Note
1 - Background
China
Fire & Security Group Inc. (the
“Company”), is a Florida corporation. The Company, through its subsidiaries, is
engaged in the design, development, manufacturing and sales of fire protection
products and services for industrial customers in China.
Note
2 - Summary of significant accounting policies
The
reporting entity
The
consolidated financial statements of China Fire & Security Group Inc. and
subsidiaries reflect its wholly-owned subsidiaries, each discussed briefly
below.
China
Fire Protection Group, Inc. (“CFPG”) was incorporated in the British Virgin
Islands as a limited liability company on June 2, 2006 as a holding
company.
Sureland
Industrial Fire Safety Limited (“Sureland Industrial”) was established as a
Sino-foreign equity joint venture in Beijing, PRC on February 22, 1995. Sureland
Industrial and its subsidiaries in China principally engage in the design,
development, manufacturing and sale of fire protection products and services
for
industrial customers in China.
Beijing
Hua An Times Fire Safety Technology Co., Ltd. (“Beijing Hua An”) is a subsidiary
of Sureland Industrial established in the PRC as a limited liability company
on
September 22, 2005 with a registered capital RMB 5,000,000 (approximately
$619,500). Hua An is a software development company, principally engage in
the
design, development and manufacturing of fire protection software.
Sureland
Industrial Fire Equipment Co., Ltd. (“Sureland Equipment”) was established as a
Sino-foreign equity joint venture in Beijing, the People’s Republic of China
(the PRC) on April 12, 2006 with a registered capital $660,000. Sureland
Equipment principally engages in the manufacturing of fire protection products.
Tianjin
Tianxiao Fire Safety Equipment Co., Ltd. (“Tianxiao Equipment”) was established
as a limited liability company in Tianjin, PRC on April 11, 2007 with a
registered capital RMB 10,000,000 (approximately $1,295,000). Tianxiao Equipment
principally engages in the manufacturing of fire protection products.
Basis
of presentation
The
accompanying consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America.
All material intercompany transactions and balances have been eliminated
in
consolidation.
Management
has included all normal recurring adjustments considered necessary to give
a
fair presentation of operating results for the periods presented. Interim
results are not necessarily indicative of results for a full year. The
information included in this Form 10-Q should be read in conjunction with
information included in the 2007 annual report filed on Form
10-KSB.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Use
of
estimates
The
preparation of financial statements in conformity with generally accepted
accounting principles of the United States of America requires management
to
make estimates and assumptions that affect the amounts reported in the combined
financial statements and accompanying notes. Management believes that the
estimates utilized in preparing its financial statements are reasonable and
prudent. Actual results could differ from these estimates.
Certain
of the Company’s accounting policies require higher degrees of judgment than
others in their application. These include the recognition of revenue and
earnings from system contracting projects under the percentage of completion
method and the allowance of doubtful accounts. Management evaluates all of
its
estimates and judgments on an on-going basis.
Revenue
recognition
Revenue
is recognized when it is probable that the economic benefits will flow to
the
Company as follows:
1. |
Revenue
from system contracting projects are recognized using the
percentage-of-completion method of accounting and, therefore, take
into
account the costs, estimated earnings and revenue to date on contracts
not
yet completed. Revenue recognized is that percentage of the total
contract
price that cost expended to date bears to anticipated final total
cost,
based on current estimates of costs to complete. Contract costs include
all direct material and labor costs and those indirect costs related
to
contract performance, such as indirect labor, supplies, tools, repairs,
and depreciation costs. Selling, general, and administrative costs
are
charged to expense as incurred. At the time a loss on a contract
becomes
known, the entire amount of the estimated ultimate loss is recognized
in
the consolidated financial statements. Claims for additional contract
costs are recognized upon a signed change order from the customer
or in
accordance with paragraphs 62 and 65 of the AICPA’S Statement of Position
("SOP") 81-1, "Accounting for Performance of Construction - Type
and
Certain Production - Type Contracts" ("SOP
81-1").
|
2. |
Revenue
from product sales is recognized when the goods are delivered and
title
has passed. Product sales revenue is presented net of a value-added
tax
(VAT). All of the Company’s products that are sold in the PRC are subject
to a Chinese value-added tax at a rate of 17% of the gross sales
price.
This VAT may be offset by VAT paid by the Company on raw materials
and
other materials included in the cost of producing their finished
product.
|
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
3. |
Revenue
from the rendering of Maintenance Services is recognized over the
service
period on a straight line basis.
|
In
accordance with SFAS 48, “Revenue Recognition when Right of Return Exists,”
revenue is recorded net of an estimate of markdowns, price concessions and
warranty costs. Such reserve is based on management’s evaluation of historical
experience, current industry trends and estimated costs.
Almost
all the Company’s products (fire detecting products, fire alarm control device,
and water mist/sprinkler systems) are sold via system contracting projects
or as
part of the integrated products sales. The composition of these three types
of
products varies significantly from project to project, both in quantity and
in
dollar amounts. Although the Company could provide a breakdown of sales
contribution for our own products for each project, it is almost impossible
to
provide revenues for each of our products when the revenue from each project
is
recognized based on percentage of completion. More importantly, the revenues
from the Company’s own products do not accurately reflect our overall financial
performance. The Company is a system contracting projects provider rather
than
product vendors who sell their own products directly or through channels.
Therefore, it is not practical to separately disclose the revenues from external
customers for each of our products.
Shipping
and handling
Costs
related to shipping and handlings are included in cost of revenue. The Company
accounts for shipping and handling fees and costs in accordance with Emerging
Issues Task Force (“EITF”) Issue No. 00-10 “Accounting for Shipping and Handling
Fees and Costs.”
Foreign
currency translation
The
reporting currency of the Company is the US dollar. The Company uses their
local
currency, Renminbi (RMB), as their functional currency. Results of operations
and cash flow are translated at average exchange rates during the period,
and
assets and liabilities are translated at the unified exchange rate as quoted
by
the People’s Bank of China at the end of the period. Translation adjustments
resulting from this process are included in accumulated other comprehensive
income in the statement of shareholders’ equity.
Translation
adjustments amounted to $6,928,716 and $3,568,117 as of June
30,
2008
and
December 31, 2007, respectively. Asset and liability accounts at June 30,
2008
were translated at 6.85 RMB to $1.00 USD as compared to 7.29 RMB at December
31,
2007. Equity accounts were stated at their historical rate. The average
translation rates applied to income statements accounts for the six months
ended
June 30, 2008 and 2007 were 7.05 RMB and 7.71 RMB, respectively. Cash flows
are
also translated at average translation rates for the period, therefore, amounts
reported on the statement of cash flows will not necessarily agree with changes
in the corresponding balances on the balance sheet.
Transaction
gains and losses that arise from exchange rate fluctuations on transactions
denominated in a currency other than the functional currency are included
in the
results of operations as incurred. Historically, the Company has not entered
any
currency trading or hedging transactions, although there is no assurance
that
the Company will not enter into such transactions in the future.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Plant
and equipment
Plant
and
equipment are stated at cost less accumulated depreciation. Depreciation
is
computed using the straight-line method over the estimated useful lives of
the
assets with 5% residual value. For the three months ended June 30, 2008 and
2007, depreciation expense amounted to $157,160 and $145,734
respectively. Depreciation
expense amounted to $326,548 and $268,868 for the six months ended June 30,
2008
and 2007, respectively.
Estimated
useful lives of the assets are as follows:
|
|
Useful
Life
|
|
Buildings
and improvements
|
|
|
40
years
|
|
Transportation
equipment
|
|
|
5
years
|
|
Machinery
|
|
|
10
years
|
|
Office
equipment
|
|
|
5
years
|
|
Furniture
|
|
|
5
years
|
|
Construction
in progress represents the costs incurred in connection with the construction
of
buildings or additions to the Company’s plant facilities. No depreciation is
provided for construction in progress until such time as the assets are
completed and placed into service.
The
cost
and related accumulated depreciation of assets sold or otherwise retired
are
eliminated from the accounts and any gain or loss is included in the statements
of income. Maintenance, repairs and minor renewals are charged directly to
expense as incurred. Major additions and betterment to buildings and equipment
are capitalized.
Long-term
assets of the Company are reviewed periodically or more often if circumstances
dictate, to determine whether their carrying value has become impaired. The
Company considers assets to be impaired if the carrying value exceeds the
future
projected cash flows from related operations. The Company evaluates the periods
of depreciation and amortization to determine whether subsequent events and
circumstances warrant revised estimates of useful lives. As of June 30, 2008,
the Company expects these assets to be fully recoverable.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Plant
and
equipment consist of the following:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Buildings
and improvements
|
|
$
|
5,403,273
|
|
$
|
5,077,373
|
|
Transportation
equipment
|
|
|
2,123,915
|
|
|
1,985,701
|
|
Machinery
|
|
|
1,104,471
|
|
|
970,500
|
|
Office
equipment
|
|
|
1,164,634
|
|
|
1,047,350
|
|
Furniture
|
|
|
38,281
|
|
|
35,972
|
|
Construction
in progress
|
|
|
638,511
|
|
|
-
|
|
Total
|
|
|
10,473,085
|
|
|
9,116,896
|
|
Less
accumulated depreciation
|
|
|
(2,913,504
|
)
|
|
(2,548,646
|
)
|
Plant
and equipment, net
|
|
$
|
7,559,581
|
|
$
|
6,568,250
|
|
Concentration
of risk
Cash
includes cash on hand and demand deposits in accounts maintained with
state owned
banks within the People’s Republic of China and Hong Kong. The Company maintains
balances at financial institutions which, from time to time, may exceed Hong
Kong Deposit Protection Board insured limits for the banks located in Hong
Kong.
Balances at financial institutions or state owned banks within the PRC are
not
covered by insurance. As of June 30, 2008 and December 31, 2007, the Company
had
deposits (including restricted cash balances) totaling to $25,257,549 and
$20,940,016, that are not covered by insurance, respectively. The Company
has
not experienced any losses in such accounts and believes it is not exposed
to
any risks on its cash in bank accounts.
