of the Verkhotina Project. In February 1994, the Corporation and AGD signed a memorandum (the 1994 Memorandum) expressed to be an integral part of the VDV Agreement and which, among other matters, established the ownership structure of a Russian joint stock company, and provided for AGD to transfer the Licence to such joint stock company when Russian legislation permitted such a transfer. In May 1994, pursuant to such amended VDV Agreement, the Corporation and the other parties to the project incorporated Almazny Bereg (AB), a Russian joint stock company, with the Corporation owning 40% of the ordinary shares. By means of a public offering through a prospectus in 1994, AB issued 300,000 preferred, non-voting shares with a par value of 20,000 old Russian rubles, at a price of 40,000 old Russian rubles each. Effective December 1996, the offering was closed and no preferred shares have been subsequently issued.

As of December 31, 2002, AB had received 1.66 billion old Russian rubles (approximately $274,000 at the historical exchange rate and $52,000 at the exchange rate at December 31, 2002) in cash relating to the issuance of 41,500 preferred shares and had received promissory notes in the aggregate amount of 10.34 billion old Russian rubles (approximately $1,712,000 at the historical exchange rate and $325,000 at the exchange rate at December 31, 2002) relating to the issuance of 258,500 preferred shares. All amounts of old Russian rubles are before the January 1, 1998 redenomination of 1,000 old rubles for 1 new ruble. The terms of the preferred shares, according to the prospectus and the AB Charter, include the right of shareholders to receive dividends of not less than 10% per annum of the shares’ nominal value. According to the AB Charter, the preferred shares of AB are not cumulative preferred shares. The AB Charter contains no specific provisions which provide for the accumulation of unpaid dividends but does refer back to the prospectus. The


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provisions of the prospectus are not clear, and it cannot be definitively concluded whether a Russian court might decide that the preferred shares are cumulative.

As no shareholders’ resolution has been passed to pay any dividend on the preferred shares, the owners of the preferred shares have the same voting rights as the common shareholders. When the first dividend on the preferred shares is paid by AB, preferred shareholders will have voting rights only with regards to a limited number of matters. While preferred shareholders have the same voting rights as the common shareholders, the Corporation has the right to vote an aggregate of 32.4% of the voting shares of AB on a fully diluted basis.

During May 1995, new Russian legislation was introduced which, in the view of the Corporation, enabled AGD to transfer the Licence in accordance with the 1994 Memorandum. Although AGD has disputed the legality of this legislation, in April 1997 the AGD Board of Directors resolved that the transfer of the Licence to AB would take place upon completion and payment by the Corporation of an agreed upon work program (the “Work Program”) on the Verkhotina Area for 1997 and the first quarter of 1998. In December 1997, the Work Program was agreed upon by the parties. In March 1998, the General Director of AGD confirmed to the Corporation that AGD had no claims in regard to the Work Program.

On May 7, 1998, the Corporation requested AGD to transfer the Licence to AB, and notified AGD in June that a dispute existed. On June 17, 1998, the Corporation advised AGD that it was temporarily suspending further funding for the Verkhotina Area as from July 1, 1998 until AGD complied with its obligations under the amended VDV Agreement. AGD continued to perform exploration in the area and the Corporation accrued for all of the exploration costs associated with the Verkhotina Area. Russian law provides inter alia the following condition for the transfer of a mineral licence to a subsidiary of a subsoil user. The shareholding of the previous subsoil user in the charter capital of such subsidiary at the moment of re-registration of a licence must be at least 50%. The total shareholding of AGD in AB has decreased below 50% (following a decrease in its holding of preferred shares), as a result of which AB does not currently qualify as a company to which the Licence can be transferred.

As the parties were unable to reach an agreement concerning Licence transfer, in August 1998, the Corporation commenced international arbitration of the matter in Stockholm, Sweden. The Arbitration Tribunal was constituted (the “First Tribunal”) and preliminarily accepted jurisdiction of the dispute.

A new agreement between the parties was reached and executed on July 15, 1999 (the “1999 Agreement”). Among other matters, the 1999 Agreement stipulated AGD would, within a period not to exceed 180 days, transfer or re-register the Licence to a new Russian joint stock company to be established, of which the Corporation would also own a 40% interest. As part of the 1999 Agreement, the Corporation agreed to suspend international arbitration for 180 days, after which time the arbitration would be discontinued if the Licence had been transferred under the terms of the 1999 Agreement.

