SCIE SpectraScience Inc (CE)

Notes to Unaudited Condensed Financial Statements

1. Nature of Business and Basis of Presentation

Description of Business

SpectraScience, Inc. was incorporated in the State of Minnesota on May 4, 1983 as GV Medical, Inc. In October 1992, GV Medical discontinued its prior business, refocused its development efforts and changed its name to SpectraScience, Inc. The “Company,” hereinafter, refers to SpectraScience, Inc. and its wholly owned subsidiaries Luma Imaging Corporation (“LUMA”), Spectra Science International, Inc. (“International”) and SpectraScience (UK) Limited (“SpectraUK”). Since 1996, the Company has focused primarily on developing the WavSTAT Optical Biopsy System (the “WavSTAT System”).

The Company has developed and received the European CE mark approval to market a proprietary, minimally invasive technology that optically illuminates tissue in real-time to distinguish between normal, pre-cancerous or cancerous cells without the need to remove the subject cell tissue from the body to make such determinations. The WavSTAT System operates by using cool, safe laser light to optically illuminate and analyze tissue, enabling the physician to make an instant diagnosis during endoscopy when screening for cancer, and if warranted, to begin immediate treatment during the same procedure. Beginning in December 2011, the WavSTAT 4 version of the product began to be sold in the European Union for clinical trials related to colon cancer detection. In June 2012, the Company entered into a distribution agreement with PENTAX Europe, GmbH.

On November 6, 2007, the Company acquired the assets of LUMA in an equity transaction accounted for as an acquisition of assets and now operates LUMA as a wholly-owned subsidiary of the Company. LUMA had acquired the assets from a predecessor company that had developed, and received FDA approval for, a non-invasive diagnostic imaging system that can detect cervical cancer precursors and which utilizes an underlying technology that is similar to that of the WavSTAT System. The addition of the LUMA technology to the Company’s existing WavSTAT System technology provides the Company with a broad suite of fluorescence-based intellectual property and know-how. During the fiscal year ended December 31, 2010, the Company wrote off the remaining fair value of the LUMA inventory in order to focus on the continued development and marketing of the WavSTAT System. The Company retained the intellectual property of LUMA for use in the development of future generations of the WavSTAT System.

The transaction was accounted for as an acquisition of assets that included intellectual property, inventory and equipment. The intellectual property consisted of a total of 34 issued U.S. patents and 28 additional patent applications.

Basis of Presentation

The accompanying unaudited financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q as they are prescribed for smaller reporting companies. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary to make the financial statements not misleading have been included. Operating results for the three month period ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. These statements should be read in conjunction with the financial statements and related notes, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

Going Concern

Historically, the Company’s sources of cash have come from the issuance and sale of equity securities and debentures. The Company’s historical cash outflows have been primarily used for operating activities including research, development, administrative and sales activities. Fluctuations in the Company’s working capital due to timing differences of its cash receipts and cash disbursements also impact its cash flow. The Company expects to incur significant additional operating losses through at least the end of 2017, as it completes proof-of-concept trials, conducts outcome-based clinical studies and increases sales and marketing efforts to commercialize the WavSTAT4 System in Europe. If the Company does not receive sufficient funding, there is substantial doubt that the Company will be able to continue as a going concern. The Company may incur unknown expenses or may not be able to meet its revenue forecast, and one or more of these circumstances would require the Company to seek additional capital. The Company may not be able to obtain equity capital or debt funding on terms that are acceptable. Even if the Company receives additional funding, such proceeds may not be sufficient to allow the Company to sustain operations until it becomes profitable and begins to generate positive cash flows from operations.

