DEFSEC TECHNOLOGIES — Annual Report 2021

Jan 29, 2021

Consolidated Financial Statements of

KWESST MICRO SYSTEMS INC.

Nine months ended September 30, 2020, and Twelve months ended December 31, 2019

(Expressed in Canadian Dollars)

Table of Contents for the Nine months Ended September 30, 2020 and twelve months ended December 31, 2019

	Page
Independent Auditor's Report	1 – 2
FINANCIAL STATEMENTS
Consolidated Statements of Financial Position	3
Consolidated Statements of Net Loss and Comprehensive Loss	4
Consolidated Statements of Changes in Shareholders' Equity	5
Consolidated Statements of Cash Flows	6
Notes to the Consolidated Financial Statements	7-44

INDEPENDENT AUDITOR'S REPORT

To the Shareholders of

KWESST Micro Systems Inc.

Opinion

We have audited the accompanying consolidated financial statements of KWESST Micro Systems Inc. (the "Company"), which comprise the consolidated statements of financial position as at September 30, 2020 and December 31, 2019, and the consolidated statements of net loss and comprehensive loss, consolidated statements of changes in shareholder's equity and cash flows for the periods then ended, and notes to the consolidated financial statements, including a summary of significant accounting policies.

In our opinion, the accompanying consolidated financial statements present fairly, in all material respects, the consolidated financial position of the Company as at September 30, 2020 and December 31, 2019 and its consolidated financial performance and its consolidated statements of cash flows for the periods then ended in accordance with International Financial Reporting Standards.

Material Uncertainty Related to Going Concern

We draw attention to Note 2 in the consolidated financial statements, which describe the events and conditions that indicate the existence of material uncertainties that may cast significant doubt about the Company's ability to continue as a going concern. Our opinion is not modified in respect of this matter.

Basis for Opinion

We conducted our audits in accordance with Canadian generally accepted auditing standards. Our responsibilities under those standards are further described in the Auditor's Responsibilities for the Audit of the Financial Statements section of our auditor's report. We are independent of the Company in accordance with the ethical requirements that are relevant to our audits of the financial statements in Canada, and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.

Emphasis of Matter - Restatement of Consolidated Financial Statements

We draw attention to note 25 in the consolidated financial statements, which explains that certain comparative information presented for the year ended December 31, 2019 has been restated. Note 25 explains the reason for the restatement and also explains the adjustments that were applied to restate certain comparative information.

Our opinion is not modified in respect of this matter.

Other Information

Management is responsible for the other information. The other information comprises Management's Discussion and Analysis.

Our opinion on the financial statements does not cover the other information and we do not and will not express any form of assurance conclusion thereon. In connection with our audits of the financial statements, our responsibility is to read the other information identified above and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audits, or otherwise appears to be materially misstated.

We obtained Management's Discussion and Analysis prior to the date of this auditor's report. If, based on the work we have performed on this other information, we conclude that there is a material misstatement of this other information, we are required to report that fact in this auditor's report. We have nothing to report in this regard.

Responsibilities of Management and Those Charged with Governance for the Financial Statements

Management is responsible for the preparation and fair presentation of the financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for assessing the Company's ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going-concern basis of accounting unless management either intends to liquidate the Company or to cease operations or has no realistic alternative but to do so.

Those charged with governance are responsible for overseeing the Company's financial reporting process.

Auditor's Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor's report that includes our opinion. Reasonable assurance is a high level of assurance, but it is not a guarantee that an audit conducted in accordance with Canadian generally accepted auditing standards will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements.

As part of an audit in accordance with Canadian general accepted auditing standards, we exercise professional judgment and maintain professional skepticism throughout the audit. We also:

• Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.
• Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control.
• Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management.
• Conclude on the appropriateness of management's use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Company's ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditor's report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditor's report. However, future events or conditions may cause the Company to cease to continue as a going concern.
• Evaluate the overall presentation, structure and content of the financial statements, including the disclosures, and whether the financial statements represent the underlying transactions and events in a manner that achieves fair presentation.
• Obtain sufficient appropriate audit evidence regarding the financial information of the entities or business activities within the Company to express an opinion on the financial statements. We are responsible for the direction, supervision and performance of the group audit. We remain solely responsible for our audit opinion.

We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audits and significant audit findings, including any significant deficiencies in internal control that we identify during our audits.

We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards.

The engagement partner on the audit resulting in this independent auditor's report is Julia Zhou.

Kreston GTA LLP

Licensed Public Accountants January 28, 2021 Markham, Canada

KWESST MICRO SYSTEMS INC. Consolidated Statements of Financial Position At September 30, 2020 and December 31, 2019

In Canadian dollars	Note	September 30, 2020 December 31, 2019
			(As restated - see
			Note 25)
ASSETS
Cash		\$ 3,073,760	\$ 21,615
Trade and other receivables	5	479,291	219,803
Prepaid expenses and other		441,837	54,075
Current assets		3,994,888	295,493
Property and equipment	6	174,644	70,122
Right-of-use assets	7	520,440	184,472
Intangible assets	8	644,702	-
Deposits	7	22,337	-
Other assets	25	150,000	150,000
Non-current assets		1,512,123	404,594
Total Assets		\$ 5,507,011	\$ 700,087
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) Liabilities
Accounts payable and accrued liabilities	9	\$ 818,274	\$ 198,687
Related party loans	10	218,276	289,828
Borrowings	11	32,273	-
Lease obligations	12	78,358	85,468
Deferred revenue	13	7,053	-
Financial derivative liabilities	14	-	29,463
Current liabilities		1,154,234	603,446
Lease obligations	12	496,394	117,218
Convertible notes	15	-	210,819
Non-current liabilities		496,394	328,037
Total Liabilities		1,650,628	931,483
Commitments and contingencies	24
Shareholders' Equity (Deficit)
Share capital	16	9,374,563	2,284,353
Contributed surplus	16	583,878	21,050
Accumulated deficit		(6,102,058)	(2,536,799)
Total Shareholders' equity (deficit)		3,856,383	(231,396)
Total Liabilities and Shareholders' Equity (Deficit)		\$ 5,507,011	\$ 700,087

See Note 2(a) Going Concern

See accompanying notes to consolidated financial statements.

On behalf of the Board of Directors:

(signed) John McCoach , Director (signed) David Luxton , Director

4 | Page

Consolidated Statements of Net Loss and Comprehensive Loss

For the nine months ended September 30, 2020 and the twelve months ended December 31, 2019

		Nine Months	Twelve Months
		Ended	Ended
		September 30	December 31
In Canadian dollars	Note	2020	2019
			(As restated -
			see Note 25)
Revenue	18	\$ 861,917	\$ 509,148
Cost of sales		(247,113)	(85,101)
Gross profit		614,804	424,047
Operating expenses
Merger and acquisition (''M&A'') costs	4, 10, 16	1,561,863	-
Personnel costs		806,880	790,967
Consulting fees		325,237	130,900
Business development		295,057	13,500
Stock-based compensation	16	283,084	-
Professional fees		190,399	97,853
Investor relations		177,883	-
Depreciation and amortization	6,7,9	125,253	102,143
Travel and conferences		112,360	64,414
General and administrative expenses	25	86,197	21,273
R&D consulting and material costs, net		79,747	164,526
Advertising and promotion		42,182	21,549
Insurance		36,487	31,251
Total operating expenses		4,122,629	1,438,376
Operating loss		(3,507,825)	(1,014,329)
Other income (expenses)
Fair value adjustments on derivatives	14	29,463	113,178
Gain on government grant	11	9,096	-
Net finance costs	10, 12, 15	(82,056)	(245,147)
Foreign exchange gain (loss)		(13,937)	(982)
Total other income (expenses)		(57,434)	(132,951)
Loss before income taxes		(3,565,259)	(1,147,280)
Income tax recovery:	19
Current tax recovery		-	-
Deferred tax recovery		-	-
Net loss and comprehensive loss		\$ (3,565,259)	\$ (1,147,280)
Net Loss per share
Basic and diluted		\$ (0.12)	\$ (0.07)
Weighted average number of shares outstanding
Basic and diluted	17	30,844,129	17,430,077

See accompanying notes to consolidated financial statements.

Consolidated Statements of Changes in Shareholders' Equity

For the nine months ended September 30, 2020 and the twelve months ended December 31, 2019

In Canadian dollars			Common Shares Contributed Surplus					Total
		Number							Shareholders'
[Refer to Note 16]	Other Notes	Issued		Share Capital		Warrants	Options	Deficit	Equity
Balance, December 31, 2018		200	\$	200	\$	-	\$ -	\$ (1,389,519)	\$ (1,389,319)
Shares issued for cash		5,075,000		1,014,948		-	-	-	1,014,948
Shares issued for debt		21,804,486		1,269,205		1,192	-	-	1,270,397
Warrants issued for debt		-		-		19,858	-	-	19,858
Net loss	25	-		-		-	-	(1,147,280)	(1,147,280)
Balance, December 31, 2019		26,879,686	\$	2,284,353	\$	21,050	\$ -	\$ (2,536,799)	\$ (231,396)
Shares and warrants issued in a brokered
private placement		4,409,553		3,087,138		60,340	-	-	3,147,478
Shares for converted debt and interest		3,666,689		1,583,881		-	-	-	1,583,881
Shares and warrants issued in non
brokered private placements		3,486,750		1,480,875		15,780	-	-	1,496,655
Shares issued for performance incentive		1,045,000		731,500		-	-	-	731,500
Shares from Foremost's qualifying
transaction	4(a)	898,498		628,949		-	41,155	-	670,104
Shares and warrants issued on
acquisition of technology asset	4(b)	697,000		167,280		180,000		-	347,280
Stock options exercised		122,000		78,080		-	(17,531)	-	60,549
Shares for consulting services		61,000		32,393		-		-	32,393
Share-based payments		-		-			283,084	-	283,084
Share offering costs		-		(699,886)		-		-	(699,886)
Net loss		-		-		-		(3,565,259)	(3,565,259)
Balance, September 30, 2020		41,266,176	\$	9,374,563	\$	277,170	\$ 306,708	\$ (6,102,058)	\$ 3,856,383

See accompanying notes to consolidated financial statements.