In January 2000, with the transfer of the Licence having not been completed within the allotted 180-day period, the Corporation formally reinstated the arbitration proceedings. A full merits hearing was held before the First Tribunal in early 2001. However, on the basis of new arguments put


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forward by AGD, the First Tribunal agreed to reconsider its jurisdiction over the dispute. By majority decision issued dated June 25, 2001, with a strong dissenting opinion, the First Tribunal overturned their initial decision on jurisdiction, ruling that the dispute was not arbitrable, and on that basis declined jurisdiction. The Corporation was advised that this decision was manifestly wrong.

Accordingly, the Corporation challenged the decision of the First Tribunal in the Stockholm District Court on July 3, 2001. Judgment was issued in the Corporation’s favour on February 20, 2004 and the decision of the First Tribunal was set aside. The Stockholm District Court ruled that the Corporation was entitled to have the dispute arbitrated and ordered AGD to pay the Corporation’s costs in the amount of Swedish Kroner 3,331,330 (approximately US$499,000). AGD filed an appeal dated March 10, 2004 with the SVEA Court of Appeal. The SVEA Court of Appeal delivered judgment on November 15, 2005, denying AGD’s appeal with costs (amounting to US $146,762) and affirming the earlier decision of the Stockholm District Court. On December 13, 2005, AGD then applied for leave to appeal to the Supreme Court of Sweden against the judgment of the SVEA Court of Appeal. On April 10, 2006 the Supreme Court denied AGD’s application for leave to appeal, which brought the Swedish court proceedings to an end.

Following the Supreme Court’s ruling, the Corporation initiated new international arbitration proceedings in Stockholm against AGD on May 5, 2006. A new Stockholm Arbitration Tribunal was constituted during October 2006 (the “Second Tribunal”). The Second Tribunal issued a detailed procedural order in January 2007 setting out the procedures, rules and timetable for the conduct of the arbitration. The Corporation was required to serve its Statement of Claim in April 2007; AGD was required to serve its Defense in October 2007; the Corporation’s Reply was due in December 2007; and AGD’s Rejoinder was due in February 2008. The proceedings were to be bifurcated into two phases, dealing respectively with liability and quantum. The hearing of the first phase, dealing with the issues of liability, was scheduled to take place in June 2008 in Stockholm. The new Stockholm arbitration proceedings proceeded substantially in accordance with such procedural order through the third quarter of 2007. In particular, the Corporation served its Statement of Claim during May 2007 and AGD served its Defense during October 2007. However, by agreement between the parties, the overall schedule was slowed down to facilitate negotiations. International arbitration proceedings can be complex, time consuming and costly.

On August 23, 2001, LUKoil, then the 74.1% owner of AGD (increased to close to 100% in 2003), filed claims with the Arbitration Court of the Arkhangel’sk Region in the Russian Federation (“Arbitration Court”) seeking a ruling, in the case of the first claim, that the arbitration provisions in the VDV Agreement were invalid and, in the case of the second claim, that the 1999 Agreement was invalid. In addition, on August 31, 2001, AGD filed a claim with the Arbitration Court of the Arkhangel’sk Region seeking a ruling that the 1994 Memorandum be declared not concluded and invalid and, further, on January 14, 2002, AGD filed a claim with the same court to terminate the VDV Agreement on the grounds that the VDV Agreement funding provisions had been breached by the Corporation.

During 2002, a number of hearings were held with respect to these claims. On October 28, 2002, the Arbitration Court ruled that the 1994 Memorandum between the Corporation and AGD was not concluded. The Corporation exhausted all avenues of appeal within the Russian Arbitration Court system but failed to overturn this ruling. However, courts and tribunals outside Russia are not necessarily bound to follow this ruling concerning the legal status of the 1994 Memorandum.


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On February 4, 2003, the Arkhangel’sk Arbitration Court resumed consideration of AGD’s claim to terminate the VDV Agreement on the grounds that the Corporation had breached its funding obligations. On April 28, 2003, the Arbitration Court issued a judgment, which found that the relevant funding obligations were not set out in the VDV Agreement itself, but in the subsequent Joint Activity Agreement (“JAA”) concluded between the Corporation, AGD and Almazny Bereg on May 10, 1994. It further found that the funding actually provided by the Corporation in relation to the Verkhotina project up to 1998 was provided within the framework of the JAA and as a contribution to the joint activity contemplated by the JAA. On those grounds, the Court dismissed AGD’s application to terminate the VDV Agreement. AGD did not appeal against the Court’s

decision and the deadlines for AGD to file any appeal have expired. Therefore, the VDV Agreement remains in force.