As of March 31, 2017, the Company had a working capital deficit of $10,647,039 and cash of $100,001, compared to a working capital deficit of $10,439,707 and cash of $3,550 as of December 31, 2016. The Company uses agents to assist it with raising capital and has commenced raising capital on its own. During the three months ended March 31, 2017, the Company raised $289,000, net of transaction costs of $20,000, under these agreements. However, if the Company does not receive additional funds in a timely manner, the Company could be in jeopardy as a going concern. The Company may not be able to find alternative capital or raise capital or debt on terms that are acceptable. Management believes that if the events defined in the Engagement Agreements occur as expected, or if the Company is otherwise able to raise a similar level of funds, such proceeds will be sufficient to allow the Company to sustain operations until it attains profitability and positive cash flows from operations. However, the Company may incur unknown expenses or may not be able to meet its revenue expectations requiring it to seek additional capital. In such event, the Company may not be able to find capital or raise capital or debt on terms that are acceptable.

The holders of Convertible Debentures control the conversion of the Convertible Debentures and certain of the Convertible Debentures were not converted at their maturity constituting a potential default on the matured, but unconverted, Convertible Debentures. In the event of such default, principal, accrued interest and other related costs are immediately due and payable in cash. As of March 31, 2017, Convertible Debentures with a face value of $5,998,875 held by 80 individual investors are in default. None of these investors have served notice of default on the Convertible Debentures held by them.

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability and classification of assets or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

2. Summary of Significant Accounting Policies

Revenue recognition

The Company recognizes revenues when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable and collectability is reasonably assured. Revenue from the sale of the Company’s products is generally recognized when title and risk of loss transfers to the customer, the terms of which are generally free on board shipping point. The Company uses customer purchase orders to determine the existence of an arrangement. The Company uses shipping documents and third-party proof of delivery to verify that title has transferred. The Company assesses whether the price is fixed or determinable based upon the terms of the agreement associated with the transaction. To determine whether collection is probable, the Company assesses a number of factors, including past transaction history with the customer and the creditworthiness of the customer.

Consolidation

The accompanying consolidated financial statements include the accounts of SpectraScience, Inc. and its wholly-owned subsidiaries LUMA, International and Spectra UK. All significant intercompany balances and transactions have been eliminated in consolidation.

Risks and Uncertainties

The Company operates in an industry that is subject to intense competition, government regulation and rapid technological change. The Company’s operations are subject to significant risk and uncertainties, including financial, operational, technological, regulatory and other risks associated with a short history of product sales, including the potential risk of business failure.

Use of Estimates

The Company prepares its consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, which requires management to make estimates and assumptions that affect the amounts reported in the financial statements and disclosures made in the accompanying notes to the financial statements. Significant estimates made by management include, among others, realization of long-lived assets including intangible assets, assumptions used to value stock options, assumptions used to value the common stock issued and assumptions related to the determination of the fair value of the derivative components associated with the Company’s Convertible Debentures. Actual results could differ from those estimates.

Inventory Valuation

The Company states its inventory at the lower of cost or market value, determined on a specific cost basis. The Company provides inventory allowances when conditions indicate that the selling price could be less than cost due to obsolescence and reductions in estimated future demand. The Company balances the need to maintain strategic inventory levels with the risk of obsolescence due to changing technology and customer demand levels. Unfavorable changes in market conditions may result in a need for additional inventory reserves that could adversely impact the Company’s gross margins. Conversely, favorable changes in demand could result in higher gross margins when the Company sells products.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

Valuation of Long-lived Assets

The Company’s long-lived assets consist of property and equipment and intangible assets. Equipment is carried at cost and is depreciated over the estimated useful lives of the assets, which are generally two to three years, and leasehold improvements are amortized over the lesser of the lease term or the estimated useful lives of the improvements. The straight-line method is used for depreciation and amortization. Intangible assets consist of patents, which are amortized using the straight-line method over the estimated useful lives of the patents. The Company does not capitalize external legal costs and filing fees associated with obtaining patents on its new discoveries. Acquired intellectual property is recorded at cost and is amortized over its estimated useful life. The Company believes the useful lives assigned to these assets are reasonable. The Company assesses the recoverability of long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. These computations utilize judgments and assumptions inherent in management’s estimate of future cash flows to determine recoverability of these assets. If management’s assumptions about these assets were to change as a result of events or circumstances, the Company may be required to record an impairment loss.