Consolidated Statements of Cash Flows

For the nine months ended September 30, 2020 and twelve months ended December 31, 2019

		Nine months	Twelve months
		ended	ended
		September 30,	December 31,
In Canadian dollars	Note	2020	2019
			(As restated -
			see Note 25)
OPERATING ACTIVITIES
Net loss		\$ (3,565,259)	\$ (1,147,280)
Items not affecting cash:
Depreciation and amortization	6, 7, 9	125,253	102,142
Share-based compensation	17	283,084	-
Shares for M&A advisory and consulting services		763,893	-
Fair value adjustments on derivative liabilities	14	(29,463)	(113,178)
Non-cash listing expense (included in M&A costs)	4(a)	814,703	-
Gain on government grant	11	(9,096)	-
Net finance costs		81,876	230,858
Changes in non-cash working capital items	21	(245,095)	(141,575)
Interest paid		(11,550)	(24,523)
Income taxes paid		-	-
Cash used in operating activities		(1,791,654)	(1,093,556)
INVESTING ACTIVITIES
Acquisition of property and equipment	6	(133,927)	(20,190)
Acquisition of technology asset	4(b)	(134,192)	-
Investments in development projects	9	(163,230)	-
Deposit for long-term office lease		(38,212)	-
Cash acquired on closing of Foremost	4(a)	78,589	-
Cash flows used in investing activities		(390,972)	(20,190)
FINANCING ACTIVITIES
Proceeds from the issuance of common shares	16	4,355,171	1,014,948
Proceeds from convertible notes and converted to equity	17	1,081,504	-
Payments of share offering costs	17	(164,716)	-
Proceeds from borrowings	11	40,000	-
Repayment of borrowings		-	(10,747)
Repayments to related party loans Proceeds from related party loans	10 10	(80,000) -	(70,513) 310,684
Repayments of lease obligations	12	(58,188)	(77,367)
Repayments of convertible notes	15	-	(31,644)
Proceeds from exercise of stock options	16	61,000	-
Cash flows provided by financing activities		5,234,771	1,135,361
Net change in cash during the period		3,052,145	21,615
Cash, beginning of period		21,615	-
Cash, end of period		\$ 3,073,760	\$ 21,615

See Note 21 for supplemental cash flow information

See accompanying notes to condensed interim financial statements.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

1. Corporate information

KWEEST Micro Systems Inc. (the "Company" or "KWESST"), formerly Foremost Ventures Corp. (''Foremost''), was incorporated on November 28, 2017, under the laws of the Province of British Columbia. The Company's registered office is located at 550 Burrard Street, Suite 2900, Vancouver, British Columbia, Canada. Its corporate office is located at Unit 1, 155 Terrence Matthews Crescent, Ottawa, Ontario, Canada.

On September 17, 2020, Foremost completed a Qualifying Transaction ("the QT") with KWESST Inc., a private company, was incorporated under the laws of the Province of Ontario on April 24, 2017. The QT constituted a reverse acquisition in accordance with IFRS as the shareholders of KWESST Inc. took control of Foremost (Note 4(a)). At the time of the QT, Foremost did not constitute a business as defined under IFRS 3 - Business Combinations, and therefore the QT was accounted for as an asset acquisition. As KWESST Inc. was deemed to be the acquirer for accounting purposes, the resulting consolidated statements of financial position was presented as a continuance of KWESST Inc.'s operations at their historical carrying values, and the comparative figures presented are those of KWESST Inc. The results of operations, the cash flows, and the assets and liabilities of Foremost have been included in these consolidated financial statements since September 17, 2020.

Following the QT, KWESST, pursuant to Section 4.8(2) of National Instrument 51-102, provided notice that KWESST has changed its fiscal year end to September 30th from December 31st. Accordingly, these consolidated financial statements presented herein are as at and for the nine months ended September 30, 2020 with comparatives as at and for the twelve months ended December 31, 2019.

KWESST develops and markets innovative products to create ''intelligent tactical systems'' and proprietary technology for game-changing applications in the military and homeland security market. KWESST's core technology has multiple applications based on its micro integrated sensor software technology, or MISST, a proprietary integration of miniaturized sensors, optics, ballistics and software that provides an advancement in affordable smart systems and mission capability.

KWESST's common stock is listed on the TSX-Venture Exchange (''TSX-V'') under the stock symbol of KWE.

2. Basis of preparation

(a) Going concern

These consolidated financial statements have been prepared assuming KWESST will continue as a going concern.

As an early-stage company, KWESST has incurred significant losses and negative operating cash flows from inception that have primarily been funded from financing activities. The Company incurred approximately \$3.6 million net loss and negative operating cash flows of approximately \$1.8 million for the nine months period ended September 30, 2020 (2019 - \$1.1 million net loss and negative operating cash flows of \$1.1 million for 12 months). At September 30, 2020, KWESST had a working capital of \$2.8 million (December 31, 2019 – working capital deficiency of \$0.3 million).

The Company's ability to continue as a going concern and realize its assets and discharge its liabilities in the normal course of business is dependent upon closing timely additional sales orders, achieving sustained profitability and the ability to raise additional debt or equity financing, if required, to fund its working capital requirements. There are various risk and uncertainties affecting KWESST's operating including, but not limited to:

• The market acceptance and rate of commercialization of the KWESST's offerings;

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

• Ability to successfully execute its business plan;
• Ability to raise additional capital at acceptable terms;
• General local and global economic conditions, including the ongoing COVID-19 pandemic, certain of which are beyond the Company's control.

KWESST's strategy to mitigate these risks and uncertainties is to execute timely a business plan aimed at continued focus on revenue growth, product development and innovation, improving overall gross profit, managing operating expenses and working capital requirements, and securing additional capital, as needed. There are no guarantees that the funds raised will be sufficient to sustain KWESST's ongoing operations beyond twelve months or that additional debt or equity financing will be available to the Company or available at acceptable terms. Failure to implement the Company's business plan could have a material adverse effect on the Company's financial condition and/or financial performance. Accordingly, there are material risks and uncertainties that cast significant doubt about KWESST's ability to continue as a going concern.

These consolidated financial statements do not include any adjustments or disclosures that would be required if assets are not realized and liabilities and commitments are not settled in the normal course of operations. If KWESST is unable to continue as a going concern, then the carrying value of certain assets and liabilities would require revaluation to a liquidation basis, which could differ materially on the values presented in the financial statements.

(b) Statement of compliance

These consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (''IFRS'') as issued by the International Accounting Standards Board ("IASB") and interpretations of the IFRS Interpretations Committee ("IFRIC'').

The consolidated financial statements were authorized for issue by the Board of Directors on January 28, 2021.

(b) Principles of consolidation

These consolidated financial statements incorporate the financial statements of KWESST and the entity it controls.

Control is achieved where KWESST has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities, are exposed to, or have rights to, variable returns from the Company's involvement with the entity and have the ability to affect those returns through its power over the entity. Subsidiaries are fully consolidated from the date on which control is transferred to the Company until the date on which control ceases. Profit or loss of subsidiaries acquired during the year are recognized from the date of acquisition or effective date of disposal as applicable. All intercompany transactions and balances have been eliminated.

At September 30, 2020, the Company has one wholly-owned subsidiary: KWESST Inc.

(c) Functional and presentation currency

The consolidated financial statements are presented in Canadian dollars ("CAD"), which is the functional currency of KWESST and its subsidiary.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

(d) Measurement basis

The consolidated financial statements have been prepared on the historical cost basis except for certain financial instruments measured at fair value. Historical cost is generally based on the fair value of the consideration given in exchange for assets.

(e) Comparative figures

Certain comparative figures in the consolidated statements of net loss and comprehensive loss have been reclassified to conform with the current period's presentation.

(f) Use of estimates and judgments

The preparation of the consolidated financial statements in accordance with IFRS requires management to make judgments, estimates, and assumptions that affect the application of accounting policies and the reported amounts of assets and liabilities, income, expenses, and disclosure of contingent liabilities. Actual results may differ from these estimates.

The continuing uncertainty around the outbreak of the novel coronavirus ("COVID-19"') pandemic required the use of judgements and estimates in the preparation of the consolidated financial statements for the nine months ended September 30, 2020. The future impact of COVID-19 uncertainties could generate, in future reporting periods, a significant impact to the reported amounts of assets, liabilities, revenue and expenses in these and any future financial statements.

Critical judgments that management has made in applying KWESST's accounting policies that the most significant effect on the amounts recognized in the consolidated financial statements include: assessment of KWESST's ability to continue as a going concern (Note 2(a)); and determination of the functional currency of the principal operations of KWESST(Note 2(c)).

Significant areas having estimation uncertainty in applying accounting policies that have the most significant effect on the amounts recognized in the financial statements:

Revenue recognition

To date, substantially all of the Company's revenue arise from providing customized tactical system solutions to customers at an amount that reflects the consideration KWESST expects to receive in exchange for the system offering.

The timing of revenue recognition often differs from contract payment milestones, resulting in revenue that has been earned but not billed. These amounts are included in unbilled receivables. Amounts billed in accordance with customer contracts, but not yet earned, are recorded and presented as part of deferred revenue. At September 30, 2020, management determined there was no unbilled receivables.

Fair value of acquired intangible assets

KWESST estimates the fair value of technology acquired based on observable market inputs. Because KWESST Inc. was a private company at the time of closing the GhostStep® Technology acquisition (see Note 4(b)), the common shares issued under this transaction were not actively trading on a stock exchange. Accordingly, management measured the fair value of the common shares based on the cash versus shares election available under the purchase agreement. Specifically, KWESST Inc. had the sole discretion to pay USD \$100,000 (CAD \$134,192) or issue 557,000 common shares to SageGuild. This implies a fair value of \$0.24 per common share of KWESST Inc. at the time of closing the transaction.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Accordingly, for the purpose of estimating the fair value of the warrants issued under this transaction (see contingent consideration below), management used \$0.24 as the underlying stock price for one of the key inputs in the Black-Scholes pricing model.

Contingent consideration

The GhostStep® Technology acquisition included contingent consideration in which KWESST Inc. issued 750,000 warrants to SageGuild which are cancellable if service condition is not met (see Note 4(b)). The rights granted under warrants shall vest and be exercisable as to 250,000 warrants on each of December 31, 2020, 2021, and 2022 if service condition is met. Subject to the service condition being met, on each of these three vesting dates, SageGuild shall be deemed to have exercised 250,000 warrants for an aggregate purchase price of \$125,000.

Under IFRS, the contingent consideration is classified as either a financial liability or equity based on the feature of the contingent consideration and how the number of shares to be issued is determined. Where a fixed number of shares either will or will not be issued depending on future events, the contingent consideration meets the definition of equity. The SageGuild warrants were classified as equity and the subsequent settlement will also be accounted for within equity. The contingent consideration is required to be recognized at the acquisition date fair value even if it is not deemed to be probable of payment at the date of the acquisition.

Treatment of development costs

Costs to develop products are capitalized to the extent that the criteria for recognition as intangible assets in IAS 38, Intangible Assets are met. Those criteria require that the product is technically and economically feasible, which management assessed based on the attributes of the development project, perceived user needs, industry trends, and expected future economic conditions. Management considers these factors in aggregate and applies significant judgment to determine whether the product is feasible.

Impairment of intangible assets

At September 30, 2020, the intangible assets relates primarily the GhostStep® Technology recorded at its fair value at the acquisition date (see Note 8). Because the GhostStep® Technology is precommercial stage with no similar technology in the current marketplace, there is significant management judgement in projecting anticipated global market demand, pricing, and gross profit for this electronic decoy technology; all key inputs in management's discounted cash flow model to determine the recoverable amount. An impairment loss is recognized if the recoverable amount of the asset is less than the carrying amount.