As a direct result of the actions by LUKoil and AGD, in November 2001 the Corporation filed a lawsuit in the Denver District Court, State of Colorado, United States, against LUKoil and AGD (the “Defendants”) seeking to recover in excess of $1 billion in damages for harm caused by a scheme of fraud, breach of contract, civil conspiracy and related claims. On October 15, 2002, the Denver District Court issued an order dismissing the Corporation’s action against LUKoil and AGD based solely on a determination that it lacked personal jurisdiction over the Defendants, but rejecting all of the Defendants’ other arguments on jurisdiction. The Corporation’s legal advisors were of the view that the Court’s decision was erroneous for a number of reasons, including the court’s failure to consider the Corporation’s fraud and other tort claims against LUKoil and AGD as a basis for personal jurisdiction and its failure to resolve factual discrepancies in favour of the plaintiff in the absence of a hearing. Accordingly, on November 27, 2002, the Corporation filed a motion with the Colorado Court of Appeals appealing the October 15, 2002 order. Oral argument before the Colorado State Court of Appeal took place January 20, 2004. On March 25, 2004, the Colorado Court of Appeal affirmed the order of the Denver District Court dismissing the Corporation's claims against AGD and LUKoil for lack of personal jurisdiction over the defendants. The Corporation's counsel advised that this judgment was incorrectly decided and, accordingly, on April 7, 2004, the Corporation filed a Motion for Reconsideration with the Court of Appeals in Colorado. The Court of Appeals denied the Corporation’s Motion by order dated June 17, 2004 without issuing any opinion. On July 16, 2004, the Corporation duly filed a petition for writ of certiorari with the Colorado Supreme Court.

On January 10, 2005, the Colorado Supreme Court granted the petition filed by the Corporation for a writ of certiorari and agreed to consider the merits of the petition as to one issue only; whether the Court of Appeals erred in concluding a trial court may decide a jurisdictional motion by weighing and resolving factual issues without an evidentiary hearing. The Corporation had argued that disputed factual issues must be resolved in favour of the plaintiff (in this case the Corporation) in the absence of an evidentiary hearing, which has been a central issue in the Corporation’s attempt to establish personal jurisdiction over AGD and LUKoil in Colorado. At the same time, the Supreme Court denied the petition in regard to various other grounds raised by the Corporation.

On November 21, 2005, the Colorado Supreme Court reversed the Court of Appeals’ decision dismissing the Corporation’s claims against LUKoil, holding that the Corporation had set forth a prima facie case of personal jurisdiction over LUKoil by “submitting competent evidence that LUKoil was active in the retail gas industry in Colorado”. At the same time, the Colorado Supreme Court affirmed the dismissal of the Corporation’s claims against AGD, holding that its contacts with


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Colorado in directing communications to the Corporation in Colorado were insufficient to establish specific personal jurisdiction.

On December 20, 2005, the Colorado Supreme Court amended its November 21, 2005 opinion in order to remand to the Colorado Court of Appeals any remaining issues which the Court of Appeals had not previously addressed on the appeal, instead of remanding the case directly back to the Denver District Court. LUKoil then moved the Court of Appeals to permit supplemental briefing on its argument that the Court of Appeals should affirm the dismissal based on forum non conveniens (i.e. whether Colorado is a convenient forum for dealing with the Corporation’s claims), albeit for different reasons than those provided by the district court. The Colorado Court of Appeals permitted the parties to file supplemental briefs but did not order a further hearing.

On June 29, 2006, the Colorado Court of Appeals issued a ruling rejecting LUKoil’s arguments that the Corporation’s lawsuit against LUKoil should be dismissed on the grounds of forum non conveniens. The Court of Appeals ruled that the Denver District Court had been wrong as a matter of law to dismiss the action under the doctrine of forum non conveniens and reversed the District Court’s decision. The case was remanded to the trial court for further proceedings consistent with the rulings of Court of Appeals and Supreme Court.