The
Company's operations are carried out in the PRC. Accordingly, the Company's
business, financial condition and results of operations may be influenced
by the
political, economic and legal environments in the PRC, and by the general
state
of the PRC's economy. The Company's operations in the PRC are subject to
specific considerations and significant risks not typically associated with
companies in the North America and Western Europe. These include risks
associated with, among others, the political, economic and legal environments
and foreign currency exchange. The Company's results may be adversely affected
by changes in governmental policies with respect to laws and regulations,
anti-inflationary measures, currency conversion and remittance abroad, and
rates
and methods of taxation, among other things.
The
Company had one major customer who represents approximately 28% and15% of
the
Company’s sales for the three months
and six
months ended June 30, 2008, respectively.
Accounts receivable from this customer was $0 as of June 30, 2008. The Company
had one major customer who represents approximately 21% and 23% of the Company’s
sales for the three months and six months ended June 30, 2007, respectively.
Accounts receivable from this customer was $0 as of June 30, 2007.
The
Company had no major suppliers accounted for more than 10% of the Company’s
total purchase and total accounts payable as of and for the three months
and six
months ended June 30, 2008 and 2007, respectively.
Cash
and cash equivalents
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
The
Company considers all highly liquid investments with original maturities
of
three months or less to be cash equivalents. Cash equivalents are carried
at
cost, which approximates at
its
market value.
Restricted
cash
Restricted
cash represents cash required to be deposited in a separate bank account
subject
to withdrawal restrictions by its system contracting projects and product
sales
customers to guarantee its contracts will be performed. The deposit cannot
be
drawn or transferred by the Company until the restriction period has expired.
The amounts are $4,563,344 and $3,829,927 as of June 30, 2008 and December
31,
2007, respectively.
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Restricted
Cash
|
|
|
|
|
|
|
|
Products
sales
|
|
$
|
410,220
|
|
$
|
102,355
|
|
System
contracting projects
|
|
|
4,153,124
|
|
|
3,727,572
|
|
Total
Restricted Cash
|
|
$
|
4,563,344
|
|
$
|
3,829,927
|
|
Inventories
Inventories
are stated at the lower of cost or market, using weighted average method.
Inventories consisted of the following at:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Raw
materials
|
|
$
|
798,599
|
|
$
|
310,255
|
|
Finished
goods
|
|
|
3,389,910
|
|
|
2,617,638
|
|
Work
in progress
|
|
|
1,360,458
|
|
|
1,120,390
|
|
Total
|
|
$
|
5,548,967
|
|
$
|
4,048,283
|
|
Raw
materials consist primarily of materials used in production. Finished goods
consist primarily of equipment used in product sales and system contracting
projects. The costs of finished goods include direct costs of raw materials
as
well as direct labor used in production. Indirect production costs such as
utilities and indirect labor related to production such as assembling, shipping
and handling costs are also included in the cost of inventory. The Company
reviews its inventories periodically to determine if any reserves are necessary
for potential obsolescence. As of June 30, 2008 and December 31, 2007 the
Company determined no reserves are necessary.
Accounts
receivable
Accounts
receivable represents amounts due from customers for products sales, maintenance
services and system contracting projects. Overdue balances are reviewed
regularly by senior management. Reserves are recorded when collection of
amounts
due are in doubt.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Accounts
receivable consists of the following:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Accounts
receivable:
|
|
|
|
|
|
System
contracting projects
|
|
$
|
11,107,591
|
|
$
|
10,296,762
|
|
Maintenance
services
|
|
|
2,047,613
|
|
|
670,357
|
|
Products
sales
|
|
|
8,771,155
|
|
|
8,234,430
|
|
Total
accounts receivable
|
|
|
21,926,359
|
|
|
19,201,549
|
|
Allowance
for bad debts
|
|
|
(2,827,972
|
)
|
|
(2,483,359
|
)
|
Accounts
receivable, net
|
|
|
19,098,387
|
|
|
16,718,190
|
|
Accounts
receivable - non-current retentions
|
|
|
(776,859
|
)
|
|
(193,029
|
)
|
Accounts
receivable - current
|
|
$
|
18,321,528
|
|
$
|
16,525,161
|
|
The
activity in the allowance for doubtful accounts for trade accounts receivable
for the six months ended June
30,
2008
and the
year ended December 31, 2007 is as follows:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Beginning
allowance for doubtful accounts
|
|
$
|
2,483,359
|
|
$
|
1,252,947
|
|
Additional
charged to bad debt expense
|
|
|
180,061
|
|
|
1,111,051
|
|
Write-off
charged against the allowance
|
|
|
-
|
|
|
(12,700
|
)
|
Foreign
currency translation adjustment
|
|
|
164,552
|
|
|
132,061
|
|
Ending
allowance for doubtful accounts
|
|
$
|
2,827,972
|
|
$
|
$2,483,359
|
|
Costs
and estimated earnings in excess of billings
The
current asset, “Costs and estimated earnings in excess of billings” on
contracts, represents revenues recognized in excess of amounts
billed.
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Contract
costs incurred plus recognized
|
|
|
|
|
|
profits
less recognized losses to date
|
|
$
|
74,045,677
|
|
$
|
50,877,880
|
|
Less:
progress billings
|
|
|
48,978,661
|
|
|
37,809,844
|
|
Costs
and estimated earnings in excess of
|
|
|
|
|
|
|
|
billings
|
|
$
|
25,067,016
|
|
$
|
13,068,036
|
|
Billings
in excess of costs and estimated earnings
The
current liability, “Billings in excess of costs and estimated earnings” on
contracts, represents billings in excess of revenues recognized.
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Progress
billings
|
|
$
|
11,684,088
|
|
$
|
15,713,786
|
|
Less:
contracts costs incurred plus recognized
|
|
|
|
|
|
|
|
profits
less recognized losses to date
|
|
|
8,863,644
|
|
|
10,831,569
|
|
Billings
in excess of costs and estimated
|
|
|
|
|
|
|
|
earnings
|
|
$
|
2,820,444
|
|
$
|
4,882,217
|
|
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
At
June
30, 2008 and December 31, 2007, retentions held by customers of system
contracting projects included in the Company’s accounts receivable as
following:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
Retentions
|
|
|
|
|
|
|
|
Current
|
|
$
|
2,112,045
|
|
$
|
2,829,250
|
|
Non-current
|
|
|
776,859
|
|
|
193,029
|
|
Total
retentions
|
|
$
|
2,888,904
|
|
$
|
3,022,279
|
|
These
balances represent portions of billings made by the Company but held for
payment
by the customer pending satisfactory completion of the project. Retention
payments are generally collected within one year of the completion of the
project.
Research
and development
Research
and development expenses include salaries, consultant fees, supplies and
materials, as well as costs related to other overhead such as depreciation,
facilities, utilities and other departmental expenses. The costs we incur
with
respect to internally developed technology and engineering services are included
in research and development expenses as incurred as they do not directly
relate
to any particular licensee, license agreement or licenses fee.
Warranties
Generally,
the Company’s products are not covered by specific warranty terms. However, it
is the Company’s policy to replace parts if they become defective within one
year after deployment at no additional charge. Historically, failure of product
parts due to materials or workmanship is rare. Therefore, at June 30, 2008
and
December 31, 2007, the Company made no provision for warranty claims for
our
products. Management continuously evaluates the potential warranty obligation.
Management will record the expenses related to the warranty obligation when
the
estimated amount become material at the time revenue is recorded.
Fair
value of financial instruments
On
January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements,
defines fair value, established a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosures requirements
for
fair value measures. The carrying amounts reported in the balance sheets
for
current assets and current liabilities qualify as financial instruments and
are
a reasonable estimate of fair value because of the short period of time between
the origination of such instruments and their expected realization and their
current market rate of interest. The three levels are defined as
follow:
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
· |
Level
1 inputs to the valuation methodology are quoted prices (unadjusted)
for
identical assets or liabilities in active
markets.
|
· |
Level
2 inputs to the valuation methodology include quoted prices for similar
assets and liabilities in active markets, and inputs that are observable
for the assets or liability, either directly or indirectly, for
substantially the full term of the financial
instruments.
|
· |
Level
3 inputs to the valuation methodology are unobservable and significant
to
the fair value.
|
The
Company invested $166,326 to Hubei Shou An Changjiang Fire Protection Co.,
Ltd
for 19% ownership and invested $1,000,000 to King Galaxy Investments Limited
for
5% ownership. Total investment as of June 30, 2008 amounted to $1,166,326.
Since
there is no quoted or observable market price for the fair value of similar
long
term in joint venture, the Company then used the level 3 inputs for its
valuation methodology. The determination of the fair value was based on the
cost
of the capital contribution to the joint ventures.
The
Company did not identify any other assets and liabilities that are required
to
be presented on the balance sheet at fair value in accordance with SFAS No.
157.
Intangible
assets
Land
use
rights - All land in the People’s Republic of China is owned by the government.
However, the government grants the user “land use rights”. The Company acquired
land use rights in 2001 for $635,757. The land use rights expire in 2051.
The
costs of these rights are being amortized over
fifty years
using
the straight-line method. As of June 30, 2008 and December 31, 2007,
accumulated
amortization amounted to $164,049 and $137,672, respectively.
Amortization expense amounted to $3,341 and $3,386 for the three months ended
June
30,
2008 and 2007,
and $
6,970 and $6,735 for the six months ended June 30, 2008 and 2007,
respectively.
Technology
rights - In May 2007, the Company acquired two technology rights to manufacture
fire protection products for $608,745. The costs of these rights are being
amortized over
ten
years
using
the straight-line method. As of June 30, 2008 and December 31, 2007,
accumulated
amortization amounted to $71,021 and $40,583, respectively. Amortization
expense amounted to $15,218 and $10,146 for the three months ended June 30,
2008
and 2007, respectively. Amortization
expense amounted to $30,438 and $10,146 for the six months ended June 30,
2008
and 2007, respectively.