Useful lives of property and equipment

As KWESST is an early-stage company, it has limited operating history to estimate the useful lives of property and equipment. Management made estimates based on anticipated use. Further, management has determined the residual value of these assets to be nil. At September 30, 2020, management concluded there was no evidence of a change in the useful lives of property and equipment.

Fair value of share-based payments and warrants

Because KWESST Inc. has limited operating history and was a private company at the time of granting stock options and issuing warrants during the nine months ended September 30, 2020, management exercised significant judgement in estimating the fair value of stock options and warrants. Fair value

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

is estimated using the Black-Scholes pricing model, which requires management to make significant judgment principally on the following key inputs: expected life of the stock option and volatility of the underlying share price. For share-based payment, management must also apply an estimated forfeiture rate to the calculated fair value, which is subject to significant judgement due to the Company's limited history.

3. Significant accounting policies

KWESST used the following significant accounting policies for the preparation of the consolidated financial statements. These policies have been applied to the comparative period.

(a) Revenue recognition

KWESST determines the amount of revenue to be recognized through application of the following fivestep process:

• (i) Identification of the contract, or contracts with a customer;
• (ii) Identification of the performance obligations in the contract;
• (iii) Determination of the transaction price;
• (iv) Allocation of the transaction price to the performance obligations in the contract; and
• (v) Recognition of revenue when or as the Company satisfies the performance obligations.

For contracts with payment milestones, Management estimates the percentage of completion and records unbilled revenue.

KWESST also recognizes an asset for the incremental costs of obtaining a contract with a customer if it expects the costs to be recoverable. Management has determined that sales commissions meet the requirements to be capitalized. Capitalized contract acquisition costs are amortized consistent with the pattern of transfer to the customer for the goods and services to which the asset relates. KWESST applies the practical expedient available under IFRS 15 and does not capitalize incremental costs of obtaining contracts if the amortization period is one year or less.

(b) Financial instruments

KWESST recognizes a financial asset or a financial liability when it becomes a party to the contractual provisions of the instrument.

Trade and other receivables without a significant financing component are initially measured at the transaction price. All other financial assets and financial liabilities are initially recognized at fair value. Transaction costs that are directly attributable to the acquisition or issue of financial assets and financial liabilities (other than financial assets and financial liabilities at fair value through profit or loss (''FVTPL'')) are added to or deducted from the fair value of the financial assets or financial liabilities, as appropriate, on initial recognition. Transaction costs directly attributable to the acquisition of financial assets or financial liabilities at fair value through profit or loss are recognized immediately in profit or loss.

Financial assets

All financial assets are recognized and de-recognized on trade date.

Financial assts are recognized at fair value and subsequently classified and measured at:

• a) Amortized cost;
• b) Fair value through other comprehensive income (''FVOCI''); or

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

c) Fair value though profit or loss (''FVTPL'').

KWESST determines the classification of its financial assets on the basis of both the business model for managing the financial assets and the contractual cash flows characteristics of the financial asset. Financial assets are not reclassified subsequent to their initial recognition unless the Company changes its business model for managing financial assets.

A financial asset is measured at amortized cost if it is held within a business model whose objective is to hold assets to collect contractual cash flows, and its contractual terms give rise on specified dates to cash flows that are solely payments of principal and interest of the principal amount outstanding. At September 30, 2020, KWESST classified the following as amortized cost:

• Cash
• Trade and other receivables
• Lease deposit (non-current other asset)

All financial assets not classified and measured at amortized cost or FVOCI are measured at FVTPL. At September 30, 2020, KWESST did not have financial assets classified as FVOCI or FVTPL.

Expected credit losses

KWESST measures a loss allowance based on the lifetime expected credit losses. Lifetime expected credit losses are estimated based on factors such as KWESST's past experience of collecting payments, the number of delayed payments in the portfolio past the average credit period, observable changes in national or local economic conditions that correlate with default on receivables, financial difficulty of the borrower, and it becoming probable that the borrower will enter bankruptcy or financial re-organization.

Financial assets are written off when there is no reasonable expectation of recovery.

Financial liabilities

Financial liabilities are recognized at fair value and subsequently classified and measured at amortized cost or fair value though profit or loss (''FVTPL'').

KWESST determines the classification of its financial liabilities at initial recognition. The Company has classified the following as amortized costs:

• Accounts payable and accrued liabilities
• Related party loans
• Borrowings
• Lease obligations
• Convertible notes

Financial liabilities at amortized cost are measured using the effective interest rate method.

At September 30, 2020 and December 31, 2019, KWESST classified financial derivative liabilities as FVTPL. Accordingly, fair value is remeasured at each reporting period with the fair value adjustment recognized in profit or loss. There was no outstanding financial derivative liability at September 30, 2020.

De-recognition of financial liabilities

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

KWESST de-recognizes financial liabilities when its obligations are discharged, cancelled or they expire.

(c) Property and equipment

Property and equipment are measured at cost less accumulated depreciation and accumulated impairment losses. Cost comprises the fair value of consideration given to acquire or construct an asset and includes the direct charges associated with bringing the asset to the location and condition necessary for putting it into use along with the future cost of dismantling and removing the asset. These assets are depreciated over their estimated useful lives using the straight-line method as this most closely reflects the expected pattern of consumption o the future economic benefits. Depreciation methods, useful lives and residual values are reviewed at each financial year end and adjusted prospectively, if appropriate.

The following table provides a summary of estimated useful lives for KWESST's property and equipment:

Property and equipment	Rate
Computer equipment	5 years
Computer software	3 years
Office furniture and equipment	5 years
R&D equipment	5 years
Leasehold improvements	Shorter of useful life or remaining term of lease

At the end of each reporting period, KWESST reviews the carrying amounts of its property and equipment to determine whether there is any indication of impairment. If any such indication exists, the recoverable amount of the asset is estimated in order to determine the extent of the impairment loss (if any). The recoverable amount is the higher of fair value less costs to sell and value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. For the purpose of impairment testing, assets that cannot be tested individually are grouped together into the smallest group of assets that generates cash inflows from continuing use that are largely independent of the cash flows of other assets or groups of assets (the ''cashgenerating unit, or CGU''). If the recoverable amount of an asset is estimated to be less than its carrying amount, the carrying amount of the asset is reduced to its recoverable amount. An impairment loss is recognized immediately in profit or loss.

Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

(d) Leases

At inception of a contract, KWESST assesses whether a contract is, or contains, a lease based on whether the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

KWESST recognizes a right-of-use asset and a lease liability at the lease commencement date. The lease obligation is measured at the present value of the remaining lease payments as of January 1, 2018, discounted using its incremental borrowing rate of 10%. The right-of-use asset is initially measured based on the initial amount of the lease liability adjusted for any lease payments made at or before the commencement date, plus any initial direct costs incurred and an estimate of costs to

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

dismantle and remove the underlying asset or to restore the underlying asset or the site on which it is located, less any lease incentives received. The assets are depreciated to the earlier of the end of the useful life of the right-of-use asset or the lease term using the straight-line method as this most closely reflects the expected pattern of consumption of the future economic benefits. The lease term includes periods covered by an option to extend if KWESST is reasonably certain to exercise that option. Lease terms range from 3 to 6 years for offices and printer. In addition, the right-of-use asset is periodically reduced by impairment losses, if any, and adjusted for certain remeasurements of the lease liability.

The lease liability is initially measured at the present value of the lease payments that are not paid at the commencement date, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, KWESST's incremental borrowing rate. Variable lease payments that do not depend on an index or rate are not included in the measurement of the lease liability.

The lease liability is measured at amortized cost using the effective interest method. It is remeasured when there is a change in future lease payments arising from a change in an index or rate, if there is a change in KWESST's estimate of the amount expected to be payable under a residual value guarantee, or if KWESST changes its assessment of whether it will exercise a purchase, extension, or termination option. When the lease liability is remeasured in this way, a corresponding adjustment is made to the carrying value of the right-of-use asset or, is recorded in profit or loss if the carrying amount of the rightof-use asset has been reduced to zero.

KWESST has elected to apply the practical expedient not to recognize right-of-use assets and lease liabilities for short-term leases that have a lease term of 12 months or less and leases of low-value assets. The lease payments associated with these leases are recognized as an expense on a straightline basis over the lease term.

(e) Intangible assets

(i) Research and development ("R&D'') costs

Expenditure on research activities, undertaken with the prospect of gaining new scientific or technical knowledge and understanding, is recognized in profit or loss when incurred.

Development activities involve a plan or design for the production of new or substantially improved products and processes. Development expenditure is capitalized only if development costs can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable, and KWESST has the intention and sufficient resources to complete the development and to use or sell the asset. The expenditure capitalized in respect of development activities includes the cost of materials, direct labor and overhead costs that are directly attributable to preparing the asset for its intended use, and capitalized borrowing costs. Other development expenditures are recognized in profit or loss when incurred.

(ii) Subsequent expenditure

Subsequent expenditure is capitalized only when it increases the future economic benefits embodied in the specific asset to which it relates. All other expenditures, including expenditure on internally generated goodwill and brands, is recognized in profit or loss as incurred.

(iii) Amortization

Amortization is a systematic allocation of the amortizable amount of an intangible asset of its useful life. The amortizable amount is the cost of the asset less its estimated residual value. KWESST recognizes in profit or loss on a sales-based rate over the estimated useful lives of the intangible assets from the date they are available for use, since this method most closely reflect

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

the expected pattern of consumption of the future economic benefits embodied in each asset. Where a sales-based rate could not be determined, the straight-line approach is used.

Internally generated intangible assets are not systematically amortized as long as they are not available for use i.e. they are not yet on site or in working condition for their intended use. Accordingly, intangible assets such as development costs are tested for impairment at least once a year, until such date as they are available for use.

(iv) Impairment

All intangible assets are periodically reviewed for impairment. The estimated present value of future cash flows associated with the intangible asset is determined and an impairment loss is recognized for the difference between this amount and the carrying amount as follows: the carrying amount of the asset is reduced to estimated present value of the future cash flows associated with the asset, discounted at the financial asset's original effective interest rate, and the resulting loss is directly recognized in profit or loss for the period.

(f) Provisions

A provision is recognized if, as a result of a past event, KWESST has a present legal or constructive obligation that can be estimated reliably, and it is probable that an outflow of economic benefits will be required to settle the obligation. Provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects current market assessments of the time value of money and the risk specific to the liability. The unwinding of the discount is recognized as a finance cost.

(g) Convertible notes

KWESST's convertible notes are segregated into their debt and equity components or derivative liability components at the date of issue, in accordance with the substance of the contractual agreements.

The conversion feature of the convertible notes is presumed to be classified as a derivative financial liability unless it meets all the criteria to recognize as equity instrument under IAS 32, Financial Instruments: Presentation. One of the criteria is that the conversion option exchanges a fixed amount of shares for a fixed amount of cash ("fixed for fixed").