Variable Conversion Rate Debentures

Starting in 2015, the Company entered into convertible debentures with floating exercise prices discounted to market prices. As a result, a significant number of shares were either issued or may be issued at deeply discounted variable conversion prices. The downward pressure placed on the Company’s stock as a result of these conversions can be classified as “death spirals” since the investors have no incentive to maintain a stable stock price. The Company accounts for these debentures as derivative liabilities which means the debentures are revalued at the end of each period and gains and losses are recognized at the issuance of the debentures and on the conversion of the debentures.

Over Commitment of Shares

Since the number of shares issuable under convertible debentures with floating exercise prices is undeterminable, the Company may be required to issue shares in excess of the number of shares authorized by its shareholders. As a result, when the Company determines that is does not have sufficient shares to meet the obligations of derivative unexercised debentures, warrants and options, the derivatives must be valued using the Black Scholes Option Pricing method and a liability is recorded as though the obligations would be settled using some means other than stock.

Stock-Based Compensation

The Company accounts for stock-based compensation under the provisions of FASB ASC Topic 718, Compensation—Stock Compensation (“ASC 718”), which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors based on estimated fair values on the grant date. The Company estimates the fair value of stock-based awards on the date of grant using the Black Scholes option-pricing model (the “Black-Scholes Model”). The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods using the straight-line method. The Company estimates forfeitures at the time of grant and revises its estimate in subsequent periods if actual forfeitures differ from those estimates.

The Company accounts for stock-based compensation awards to non-employees in accordance with FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees (“ASC 505-50”). Under ASC 505-50, the Company determines the fair value of the warrants or stock-based compensation awards

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

granted as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.

All issuances of stock options or other equity instruments to employees and non-employees as the consideration for goods or services received by the Company are accounted for based on the fair value of the equity instruments issued. Any stock options issued to non-employees are recorded in expense and additional paid-in capital in shareholders’ equity over the applicable service periods using variable accounting through the vesting dates based on the fair value of the options at the end of each reporting period.

As of March 31, 2017, the Company had one stock-based employee compensation plan under which it makes grants, the 2011 Equity Incentive Plan (the “EIP”). The EIP provides for the grant of incentive stock options (“ISOs”), nonqualified stock options (“NQSOs”) and restricted stock awards to full-time employees (who may also be directors) and NQSOs and restricted stock awards to non-employee directors, consultants, customers, vendors or providers of services. The exercise price of any ISO may not be less than the fair market value of the common stock on the date of grant and the term shall not exceed ten years. The amount reserved under the 2011 EIP is 40,000,000 shares of common stock. At March 31, 2017, the Company had options outstanding exercisable into up to 34,168,800 shares of stock under the EIP of which up to 26,725,761 shares were exercisable. Awards under the Company’s EIP generally vest over four years.

The fair value of options granted are estimated at the date of grant using a Black Scholes Model which includes several variables including expected life, risk free interest rate, expected stock price volatility, stock option exercise patterns and expected dividend yield. The Company also must estimate forfeitures for employee stock options. There were no stock options granted during the three month periods ended March 31, 2017 and 2016.

Earnings (Loss) Per Share

Basic loss per share is computed by dividing loss available to common shareholders by the weighted-average number of common shares outstanding. Diluted loss per share is computed similar to basic loss per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. Common equivalent shares are excluded from the computation if their effect is anti-dilutive.

For the three month periods ended March 31, 2017 and 2016, the following common equivalent shares were excluded from the computation of loss per share since their effects are anti-dilutive.

The following table sets forth the computation of basic and diluted loss per share for the three month periods ended March 31, 2017 and 2016:

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

During the year ended December 31, 2016, the Company purchased the inventory of Oncoscope, Inc. from the Trustee of Ondoscope’s bankruptcy proceeding for a total of $40,000. This amount, net of amounts sold of $2,100, has been included in raw materials.