Intangible
assets of the Company are reviewed annually to determine whether their carrying
value has become impaired. The Company considers assets to be impaired if
the
carrying value exceeds the future projected cash flows from related operations.
The Company also evaluates the periods of amortization to determine whether
subsequent events and circumstances warrant revised estimates of useful lives.
As of June 30, 2008, the Company expects these assets to be fully recoverable.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Income
taxes
The
Company adopted Statement of Financial Accounting Standards No. 109, “Accounting
for Income Taxes” (SFAS 109). SFAS 109 requires the recognition of deferred
income tax liabilities and assets for the expected future tax consequences
of
temporary differences between income tax basis and financial reporting basis
of
assets and liabilities. Provision for income taxes consist of taxes currently
due plus deferred taxes. There are no deferred tax amounts at June 30, 2008
and
December 31, 2007.
The
Company adopted FASB Interpretation 48, “Accounting for Uncertainty in Income
Taxes” (“FIN 48”), as of January 1, 2007. A tax position is recognized as a
benefit only if it is “more likely than not” that the tax position would be
sustained in a tax examination, with a tax examination being presumed to
occur.
The amount recognized is the largest amount of tax benefit that is greater
than
50% likely of being realized on examination. For tax positions not meeting
the
“more likely than not” test, no tax benefit is recorded. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting
in
interim periods, disclosures, and transition. The adoption had no affect
on the
Company’s financial statements.
The
Company’s operations are subject to income and transaction taxes in the United
States and in the PRC jurisdictions. Significant estimates and judgments
are
required in determining the Company’s worldwide provision for income taxes. Some
of these estimates are based on interpretations of existing tax laws or
regulations. The ultimate amount of tax liability may be uncertain as a
result.
The
Company does not anticipate any events which could cause change to these
uncertainties.
The
Company is subject to taxation in the U.S. and in the PRC jurisdictions.
There
are no ongoing examinations by taxing authorities at this time. The years
2005
to 2008 remain subject to examination by the United States tax authorities.
The
year 2008 remain subject to examination by the PRC tax authorities.
The
charge for taxation is based on the results for the year as adjusted for
items,
which are non-assessable or disallowed. It is calculated using tax rates
that
have been enacted or substantively enacted by the balance sheet
date.
Deferred
tax is accounted for using the balance sheet liability method in respect
of
temporary differences arising from differences between the carrying amount
of
assets and liabilities in the financial statements and the corresponding
tax
basis used in the computation of assessable tax profit.
In
principle, deferred tax liabilities are recognized for all taxable temporary
differences, and deferred tax assets are recognized to the extent that it
is
probably that taxable profit will be available against which deductible
temporary differences can be utilized. Deferred tax is calculated using tax
rates that are expected to apply to the period when the asset is realized
or the
liability is settled. Deferred tax is charged or credited in the income
statement, except when it is related to items credited or charged directly
to
equity, in which case the deferred tax is also dealt with in equity. Deferred
tax assets and liabilities are offset when they relate to income taxes levied
by
the same taxation authority and the Company intends to settle its current
tax
assets and liabilities on a net basis.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Beginning
January 1, 2008, the new Enterprise Income Tax (“EIT”) law will replace the
existing laws for Domestic Enterprises (“DES”) and Foreign Invested Enterprises
(“FIEs”).
Value
Added Tax
Enterprises
or individuals who sell products, engage in repair and maintenance or import
and
export goods in the PRC are subject to a value added tax in accordance with
Chinese laws. The value added tax standard rate is 17% of the gross sales
price.
A credit is available whereby VAT paid on the purchases of semi-finished
products or raw materials used in the contract and production of the Company’s
finished products can be used to offset the VAT due on sales of the finished
product.
VAT
on
sales and VAT on purchases amounted to $1,753,759 and $1,328,652 for the
three
months ended June 30, 2008, and $1,379,908 and $1,466,771 for the three months
ended June 30, 2007 respectively. VAT on sales and VAT on purchases amounted
to
$2,718,120 and $2,070,716 for the six months ended June 30, 2008, and $2,626,243
and $2,426,434 for the six months ended June 30, 2007 respectively. Sales
and
purchases are recorded net of VAT collected and paid as the Company acts
as an
agent for the government. VAT taxes are not impacted by the income tax
holiday.
Stock
based compensation
The
Company adopted Statement of Financial Accounting Standards No. 123R “Accounting
for Stock-Based Compensation” (“SFAS 123R”) at the beginning of 2006, which
defines a fair-value-based method of accounting for stock based employee
compensation and transactions in which an entity issues its equity instruments
to acquire goods and services from non-employees. Stock compensation for
stock
granted to non-employees has been determined in accordance with SFAS 123R
and
the Emerging Issues Task Force consensus Issue No. 96-18, "Accounting for
Equity
Instruments that are issued to Other than Employees for Acquiring, or in
Conjunction with Selling Goods or Services" ("EITF 96-18"), as the fair value
of
the consideration received or the fair value of equity instruments issued,
whichever is more reliably measured.
Recently
issued accounting pronouncements
In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities—including an amendment of FASB Statement No.
115 (“FAS 159”). FAS 159 permits companies to choose to measure many financial
instruments and certain other items at fair value that are
not
currently required to be measured at fair value. The objective of FAS 159
is to
provide opportunities to mitigate volatility in reported earnings caused
by measuring
related assets and liabilities differently without having to apply hedge
accounting provisions. FAS 159 also establishes presentation and
disclosure requirements
designed to facilitate comparisons between companies that choose different
measurement attributes for similar types of assets and liabilities. SFAS
No. 159
is effective as of the beginning of an entity’s first fiscal year that begins
after November 15, 2007. The Company adopted SFAS No. 159 on January 1, 2008.
The Company chose not to elect the option to measure the fair value of eligible
financial assets and liabilities.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
In
June
2007, the
FASB
issued FASB Staff Position No. EITF 07-3, “Accounting for Nonrefundable Advance
Payments for Goods or Services Received for use in Future Research and
Development Activities” (“FSP EITF 07-3”), which addresses whether nonrefundable
advance payments for goods or services that used or rendered for research
and
development activities should be expensed when the advance payment is made
or
when the research and development activity has been performed. FSP EITF 07-3
will be effective for an entity’s financial statements issued for fiscal years
beginning after than December 15, 2007. The adoption of FSP EITF 07-3 did
not
impact our consolidated financial statements.
In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements - an amendment of Accounting Research Bulletin
No. 51” (“SFAS 160”), which establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent,
the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained non-controlling equity investments when a subsidiary
is
deconsolidated. The Statement also establishes reporting requirements that
provide sufficient disclosures that clearly identify and distinguish between
the
interests of the parent and the interests of the non-controlling owners.
SFAS
160 is effective for fiscal years beginning after December 15, 2008. The
Company
has not determined the effect that the application of SFAS 160 will have
on its
consolidated financial statements.
In
December 2007, Statement of Financial Accounting Standards No. 141(R),
Business
Combinations,
was
issued. SFAS No. 141R replaces SFAS No. 141, Business
Combinations. SFAS
141R
retains the fundamental requirements in SFAS 141 that the acquisition method
of
accounting (which SFAS 141 called the purchase
method)
be used
for all business combinations and for an acquirer to be identified for each
business combination. SFAS 141R requires an acquirer to recognize the assets
acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree at the acquisition date, measured at their fair values as of that
date,
with limited exceptions. This replaces SFAS 141’s cost-allocation process, which
required the cost of an acquisition to be allocated to the individual assets
acquired and liabilities assumed based on their estimated fair values. SFAS
141R
also requires the acquirer in a business combination achieved in stages
(sometimes referred to as a step acquisition) to recognize the identifiable
assets and liabilities, as well as the noncontrolling interest in the acquiree,
at the full amounts of their fair values (or other amounts determined in
accordance with SFAS 141R). SFAS 141R applies prospectively to business
combinations for which the acquisition date is on or after the beginning
of the
first annual reporting period beginning on or after December 15, 2008. An
entity
may not apply it before that date. The Company is currently evaluating the
impact that adopting SFAS No. 141R will have on its financial
statements.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
In
March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities - An Amendment of SFAS No. 133” (“SFAS
161”). Effective on January 1, 2009, SFAS 161 seeks to improve financial
reporting for derivative instruments and hedging activities by requiring
enhanced disclosures regarding the impact on financial position, financial
performance, and cash flows. To achieve this increased transparency, SFAS
161
requires (1) the disclosure of the fair value of derivative instruments and
gains and losses in a tabular format; (2) the disclosure of derivative
features that are credit risk-related; and (3) cross-referencing within the
footnotes. The Company is in the process of evaluating the new disclosure
requirements under SFAS 161.
In
May
2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted
Accounting Principles" ("SFAS 162"). FAS 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. GAAP for nongovernmental entities. SFAS
162 is
effective 60 days following the SEC's approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly
in
Conformity with Generally Accepted Accounting Principles." The Company is
in the
process of evaluating the impact of adoption of this statement on the results
of
operations, financial position or cash flows.
In
June
2008, the FASB issued Emerging Issues Task Force Issue 07-5 “Determining whether
an Instrument (or Embedded Feature) is indexed to an Entity’s Own Stock” (“EITF
No. 07-5”). This Issue is effective for financial statements issued for fiscal
years beginning after December 15, 2008, and interim periods within those
fiscal
years. Early application is not permitted. Paragraph 11(a) of SFAS No 133
“Accounting for Derivatives and Hedging Activities” (“SFAS 133”) specifies that
a contract that would otherwise meet the definition of a derivative but is
both
(a) indexed to the Company’s own stock and (b) classified in
stockholders’ equity in the statement of financial position would not be
considered a derivative financial instrument. EITF No.07-5 provides a new
two-step model to be applied in determining whether a financial instrument
or an
embedded feature is indexed to an issuer’s own stock and thus able to qualify
for the SFAS 133 paragraph 11(a) scope exception. This
standard triggers liability accounting on all options and warrants exercisable
at strike prices denominated in any currency other than the functional currency
of the operating entity in China (Renminbi). The
Company is currently evaluating the impact of the adoption of EITF No. 07-5
on
the Company’s consolidated financial statements.