If the conversion feature meets the fixed for fixed criteria, the conversion option will be classified as equity components. Equity instruments are instruments that evidence a residual interest in the assets of an entity after deducting all of its liabilities. Therefore, when the initial carrying amount of the convertible notes is allocated to its equity and liability components, the equity component is assigned the residual amount after deducting from the fair value of the instrument as a whole the amount separately determined for the liability component. The sum of the carrying amounts assigned to the liability and equity components on initial recognition is always equal to the fair value that would be ascribed to the instrument as a whole. No gain or loss arises from initially recognizing the components of the instrument separately.

If the conversion feature does not meet the fixed for fixed criteria, the conversion option will be recorded as derivative financial liability, which must be separately accounted for at fair value on initial recognition. The carrying amount of the debt component, on initial recognition, is recalculated as the difference between the proceeds of the convertible notes as a whole and the fair value of the derivative financial liabilities. Subsequent to initial recognition, the derivative financial liability is re-measured at fair value at the end of each reporting period with changes in fair value recognized in the consolidated

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

statements of comprehensive loss for each reporting period, while the debt component is accreted to the face value of the debt using the effective interest method.

Incremental costs incurred in respect of raising capital or debt are charged against the equity or debt proceeds raised, unless the instrument to which the transaction costs relate is classified as hled for trading, in which case the incremental costs are expensed to profit or loss immediately.

(h) Income taxes

Income tax expense comprises current income tax expense and deferred income tax expense. Current and deferred income taxes are recognized as an expense and included in profit or loss for the period, except to the extent that the tax arises from a transaction which is recognized in other comprehensive income or directly in shareholder's deficiency.

Current income tax

Current tax expense is the amount of income taxes payable (recoverable) in respect of the taxable income (tax loss) for a period. Current liabilities (assets) for the current and prior periods are measured at the amount expected to be paid to (recovered from) the taxation authorities, using the tax rates that have been enacted or substantively enacted by the end of the reporting period.

Deferred income tax

Deferred tax assets and liabilities are recognized for the temporary differences between transactions that have been included in the consolidated financial statements or income tax returns. Deferred income taxes are provided for using the liability method. Under the liability method, deferred income taxes are recognized for all significant temporary differences between that the tax and financial statement bases of assets and liabilities and for certain carry-forward items. Deferred income tax assets are recognized only to the extent that, in the opinion of management, it is probable that the deferred income tax assets will be realized.

Deferred tax assets and liabilities are measured at the tax rates that are expected to apply in the year when the asset is realized or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted at the reporting period. Deferred income tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of the enactment or substantive enactment. Deferred tax assets and liabilities are offset when there is a legally enforceable right to set off current tax assets against current tax liabilities and when they relate to income taxes levied by the same taxation authority and KWESST intends to settle its current tax assets and liabilities on a net basis.

Investment tax credits

Investment tax credits relating to scientific research and experimental development expenditures are recorded in the fiscal period the qualifying expenditures are incurred based on management's interpretation of applicable legislation in the Income Tax Act of Canada. Credits are recorded provided there is reasonable assurance that the tax credit will be realized. Credits claimed are subject to review by the Canada Revenue Agency.

Credits claimed in connection with R&D activities are accounted for using the cost reduction method. Under this method, assistance and credits relating to the acquisition of equipment is deducted from the cost of the related assets, and those relating to current expenditures, which are primarily salaries and related benefits, are included in the determination of profit or loss as a reduction of the R&D expenses.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

(i) Related party transactions

Parties are considered to be related if one party has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operating decisions. Parties are also considered to be related if they are subject to common control or common significant influence. Related parties may be individuals or corporate entities. A transaction is considered to be a related party transaction when there is a transfer of resources or obligations between related parties. Related party transactions are in the normal course of business and have commercial substance.

(j) Share-based payments

KWESST records share-based compensation related to its stock options and certain warrants granted from the Company. Stock-based compensation for stock options and warrants are measured at fair value using a Black Scholes option-pricing model. The market value of KWESST's shares on the date of the grant is used to determine the fair value of options and warrants. Each tranche of an award is considered a separate award with its own vesting period and grand date fair value. Compensation cost is recognized as employee benefits expense over the vesting period in which employees unconditionally become entitled to the award. The amount recognized as an expense is adjusted to reflect only the number of awards for which related service conditions are expected to be met, such that the amount ultimately recognized as an expense is based on the number of awards that meet the related service conditions at the vesting date.

Where the terms of an equity-settled transaction award are modified, the minimum expense recognized is the expense as if the terms had not been modified and if the original terms of the award are met. An additional expense is recognized for any modification that increases the total fair value of the sharebased payment transaction or is otherwise beneficial to the employees as measured at the date of acquisition.

(k) Foreign currency

Transactions in foreign currencies are translated to the respective functional currencies of KWESST at the exchange rate in effect at the transaction date. Monetary assets and liabilities denominated in other than the functional currency are translated at the exchange rates in effect at the reporting date. Nonmonetary items that are measured in terms of historical cost in other than the functional currency are translated using the exchange rate at the date of the transaction. The resulting exchange gains and losses are recognized in profit or loss.

(l) Earnings (loss) per share

Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the period. KWESST uses the treasury stock method to compute the dilutive effect of options, warrants, and similar instruments. Under this method, the dilutive effect on earnings per share is calculated presuming the exercise of outstanding options, warrants, and similar instruments. It assumes that the proceeds of such exercise would be used to repurchase common shares at the average market price during the period.

However, the calculation of diluted loss per share excludes the effects of various conversions and exercises of convertible debt, options and warrants that would be anti-dilutive.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

(m) Reverse acquisition

KWESST was a capital pool company, which did not constitute a business as defined under IFRS 3 – Business Combination at the time of the QT and is therefore not within the scope of IFRS 3. However, the QT has some features of a reverse acquisition under IFRS 3. In the absence of a Standard that specifically applies to the QT, KWESST applied by analogy the guidance in IFRS 3 for reverse acquisitions in accordance with IAS 8 accounting policies, changes in accounting estimates and errors.

Application of the reverse acquisitions guidance by analogy results in the private operating entity KWESST Inc. being identified as the accounting acquirer, and the listed non-operating entity KWESST being identified as the accounting acquiree. The accounting acquirer is deemed to have issued shares to obtain control of the accounting acquiree KWESST. Because the QT is not within the scope of IFRS 3, KWESST accounted for it as an asset acquisition and the consideration as a share-based payment transaction which was accounted for in accordance with IFRS 2 – Share-based Payment.

According to IFRS 2, any difference in the fair value of the shares deemed to have been issued by the accounting acquirer and the fair value of the accounting acquiree's identifiable net assets represents a service received by the accounting acquirer. Regardless of the level of monetary or non-monetary assets owned by the non-listed operating entity, the entire difference was considered to be payment for a service of a stock exchange listing for its shares, and that no amount should be considered a cost of raising capital. The service received in the form of a stock exchange listing does not meet the definition of an intangible asset because it is not identifiable in accordance with IAS 38 Intangible Assets (it is not separable) and does not meet the definition of an asset that should be recognized in accordance with other Standards and the Conceptual Framework, therefore the services received was recognized as listing expense (included in merger & acquisition costs in the consolidated statements of net loss and comprehensive loss).

New accounting standards issued but not yet in effect

Classification of liabilities as current or non-current (Amendments to IAS 1)

The IASB has published Classification of Liabilities as Current or Non-Current (Amendments to IAS 1), which clarified the guidance on whether a liability should be classified as either current or noncurrent. The amendments were as follows:

• (i) Clarified that the classification of liabilities as current or non-current should only be based on rights that are in place at the end of the reporting period.
• (ii) Clarified that classification is unaffected by expectations about whether an entity will exercise its right to defer settlement of a liability; and
• (iii) Made clear that settlement includes transfers to the counterparty of cash, equity instruments, other assets or services that result in extinguishment of the liability.

This new guidance is effective for annual periods beginning on or after January 1, 2022. Earlier application is permitted. KWESST has not yet assessed the impact of adoption of this guidance. Further, there is currently a proposal outstanding that would defer the effective date until January 1, 2023.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

4. Acquisitions

a) Reverse acquisition

On September 17, 2020, Foremost completed the QT with KWESST Inc. pursuant to the policies of the TSX Venture Exchange (''TSX-V''). Prior to the completion of the QT, Foremost effected a consolidation of its outstanding common shares on the basis of one post-consolidation common share for every 4.67 pre-consolidation common shares. The QT was done by way of a three-cornered amalgamation (the "Amalgamation") pursuant to which, among other things:

• (i) KWESST Inc. amalgamated with a wholly-owned subsidiary of Foremost, incorporated for the purposes of the Amalgamation, pursuant to the provisions of the Business Corporations Act (Ontario),
• (ii) Foremost changed its name to KWESST Micro Systems Inc., and
• (iii) all of the outstanding common shares of KWESST Inc. (the "KWESST Shares") were cancelled and, in consideration therefor, the holders thereof received post-consolidation common shares of KWESST Micro Systems Inc. on the basis of one KWESST Micro System Inc. share for each KWESST Share.

Immediately following the QT, there were 41,266,176 shares of KWESST outstanding, of which 40,367,678 were held by the former shareholders of KWESST Inc. (representing approximately 97.8% of the outstanding shares of the Company) and 898,498 were held by the shareholders of Foremost prior to the QT. Accordingly, this transaction was accounted for as a reverse acquisition where KWESST Inc. is deemed to be the acquirer for accounting purposes.

The reverse acquisition of Foremost was accounted for under IFRS 2, Share-based Payment. Accordingly, the fair value of the purchase consideration was accounted for at the fair value of the equity instruments granted by the shareholders of KWESST Inc. to the shareholders and option holders of Foremost.

The following represents management's estimate of the fair value of the net assets acquired and total consideration transferred at September 17, 2020, the closing date of the QT.

Number of common shares issued
to Foremost shareholders	898,498
KWESST's stock price at closing of reverse acquisition (1)	\$ 0.70
Common shares	\$ 628,949
Options	41,155
Total consideration transferred	\$ 670,104

⁽¹⁾ At closing, the subscription receipts issued by KWESST Inc. on July 9, 2020 pursuant to a brokered private placement (the "KWESST Subscription Receipts"), were automatically converted, into shares of KWESST. The private placement which was completed through PI Financial Corp. as agent, consisted of 4,409,553 KWESST Subscription Receipts issued at \$0.70 per KWESST Subscription Receipt for gross proceeds of about \$3.1 million before share issuance costs. See Note 16.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

The total fair value consideration was allocated to Foremost's net assets as follows:

Total fair value consideration	\$ 670,104
Foremost's net assets (liabilities):
Cash	\$ 78,589
Other receivables	1,900
Accounts payable and accrued liabilities	(225,088)
Net assets (liabilities) at fair value	(144,599)
Residual balance allocated to listing expense (included in M&A costs)	814,703
Total	\$ 670,104

The results of operations of Foremost are included in these consolidated statements of comprehensive loss from September 17, 2020.

The listing expense of \$814,703 is a non-cash item – see consolidated statements of cash flows.