Recently Adopted and Issued Accounting Pronouncements

In August 2014, the FASB issued FASB ASU2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. FASB ASU 2014-15 changes to the disclosure of uncertainties about an entity’s ability to continue as a going concern. These changes require an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that financial statements are issued. Substantial doubt is defined as an indication that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that financial statements are issued. If management has concluded that substantial doubt exists, then the following disclosures should be made in the financial statements: (i) principal conditions or events that raised the substantial doubt, (ii) management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, (iii) management’s plans that alleviated the initial substantial doubt or, if substantial doubt was not alleviated, management’s plans that are intended to at least mitigate the conditions or events that raise substantial doubt, and (iv) if the latter in (iii) is disclosed, an explicit statement that there is substantial doubt about the entity’s ability to continue as a going concern. These changes became effective for the Company for the 2016 annual period. Management has evaluated the impact of the adoption of these changes and has determined there will be no material impact on the consolidated financial statements. Subsequent to adoption, this guidance will need to be applied by management at the end of each annual period and interim period therein to determine what, if any, impact there will be on the consolidated financial statements in a given reporting period.

In April 2015, the FASB issued ASU No 2015-3, Simplifying the Presentation of Debt Issuance Costs. This update changes the presentation of debt issuance costs in the balance sheet. ASU 2015-03 requires debt issuance costs related to a recognized debt obligation to be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability rather than being presented as an asset. Amortization of debt issuance costs will continue to be reported as interest expense. In August 2015, the FASB issued ASU 2015-15, “Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements”. This ASU clarified guidance in ASC 2015-03 stating that the SEC staff would not object to a company presenting debt issuance costs related to a line-of-credit arrangement on the balance sheet as a deferred asset, regardless of whether there were any outstanding borrowings at period-end. This update is effective for annual and interim periods beginning after December 15, 2015, which required us to adopt these provisions in the first quarter of 2016. This update was applied on a retrospective basis, wherein the balance sheet of each period presented was adjusted to reflect the effects of applying the new guidance. The adoption of this guidance did not have a material impact on our consolidated financial statements.

In November 2015, the FASB issued ASU No 2015-17, Income Taxes (Topic 740). The amendments in ASU 2015-17 change the requirements for the classification of deferred taxes on the balance sheet. Currently, GAAP requires an entity to separate deferred income tax liabilities and assets into current and noncurrent amounts in a classified statement of financial position. To simplify the presentation of deferred income taxes, the amendments in this ASU require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The pronouncement is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2016. Earlier application is permitted for all entities as of the beginning of an interim or annual reporting period. The Company has early adopted this pronouncement for the fiscal reporting period ended December 31, 2016, and has reclassified the presentation of deferred income taxes in the prior period to conform with the current year classification in the consolidated balance sheets. As a result of the Company having recognized a valuation reserve for the entire deferred tax liability balance at March 31, 2017 and December 31, 2016, there is no impact of the presentation of deferred income taxes in our financial statements.

In January 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The update intends to enhance the reporting model for financial instruments to provide users of financial statements with more decision-useful information and addresses certain aspects of the recognition, measurement, presentation, and disclosure of financial instruments. The new standard affects all entities that hold financial assets or owe financial liabilities. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Management is evaluating the impact of the adoption of these changes will have on the consolidated financial statements.

Reclassifications

Certain reclassifications have been made to the 2016 financial statements in order for them to conform to the 2017 presentation. Such reclassifications have no impact on the Company’s financial position or results of operations.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

3. Liabilities

Note Payable

In November 2014, the Company issued for cash of $100,000 an unsecured note payable and a five-year warrant with an exercise price of $0.09 per share for the purchase of up to 50,000 shares of common stock. The terms of the note were a repayment of $115,000 if paid by February 18, 2015 and, if paid thereafter, the principal balance of the note was to be increased to $137,982 as of October 1, 2015 and interest accrues at 20% from October 1, 2015 until paid. During the three months ended March 31, 2017, $25,000 principal of this note was assigned to a third party who paid a like amount to the holder of the note. The balance of the note outstanding at March 31, 2017, $112,982, continues to accrue interest at 20%.