Reclassifications
Certain
prior period amounts have been reclassified to conform to the current period
presentation. These reclassifications have no effect on net income or cash
flows.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Note
3 - Earnings per share
The
Company reports earnings per share in accordance with the provisions of SFAS
No.
128, “Earnings per Share.” SFAS No. 128 requires presentation of basic and
diluted earnings per share in conjunction with the disclosure of the methodology
used in computing such earnings per share. Basic earnings per share is computed
by dividing income available to common stockholders by the weighted average
common shares outstanding during the period. Diluted earnings per share takes
into account the potential dilution that could occur if securities or other
contracts to issue common stock were exercised and converted into common
stock.
The
following is a reconciliation of the basic and diluted earnings per share
computation for the three months and six months ended June 30, 2008 and
2007:
|
|
For
the three months ended June 30,
|
|
For
the six months ended June 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
Net
income for earnings per share
|
|
$
|
6,676,100
|
|
$
|
4,244,521
|
|
$
|
11,416,880
|
|
$
|
8,372,640
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average shares used in basic computation
|
|
|
27,557,297
|
|
|
26,461,678
|
|
|
27,557,095
|
|
|
26,461,678
|
|
Diluted
effect of stock options and warrants
|
|
|
643,488
|
|
|
702,529
|
|
|
622,500
|
|
|
624,129
|
|
Weighted
average shares used in diluted computation
|
|
|
28,200,785
|
|
|
27,164,207
|
|
|
28,179,595
|
|
|
27,085,807
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings
per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
$
|
0.24
|
|
$
|
0.16
|
|
$
|
0.41
|
|
$
|
0.32
|
|
Diluted
|
|
$
|
0.24
|
|
$
|
0.16
|
|
$
|
0.41
|
|
$
|
0.31
|
|
At
June
30, 2008, all outstanding stock options and warrants were included in the
calculation of diluted earnings per share.
Note
4 - Notes receivable
Notes
receivable represents trade accounts receivable due from various customers
where
the customers’ bank has guaranteed the payment of the receivable. This amount is
non-interest bearing and is normally paid within three to six months. The
Company has the ability to submit their request for payment to the customer’s
bank earlier than the scheduled payment date. However, the Company will incur
an
interest charge and a processing fee when they submit the payment request
early.
The Company‘s notes receivable totaled $6,209,671 and $3,315,811 as of June 30,
2008 and December 31, 2007, respectively.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Note
5 - Other receivable from related party
The
Company has other receivable from Hubei Shou An Changjiang Fire Protection
Co.,
Ltd. (“Hubi Shou An”), which the Company has 19% interest in. Receivable due
from Hubei Shou An was $325,177 and $0 as of June 30, 2008 and December 31,
2007, respectively. This balance was for the operating cash flow in Hubei
Shou
An and expected to be repaid by December 31, 2008 in cash. Receivable is
non-interest bearing and unsecured.
Note
6 - Prepayments and deferred expenses
Prepayments
and deferred expenses are monies deposited with or advanced to subcontractors
to
perform services on System Contracting Projects. Some subcontractors require
a
certain amount of money to be deposited as a guarantee payment in order for
them
start performing the services. Prepayments and deferred expenses also include
monies deposited or advanced to vendors on future inventory purchases to
ensure
timely delivery. The total outstanding amount was $3,203,575 and $2,218,391
as
of June 30, 2008 and December 31, 2007, respectively.
Note
7 - Investment in joint ventures
During
the second quarter of 2007, the Company invested $166,326 for a 19% interest
in
Hubei Shou An Changjiang Fire Protection Co., Ltd., located in China Hubei,
PRC.
Investment is recorded under cost method.
During
the third quarter of 2007, the Company invested $1,000,000 for a 5% interest
in
King Galaxy Investments Limited. King Galaxy through its wholly owned
subsidiary, China Alliance Security Holdings Company Limited owns 100% of
Wan
Sent (China) Technology Co., Ltd. (“Wan Sent”), an emerging Chinese fire
emergency remote-monitoring system provider based in Beijing, PRC. The
investment has been recorded under the cost accounting method.
The
Company has not consolidated the financial statements of these two joint
ventures into its financial statements as the Company does not have the ability
to exercise significant influence over the joint venture companies.
Note
8 - Customer deposits
Customer
deposits represent amounts advanced by customers on products orders, maintenance
services deposits and system contracting projects deposits. The product or
service normally is shipped or performed within six months after receipt
of the
advance payment and the related sale is recognized in accordance with the
Company’s revenue recognition policy. As of June 30, 2008 and December 31, 2007,
customer deposits amounted to $13,105,751 and $4,757,179,
respectively.
Note
9 - Accrued liabilities
Accrued
liabilities represent subcontractors’ expenses incurred as of balance sheet date
for system contracting projects. As of June 30, 2008 and December 31, 2007,
accrued liabilities amounted to $6,315,280 and $4,214,530,
respectively.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Note
10 - Income taxes
Prior
to
January 1, 2008, under the Income Tax Laws of PRC, the Company’s subsidiaries
are generally subject to an income tax at an effective rate of 25% on income
reported in the statutory financial statements after appropriate tax
adjustments, unless the enterprise is located in a specially designated region
where it allows enterprises a three-year income tax exemption and a 50% income
tax reduction for the following three years or the enterprise is a manufacturing
related joint venture with a foreign enterprise or a wholly owned subsidiary
of
a foreign enterprise, where it allows enterprises a two-year income tax
exemption and a 50% income tax reduction for the following three
years.
Under
the
Income Tax Laws of Beijing State Administration Taxation of PRC, any
enterprise
with manufacturing operations in the City of Beijing who is a wholly owned
subsidiary of a foreign enterprise is subject to income tax rate of
24%.
On
July
19, 2006, Sureland Industrial became a wholly owned subsidiary of the Company,
a
foreign enterprise, and will start enjoying the exemption from January 1,
2007
to December 31, 2008, and is entitled to a 50% reduction of the special income
tax rate of 24%, which is a rate of 12% from January 2009 to December 31,
2011.
On
August
4, 2006, Sureland Equipment became a wholly owned subsidiary of the Company,
a
foreign enterprise, and was granted income tax exemption from April 2006
to
December 31, 2007, and is entitled to a 50% reduction of the special income
tax
rate of 24%, which is a rate of 12% from January 2008 to December 31,
2010.
Beijing
Hua An were established and registered in the New Technology Enterprise
Development Zone, Beijing, PRC and are subject to the rate of 15% and have
been
certified by the relevant PRC authorities high technology enterprises. However
pursuant to approval documents issued by the relevant tax bureau, Beijing
Hua An
obtained additional tax benefits. Beijing Hua An is exempt from income taxes
from January 2006 to December 31, 2008 and is entitled to a 50% reduction
of
the
special income tax rate of 15% which is a rate of 7.5% from January 2009
to
December 31, 2011.
Tianxiao
Equipment has no income tax exemption and therefore it has an income tax
rate of
33% from its establishment.
Beginning
from January 1, 2008, the new Enterprise Income Tax (“EIT”) law will replace the
existing income tax laws for Domestic Enterprises (“DES”) and Foreign Invested
Enterprises (“FIEs”).
The
key
changes are:
a. |
The
new standard EIT rate of 25% will replace the 33% rate currently
applicable to both DES and FIEs, except for High Tech companies who
pays a
reduced rate of 15%;
|
b. |
Companies
established before March 16, 2007 will continue to enjoy tax holiday
treatment approved by local government for a grace period of the
next 5
years or until the tax holiday term is completed, whichever is sooner.
|
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Beginning
from January 1, 2008, Sureland Industrial will
continue to enjoy the exemption from income tax till December 31, 2008 and
be
entitled
to a 50% reduction
of
the
income tax rate of 25% which is a rate of 12.5% from January 2009 to December
31, 2011. Beginning January 1, 2012, Sureland Industrial will be entitled to an
income tax rate of 25%.
Beginning
from January 1, 2008, Sureland Equipment will
continue to enjoy
a 50%
reduction
of
the
income tax rate of 25%, which is a rate of 12.5%, till December 31, 2010.
Beginning January 1, 2011, Sureland Equipment will be entitled to an income
tax
rate of 25%.
Beginning
from January 1, 2008, Tianxiao Equipment will
be
entitled to an income tax rate of 25%.
Beginning
from January 1, 2008, Beijing Hua An will
continue to enjoy the exemption from income tax till December 31, 2008 and
be
entitled
to a reduced
income
tax rate of 10%, 11%, 12% for 2009, 2010 and 2011 respectively. Beginning
January 1, 2012, Beijing Hua An will be entitled to an income tax rate of
25%.
The
provision for income taxes for the three months ended June 30, 2008 and 2007
amounted to $11,453 and $0, respectively and $60,095 and $0 for the six months
ended June 30, 2008 and 2007, respectively.
The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the three months and six months ended June 30:
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
U.S.
Statutory rates
|
|
|
34.0
|
%
|
|
34.0
|
%
|
Foreign
income not recognized in USA
|
|
|
(34.0
|
)
|
|
(34.0
|
)
|
China
income taxes
|
|
|
25.0
|
|
|
33.0
|
|
China
income tax exemption
|
|
|
(24.0
|
)
|
|
(33.0
|
)
|
Total
provision for income taxes
|
|
|
1.0
|
%
|
|
-
|
%
|
The
estimated tax savings for the three months ended June 30, 2008 and 2007 amounted
to $1,955,426 and $1,300,563, respectively. The net effect on basic earnings
per
share if the income tax had been applied would decrease basic earnings per
share
for the three months ended June
30,
2008 and 2007
by $0.07
and $0.12, respectively. The estimated tax savings for the six months ended
June
30, 2008 and 2007 amounted to $3,196,996 and $2,486,028, respectively. The
net
effect on basic earnings per share if the income tax had been applied would
decrease basic earnings per share for the six months ended June 30, 2008
and
2007 by $0.12 and $0.22, respectively.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
China
Fire & Security Group, Inc. was incorporated in the United States and has
incurred net operating losses of $0 for income tax purposes for the six months
ended June 30, 2008. The net operating loss carry forwards for United States
income taxes amounted to $1,004,414 which may be available to reduce future
years’ taxable income. These carry forwards will expire, if not utilized,
beginning in 2025 and continue through 2027. Management believes that the
realization of the benefits from these losses appears uncertain due to the
Company’s limited operating history and continuing losses for United States
income tax purposes. Accordingly, the Company has provided a 100% valuation
allowance on the deferred tax asset benefit to reduce the asset to zero.