In addition, 1,000,000 common shares with fair value of \$700,000 were issued to two M&A / capital market advisors for successfully assisting KWESST to complete the QT. One of the two advisors is a related party (Note 16).

b) Asset acquisition

On June 12, 2020, KWESST Inc. entered into the GhostStep Technology Purchase Agreement (the "Purchase Agreement") with SageGuild LLC ("SageGuild") pursuant to which KWESST Inc. acquired the GhostStep® Technology. Management determined that this transaction did not meet the definition of a business under IFRS 3 and therefore this transaction was accounted for as an asset acquisition.

The total purchase consideration ("Purchase Price") comprised of:

• (i) a cash payment made on June 12, 2020 in the amount of USD \$100,000 (CAD \$134,192);
• (ii) the issuance on June 12, 2020 of 140,000 common shares of KWESST; and
• (iii) either the payment of USD \$100,000 in cash or the issuance of 557,000 common shares of KWESST at a deemed price of \$0.50 per common share (CAD \$278,500), at KWESST's sole discretion, upon the completion of KWESST's QT.

As a result of completing the QT, KWESST Inc. has elected to issue 557,000 common shares to SageGuild.

In addition to the Purchase Price, pursuant to the Purchase Agreement KWESST Inc. has:

• (i) agreed to make annual payments ("Yearly Payments") to SageGuild of \$125,000 on each of December 31, 2020, 2021 and 2022, subject to certain conditions; and
• (ii) issued 750,000 warrants to SageGuild exercisable at \$0.50 per share and expiring on January 15, 2023 (the "Warrants") – see Notes 16 and 26(f).

The Warrants will vest in equal tranches of 250,000 warrants on each of December 31, 2020, 2021 and 2022. KWESST has the right to apply the Yearly Payments against the exercise price of the Warrants.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Accordingly, the total purchase consideration amounted to:

Cash consideration	\$ 134,192
Share issuance with no condition	33,600
Elected share issuances	133,680
Contingent consideration	180,000
Total purchase consideration	\$ 481,472

The above total purchase consideration was recognized as intangible assets (see Note 8).

In addition to the above total purchase consideration, KWESST Inc. has agreed to pay SageGuild royalties at a rate of 20% on amounts received in consideration of the grant of licenses and on sales of the GhostStep® Technology until KWESST has paid SageGuild a total of USD \$3 million in royalties. Once KWESST has paid SageGuild a total of USD \$3 million in royalties, the royalty rate will decrease to 5%. The obligation to pay royalties will terminate automatically once KWESST has paid SageGuild a total of USD \$20 million in royalties. The Purchase Agreement became effective on June 12, 2020 and will continue in full force and effect until the earliest of (i) June 12, 2040 or (ii) the date of the expiration of the last of the patents or any of the patents (which are expected to be valid for a period of seventeen years from the date of issuance) related to improvements of the GhostStep® Technology to which SageGuild, or its principal Mr. Jeffrey M. Dunn, materially contributes, unless the terminated earlier in accordance with the terms and conditions of the agreement.

In the event KWESST is in default of payment of any royalty payment as outlined above for a period of 30 days, SageGuild may terminate the agreement and KWESST will be required to, among other things, transfer the GhostStep® Technology back to SageGuild.

KWESST Inc. did not have any sales during the nine months ended September 30, 2020 that would have triggered royalty payments payable to SageGuild.

5. Trade and other receivables

	September 30,	December 31,
	2020		2019
Trade accounts receivable	\$ 209,169	\$	1,191
Sales tax recoverable	142,797		55,684
Investment tax credits refundable	127,325		162,928
	\$ 479,291	\$	219,803

The following table presents trade and other receivables for KWESST:

There was no impairment of trade and other receivables during the nine months ended September 30, 2020 (2019 - \$nil).

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

6. Property and equipment

The following is summary of changes in property and equipment for KWESST:

			Office
			furniture			Total
	Computer	Computer	and	R&D	Leasehold	property and
Cost	equipment	software	equipment	equipment	improvements	equipment
Balance at Decembe 31, 2018	\$ -	\$ 8,145	\$ 31,873	\$ 41,379	\$ 8,607	\$ 90,004
Additions	14,073	-	908	5,209	-	20,190
Disposals	-	-	-	-	-	-
Balance at December 31 2019	\$ 14,073	\$ 8,145	\$ 32,781	\$ 46,588	\$ 8,607	\$ 110,194
Additions	18,734	-	49,057	7,046	59,090	133,927
Disposals	-	-	-	-	(8,607)	(8,607)
Balance at September 30, 2020	\$ 32,807	\$ 8,145	\$ 81,838	\$ 53,634	\$ 59,090	\$ 235,514

			Office
			furniture			Total
	Computer	Computer	and	R&D	Leasehold	property and
Accumulated depreciation	equipment	software	equipment	equipment	improvements	equipment
Balance at Decembe 31, 2018	\$ -	\$ 3,396	\$ 9,587	\$ 5,257	\$ 2,497	\$ 20,737
Amortization for 12 months	241	2,715	6,556	8,102	1,721	19,335
Balance at Decembe 31, 2019	241	6,111	16,143	13,359	4,218	40,072
Amortization for 9 months	5,821	1,526	6,149	7,478	8,434	29,408
Disposals	-	-	-	-	(8,607)	(8,607)
Balance at September 30, 2020	\$ 6,062	\$ 7,637	\$ 22,292	\$ 20,837	\$ 4,045	\$ 60,873
Carrying value at December 31, 2018	\$ -	\$ 4,749	\$ 22,286	\$ 36,122	\$ 6,110	\$ 69,267
Carrying value at December 31, 2019	\$ 13,832	\$ 2,034	\$ 16,638	\$ 33,229	\$ 4,389	\$ 70,122
Carrying value at September 30, 2020	\$ 26,745	\$ 508	\$ 59,546	\$ 32,797	\$ 55,045	\$ 174,641

7. Right-of-use assets

The following table presents right-of-use assets for KWESST:

			Total right-of-use
	Offices	Printer	assets
Balance at December 31, 2018	\$ 254,159	\$ 13,120	\$ 267,279
Additions	-	-	-
Depreciation	(76,248)	(6,559)	(82,807)
Balance at December 31, 2019	\$ 177,911	\$ 6,561	\$ 184,472
Additions	571,604	-	571,604
Termination	(139,787)	-	(139,787)
Depreciation	(92,567)	(3,282)	(95,849)
Balance at September 30, 2020	\$ 517,161	\$ 3,279	\$ 520,440

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

During 2020, KWESST Inc. terminated an office lease agreement due to breach of contract by the former landlord and as a result KWESST de-recognized the related right-of-use asset and lease obligation (see Note 12).

As a result of the above, KWESST Inc. entered into a new office lease agreement with a 74-month lease term starting from March 1, 2020. In connection with this new lease, KWESST Inc. made a total deposit of \$38,214 to be released only at the end of this lease. This was recognized at fair value, discounted using the implied interest rate in the lease. At September 30, 2020, \$22,337 was the estimated fair value and reported as non-current other assets in the consolidated statements of financial position.

8. Intangible assets

The following table presents intangible assets for KWESST:

	Development		Technology
		Costs	Asset	Total
Cost
Balance at December 31, 2019	\$	-	\$ -	\$ -
Additions		163,230	-	163,230
Additions through acquisition (Note 4)		-	481,472	481,472
Balance at September 30, 2020	\$	163,230	\$ 481,472	\$ 644,702

During the nine months ended September 30, 2020, KWESST capitalized development costs of \$163,230 in connection with a funded development project to support a U.S. military customer, featuring KWESST's signature Tactical Awareness and Situational Control System ("TASCS") - see Note 26 (a).

As disclosed in Note 4(b), KWESST acquired technology assets of \$481,272, comprising intellectual property rights, including trademark rights, of the GhostStep® Technology, an electronic decoy system. Management has estimated a useful life of five years; however, as this technology has not yet reached commercialization, no amortization charge was recorded for the nine months period ended September 30, 2020.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

9. Accounts payable and accrued liabilities

The following table presents the accounts payable and accrued liabilities for KWESST:

	September 30,	December 31,
	2020	2019
Trade payable	\$ 493,027	\$ 126,481
Accrued liabilities	188,265	29,822
Payroll taxes payable	67,229	-
Salary and vacation payable	65,722	29,343
Other	4,031	13,041
Total	\$ 818,274	\$ 198,687

10. Related party transactions

Key management personnel compensation

Key management personnel are those having authority and responsibility for planning, directing and controlling the activities of KWESST directly or indirectly, including any directors (executive and nonexecutive) of KWESST. The key management personnel of KWESST are the executive management team and Board of Directors, who collectively control approximately 38% of the issued and outstanding common shares of KWESST at September 30, 2020.

Key management personnel compensation comprised the following:

	Nine months	Twelve months
	ended	ended
	September 30,	December 31,
	2020	2019
Wages and benefits	\$ 165,769	\$ 48,343
Consulting fees	145,000	30,000
Share-based compensation	24,959	-
Total	\$ 335,728	\$ 78,343

The consulting fees relate to compensation paid to KWESST's Executive Chairman (via his private corporation, DEFSEC Corporation), including a one-time \$15,000 payment for prior year expenses in accordance with the consulting agreement.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Related party loans

The following table summarizes the related party loans.

	Loans from		Employee	Loans from
		CEO(1)	loan (2), (5)	investors (3), (4)	Total
Balance at Decembe 31, 2018	\$	612,171	\$ 81,253	\$ 191,789	\$ 885,213
Additions		309,912	-	772	310,684
Transferred to convertible debentures		-	-	(192,561)	(192,561)
Converted into common shares		(649,500)	-	-	(649,500)
Converted into warrants		(19,858)	-	-	(19,858)
Repayment of loans		(45,513)	(25,000)	-	(70,513)
Accrued interest		22,706	3,657	-	26,363
Balance at December 31, 2019	\$	229,918	\$ 59,910	\$ -	\$ 289,828
Repayment of loans		(30,000)	(50,000)	-	(80,000)
Accrued interest		7,174	1,274	-	8,448
Balance at September 30, 2020	\$	207,092	\$ 11,184	\$ -	\$ 218,276

(1) In prior years, KWESST's CEO and his spouse (major shareholders) advanced funds to KWESST to fund its working capital requirements. The loans are due on demand and accrue annual interest at TD Bank prime plus 1.55%.

(2) In prior years, KWESST borrowed funds from an employee to fund its working capital requirements. The loan bears interest at 5% per annum and is due upon demand. This loan was fully repaid during the first quarter of fiscal 2021.

(3) On April 20, 2018, KWESST issued two Subscriptions for Revenue Sharing in the principal amount of \$50,000 each to an investor. An additional amount of \$26,961 was invested to the Company on December 14, 2018. The total loan of \$126,960 and was subsequently reclassified as convertible notes on October 23, 2019 (see Note 15).