Notes Payable- Related Parties

During the three months ended March 31, 2016, two affiliates of the Company advanced to the Company cash in an accumulated amount of $35,000 in exchange for six-month 10% promissory notes. The balance of the notes remains $35,000 at March 31, 2017.

Convertible Debentures

As of March 31, 2017, the Company has issued and outstanding fixed rate Convertible Debentures (“Debentures”) with original terms of three months to one year, an interest rate ranging from 10-20% per year and an original issue discount ranging from 5% to 10% which, at the option of the holder, may convert into common stock at initial conversion prices ranging from $0.01 to $0.099 per share.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

The Debentures were issued with detachable five year cashless Holders Warrants that allow the holders to purchase one share of stock for each two shares available under the converted Debentures at an exercise price ranging from $0.02 to $0.1287 per share. In addition, the Company issued five-year cashless Agent Warrants equal to 10% of the total number of shares issuable under the Debentures and Holders Warrants at exercise prices ranging from $0.0745 to $0.1287 per share. For debentures issued through March 31, 2013, at the option of the Debenture holder, the terms of the Debentures and Holders Warrants are subject to an exchange feature in the event that the Company issues securities with terms more favorable than those of the then outstanding Debentures and Holders Warrants. Debentures issued subsequent to March 31, 2013 do not contain such an exchange clause. During the three months ended March 31, 2017, Debentures with an accumulated principal balance of $150,000 and $13,767 of accrued interest were assigned to a third party note holder. The new notes contain variable conversion rates discussed below. The gross amount of Debentures with fixed conversion rates outstanding is $5,977,082 as of March 31, 2017.

During the three months ended March 31, 2017, the Company has issued and outstanding Convertible Debentures (“Variable Debentures”) with original terms of 9 months to one year, interest rates ranging from 0-10% per year and original issue discounts ranging from 0-10% which contain variable conversion rates ranging from discounts of 40-50% of the Company’s common stock based on the Company’s common stock trading prices ranging from 10-25 days previous to conversion. The Variable Debentures contain prepayment options which enable the Company to prepay the notes for periods of 0-180 days subsequent to issuance at premiums ranging from 0-50%. The gross amount of Variable Debentures outstanding is $480,040 as of March 31, 2017.

As of March 31, 2017 and December 31, 2016, the balances of the Debentures and Variable Debentures are as follows:

Secured Convertible Note

During the three months ended March 31, 2017, the Company issued for cash of $250,000 Secured Convertible Debentures (the “Secured Debentures”) to two accredited investors. The terms of the Debentures are for three years, a conversion price of $0.01 per share and an annual interest rate of 8%. The secured interest is on all of the assets of the Company. In addition, the Company issued to the holder of $100,000 Secured Debentures, a five year common stock purchase warrant to purchase up to 5,000,000 shares of common stock with an exercise price of $0.02 per share. The value of this warrant, $292, was determined using the Black Sholes Method and was reflected as a discount to the Secured Debenture.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

Derivative Liability

Since the Company issued Convertible Debentures which included Holders Warrants, Agent Warrants and a conversion option that includes a possible exchange feature in the event of a future financing on terms more favorable than those of the existing warrants and debentures, this results in the warrants and conversion feature of the debentures being recorded as a liability and measured at

fair value. In addition, outstanding Variable Debentures contain variable conversion rates based on unknown future prices of the Company’s common stock resulting in a conversion feature. The Company measures these warrants and conversion features using the Black Scholes Model. The period over which the Company will be required to evaluate the fair value of the warrants is approximately five years and the period over which the Company will be required to evaluate the fair value of the conversion features are six to twelve months or conversion.