LUKoil then filed a further petition for writ of certiorari to the Colorado Supreme Court on August 28, 2006 in relation to the question of forum non conveniens. The Colorado Supreme Court denied LUKoil’s petition for certiorari on March 5, 2007 and remanded the case back to the Denver District Court for further proceedings. LUKoil filed a new motion for dismissal for lack of personal jurisdiction and sought an early determination of the remaining factual issue in dispute going to jurisdiction, i.e. LUKoil’s alleged ownership of a gas station in Colorado at the material time. Although the Corporation opposed LUKoil’s motion and argued that LUKoil should file a full answer to the Corporation’s original complaint, the Denver Court granted LUKoil’s motion on July 7, 2007. The Denver Court ruled that, in accordance with the Colorado Supreme Court’s directions on remand of the case, it was appropriate to determine whether LUKoil was subject to jurisdiction in Colorado before proceeding to full discovery or a trial on the merits. Accordingly, the Denver Court ordered a pre-trial evidentiary hearing with limited discovery on whether LUKoil is subject to general personal jurisdiction in Colorado through its alleged ownership or maintenance of a gas station in Glendale, Colorado during the relevant time period. The evidentiary hearing date was originally set for December 3, 2007 and the limited discovery process commenced. By consent of the parties, in the context of the negotiation process, the evidentiary hearing date was deferred to a future date to be determined and the limited discovery process remains to be completed. According to the original Licence conditions, during the first five years of prospecting, evaluation and detailed exploration (the “First Stage”) of the Verkhotina Area, the Corporation had a requirement to pay a tax of 1.5% of the annual expenditure costs associated with prospecting and evaluation, 4.0% of the expenditure costs during the period of detailed exploration, and 4.0% of the value of any diamonds recovered during the First Stage. Should this First Stage extend beyond five years, the required tax payments could increase by 50%.


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In August 1999, application was made by AGD to the appropriate Russian agencies requesting an extension of the five year term of the First Stage. In September 1999, this request for an extension was granted for the Verkhotina Area until December 31, 2002 and the tax for prospecting and evaluation during this stage was increased to 2.25%.

Following the privatisation of AGD in 1996, the Licence was re-issued on April 12th, 1996 with reference number АРХ 00248 KP (Russian lettering). The Licence was re-issued again on August 22nd, 2005 following a name change of AGD with its current reference number APX 13267 KP (Russian lettering). The licence agreement, which forms an integral part of the Licence, was amended by an Addendum Agreement executed between AGD and the Russian licensing authorities and duly registered on April 1st, 2008. The Addendum Agreement brings certain provisions of the former Licence agreement into conformity with Russian legislation and stipulates certain deadlines for the achievement of project milestones in relation to the exploration and development of the Verkhotina Area.

Due to the disputes discussed above and the Corporation’s extended delay in exploration activity, the Corporation wrote down deferred mineral property costs associated with the Verkhotina Area during the year ended December 31, 2001 to $1.

The Corporation continues to direct considerable efforts towards seeking to resolve the dispute over the Verkhotina License through discussion and negotiation which the Corporation believes to be in the best interests of shareholders.

There is an ongoing obligation on the License holder, AGD, to keep the Verkhotina License in good standing. It is fair to assume that the Verkhotina License will remain under scrutiny by the relevant Russian licensing authorities in line with Russian Government policy.

6. SHARE CAPITAL Authorized

Unlimited number of common shares without par value

Issued Numberof Shares Amount

Balance, December 31, 2005 76,279,558 34,902,912$

Shares issued during year:Private offering 6,730,769 6,923,207 Options exercised 100,000 30,785

Balance, December 31, 2006 83,110,327 41,856,904

Shares issued during the year: Options exercised 1,900,000 967,580 Balance, December 31, 2007 85,010,327 42,824,484$


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6. SHARE CAPITAL (continued)

Stock options

The Corporation has adopted a stock option plan in order to provide incentive to its employees. Stock options are granted by the board of directors and have an expiry period of no more than ten years. For stock options granted, unless specifically resolved, one-third will vest immediately, one-third will vest 12 months from date of grant and the balance will vest 24 months from the date of grant. All options are exercisable in Canadian dollars.