(4) On June 5, 2018, KWESST issued a Subscription for Revenue Sharing in the principal amount of \$64,829 (USD\$50,000) to one of KWESST's officer. This loan was subsequently reclassified as convertible debentures on October 23, 2019 (see Note 15).

Other related party transactions during the nine months ended September 30, 2020:

• Two directors of KWESST were investors in the 2019 convertible notes (see Note 15), in which KWESST incurred interest expense of \$6,585 on these two convertible notes. This interest expense was converted to KWESST common shares.
• KWESST hired a consulting firm to provide capital markets advisory services, including assistance to complete KWESST's Qualifying Transaction with Foremost (see Note 4 (a)) and to raise capital. This consulting firm is also a significant shareholder and holds 1,500,000 warrants and 200,000 options of KWESST, including securities held by the owner of this firm. Total cash and share-based remuneration amounted to \$494,325.
• The lease for the 3-D printer was with a private company owned by KWESST's President and CEO and his spouse (see Note 12).

At September 30, 2020 and December 31, 2019, there was no outstanding amount in accounts payable and accrued liabilities due to officers and directors of KWESST.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

11. Borrowings

In April 2020, KWESST was approved and received a \$40,000 term loan with TD Bank under the Canada Emergency Business Account (''CEBA Term Loan'') program funded by the Government of Canada. The CEBA Term Loan is non-interest and can be repaid at any time without penalty. KWESST has recorded a fair value of \$30,904 at inception, discounted using its incremental borrowing rate of 10%. The difference of \$9,096 between the fair value and the total amount of CEBA Term Loan received has been recorded as a gain on government grant for the nine months period ended September 30, 2020. See Note 26(b).

12. Lease obligations

KWESST's leases are for office space and 3D printers. The office lease includes the right to renew for an additional five years. Management has not included the renewal option because it was deemed too uncertain whether the KWESST would renew at this time. At the end of the 3D printer lease, the title ownership will be transferred to KWESST.

				Current	Non-current
	Offices	Printer (1)	Total	Portion	portion
Balance at December 31, 2018	\$ 266,292 \$	13,761	\$ 280,053	\$ 77,367	\$ 202,686
Lease payments (including interest)	(94,270)	(7,620)	(101,890)
Interest expense	23,441	1,082	24,523
Balance at December 31, 2019	195,463	7,223	202,686	85,468	117,218
Addition	554,069	-	554,069
Termination	(157,315)	-	(157,315)
Lease payments (including interest)	(59,873)	(7,620)	(67,493)
Interest expense	42,408	397	42,805
Balance at September 30, 2020	\$ 574,752 \$	-	\$ 574,752	\$ 78,358	\$ 496,394

The following table presents lease obligations for KWESST:

(1) Leased from a company controlled by KWESST's President & CEO.

As disclosed in Note 7, KWESST Inc. terminated an office lease prior to expiration. The de-recognition of this lease obligation and the related unamortized book value of the right-of-use asset resulted in a gain of \$17,528, which is included in net finance costs in the consolidated statements of net loss and comprehensive loss. Under the new office lease, KWESST Inc. benefited from the following lease inducements:

• Free rent from inception to November 1, 2020; and
• Free rent from November 1, 2021 to March 1, 2022,

The following table presents the contractual undiscounted cash flows for the lease obligations:

	September 30,			December 31,
		2020		2019
Less than one year	\$	127,830		101,890
One to five years		636,945		125,693
Total	\$	764,775	\$	227,583

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

When measuring the lease obligation, the Company discounted the remaining lease payments using the incremental borrowing rate of Company which is 10% per annum.

13. Deferred revenue

The following table presents the changes in deferred revenue:

	September 30,		December 31,
		2020	2019
Balance, beginning of period	\$	-	\$ -
Amounts invoiced and revenue deferred		7,053	-
Recognition of deferred revenue included in the balance at the beginning of period		-	-
Balance, end of period	\$	7,053	\$ -

14. Financial derivative liabilities

In connection with the issuance of the 2019 Convertible Notes (see Note 15), management determined that the conversion feature was a financial derivative liability which is remeasured at fair value at each reporting period (see Note 20).

The following table summarizes the financial derivative liabilities:

	Total
Balance at Decembe 31, 2018	\$ 111,953
Fair value adjustment when notes were converted into common shares	(111,953)
Fair value of financial derivative liabilities on initial recognition	30,688
Fair value adjustment	(1,225)
Balance at December 31, 2019	29,463
Fair value adjustment	(29,463)
Balance at September 30, 2020	\$ -

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

15. Convertible notes

The following table presents the convertible notes for KWESST:

Balance at Decembe 31, 2018	\$ 521,515
Related party loans transferred to convertible notes (Note 10)	192,561
Converted into common shares (Note 16)	(620,897)
Repayment of debt	(31,644)
Less fair value of conversion feature	(30,688)
Accrued interest	74,707
Accretion expenses	105,265
Balance at December 31, 2019	210,819
Accrued interest	16,769
Accretion expenses	28,130
Converted in common shares (Note 16)	(255,718)
Balance at September 30, 2020	\$ -

Activities in 2019

During the year ended December 31, 2018, KWESST issued convertible notes to investors in the total principal amount of \$601,961 bearing an interest of 10% per annum.

On October 23, 2019, KWESST converted \$560,007 of debt and \$60,890 of interest into 3,104,486 common shares at a price of \$0.20 relating to all debts noted above and repaid \$31,644 debt by cash. The remaining \$234,515 was issued as new convertible debentures at a rate of 10% per annum and due on October 23, 2021. Upon the occurrence of a Liquidity Event, the new convertible note will automatically convert into common shares of KWESST at a conversion rate equal to a 20% discount to the value assigned to the common shares of KWESST under such Liquidity Event for the entire amount of the principal amount plus all accrued interest.

"Liquidity Event" means either (1) the completion of an initial public offering which results in the common shares of KWESST being listed and posted for trading or quoted on any of the Toronto Stock Exchange, the TSX Venture Exchange, the New York Stock Exchange, the American Stock Exchange, the Nasdaq National Market, the London Stock Exchange or any successor exchange or market thereto; or (2) the closing of a merger, amalgamation plan of arrangement or other transaction or series of related transactions resulting in the holders of common shares receiving consideration in securities listed on a Qualified Exchange.

The conversion feature of convertible debentures is presumed to be classified as a derivative financial liability unless it meets all the criteria to recognize as equity instrument under IAS 32 - Financial Instruments: Presentation. One of criteria is that the conversion feature exchanges a fixed amount of shares for a fixed amount of cash ("fixed for fixed"). The convertible debentures are convertible to % of the shares of the Company on a fully diluted basis which is not a fixed amount of shares, therefore the fixed for fixed criteria is not met. As such, the conversion feature was classified as financial derivative liabilities instead of an equity instrument. KWESST separated the convertible debentures into two components at initial recognition, with the debt carried at amortized cost, and the conversion feature carried at fair value as financial derivative liabilities.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Activities in 2020

As disclosed in Note 4(a), a Liquidity Event occurred which resulted in the conversion of the \$255,718 outstanding convertible note, including accrued interest up to Liquidity Event, into 456,639 common shares.

16. Share capital and Contributed Surplus

Share capital

Authorized

KWESST is authorized to issue an unlimited number of common shares.

Issued Common Shares

		Issued
	Number	Price	Amount
Outstanding at December 2018	200	\$ 1.000	\$ 200
Issued for directors converted loans (1)	6,500,000	\$ 0.005	31,308
Issued for parent company converted loans (2)	10,700,000	\$ 0.044	467,000
Issued for directors converted loans (3)	1,500,000	\$ 0.100	150,000
Issued for converted debt and accrued interest (4)	3,104,486	\$ 0.200	620,897
Issued in private placement (5)	5,075,000	\$ 0.200	1,014,948
Outstanding at December 31, 2019	26,879,686		\$ 2,284,353
Issued in private placement (6)	2,625,000	\$ 0.400	1,050,000
Issued in private placement (6)	845,750	\$ 0.500	422,875
Issued in asset acquisition (7)	697,000	\$ 0.240	167,280
Issued for converted debt and accrued interest (8)	456,639	\$ 0.560	255,718
Issued for new converted debt and accrued interest (9)	3,210,050	\$ 0.414	1,328,163
Issued in private placement (10)	16,000	\$ 0.500	8,000
Issued for consulting services (11)	61,000	\$ 0.531	32,393
Issued for exercise of stock options (12)	122,000	\$ 0.640	78,080
Issued for performance bonus (13)	1,045,000	\$ 0.700	731,500
Issued in brokered private placement (14)	4,409,553	\$ 0.700	3,087,138
Shares from Foremost's QT (15)	898,498	\$ 0.700	628,949
Outstanding at September 30, 2020	41,266,176		\$ 10,074,449
Less: share offering costs			(699,886)
Total share capital at September 30, 2020			\$ 9,374,563

2019 Activities

(1) During the first quarter of 2019, the directors converted \$32,500 of loans into 6,500,000 of units of KWESST Inc. (''Units''). Each Unit is comprised of one common share and one common share purchase warrant.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Each warrant entitles the holder to acquire a common share at a price of \$0.20 per share and with an expiry date of June 14, 2024.

• (2) During the first quarter of 2019, the corporate shareholder of KWEEST Inc. converted \$467,000 of loans into 10,700,000 common shares.
• (3) During the third quarter of 2019, the directors converted \$150,000 of loans into 1,500,000 common shares.
• (4) During the third quarter of 2019, KWESST Inc. converted \$560,007 of debt and \$60,890 of interest into 3,104,486 common shares.
• (5) During the third quarter of 2019, KWESST Inc. closed a non-brokered private placement raising \$1,014,948 at a value of \$0.20 per share by issuing 5,075,000 common shares.

2020 Activities

• (6) During the first quarter of 2020, KWESST Inc. closed a non-brokered private placement, raising gross proceeds of \$1,050,000 at \$0.40 per share and another non-brokered private placement raising gross proceeds of \$422,875 at \$0.50 per share. Total share offering costs amounted to \$45,283.
• (7) See Note 4(b).
• (8) See Note 15.
• (9) During the second quarter of fiscal 2020, KWESST Inc. closed on approximately \$1.1 million gross proceeds from a non-brokered private placement for unsecured convertible notes, with automatic conversion upon a Liquidity Event including the listing of the Company on the TSX-V. In light of the Company going public during the third quarter of fiscal 2020, resulting in the automatic conversion of these notes, management concluded that under IAS 38 the recognition of these notes should be equity and not debt. At the QT, these convertible notes were converted to 2,477,851 common shares. In connection with these notes, the note holders earned interest at a rate of 15% per annum. Because the notes were treated as equity instruments, the total accrued interest of \$59,112 was not recognized in the profit or loss. This accrued interest was converted to 131,360 common shares at QT. Additionally, as an inducement, the note holders also received 25% of the principal amount in the from KWESST common shares based on a stock price of \$0.45, resulting in the issuance 600,839. In connection with this private placement, KWESST incurred \$58,065 of offering costs settled in cash and warrants.
• (10) During the second quarter of fiscal 2020, KWESST issued 16,000 common shares under a non-brokered private placement.
• (11) During the second quarter of fiscal 2020, KWESST issued 61,000 common shares as settlement for consulting services rendered.
• (12) See below Stock Options.
• (13) During the third quarter, KWESST settled performance bonuses in the form of 45,000 common shares. Additionally, KWESST awarded 500,000 common shares each to two M&A / capital market advisors for successfully assisting KWESST to complete a QT, in accordance with their respective consulting agreement. One of the two advisors is a related party (see Note 10).
• (14) During the third quarter and as part of the QT, KWESST closed a brokered private placement led by PI Financial Corp., resulting in gross proceeds of \$3,086,687 before share offering costs of \$325,887 settled in both cash and warrants.
• (15) See Note 4(a).