The
accumulated valuation allowance as of June 30, 2008 amounted to $341,501.
Management will review this valuation allowance periodically and make
adjustments as warranted.
Taxes
payable
Taxes
payable as of June 30, 2008 and December 31, 2007 consisted of the
following:
|
|
June
30, 2008
|
|
December
31, 2007
|
|
VAT
taxes (credit) payable
|
|
$
|
(63,939
|
)
|
$
|
71,367
|
|
Income
taxes payable
|
|
|
45,462
|
|
|
5,915
|
|
Sales
taxes
|
|
|
1,467,109
|
|
|
979,999
|
|
Other
taxes payable
|
|
|
22,132
|
|
|
31,054
|
|
Total
|
|
$
|
1,470,764
|
|
$
|
1,088,335
|
|
Note
11 - Retirement plan
The
Company
and its
subsidiaries are required to participate in a central pension scheme operated
by
the local municipal government. The Company is required to contribute 20%
of its
payroll costs to the central pension scheme in 2008 and 2007. The contributions
are charged to the income statement of the Company as they become payable
in
accordance with the rules of the scheme.
The
aggregate contributions of the Company to retirement benefit schemes amounted
to
$74,147 and $38,691 for
the
three months ended June 30, 2008 and 2007,
respectively. The aggregate contributions of the Company to retirement benefit
schemes amounted to $124,927 and $75,687 for
the
six months ended June 30, 2008 and 2007,
respectively.
Note
12 - Statutory reserves
The
laws
and regulations of the People’s Republic of China require that before an
enterprise distributes profits to its partners, it must first satisfy all
tax
liabilities, provide for losses in previous years, and make allocations,
in
proportions determined at the discretion of the board of directors, after
the
statutory reserve. The statutory reserves include surplus reserve fund and
the
enterprise fund. These
statutory reserves represent restricted retained earnings.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Surplus
reserve fund
The
Company is required to transfer 10% of its net income, as determined in
accordance with the PRC accounting rules and regulations, to a statutory
surplus
reserve fund until such reserve balance reaches 50% of the Company’s registered
capital.
The
transfer to this reserve must be made before distribution of any dividend
to
shareholders. For the six months ended June 30, 2008 and 2007, the Company
did
not make any contribution to this fund. The surplus reserve fund is
non-distributable other than during liquidation and can be used to fund previous
years’ losses, if any, and may be utilized for business expansion or converted
into share capital by issuing new shares to existing shareholders in proportion
to their shareholding or by increasing the par value of the shares currently
held by them, provided that the remaining reserve balance after such issue
is
not less than 25% of the registered capital.
On
May
17, 2007, the Beijing Shunyi District Business Administration approved the
Company to increase registered capital from RMB 50,000,000 to RMB 100,000,000.
$605,000 or RMB 5,000,000 was approved by the Beijing Shunyi District Business
Administration to be transferred out from this surplus reserve fund as an
increase of registered capital.
Enterprise
fund
The
enterprise fund may be used to acquire plant and equipment or to increase
the
working capital to expend on production and operation of the business. No
minimum contribution is required and the Company did not make any contribution
to this fund for the six months ended June 30, 2008 and 2007.
Note
13 - Shareholders’ equity
On
October 27, 2006, pursuant to a Securities Purchase Agreement dated October
27,
2006 (“SPA”), the Company issued 1,538,600 units of common stock at $3.25 per
share, Series A warrants expiring on October 27, 2011 to acquire 307,723
shares
at $3.58 per share and Series B warrants expiring on October 27, 2011 to
acquire
307,723 shares at $4.88 per share. The Company also issued 115,395 warrants
at
exercise price of $3.25 per share, expiring on October 27, 2011.
On
December 5, 2006, under the SPA, the Company issued 923,078 units of common
stock at $3.25 per share, Series
A
warrants expiring on December 5, 2011 to acquire 184,617 shares at $3.58
per
share and Series B warrants also on December 5, 2011 to acquire 184,617 shares
at $4.88 per share. The Company issued 69231 warrants at exercise price of
$3.25
per share, expiring December 5, 2011.
On
January 30, 2008, the Company’s 2008 Omnibus Long-term Incentive Plan was
adopted and approved by shareholders. Pursuant to the 2008 Omnibus Long-term
Incentive Plan, the Company reserved 2,000,000 shares of our common stock
for
issuance.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
On
March
12, 2008, the Company’s Board of Directors authorized the repurchase of up to
$10 million of the Company's outstanding common stock.
Warrants
In
order
for the warrants to be accounted for as equity, the warrants must comply
with
FAS 133 and EITF 00-19. Under the original terms, the Series A and Series
B
warrant agreements, the warrant holders under certain circumstances, at their
option, could elect to receive an amount in cash equal to the fair value
of the
warrant calculated in accordance with the Black-Scholes formula. Thus, the
warrant holders had rights to a cash payment that are not available to other
common stockholders, which failed the test in paragraph 27 of EITF 00-19.
The
failure of this test therefore resulted in classification of the warrants
as
derivative instrument liabilities, rather than as equity instruments. The
Company allocated the proceeds received between the common stock and warrants
based upon the fair values on the dates the proceeds were received. The value
of
the warrants was determined using the Cox-Ross-Rubinstein binomial model
using
the following assumptions: volatility 75%; risk free interest rate 4.64%;
dividend yield of 0% and expected term of 5 years. Net proceeds were allocated
as the follows:
Warrants
|
|
$
|
1,110,236
|
|
Common
stock
|
|
|
6,030,602
|
|
Total
Net Proceeds
|
|
$
|
7,140,838
|
|
Subsequent
to the initial recording, the change in the fair value of the warrants,
determined under the Cox-Ross-Rubinstein binomial model, at each reporting
date
was recorded as a gain or loss on derivative instruments.
On
April
26, 2007, the Company amended its Series A Warrants and Series B Warrants
issued
to certain investors on October 27 and December 5, 2006 pursuant to the
Securities Purchase Agreement in connection with a private placement (the
“Amendment”). The Amendment eliminates the right of the warrant holders to be
paid in cash in the event of a merger or other types of reorganization. The
warrants no longer need to be accounted for as derivative instrument
liabilities. The fair value of the warrants were transferred to equity on
the signing date and no further accounting (i.e., no mark-to-market) is required
going forward. As of December 31, 2006 the fair value of the derivative
instrument totaled $2,680,811. At April 26, 2007, the Company determined
the
fair value of the warrants was $1,475,020 using the Cox-Ross-Rubinstein binomial
model with the following assumptions: volatility 25%; risk free interest
rate
4.59%; dividend yield of 0% and expected term of 4.5 years. A gain of $1,205,791
was recognized in the accompanying income statement based on the decrease
in
fair value since prior period ended December 31, 2006. On April 26, 2007,
the
fair value of the warrants was transferred to additional paid-in capital.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
In
2007,
a total of 492,340 series A warrants exercised at $3.58 and 492,340 series
B
warrants exercised at $4.88 for a total of 984,680 shares of common stock.
The
Company received a total of $4,165,197 from various warrant holders.
In
2007,
a total of 179,626 warrants were converted into 110,535 shares of common
stock
by the warrants holders using the cashless exercise options.
On
February 1, 2007, CFPG issued 50,000 warrants to Hayden Communication, the
Company’s investor relations consultant, as part of its compensation. These
warrants meet the conditions for equity classification pursuant to FAS 133
and
EITF 00-19. Therefore, the warrants were classified as equity and accounted
as
compensation expenses. The warrants vest one year from the grant date. The
Company used the Black Scholes model to value the options at the time they
were
issued, based on the exercise price of $4.25 and expiration dates of the
instruments and using a risk-free rate of 4.84% and the volatility at 50%
that
was estimated by analyzing the trading history of the Company’s stock. At that
market price, the 50,000 warrants had a fair value of approximately $94,274.
The
service that the investor relation consultant provides started from the second
quarter of 2007; the related compensation expense is recognized on a
straight-line basis over the total service period and has been fully expensed
in
2007.
On
June
23, 2008, a total of 5,000 warrants were converted into 3,634 shares of common
stock by the warrants holders using the cashless exercise options.
The
Company’s warrant activity is as follows:
|
|
|
|
|
|
Weighted
|
|
Average
|
|
|
|
Warrants
|
|
Warrants
|
|
Average
Exercise
|
|
Remaining
Contractual
|
|
|
|
Outstanding
|
|
Exercisable
|
|
Price
|
|
Life
|
|
Outstanding,
December 31, 2006
|
|
|
1,169,306
|
|
|
1,169,306
|
|
$
|
4.23
|
|
|
4.58
|
|
Granted
|
|
|
50,000
|
|
|
|
|
$
|
4.25
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(1,164,306
|
)
|
|
(1,164,306
|
)
|
$
|
4.23
|
|
|
|
|
Outstanding,
December 31, 2007
|
|
|
55,000
|
|
|
5,000
|
|
$
|
4.19
|
|
|
4.08
|
|
Granted
|
|
|
|
|
|
50,000
|
|
$
|
4.25
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(5,000
|
)
|
|
(5,000
|
)
|
$
|
3.25
|
|
|
|
|
Outstanding,
June 30, 2008
|
|
|
50,000
|
|
|
50,000
|
|
$
|
4.25
|
|
|
3.58
|
|
Note
14 - Options issued to employees
On
July
1, 2006, CFPG issued 750,000 options to the employees of Sureland Industrial.