On May 30, 2006, the Corporation completed a private offering of 6,730,769 common shares at a subscription price of $1.04 (CDN $1.19). The common shares issued pursuant to the private offering were subject to a hold period of four months, which expired September 30, 2006, in accordance with the rules and policies of the TSX Venture Exchange and applicable Canadian securities laws. Cencan S.A., which owned or controlled 59.4% of the pre-closing issued shares of

the Corporation, acquired an aggregate of 3,998,077 common shares, equal to its pro rata portion of the private offering, and thereby maintained its 59.4% interest.

Outstanding director, service providers and employee options are as follows:

Exercise Outstanding Granted Exercised Expired Outstandingprice December 31, during during during December 31,

Expiry date Cdn$ 2006 year year year 2007

January 20, 2007 0.35$ 1,500,000 - (1,500,000) - - May 1, 2007 0.19$ 250,000 - (200,000) (50,000) - May 8, 2007 0.17$ 100,000 - (100,000) - - October 9, 2007 0.23$ 100,000 - (100,000) - -

1,950,000 - (1,900,000) (50,000) -

Weighted average exercise price 0.31$ -$ 0.19$ -$ -$

Exercise Outstanding Granted Exercised Expired Outstandingprice December 31, during during during December 31,

Expiry date Cdn$ 2005 year year year 2006

January 20, 2007 0.35$ 1,500,000 - - - 1,500,000 May 1, 2007 0.19$ 350,000 - (100,000) - 250,000 May 8, 2007 0.17$ 100,000 - - - 100,000 October 9, 2007 0.23$ 100,000 - - - 100,000

2,050,000 - (100,000) - 1,950,000

Weighted average exercise price 0.31$ -$ 0.19$ -$ 0.31$

No stock options were granted and no stock options vested during 2006 or 2007; therefore no stock option expense has been recorded for 2006 or 2007. As at December 31, 2007, all stock options granted have been exercised or have expired, leaving Cencan S.A. with an interest of 58.0%.


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7. FUTURE INCOME TAXES

Income tax expense (recovery) differs from the amounts computed by applying the combined federal and provincial income tax rate of 36.12% (2006 – 36.12%) to pretax loss as a result of the following:


Loss for the year before income taxes 5,113,409$ 2,159,464$

Tax recovery at statutory rate 1,846,963$ 779,998$ Unrecognized tax benefit relating to losses (1,846,963) (779,998) Income tax expense (recovery) - $ - $

As at December 31, 2007 and 2006, the significant components of the Corporation’s future tax asset are as follows:


Loss carryforwards 3,351,140$ 2,001,590$ Valuation allowance (3,351,140) (2,001,590)

Future income tax asset - $ - $

The tax benefit of pre-acquisition tax pools related to the mineral property and deferred exploration costs and loss carryforwards have not been recognized as these tax pools are restricted in their utilization to income from specific properties or operating activities due to the acquisition of control on December 19, 2002. The amount of these resource expenditures and loss carryforwards incurred prior to the acquisition of control was approximately $29,398,617 (CDN$29,048,773) and $4,318,954 (CDN$4,267,558), respectively.

As at December 31, 2007, the Corporation has approximately $12,018,115 (CDN$11,875,099) of loss carry forwards incurred subsequent to the acquisition of control, which may be used to reduce future Canadian income taxes otherwise payable.


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7. FUTURE INCOME TAXES (continued)

Successored RegularLosses by year of expiry

2008 4,318,954$ -$ 2009 - 13,946 2010 - 1,910,353 2011 - 1,441,361 2015 - 1,269,513 2026 - 2,269,533 2027 - 5,113,409

4,318,954$ 12,018,115$

8. FINANCIAL INSTRUMENTS

The Corporation’s financial instruments consist of cash and cash equivalents, restricted deposits, accounts receivable, accounts payable and accrued related party loan.

Fair values The carrying value of the Corporation’s accounts receivable and accounts payable and accrued liabilities have fair values which approximate their carrying values due to their immediate or short-term nature of these financial instruments. The fair values of cash and cash equivalents is based on quoted market prices from major financial institutions. The carrying value of the Corporation’s related party loan is based on amortized cost and the fair value is based on quoted market prices. Interest rate risk The Corporation is exposed to interest rate risk that arises from fluctuations in interest rates on its cash equivalents and related party loans. Currency risk The Corporation has no material currency risk as all of the Corporation’s revenues and a majority of the Corporation’s expenses are denominated in United States dollars. Credit risk The Corporation is exposed to credit risk associated with its accounts receivable. Credit risk is minimized substantially by ensuring the credit worthiness of entities.