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Warrants

The following reflects the warrant activities for KWESST:

				Weighted average
	# of	Exercise		remaining life
	Warrants	Price	Fair Value	(years)	Expiry Date
Warrants outstanding at December 31 2018	-	\$ -	\$ -	-
Granted	6,500,000	\$ 0.20	\$ 1,192	3.25	January 1 2024
Granted	2,000,000	\$ 0.20	\$ 19,858	3.71	June 14 2024
Warrants outstanding at December 31, 2019	8,500,000		\$ 1,192
Issued in private placement	15,000	\$ 0.40	\$ 2,265	1.33	January 30 2022
Issued in private placement	84,622	\$ 0.45	\$ 13,515	1.60	May 8 2022
Issued in asset acquistion (see Note 4)	750,000	\$ 0.50	\$ 180,000	2.29	June 12 2022
Issued in private placement	235,428	\$ 0.70	\$ 60,340	1.77	July 9 2022
Warrants outstanding at September 30, 2020	9,585,050		\$ 257,312	3.22

2019 Activities:

Warrants were issued to major shareholders, which a portion was subsequently reallocated to the Executive Chairman's controlling company (DEFSEC) and strategic advisor (See Note 10). Management determined that the estimated fair value for 6.5 million warrants issued on January 1, 2019, was insignificant. For the remaining two million warrants, management estimated the fair value for these warrants using the Black-Sholes pricing model with the following inputs:

	Warrants @
		\$0.20
Stock price	\$	0.044
Volatility		66.75%
Dividend Yield		Nil
Risk-free interest rate		1.40%
Expected life		5
Weighted average fair value per warrant	\$	0.0099

2020 Activities:

In connection with private placements, warrants were issued as compensation to brokers and consultants. Additionally, KWESST issued 750,000 warrants to SageGuild LLC in connection with the technology acquisition.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Management estimated fair value of the warrants using the Black-Scholes pricing model with the following key inputs:

	Warrants @		Warrants		Warrants
		\$0.40		@ \$0.45		@ \$0.70
Stock price	\$	0.40	\$	0.50	\$	0.70
Volatility		67.75%		68.24%		66.98%
Dividend Yield		Nil		Nil		Nil
Risk-free interest rate		1.47%		0.27%		0.29%
Expected life		2		2		2
Estimated fair value per warrant	\$	0.15	\$	0.20	\$	0.26

Stock options

KWESST has a rolling stock option plan (the ''Plan'') that authorizes the Board of Directors to grant incentive stock options to directors, officers, consultants and employees, whereby a maximum of 10% of the issued common shares are reserved for issuance under the Plan. Under this Plan, the exercise price of each option may not be less than the market price of KWESST's shares at the date of grant. The maximum term for options is five years. Options are granted periodically and generally vest over two years.

The following table shows the status of the Plan:

	Number of options	Weighted average exercise price
Options outstanding at December 31, 2019	-	\$ -
Granted Options from the Foremost qualifying transaction Exercised	2,055,000 85,714 (122,000)	0.65 0.47 0.50
Options outstanding at September 30, 2020	2,018,714	\$ 0.65
Options exercisable at September 30, 2020	523,214	\$ 0.60

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

The following table presents information about stock options outstanding at September 30, 2020:

Range of exercise prices	Number outstanding	Weighted average remaining contractual life	Number exercisable
\$0.47	85,714	2.71	85,714
\$0.50	183,000	0.67	-
\$0.65	925,000	4.41	231,250
\$0.70	825,000	4.79	206,250
	2,018,714	4.15	523,214

At September 30, 2020, there were 2,107,904 stock options available for grant under the Plan.

During 2020, KWESST granted 2,055,000 options (2019 – nil) and recorded stock-based compensation expenses of \$283,084 (2019 – \$nil) related to the vesting of options. The per share weighted-average fair value of stock options granted in 2020 was \$0.23 on the date of grant using the Black-Scholes option model with the following weighted-average assumptions:

Stock price	\$0.40 to \$0.70
Exercise price	\$0.40 to \$0.70
Volatility	67.71%
Dividend Yield	Nil
Risk-free interest rate	0.65%
Expected life (years)	3.38
Weighted-average fair value per option	\$ 0.23

Management estimated a forfeiture rate of nil%, except for an option grant of 500,000 at \$0.70 each where forfeiture rate was set at 50% based information available subsequent to September 30, 2020.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

17. Earnings (loss) per share

The following table summarizes the calculation of the weighted average basic number of basic and diluted common shares:

	Nine months	Twelve months
	ended	ended
	September 30,	December 31,
	2020	2019
Issued common shares, beginning of period	26,879,686	200
Effect of shares issued from:
Conversion of directors converted loans	-	7,082,192
Conversion of parent company converted loans	-	8,823,836
Exercise of options	31,282	-
Conversion of convertible notes, including interest	498,810	1,523,849
Issuance for services	96,081	-
Issuance for technology acquisition (Note 4 (b))	89,055	-
Issuance of for equity private placements	3,196,518	-
Qualifying transaction (Note 4(a))	52,697	-
Weighted average number of basic common shares	30,844,129	17,430,077
Dilutive securities:
Stock options	-	-
Warrants	-	-
Weighted average number of dilutive common shares	30,844,129	17,430,077

At September 30, 2020 and December 31, 2019, all the stock options and warrants were anti-dilutive because of KWESST's net loss for both periods.

18. Revenue

The following table presents the key streams of revenue for KWESST:

	Nine months	Twelve months
	ended	ended
	September 30,	December 31,
	2020	2019
Systems Other	\$ 835,097 26,820	\$ 472,749 36,399
	\$ 861,917	\$ 509,148

Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized ("contracted not yet recognized") and includes unearned revenue and amounts

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

that will be invoiced and recognized as revenue in future periods. At September 30, 2020, KWESST's contracted not yet recognized revenue was \$233,193, of which 100% of this amount is expected to be recognized over the next 12 months.

19. Income tax recovery

a) Reconciliation of effective income tax rate

KWESST's effective income tax rate differs from the statutory rate of 26.5% that would be obtained by applying the combined Canadian basic federal and provincial income tax rate to loss before income taxes. These differences result from the following:

	Nine months	Twelve months
	ended	ended
	September 30,	December 31,
	2020	2019
		(Restated - see
		Note 25)
Loss before income taxes	\$ (3,565,259)	(1,147,280)
Expected statutory tax rate	26.5%	26.5%
Expected tax recovery resulting from loss	(944,794)	(304,029)
Increase (reduction) in income taxes resulting from:
Non-deductible expenses	275,273	28,115
Unrecognized temporary differences	669,521	275,914
	\$ -	\$ -

KWESST claims research and development deductions and related Investment Tax Credits ("ITC") for tax purposes based on management's interpretation of the applicable legislation in the Income Tax Act of Canada. These claims are subject to audit by the Canada Revenue Agency ("CRA") and any adjustments that results could affect ITCs recorded in the consolidated financial statements. During the nine months ended September 30, 2020, KWESST recognized estimated investment tax credits of \$127,325 for the current period and the twelve months ended December 31, 2019. This was presented as a reduction to R&D consulting and material costs in the consolidated statements of net loss and comprehensive loss.

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

b) Deferred tax balances

The following tables deferred tax assets (liabilities) have been recognized in the consolidated financial statements:

	Balance at			Balance at
	December 31,	Recognized in	Recognized in	September 30,
	2019	profit or loss	equity	2020
Deferred tax assets (liabilities): Net operating loss carryforwards Intangible assets	\$ - -	\$ 48,045 (48,045)	\$ -	\$ 48,045 (48,045)
	\$ -	\$ -	\$ -	\$ -

c) Unrecognized net deferred tax assets

Deferred taxes reflect the impact of loss carryforwards and of temporary differences between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by enacted tax laws. However, KWESST has not recorded net deferred tax assets at September 30, 2020 and December 31, 2019, due to the uncertainty involved in determining whether these deferred tax assets will be realized upon expiration due to KWESST's limited history and operating losses since its inception.

The following is a summary of KWESST's unrecognized deductible temporary differences:

	Balance at	Balance at
	September 30,	December 31,
	2020	2019
Net operating loss carryforwards	\$ 4,279,494	\$ 2,111,531
Share issuance costs	1,496,239	17,281
Scientific research and development expenditures	218,235	170,940
Other	46,891	22,106
	\$ 6,040,859	\$ 2,321,858

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019

(Expressed in Canadian dollars, except share and per share amounts)

d) Available net operating losses

At September 30, 2020, KWESST has the following net operating losses in Canada available to reduce future year's taxable income which expire as follows:

Year of expiry	Amount
2036	\$ 512,163
2037	611,677
2038	1,174,797
2039	1,829,518
2040	332,641
	\$ 4,460,796

20. Financial instruments

Fair value of financial instruments

The fair values of KWESST's cash, trade and other receivables, accounts payables and accrued liabilities, lease deposits (included in non-current other assets), related parties, and convertible notes approximate carrying value because of the short-term nature of these instruments.

The lease deposits, convertible notes, and lease obligations were recorded at fair value at initial recognition. Subsequently, these were measured at amortized cost and accreted to their nominal value over their respective terms.

Financial derivative liabilities are the only instruments classified as a Level 2 in the fair value hierarchy, as a result of measuring its fair value at each reporting date using the Black-Scholes pricing model. Under IFRS, the levels of fair value hierarchy is as follows:

Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities; Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and Level 3: inputs for the asset or liability that are not observable market data (unobservable inputs).

Financial risk management

The Company is exposed to a number of financial risks arising through the normal course of business as well as through its financial instruments. The Company's overall business strategies, tolerance of risk and general risk management philosophy are determined by the directors in accordance with prevailing economic and operating conditions.

(a) Interest rate risk

Interest rate risk is the risk that the fair value of cash flows of a financial instrument will fluctuate because of changes in market interest rates. KWESST's related party loans have fixed interest rate terms and therefore KWESST is not exposed to interest rate risk.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

(b) Foreign currency risk

Foreign currency risk is the risk that the future cash flows or fair value of the Company's financial instruments that are denominated in a currency that is not KWESST's functional currency will fluctuate due to a change in foreign exchange rates.