Fifty percent of the options vested immediately, with the balance vesting
evenly
each quarter over the following two years. The Company used the
Cox-Ross-Rubinstein binomial model to value the options at the time they
were
issued, based on the stated exercise prices and expiration dates of the
instruments and using a risk-free rate of 5.11%. Because the Company does
not
have a history of employee stock options, the estimated life is based on
one
half of the sum of the vesting period and the contractual life of the option.
This is the same as assuming that the options are exercised at the mid-point
between the vesting date and expiration date.
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
The
Company’s stock was not traded when the options were granted. Therefore, the
Company had to estimate the market value of its shares. There was no significant
change in the business between July and October 2006, therefore, the Company
used the fair value from the October 27 transaction of $2.26 and took a discount
of 30%, to estimate a market price of $1.58. At that market price, the 750,000
employee options had a fair value of approximately $834,000. Because 50%
of the
options vested immediately, the related compensation expense was recognized
as
the options vest, rather than on a straight-line basis over the total vesting
period, as the amount recognized at any point in time must be at least equal
to
the portion vested. For the three months ended June 30, 2008 and 2007, the
expense recognized amounted to $7,000 and $47,000, respectively. The expense
recognized for the six months ended June 30, 2008 and 2007 amounted to $21,000
and $112,000, respectively.
On
April
20, 2007, CFPG issued 9,500 options to the Company’s four independent directors
as part of their compensation. The options will vest immediately after one
year
from the issuance date. The fair value of these warrants was determined to
be
$19,428 using the Black Sholes model with the following assumptions: volatility
45%; risk free interest rate 4.57%; dividend yield of 0% and expected term
of 5
years. Options were vested immediately at exercise price of $4.51 per share
which was the close price of the Company’s stock on April 19, 2007. Because the
services that the independent directors are to provide started from the second
quarter of 2007 and will last for one year, the related compensation expense
is
recognized on a straight-line basis over the total service period. The
compensation expense for the three months ended June 30, 2008 and 2007 was
$4,856 and $0, respectively.
The
compensation expense for the six months ended June 30, 2008 was $4,856 and
$4,857, respectively.
On
July
1, 2007, CFPG issued 20,000 options to Mr. Yuan, Xiaoyuan, who joined the
Company as Chief Accounting Officer on the same day. The options will vest
evenly each quarter over the following four years, starting from the third
quarter of 2007. The Company used the Black Sholes model to value the options
at
the time they were issued, based on the exercise price of $6.70, which was
the
close price of the Company’s stock on June 30, 2007 and expiration dates of the
instruments and using a risk-free rate of 4.84% and the volatility of 40%
that
was estimated by analyzing the trading history of the Company’s stock. At that
market price, the 20,000 employee options had a fair value of $57,178. Because
the options will vest each quarter over the following four years, the related
compensation expense is recognized on a straight-line basis over the total
vesting period. The expense recognized for the three months and six months
ended
June 30, 2008 was $3,574 and $7,148, respectively.
The
Company has stock options as follows:
|
|
|
|
Weighted
|
|
|
|
|
|
Options
|
|
Average
Exercise
|
|
Aggregate
|
|
|
|
Outstanding
|
|
Price
|
|
Intrinsic
Value
|
|
Outstanding,
December 31, 2006
|
|
|
750,000
|
|
$
|
1.25
|
|
|
2,250,000
|
|
Granted
|
|
|
29,500
|
|
$
|
5.99
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
|
|
|
|
|
Outstanding,
December 31, 2007
|
|
|
779,500
|
|
$
|
1.43
|
|
|
8,925,615
|
|
Granted
|
|
|
|
|
|
|
|
|
|
|
Forfeited
|
|
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
|
|
|
|
|
|
|
|
Outstanding,
June 30, 2008
|
|
|
779,500
|
|
$
|
1.43
|
|
|
5,160,290
|
|
CHINA
FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES
NOTES
TO
CONSOLIDATED FINANCIAL STATEMENTS
June
30,
2008
(Unaudited)
Following
is a summary of the status of options outstanding at June 30, 2008:
Outstanding
Options
|
|
Exercisable
Options
|
|
Number
of Options
|
|
Exercise
Price
|
|
Average
Remaining Contractual Life
|
|
Number
of Options
|
|
Exercise
Price
|
|
Average
Remaining Contractual Life
|
|
750,000
|
|
|
1.25
|
|
|
3.00
|
|
|
703,125
|
|
|
1.25
|
|
|
3.00
|
|
9,500
|
|
|
4.51
|
|
|
3.83
|
|
|
9,500
|
|
|
4.51
|
|
|
3.83
|
|
20,000
|
|
|
6.70
|
|
|
4.00
|
|
|
5,000
|
|
|
6.70
|
|
|
4.00
|
|
Note
15 - Restructuring
of subsidiaries
On
April
2, 2007, the Company evaluated the operations of its subsidiary, Beijing
Zhong
Xiao Fire Safety Technology Co., Ltd. (“Beijing Zhong Xiao”) and noted
efficiencies could be obtained by consolidating the operations of Beijing
Zhong
Xiao into Sureland Equipment.
Beijing
Zhong Xiao was a subsidiary of Sureland Industrial established in the PRC
as a
limited liability company on March 18, 2003. On April 3, 2007, Sureland
Industrial signed an agreement to transfer 100% ownership in Beijing Zhong
Xiao
to Gong Gang Qiang, a Chinese individual, for consideration price equal to
the
net assets of Beijing Zhong Xiao as of March 31, 2007.
After
the
restructuring of Beijing Zhong Xiao, the Company still has a significant
continuing involvement in the historical operations of the manufacturing
of fire
safety and protection products through Sureland Equipment, which results
in the
Company failing the test in paragraph 42 of FAS 144 “Accounting for the
Impairment or Disposal of Long-Lived Assets”. The failure of this test therefore
does not require the classification of the disposal of Beijing Zhong Xiao
as
a
discontinued operation.
The
following discussion and analysis provides information which the management
of
China Fire & Security Group, Inc., (the "Company" or "CFSG") believes to be
relevant to an assessment and understanding of the Company's results of
operations and financial condition. This discussion should be read together
with
the Company's financial statements and the notes to financial statements,
which
are included in this report.
Overview
We
are
engaged in the design, development, manufacturing and sale of fire protection
products and services for large industrial consumers in China. We have developed
a proprietary product line that addresses all aspects of industrial fire
safety
from fire detection to fire system control and extinguishing. The Company
is the
first in China to leverage high technology for fire protection and safety
to
clients such as iron and steel companies, power plants, petrochemical plants,
as
well as, special purpose construction in China.
Reorganization
We
were
organized as a Florida corporation on June 17, 2003.
On
September 1, 2006, we entered into a share exchange agreement, pursuant to
which
we acquired all of the outstanding capital shares of China Fire Protection
Group
Inc. in exchange for a controlling interest in our common shares. The
transaction was completed on Oct 27, 2006.
China
Fire Protection Group was organized on June 2, 2006 for the purpose of acquiring
all of the capital shares of Sureland Industrial Fire Safety Limited (Sureland
Industrial), a Chinese corporation, and, Sureland Industrial Fire Equipment
Co.,
Ltd. (Sureland Equipment), a Chinese corporation, which collectively engage
in
the design, development, manufacturing and sale of fire protection products
and
services for large industrial consumers in China. As a result of the
transactions described above, both Sureland Industrial Fire Safety Limited
and
Sureland Industrial Fire Equipment Co., Ltd became wholly-owned subsidiaries
of
China Fire Protection Group Limited, and China Fire Protection Group Limited
is
a wholly-owned subsidiary of Unipro.
On
February 9, 2007, Unipro changed its name to China Fire & Security Group,
Inc. (CFSG) and started trading on OTC Bulletin Board under its new ticker
symbol CFSG. On July 16, 2007, China Fire & Security Group, Inc. began
trading on Nasdaq Capital Market and retained the ticker symbol
CFSG.
CFSG
owns, through its wholly owned subsidiary China Fire Protection Group, Inc.,
Sureland Industrial and Sureland Equipment (jointly “Sureland”). Sureland is
engaged primarily in the design, development, manufacture and sale in China
of a
variety of fire safety products for the industrial fire safety market and
of
design and installation of industrial fire safety systems in which it uses
its
own fire safety products. To a minor extent, it provides maintenance services
for customers of its industrial fire safety systems. Its business is primarily
in China, but it has recently begun contract manufacturing products for the
export market and it has begun to provide a fire safety system for a Chinese
company operating abroad.
Sureland
markets its industrial fire safety products and systems primarily to major
companies in the iron and steel, power and petrochemical industries in China.
It
has also completed projects for highway and railway tunnels, wine distilleries,
tobacco warehouses and a nuclear reactor. It is developing its business in
the
transportation, wine and tobacco, vessels, nuclear energy, and public space
markets. Its products can be readily adapted for use on vessels and in
exhibition halls and theatres. It plans to expand its marketing efforts to
secure business in these industries.
By
December 31, 2007, Sureland operates more than 30 sales and liaison offices
in
China.
Sureland
has been ranked as the leading Chinese industrial fire safety company two
times
by the China Association for Fire Prevention based on six major factors
including total revenue, growth rate, net profit, return on assets, investment
in research and development and intellectual property. Its key products include
linear heat detectors and water mist extinguishers, whose sales volumes are
the
largest in China. Its products have been used by its customers in more than
20
provinces throughout China.
Critical
Accounting Policies and Estimates
While
our
significant accounting policies are more fully described in Note 2 to our
consolidated financial statements appearing at the end of this quarterly
report,
we believe that the following accounting policies are the most critical to
aid
you in fully understanding and evaluating our reported financial
results.