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9. RELATED PARTY TRANSACTIONS

(a) De Beers Canada Inc., a company under common control, provided management services to the Corporation. These services were charged at cost and for the year ended December 31, 2007 amounted to $55,732 (2006 - $54,199). As at December 31, 2007, there was no balance owing (2006 – $nil) and regular vendor payment terms apply.

(b) Cencan S.A., the Corporation’s major shareholder, extended a credit facility in the maximum principal amount of $4,500,000 on October 31, 2007. The term of the agreement was not to extend beyond April 30, 2009. Interest is charged at US$ LIBOR plus 275 basis points per annum. During the year ended December 31, 2007, the Corporation drew down $1,000,000 on the credit facility and related interest expense related to this loan amounted to $2,511. Accrued interest on the loan as at December 31, 2007 was $2,511.

10. COMMITMENTS AND CONTIGENCIES

(a) In continuing to direct efforts towards resolving the dispute over the Verkhotina License through discussion and negotiation, the Corporation has sought the assistance of financial advisors. For the latter a settlement, which is deemed to be in the best interests of shareholders, would result in an element of success based reward up to a maximum payable amount of $2.5 million.

(b) The Corporation has committed to consulting fees for the period January to May 2008 in the amount of $200,000.

11. SUBSEQUENT EVENT

The Corporation announced on April 15, 2008 that it has entered into definitive agreements with respect to the acquisition from LUKOIL of a 49.99% equity interest in AGD (the “Transaction”) for US$100 million in cash (the “Initial Payment”) on the date of completion of the Transaction (“Completion”). LUKOIL will retain the remaining equity interest in AGD. The Initial Payment will be subject to adjustment, as determined by completion accounts, for agreed cash, debt and other working capital items existing in AGD as at Completion. In addition to the Initial Payment, two deferred cash payments may become payable by the Corporation as follows:

• US$75 million upon LUKOIL and the Corporation taking a joint decision in writing to proceed with construction of a diamond mine at the Grib Pipe and AGD’s Board passing a decision to mine; and

• US$50 million upon the commencement of commercial diamond production from the Grib Pipe (as defined in the Share Purchase Agreement dated April, 15 2008 between the Corporation, LUKOIL and De Beers S.A.).


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11. SUBSEQUENT EVENT (continued)

Completion of the Transaction is subject to, among others, the following conditions precedent:

• the receipt of all required consents or approvals from the Anti-Monopoly Service of the Russian Federation with respect to the Transaction and, if applicable, any approval required pursuant to the new draft Russian foreign investment law if enacted and in force prior to Completion; and

• the approval of the Transaction by the TSX Venture Exchange.

All conditions precedent must be satisfied prior to 1 June 2008, failing which either LUKOIL or the Corporation is entitled to terminate the Transaction.

Completion will settle the claims pursued by the Corporation in the Stockholm arbitration against AGD and the lawsuit in the Denver District Court, State of Colorado, USA against LUKOIL. Pending Completion, each party has reserved its respective rights and remedies.

In order to satisfy its obligations pursuant to the Transaction, retire existing loans and provide adequate working capital, the Corporation will undertake a private placement of securities (the “Financing”) to raise a proposed US$200 million, the terms of which are to be determined, and has engaged the services of Canaccord Capital Corporation and RBC Capital Markets to act as agents for the Financing.

If the Corporation fails to raise a minimum US$150 million by Completion, De Beers has agreed to provide an unsecured, non-convertible, interest bearing standby term loan to the Corporation in the amount of US$115 million in order to ensure that the Corporation has sufficient funds to meet the Initial Payment and short term working capital requirements. If drawn, the Corporation has a best endeavours obligation to repay the standby loan within nine months and an absolute obligation to repay the standby loan within twelve months from the date of drawdown, and interest would be payable at LIBOR plus 3.5% per annum. In consideration for the provision of the standby loan facility, the Corporation has agreed to pay De Beers a corporate finance fee of 1% flat based on the US$115 million standby loan facility commitment.

The trading of the Corporation’s shares on the TSX Venture Exchange which was voluntarily halted effective November 9, 2007, resumed on April 28, 2008.

Documents

Archangel Diamond Corporation -127 #8802