For the nine months ended September 30 2020, KWESST's revenue was substantially denominated in US dollar driven by contracts with U.S. prime contractors in the defense sector. Accordingly, KWESST is exposed to the US dollar currency. A significant change in the US dollar currency could have a significant effect on KWESST's financial performance, financial position and cash flows. Currently, KWESST does not use derivative instruments to hedge its US dollar exposure.

At September 30, 2020, KWESST had the following net US dollar exposure:

	Total USD
Assets	\$ 222,262
Liabilities	(88,019)
Net exposure at September 30, 2020	\$ 134,243

\$ 6,712 Impact to profit or loss if 5% movement in the US dollar

During the nine months ended September 30, 2020, KWESST recorded foreign exchange loss of \$13,937 (12 months in 2019: \$982 loss)

(c) Credit risk

Credit risk is the risk of financial loss to the Company if a counterparty to a financial instrument fails to meet its contractual obligations. KWESST's credit risk exposure is limited to cash, and trade and other receivables. Refer to Note 5 for the breakdown of KWESST's trade and other receivables. KWESST enters into contracts with large, financially sound US general contractors, which mitigates the credit risk. Since September 30, 2020, KWESST has fully collected from the U.S. customer. The remaining receivable is due from the Canadian Federal and Provincial Government for sales tax recoverable and investment tax credits.

(d) Liquidity risk

Liquidity risk is the risk that KWESST will be unable to meet its financial obligations as they become due. KWESST's objective is to ensure that it has sufficient cash to meet its near term obligation when they become due, under both normal and stressed condition, without incurring unacceptable losses or risking reputational damage to KWESST. A key risk in managing liquidity is the degree of uncertainty in KWESST's cash flows due to its early stage in operations and the need for additional capital to fund its business strategies (see Note 2(a)).

At September 30, 2020, KWESST had approximately \$3.1 million cash and \$2.8 million in working capital (current assets less current liabilities).

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

21. Supplemental cash flow information

The following table presents changes in non-cash working capital:

	Nine months ended September 30, 2020	Year ended December 31, 2019
		(As restated -
		see Note 25)
Trade and other receivables	\$ (257,588)	\$ (41,465)
Prepaid expenses and other	(387,762)	(36,629)
Other assets	-	(150,000)
Accounts payable and accrued liabilities	393,202	86,519
Deferred revenue	7,053	-
	\$ (245,095)	\$ (141,575)

The following is a summary of non-cash items that were excluded from the consolidated statements of cash flows for the nine months ended September 30, 2020:

• \$554,069 of right-of-use asset and lease obligations relating to the new office lease;
• \$139,787 of right-of-use asset and \$157,315 lease obligations de-recognized from KWESST's consolidated financial position relating to the former lease office;
• \$347,280 of KWESST's common shares and warrants for the asset acquisition of GhostStep® Technology;
• \$255,718 of convertible notes, including accrued interest, settled in KWESST's common shares;
• \$322,779 of share offering costs settled in KWESST's common shares;
• \$41,155 of options adjustment due to QT (see note 4(a)); and
• \$17,531 fair value of options exercised and transferred to KWESST's common shares.

The following is a summary of non-cash items that were excluded from the consolidated statements of cash flows for the twelve months ended December 31, 2019:

• \$1,290,255 common shares and warrants for loans.

22. Segmented information

KWESST's Executive Chairman has been identified as the chief operating decision maker. The Executive Chairman evaluates the performance of the Company and allocates resources based on the information provided by KWESST's internal management system at a consolidated level. KWESST has determined that it has only one operating segment.

Notes to Consolidated Financial Statements Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

Geographic information

The following table presents external revenue on a geographic basis:

	Nine months			Twelve months
		ended	ended
		September 30,	December 31,
		2020		2019
United States Canada	\$	835,097 26,820	\$	472,749 36,399
	\$	861,917	\$	509,148

All of KWESST's property and equipment are located in Canada, including the right-of-use assets.

Concentration of customers information

For the nine months ended September 30, 2020, two customers accounted for the revenue based in the United States. For the twelve months ended December ended December 31, 2019, one customer accounted for the revenues based in United States.

23. Capital management

KWESST's objective in managing its capital is to safeguard its ability to continue as a going concern and to sustain future development of the business. The Company's senior management is responsible for managing the capital through regular review of financial information to ensure sufficient resources are available to meet operating requirements and investments to support its growth strategy. The Board of Directors is responsible for overseeing this process. From time to time, KWESST could issue new common shares or debt to maintain or adjust its capital structure. KWESST is not subject to any externally imposed capital requirements.

KWESST's capital is composed of the following:

	September 30,	December 31,
	2020	2019
Debt:
Related party loans	\$ 218,276	\$ 289,828
Borrowings	32,273	-
Lease obligations	574,752	202,686
Convertible notes	-	210,819
Equity:
Share capital	9,374,563	2,284,353
Contributed surplus	583,878	21,050
Accumulated deficit	(6,102,058)	(2,536,799)
	\$ 4,681,684	\$ 471,937

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

24. Commitments and contingencies

a) Minimum royalties

On November 18, 2019, KWESST entered into a non-exclusive license agreement with a third party for its product named DroneBullet, a drone whose principal function and operation is acting as a projectile to intercept aerial threats using kinetic force. Under this license agreement, KWESST will pay 8% royalty on annual sales of the DroneBullet to the third party, subject to the following minimum annual payments.

• \$150,000 for March 31, 2020 to December 31, 2020;
• \$200,000 for January 1, 2021 to December 31, 2021;
• \$300,000 for January 1, 2022 to December 31, 2022;
• \$400,000 for January 1, 2023 to December 31, 2023; and
• \$500,000 for January 1, 2024 to December 31, 2024.

In accordance with this license agreement, KWESST paid \$150,000 advanced royalty to the third party in 2019 (see Note 25). Due to delays in completing a fully functional DroneBullet, the third party delayed its minimum annual royalty payment. In light of this delay, KWESST and the third party are currently renegotiating the contract to amend certain terms, including the timing for the first minimum annual payment.

This agreement will expire on March 31, 2025.

25. Restatement of previously reported audited financial statements

Subsequent to the issuance of the previously reported audited financial statements for the year ended December 31, 2019, management discovered an error with the accounting for a \$150,000 advanced royalty paid to a third party. This advanced royalty payment was an advance on future royalty payments under the licencing agreement (see Note 24) and therefore this payment should have been recognized as non-current other asset rather than a charge to profit or loss. It is classified as noncurrent because the application of the advanced royalty is limited to sales royalties in excess of the minimum annual royalties, subject to a maximum of \$50,000 per year.

The following tables summarizes the effects of the adjustments described above.

Line item on the consolidated statements of financial position and consolidated statement of changes in shareholders' equity:

	As at					As at
	December 31, 2019 Adjustment					December 31, 2019
	(Previously Reported)					(As Restated)
Other assets	\$	-	\$	150,000	\$	150,000
Non-current assets	\$	254,594	\$	150,000	\$	404,594
Total assets	\$	550,087	\$	150,000	\$	700,087
Deficit	\$	(2,686,799) \$		150,000	\$	(2,536,799)
Total shareholders' equity (deficit)	\$	(381,396) \$		150,000	\$	(231,396)
Total liabilities and shareholders' equity (deficit)	\$	550,087	\$	150,000	\$	700,087

Line item on the consolidated statements of net loss and comprehensive loss:

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

	Twelve month ended					Twelve months ended
	December 31, 2019 Adjustment					December 31, 2019
	(Previously Reported)					(As Restated)
General and administrative expenses	\$	171,273	\$	(150,000)	\$	21,273
Total operating expenses	\$	295,493	\$	(150,000)	\$	145,493
Operating loss	\$	(1,164,329) \$		150,000	\$	(1,014,329)
Loss before income taxes	\$	(1,297,280) \$		150,000	\$	(1,147,280)
Net loss and comprehensive loss	\$	(1,297,280) \$		150,000	\$	(1,147,280)
Net loss per share	\$	(0.07) \$		150,000	\$	(0.07)

Line item on the consolidated statements of cash flows:

	Twelve month ended				Twelve months ended
	December 31, 2019 Adjustment			December 31, 2019
	(Previously Reported)				(As Restated)
Net loss per share	\$	(1,297,280) \$		150,000	\$ (1,147,280)
Changes in non-cash working capital items	\$	8,425	\$	(150,000)	\$ (141,575)

26. Subsequent Events

a) Debt for equity settlement

During the first quarter of Fiscal 2021, KWESST settled the following liabilities with its common shares:

• \$47,000 of legal fees for 67,142 common shares; and
• \$16,950 of online advertising services for 24,214 common shares.

b) Borrowings

In December 2020, the Canadian Federal Government amended the CEBA Term Loan program to increase the loan amount by \$20,000 to \$60,000. KWESST has increased its borrowings accordingly. Additionally, effective January 1, 2021, the outstanding balance of the CEBA Term Loan was automatically converted to a 2-year interest free term loan. The CEBA Term Loan may be repaid at any time without notice or the payment of any penalty. If 75% of the CEBA Term Loan is repaid on or before December 31, 2022, the repayment of the remaining 25% shall be forgiven. If on December 31, 2022, KWESST exercises the option for a 3-year term extension, a 5% annual interest will be applied on the any balance remaining during the extension period.

c) Technology acquisition

On January 18, 2021, KWESST announced its Board of Directors approved the acquisition of a proprietary non-lethal munitions technology system, referred as the Low Energy Cartridge (''LEC'')

Notes to Consolidated Financial Statements

Nine months ended September 30, 2020 and twelve months ended December 31, 2019 (Expressed in Canadian dollars, except share and per share amounts)

technology, from DEFSEC (a private company owned by KWESST's Executive Chairman), subject to closing conditions including TSX-V's approval.

The purchase consideration consists:

• 1,000,000 common shares of KWESST; and
• 500,000 warrants to purchase KWESST's common shares at \$0.70 each; 25% vesting on the first anniversary of the closing of the LEC Technology acquisition and 25% per annum thereafter.

Additionally, KWESST will pay 7% royalty on annual sales of the LEC Technology to DEFSEC, net of taxes and duties, up to a maximum of \$10 million, subject to minimum annual royalty payments starting in 2022.

d) Stock option activities

Stock option exercised

Subsequent to September 30, 2020, 484,456 options were exercised for total proceeds of \$390,657.

Stock option grant

Subsequent to September 30, 2020, KWESST granted 1,652,500 stock options to employees, directors and consultant, with exercise prices ranging from \$0.70 to \$1.72 per share. Each of these options was granted for a term of five years and will vest quarterly between one to two years, except for 50,000 options which vested immediately.

Stock option grant amended

Subsequent to September 30, 2020, KWESST amended a consulting agreement for investor relation services, which resulted in the cancellation of 250,000 options.

e) Warrants exercised

Effective December 31, 2020, SageGuild exercised 250,000 warrants at \$0.50 each. This was a cashless exercise of the exercise proceeds of \$125,000 was offset by the \$125,000 annual payment owed by KWESST to SageGuild.