The assumptions used in determining fair value represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change, including changes in the market value of the Company’s common stock, managements’ assessment of the probability of a more favorably priced future financing or significant fluctuations in the volatility of the trading market for the Company’s common stock, the Company’s fair value estimates could be materially different in the future.

The Company computes the fair value of the derivative liability at each reporting period and the change in the fair value is recorded as non-cash expense or non-cash income. The key component in the value of the derivative liability is the Company’s stock price, which is subject to significant fluctuation and is not under the Company’s control. Therefore, the resulting effect on net loss is subject to significant fluctuation and will continue to be so until the Company’s Debentures, which the convertible feature is associated with, are converted into common stock or paid in full with cash. Assuming all other fair value inputs remain constant, the Company will record non-cash expense when its stock price increases and non-cash income when its stock price decreases.

In addition, since the number of shares issuable under the Variable Debentures are undeterminable, the Company may be required to issue shares in excess of the number of shares authorized by its shareholders. As a result, when the Company determines that is does not have sufficient shares to meet the obligations of derivative unexercised debentures, warrants and options, the derivatives must be valued using the Black Scholes Option Pricing method and a liability is recorded as though the obligations would be settled using some means other than stock. For the three months ended March 31, 2017, the Company determined that it was over committed to the number of shares issuable on the exercise of outstanding debentures, stock options and warrants for approximately 1,166,000,000 shares.

As of March 31, 2017 and December 31, 2016, the balances of the Derivative Liability are as follows:

Debentures with warrants attached issued subsequent to March 31, 2013 did not contain an exchange provision and were accounted for using the equity method of valuing the note and warrant.

4. Shareholders’ Deficit

Common Stock

During the three months ended March 31, 2017, holders of Convertible Debentures with a face value of $82,345 and accrued interest of $6,074 converted their debentures into 529,648,837 shares of common stock. In addition, associated with these debentures, the Company recorded a gain on extinguishment of debt of $15,651.

Warrants

During the three months ended March 31, 2017, in conjunction with the sale of Convertible Debentures, the Company issued a five-year common stock purchase warrant to acquire up to 5,000,000 shares to holders of the Debentures. In addition, the Company issued a five-year common stock purchase warrant to acquire up to 500,000 shares to an agent who assisted in this financing. These warrants have an exercise price of $0.02 per share. The value of the warrants was determined using the Black Sholes Model. The value of the warrant issued to the note holder, $2,925, was reflected as a discount to the note and the value of the warrant issued to the agent, $292, was reflected as a non-cash operating expense.

In March 2016, the Company issued a warrant exercisable into up to 1,000,000 shares of common stock in exchange for services provided by a consultant. The value of these warrants, $1,652, was determined using the Black Scholes Model and was included as non-cash expenses and additional paid-in capital during the three months ended March 31, 2016.

At March 31, 2017, total unrecognized estimated employee compensation cost related to non-vested stock options granted prior to that date is $133,323, which we expect to be recognized over the next year.

Series AA Preferred Shares

On April 15, 2016, the Board of Directors of the Company authorized an amendment to the Company’s Articles of Incorporation, as amended (the “Articles of Incorporation”), in the form of a Certificate of Designation that authorized the issuance of up to three thousand (3,000) shares of a new series of preferred stock, par value $0.001 per share, designated “Series AA Super Voting Preferred Stock,” for which the board of directors established the rights, preferences and limitations thereof.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

Each holder of outstanding shares of Series AA Super Voting Preferred Stock shall be entitled to one million (1,000,000) votes for each share of Series AA Super Voting Preferred Stock held on the record date for the determination of stockholders entitled to vote at each meeting of stockholders of the Company. The holders are restricted from voting the preferred shares for any proposal on the election of directors. The Company recorded a special dividend and valued the Series AA Super Voting Preferred Stock at $25,000 as of March 31, 2017 and December 31, 2016.