Revenue
recognition
Revenue
is recognized when it is probable that the economic benefits will flow to
the
Company as follows:
1.
|
Revenue
from system contracting projects are recognized using the
percentage-of-completion method of accounting and, therefore, take
into
account the costs, estimated earnings and revenue to date on contracts
not
yet completed. Revenue recognized is that percentage of the total
contract
price that cost expended to date bears to anticipated final total
cost,
based on current estimates of costs to complete. Contract costs
include
all direct material and labor costs and those indirect costs related
to
contract performance, such as indirect labor, supplies, tools,
repairs,
and depreciation costs. Selling, general, and administrative costs
are
charged to expense as incurred. At the time a loss on a contract
becomes
known, the entire amount of the estimated ultimate loss is recognized
in
the consolidated financial statements. Claims for additional contract
costs are recognized upon a signed change order from the customer
or in
accordance with paragraphs 62 and 65 of AICPA Statement of Position
81-1,
"Accounting for Performance of Construction - Type and Certain
Production
- Type Contracts" ("SOP 81-1")
|
2.
|
Revenue
from product sales is recognized when the goods are delivered and
title
has passed. Product sales revenue represents the invoiced value
of goods,
net of a value-added tax (VAT). All of the Company’s products that are
sold in the PRC are subject to a Chinese value-added tax at a rate
of 17
percent of the gross sales price. This VAT may be offset by VAT
paid by
the Company on raw materials and other materials included in the
cost of
producing their finished product.
|
3.
|
Revenue
from the rendering of Maintenance Services is recognized when such
services are provided.
|
4.
|
Dividend
income is recognized when the shareholders’ right to receive payment has
been established.
|
5.
|
Provision
is made for foreseeable losses as soon as they are anticipated
by
management.
|
6.
|
Where
contract costs incurred to date plus recognized profits less recognized
losses exceed progress billings, the surplus is treated as an amount
due
from contract consumers. Where progress billings exceed contract
costs
incurred to date plus recognized profits less recognized losses,
the
surplus is treated as an amount due to contract
customers.
|
Foreign
currency translation
The
reporting currency of the Company is the US dollar. The Company uses their
local
currency, Renminbi (RMB), as their functional currency. Results of operations
and cash flow are translated at average exchange rates during the period,
and
assets and liabilities are translated at the unified exchange rate as quoted
by
the People’s Bank of China at the end of the period. Translation adjustments
resulting from this process are included in accumulated other comprehensive
income in the statement of shareholders’ equity. Transaction gains and losses
that arise from exchange rate fluctuations on transactions denominated in
a
currency other than the functional currency are included in the results of
operations as incurred. Historically, the Company has not entered any currency
trading or hedging, although there is no assurance that the Company will
not
enter into such activities in the future.
Plant
and
equipment are stated at cost less accumulated depreciation. Depreciation
is
computed using the straight-line method over the estimated useful lives of
the
assets with 5 percent residual value.
Use
of
estimates
The
preparation of financial statements in conformity with generally accepted
accounting principles of the United States of America requires management
to
make estimates and assumptions that affect the amounts reported in the combined
financial statements and accompanying notes. Management believes that the
estimates utilized in preparing its financial statements are reasonable and
prudent. Actual results could differ from these estimates.
Certain
of the Company’s accounting policies require higher degrees of judgment than
others in their application. These include the recognition of revenue and
earnings from system contracting projects under the percentage of completion
method and the allowance of doubtful accounts. Management evaluates all of
its
estimates and judgments on an on-going basis.
Inventories
Inventories
are stated at the lower of cost or market, using the weighted average method.
Inventories consist of raw materials, work in progress, finished goods and
consumables. Raw materials consist primarily of materials used in production.
Finished goods consist primarily of equipment used in project contracts.
The
cost of finished goods included direct costs of raw materials as well as
direct
labor used in production. Indirect production costs such as utilities and
indirect labor related to production such as assembling, shipping and handling
costs are also included in the cost of inventory. The Company reviews its
inventory annually for possible obsolete goods or to determine if any reserves
are necessary for potential obsolescence.
Accounts
receivable
Accounts
receivable represents the product sales, maintenance services and system
contracting projects with its customers that were on credit. The credit term
is
generally for a period of three months for major customers. Each customer
has a
maximum credit limit. The Company seeks to maintain strict control over its
outstanding receivables. Overdue balances are reviewed regularly by senior
management.
Results
of Operations
The
following is a schedule showing results of our business.
Three
Months Financial Results
Comparison
of the three months ended on June 30, 2008 and 2007:
|
|
Three
months ended
June
30,
|
|
|
|
2008
|
|
2007
|
|
Revenues
|
|
$
|
16,653,724
|
|
$
|
11,547,185
|
|
Cost
of revenues
|
|
|
6,469,431
|
|
|
5,237,672
|
|
Gross
profits
|
|
|
10,184,293
|
|
|
6,309,513
|
|
Operating
expenses
|
|
|
3,585,029
|
|
|
2,785,091
|
|
Income
from operations
|
|
|
6,599,264
|
|
|
3,524,422
|
|
Total
other income(expense)
|
|
|
88,289
|
|
|
718,099
|
|
Change
in fair value of derivative instruments
|
|
|
-
|
|
|
371,628
|
|
Income
before income taxes and minority interest
|
|
|
6,687,553
|
|
|
4,242,521
|
|
Income
taxes
|
|
|
11,453
|
|
|
-
|
|
Minority
interest
|
|
|
-
|
|
|
-
|
|
Net
profit (loss)
|
|
|
6,676,100
|
|
|
4,242,521
|
|
Foreign
exchange adjustment
|
|
|
1,293,683
|
|
|
514,775
|
|
Comprehensive
income
|
|
|
7,969,783
|
|
|
4,757,296
|
|
weighted
average number of shares-basic
|
|
|
27,557,297
|
|
|
26,461,678
|
|
weighted
average number of shares-diluted
|
|
|
28,200,785
|
|
|
27,164,207
|
|
earning
per share-basic
|
|
|
0.24
|
|
|
0.16
|
|
earning
per share-diluted
|
|
|
0.24
|
|
|
0.16
|
|
Total
revenues were approximately $16.7 million for the three months ended June
30,
2008 as compared to approximately $11.5 million for the three months ended
June
30, 2007, an increase of approximately $5.1 million or 44.2 percent. This
increase was primarily due to increases in our revenues from system contracting
projects and maintenance services during the period. The Company recognized
revenues from 177 total solution, product sales and maintenance contracts
for
the three months ended June 30, 2008 as compared to 109 contracts for the
three
months ended June 30, 2007.
The
revenues from total solution contracts increased by 47.2 percent to $14.6
million with 104 contracts executed for the three months ended June 30, 2008,
compared to $9.9 million with 71 contracts executed for the same period of
last
year. The revenues from product sales were $1.5 million with 39 contracts
executed for the three months ended June 30, 2008, compared to $1.5 million
with
29 contracts executed for the same period of last year. The revenues from
maintenance service increased by 364.1 percent to $0.6 million with 34 contracts
executed for the three months ended June 30, 2008, compared to $0.1 million
with
9 contracts executed for the same period of last year. In particular, the
three
largest customers were Capital Iron and Steel Group, Anshan Iron and Steel
Group
and Baotou Iron and Steel Group, which collectively contributed approximately
$9.3 million of the revenues, representing 55.3 percent of our total revenues
for this period.
Gross
profit for the three months ended June 30, 2008 was approximately $10.2 million
compared to $6.3 million for the three months ended June 30, 2007, an increase
of approximately $3.9 million. Gross margin during this period was 61.2 percent,
which is higher than the gross margin of 54.6 percent for the same period
of
2007. The increase in the gross margin was mainly attributable to the execution
of total solution contracts contributing higher gross margins and a higher
percentage of revenue contribution from the sales of the Company’s
self-manufactured proprietary products which enjoy higher gross margins.
Operating
expenses were approximately $3.6 million for the three months ended June
30,
2008 compared to approximately $2.8 million for the three months ended June
30,
2007. This represents an increase of approximately $0.8 million or 28.7 percent.
Compared to the same period of last year, the Company increased the number
of
employees and the expenditure in sales incentive compensation and raised
the
compensation for management to be in line with other US public companies.
The
increase in operating expenses is also attributable to increased R&D
expenses in new product development and improvement in our existing product
offerings.
Operating
income was approximately $6.6 million for the three months ended June 30,
2008
as compared to approximately $3.5 million for the three months ended June
30,
2007, representing an increase of 87.2 percent. The improvement in operating
income was mainly attributable to the increased revenues and improved gross
margin during the period.
Total
other income was $88,289 for the three months ended June 30, 2008, compared
to
$718,099 for the three months ended June 30, 2007, which included a one-time
non-cash gain of $371,628 due to the change in fair value of derivative
instruments in 2007.
Provision
for income tax was $11,453 for the three months ended June 30, 2008, compared
to
no provisions for income tax for the three months ended June 30, 2007.
Net
income was approximately $6.7 million for the three months ended June 30,
2008
as compared to approximately $4.2 million net income for the three months
ended
June 30, 2007, representing an increase of $2.4 million or 57.4 percent.
Excluding
a one-time non-cash gain of $371,628 for the change in fair value of
derivative instrument in the three months ended June 30, 2007, the non-GAAP
net
income for the three months ended June 30, 2007 was $3.9 million. Our GAAP
net
income for the three months ended June 30, 2008 increased 72.5 percent in
comparison to the non-GAAP net income for the three months ended June 30,
2007.
The reason for the increase in our net income was mainly due to the increase
in
the Company’s revenues and the improvement in gross margin.
Currency
translation adjustments resulting from
RMB
appreciation
process
amounted to $1.3 million and $0.5 million for the three months ended June
30,
2008 and 2007, respectively.
The
comprehensive income, which adds the currency adjustment to the net income,
was
approximately $8.0 million for the three months ended June 30, 2008 as compared
to approximately $4.8 million comprehensive income for the three months ended
June 30, 2007, representing an increase of $3.2 million or 67.5
percent.
Six
Months Financial Results
Comparison
of the six months ended on June 30, 2008 and 2007:
|
|
Six
months ended
June
30,
|
|
|
|
2008
|
|
2007
|
|
Revenues
|
|
$
|
31,350,350
|
|
$
|
21,046,647
|
|
Cost
of revenues
|
|
|
13,121,662
|
|
|
9,721,227
|
|
Gross
profits
|
|
|
18,228,688
|
|
|
11,325,420
|
|
Operating
expenses
|
|
|
6,979,712
|
|
|
4,524,322
|
|
Income
from operations
|
|
|
11,248,976
|
|
|
6,801,098
|
|
Total
other income(expense)
|
|
|
227,999
|
|
|
1,571,542
|
|
Change
in fair value of derivative instruments
|
|
|
-
|
|
|
1,205,791
|
|
Income
before income taxes and minority interest
|
|
|
11,476,975
|
|
|
8,372,640
|
|
Income
taxes
|
|
|
60,095
|
|
|
-
|
|
Minority
interest
|
|
|
-
|
|
|
-
|
|
Net
profit (loss)
|
|
|
11,416,880
|
|
|
8,372,640
|
|
Foreign
exchange adjustment
|
|
|
3,360,599
|
|
|
810,334
|
|
Comprehensive
income
|
|
|
14,777,479
|
|
|
9,182,974
|
|
weighted
average number of shares-basic
|
|
|
27,559,095
|
|
|
26,461,678
|
|
weighted
average number of shares-diluted
|
|
|
28,179,595
|
|
|
27,085,807
|
|
earning
per share-basic
|
|
|
0.41
|
|
|
0.32
|
|
earning
per share-diluted
|
|
|
0.41
|
|
|
0.31
|
|
Total
revenues were approximately $31.4 million for the six months ended June 30,
2008
as compared to approximately $21.0 million for the six months ended June
30,
2007, an increase of approximately $10.3 million or 49.0 percent. This increase
was primarily due to increases in our revenues from system contracting projects
and maintenance services during the period. The Company recognized revenues
from
233 total solution, product sales and maintenance contracts for the six months
ended June 30, 2008 as compared to 144 contracts for the six months ended
June
30, 2007.
The
revenues from total solution contracts increased by 50.8 percent to $25.9
million with 138 contracts executed for the six months ended June 30, 2008,
compared to $17.2 million with 81 contracts executed for the same period
of last
year. The revenues from product sales were $4.4 million with 59 contracts
executed for the six months ended June 30, 2008, compared to $3.6 million
with
49 contracts executed for the same period of last year. The revenues from
maintenance service increased by 332.6 percent to $1.0 million with 36 contracts
executed for the six months ended June 30, 2008, compared to $0.2 million
with
14 contracts executed for the same period of last year. In particular, the
three
largest customers were Capital Iron and Steel Group, Anshan Iron and Steel
Group
and Datang Tashan Power Plant, which collectively contributed approximately
$11.8 million of the revenues, representing 37.7 percent of our total revenues
for this period.
Gross
profit for the six months ended June 30, 2008 was approximately $18.2 million,
as compared to $11.3 million for the six months ended June 30, 2007, an increase
of approximately $6.9 million. Gross margin during this period was 58.1 percent,
which is higher than the gross margin of 53.8 percent for the same period
of
2007. The increase in the gross margin was mainly attributable to the execution
of total solution contracts which contributed higher gross margins and a
higher
percentage of revenue contribution from the sales of the Company’s
self-manufactured proprietary products which enjoy higher margins.
Operating
expenses were approximately $7.0 million for the six months ended June 30,
2008,
as compared to approximately $4.5 million for the six months ended June 30,
2007. This represents an increase of approximately $2.5 million or 54.3 percent.
Compared to the same period of last year, the Company increased the number
of
employees, its expenditures in sales incentive compensation and raised the
compensation for management to be in line with other US public companies.
The
increase in operating expenses is also attributable to increased R&D
expenses in new product development and improvement in our existing product
offerings.
Operating
income was approximately $11.2 million for the six months ended June 30,
2008 as
compared to approximately $6.8 million for the six months ended June 30,
2007,
representing an increase of 65.4 percent. The improvement in operating income
was mainly attributable to the increased revenues and improved gross margin
during the period.
Total
other income was $227,999 for the six months ended June 30, 2008, compared
to
$1,571,542 for the six months ended June 30, 2007, which included a one-time
non-cash gain of $1,205,791 million due to the change in fair value of
derivative instruments.
Provision
for income tax was $60,095 for the six months ended June 30, 2008, compared
to
no provisions for income tax for the six months ended June 30, 2007.
Net
income was approximately $11.4 million for the six months ended June 30,
2008 as
compared to approximately $8.4 million net income for the six months ended
June
30, 2007, representing an increase of $3.0 million or 36.4 percent. Excluding
a
one-time non-cash gain of $1.2 million for the change in fair value of
derivative in the six months ended June 30, 2007, the non-GAAP net income
for
the six months ended June 30 of 2007 was $7.2 million. Our GAAP net income
for
the six months ended June 30, 2008 increased 59.3 percent in comparison to
the
non-GAAP net income for the six months ended June 30, 2007. The reason for
the
increase in the net income was mainly due to the increase in the Company’s
revenues and improvement in gross margin.
Currency
translation adjustments resulting from RMB appreciation process amounted
to $3.4
million and $0.8 million for the six months ended June 30, 2008 and 2007,
respectively.
The
comprehensive income, which adds the currency adjustment to the net income,
was
approximately $14.8 million for the six months ended June 30, 2008 as compared
to approximately $9.2 million comprehensive income for the six months ended
June
30, 2007, representing an increase of $5.6 million or 60.9 percent.
Liquidity
and Capital Resources
As
of
June 30, 2008, we had working capital of $54.1 million including cash and
cash
equivalents of $20.5 million. The following table sets forth a summary of
our
cash flows for the periods indicated:
Statement
of Cash Flow
|
|
Six
Months Ended
June
30,
|
|
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
Net
cash provided by (used in) operating activities
|
|
$
|
3,457,448
|
|
$
|
(62,359
|
)
|
Net
cash (used in) investing activities
|
|
|
(663,537
|
)
|
|
(783,313
|
)
|
Net
cash provided by financing activities
|
|
|
(474,018
|
)
|
|
(325,736
|
)
|
Effect
of foreign currency translation on cash and cash
equivalents
|
|
|
1,088,574
|
|
|
232,635
|
|
Net
cash flow
|
|
$
|
3,408,467
|
|
$
|
(938,773
|
)
|
Operating
Activities
Net
cash
provided by operating activities was approximately $3.5 million for the six
months ended June 30, 2008 as compared to $62,359 net cash used in operating
activities for the same period in 2007. Net cash provided by operating
activities in the six months ended June 30, 2008 was mainly due to the results
of net income of $11.4 millions during the period, a $7.8 million increase
in
customer deposits and a $1.8 million increase in accrued liabilities, offset
by
a $1.5 million increase in account receivable, a $2.6 million increase in
notes
receivable, a $1.2 million increase in inventories, a $10.8 million increase
in
costs and estimated earnings in excess of billings and a $2.3 million decrease
in billings in excess of costs and estimated earnings.
The
increase of $10.8 million in costs and estimated earnings in excess of billings
was mainly due to the increased number of projects where we have recognized
revenues more than we have billed the customers for these projects, while
the
decrease of $2.3 million in billings in excess of costs and estimated earnings
was mainly due to the decreased number of projects where we have billed our
customers less than we have recognized revenues for these projects.
Investing
Activities
Net
cash
used in investing activities in the six months ended June 30, 2008 was $663,537
as compared to net cash used in investing activities of $783,313 in the same
period of 2007. The cash used in investing activities in the six months ended
June 30, 2008 was mainly attributable to capital expenditure in the purchase
of
new equipments and the improvement of office and manufacturing facilities.
Financing
Activities
Net
cash
used by financing activities in the six months ended June 30, 2008 totaled
$474,018 as compared to $325,736 used in financing activities in the same
period
of 2007. The cash used by financing activities in the six months ended June
30,
2008 was mainly attributable to the increase in restricted cash during the
period.
As
a
result of the total cash activities, net cash increased $3.4 million from
December 31, 2007 to June 30, 2008. We believe that our currently
available working capital of $54.1 million including cash and cash equivalents
of $20.5 million should be adequate to sustain our operations at our current
level and our anticipated expansion.
Off-Balance
Sheet Arrangements
We
do not
have any off-balance sheet financing arrangements.
Item
3. Quantitative and Qualitative Disclosures about Market
Risk
Not
required.
Item
4. Controls and Procedures.
a)
Evaluation
of Disclosure Controls.
Brian
Lin, our Chief Executive Officer and Robert Yuan, our Principal Accounting
Officer evaluated the effectiveness of our disclosure controls and procedures
as
of the end of our second fiscal quarter 2008 pursuant to Rule 13a-15(b) of
the
Securities and Exchange Act. Disclosure controls and procedures are controls
and
other procedures that are designed to ensure that information required to
be
disclosed by us in the reports that we file or submit under the Exchange
Act is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms. Disclosure controls and procedures include,
without limitation, controls and procedures designed to ensure that information
required to be disclosed by us in the reports that we file under the Exchange
Act is accumulated and communicated to our management, as appropriate to
allow
timely decisions regarding required disclosure. Based on their evaluations,
Mr.
Lin and Mr. Yuan concluded that our disclosure controls and procedures were
effective as of June 30, 2008.
It
should
be noted that any system of controls, however well designed and operated,
can
provide only reasonable, and not absolute, assurance that the objectives
of the
system are met. In addition, the design of any control system is based in
part
upon certain assumptions about the likelihood of future events. Because of
these
and other inherent limitations of control systems, there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions.
(b)
Changes
in internal control over financial reporting.
Other
than training our staff in US GAAP accounting skills and implementing stronger
internal audit function during the last quarter, there have been no changes
in
our internal control over financial reporting that occurred during the last
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. Our management
team will continue to evaluate our internal control over financial reporting
in
2008 as we implement our Sarbanes Oxley Act testing.