5. Fair Value Measurements

Accounting guidance on fair value measurements and disclosures defines fair value, establishes a framework for measuring the fair value of assets and liabilities using a hierarchy system, and defines

required disclosures. It clarifies that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business.

The Company’s balance sheet contains derivative and warrant liabilities that are recorded at fair value on a recurring basis. The three-level valuation hierarchy for disclosure of fair value is as follows:

Level 1: uses quoted market prices in active markets for identical assets or liabilities.

Level 2: uses observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: uses unobservable inputs that are not corroborated by market data.

The fair value of the Company’s recorded derivative and warrant liabilities is determined based on unobservable inputs that are not corroborated by market data, which require a Level 3 classification. The Black Sholes Model was used to determine the fair value with similar assumptions to those described under “Stock-Based Compensation”. The Company records derivative and warrant liabilities on the condensed consolidated balance sheets at fair value with changes in fair value recorded in the condensed consolidated statements of operation.

The following table presents changes in the derivative liabilities with significant unobservable inputs (Level 3) for the three months ended March 31, 2017:

(1) Included in the Condensed Statements of Operation on the line “Change in fair value of derivative and warrant liabilities.”

Management used the following inputs to value the Derivative and Warrant Liabilities for the three months ended March 31, 2017:

In computing the fair value of the derivative and warrant liability at March 31, 2017, management estimated a 60% probability of a down round financing event at a price of $0.025 and a 9% to 34% probability that existing note holders with exchange privileges would exchange their existing debentures and warrants for new debentures and warrants.

SpectraScience, Inc.

Notes to Unaudited Condensed Financial Statements (continued)

6. Contingencies

Legal Proceedings

On July 7, 2016, Oakmore Opportunity Fund I LP, a variable rate noteholder of SprectraScience, filed for a preliminary judgement of $116, 500 in the Superior Court for the County of Los Angeles, case number BC622542, related to a Convertible Note. Oakmore asserts that SpectraScience breached the terms of the Convertible Note due to not having sufficient authorized shares to enable Oakmore to convert its Note with a balance of $22,500. The Company did not object to the preliminary judgement. On October 19, 2016, the Judge issued a final judgement of $521,100. The Company is retaining litigation counsel and intends to vigorously defend the amount of the judgement. The amount of ultimate liability with respect to the foregoing cannot be determined, however, the Company has established a $150,000 contingency to cover the costs of litigation and the judgement. Despite the inherent uncertainties of litigation, the Company at this time does not believe that Oakmore’s claim will have a material adverse impact on its financial condition, results of operations, or cash flows.

7. Subsequent Events

Secured Convertible Debentures

In May 2017, the Company issued a $60,000 Secured Convertible Debenture (the “Debenture”) to one accredited investor for cash consideration of $50,000. The Debenture matures in three years, carries a fixed conversion price of $0.01, and an annual interest rate of 8%. The secured interest is on all of the assets of the Company and is shared equally with a previous secured party. In addition, the Company issued a five year common stock purchase warrant exercisable into up to 3,000,000 shares of common stock at an exercise price of $0.02.

Variable Rate Convertible Debentures

In April 2017, a holder of Variable Rate Convertible Debentures with principal of $4,116 and accrued interest of $3,309 converted the remaining portion of one of their debentures into 27,000,000 shares of common stock. In addition, in May 2017, the Company entered into a variable rate note accumulating $75,000 that can be repaid for a premium ranging from 20% to 35% if paid within 180 days. If paid subsequent to 180 days, the notes are convertible into common stock at a discount to the market price.

Increase in Authorized Shares

On April 24, 2017, the Company’s shareholders approved an increase in authorized capital stock from 2 billion shares to 3 billion shares. The increase in authorized shares will become effective 20 days after the mailing of a Definitive 14C to shareholders.

Subsequent events have been evaluated through the date financial statements are filed with the Securities and Exchange Commission.