Filed Pursuant to Rule 424(b)(3)
Registration No. 333-163803
PROSPECTUS SUPPLEMENT NO. 3
(To Prospectus dated May 14, 2012)

VLOV INC.

586,726 shares of Common Stock

This Prospectus Supplement No. 3 of VLOV Inc. (the “ Company ”), together with the Prospectus dated May 14, 2012 (the “Prospectus”), Prospectus Supplement No. 1 dated May 16, 2012 (“Prospectus Supplement No. 1”), and Prospectus Supplement No. 2 dated August 14, 2012 (“Prospectus Supplement No. 2”), is required to be delivered by certain holders of the above-referenced shares or by their transferees, pledgees, donees, or their successors in connection with the offer and sale of the above-referenced shares.

This Prospectus Supplement No. 3, as supplemented by Prospectus Supplement No. 1 and Prospectus Supplement No. 2, supplements the information in the Prospectus with the following additions and changes:

 
(1)
Update, amend and supplement the Prospectus with information in the attached Quarterly Report on Form 10-Q of the Company for the quarterly period ended September 30, 2012, as filed with the Securities and Exchange Commission on November 7, 2012.

The attached information modifies and supersedes, in part, the information in the Prospectus, as previously supplemented. Any information that is modified or superseded in the Prospectus shall not be deemed to constitute a part of the Prospectus except as modified or superseded by this Prospectus Supplement No. 3. This Prospectus Supplement No. 3 should be read in conjunction with the Prospectus, as previously supplemented, and may not be delivered or utilized without, the Prospectus.

INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. SEE “RISK FACTORS” BEGINNING ON PAGE 8 OF THE PROSPECTUS, AND ANY OF OUR OTHER FILINGS INCORPORATED THEREIN BY REFERENCE.

NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF THIS PROSPECTUS SUPPLEMENT IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.

The date of this Prospectus Supplement is November 8, 2012

 
 
 

 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the quarterly period ended
September 30, 2012
 
or

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from 
____________________________________ to ________________________________________
 
     
Commission File Number:
000-53155
 
 
VLOV INC .
(Exact name of registrant as specified in its charter)

Nevada
 
20-8658254
(State or other jurisdiction of incorporation or
organization)
 
(I.R.S.  Employer Identification Number)
     
5F, No. 151 Taidong Road
Xiamen Guanyin Shan International Business Center
Siming District, Xiamen City, Fujian Province
People’s Republic of China
 
 
 
 
361008
 (Address of principal executive offices)
 
(Zip Code)

+86-592-2345999
(Registrant’s telephone number, including area code)
 
11F, No. 157 Taidong Road
Xiamen Guanyin Shan International Business Center
Siming District, Xiamen City, Fujian Province
People’s Republic of China
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.        Yes  þ    No  o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every, Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Sec.232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).          Yes  þ  No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
 
 
Large Accelerated Filer  o
Accelerated Filer                    o
 
Non-accelerated filer     o
Smaller reporting company   þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).         Yes  o    No  þ
 
As of November 1, 2012, the registrant had 2,603,481 shares of common stock, par value $0.00001 per share, outstanding.
 
 
 

 
 
TABLE OF CONTENTS
 
TO QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2012

     
Page
PART I
FINANCIAL INFORMATION
   
Item 1.
Financial statements (unaudited)
  2
 
Condensed consolidated balance sheets as of September 30, 2012 (unaudited) and December 31, 2011
  2
 
Condensed consolidated statements of income and comprehensive income for the three and nine months ended September 30, 2012 and 2011 (unaudited)
  3
 
Condensed consolidated statements of stockholders’ equity for the nine months ended September 30, 2012 (unaudited)
  4
 
Condensed consolidated statements of cash flows for the nine months ended September 30, 2012 and 2011 (unaudited)
  5
 
Notes to the unaudited condensed consolidated financial statements
  6
Item 2.
Management's discussion and analysis of financial condition and results of operations
  24
Item 3.
Quantitative and qualitative disclosures about market risk
  31
Item 4.
Controls and Procedures
  31
PART II
OTHER INFORMATION
   
Item 1.
Legal proceedings
  32
Item 1A.       
Risk factors
  32
Item 2.
Unregistered sales of equity securities and use of proceeds
  32
Item 3.
Defaults upon senior securities
  32
Item 4.
Reserved
  32
Item 5.
Other information
  32
Item 6.
Exhibits
  32
Signatures
    33
 
 
 

 
 
CAUTION REGARDING FORWARD-LOOKING INFORMATION

All statements contained in this quarterly report on Form 10-Q (“Form 10-Q”), other than statements of historical facts, that address future activities, events or developments are forward-looking statements, including, but not limited to, statements containing the words “believe,” “anticipate,” “expect” and words of similar import.  These statements are based on certain assumptions and analyses made by us in light of our experience and our assessment of historical trends, current conditions and expected future developments as well as other factors we believe are appropriate under the circumstances.  However, whether actual results will conform to the expectations and predictions of management is subject to a number of risks and uncertainties that may cause actual results to differ materially.

Such risks include, among others, the following: national and local general economic and market conditions; our ability to sustain, manage or forecast our growth; raw material costs and availability; new product development and introduction; existing government regulations and changes in, or the failure to comply with, government regulations; adverse publicity; competition; the loss of significant customers or suppliers; fluctuations and difficulty in forecasting operating results; changes in business strategy or development plans; business disruptions; the ability to attract and retain qualified personnel; the ability to protect technology; and other factors referenced in this and previous filings.

Consequently, all of the forward-looking statements made in this Form 10-Q are qualified by these cautionary statements and there can be no assurance that the actual results anticipated by management will be realized or, even if substantially realized, that they will have the expected consequences to or effects on our business operations.
 
OTHER PERTINENT INFORMATION
 
All share and per share information in this Form 10-Q give effect to the 1-for-2.5 reverse split of our common stock  effected on December 12, 2011, and the 1-for-3 reverse split of our common stock effected on September 24, 2012.
 
 
1

 
 
PART I - FINANCIAL INFORMATION
 
ITEM 1.
FINANCIAL STATEMENTS
VLOV INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)

   
September 30,
2012
   
December 31,
2011
 
   
(unaudited)
       
ASSETS
Current assets:
           
Cash and cash equivalents
 
$
20,608
   
$
14,725
 
Accounts and other receivables
   
36,366
     
36,233
 
Trade deposits
   
-
     
3,482
 
Inventories
   
9,624
     
1,880
 
Prepaid expenses
   
60
     
85
 
Total current assets
   
66,658
     
56,405
 
Property, plant and equipment, net
   
1,400
     
2,197
 
Goodwill
   
5,247
     
5,219
 
TOTAL ASSETS
 
$
73,305
   
$
63,821
 
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
Current liabilities:
               
Accounts payable
 
$
7,769
   
$
7,173
 
Accrued expenses and other payables
   
1,841
     
1,967
 
Amount due to a director/officers
   
699
     
1,216
 
Derivative liability - common stock warrants
   
10
     
673
 
Income and other taxes payable
   
2,047
     
3,002
 
Total current liabilities
   
12,366
     
14,031
 
                 
Stockholders’ equity:
               
Common stock, $0.00001 par value, 13,333,334 shares authorized, 2,599,321 and 2,528,914 shares issued and outstanding as of September 30, 2012 and December 31, 2011, respectively
   
1
     
1
 
Preferred stock, $0.00001 par value, 100,000,000 shares authorized, 423,578 and 632,853 shares issued and outstanding as of September 30, 2012 and December 31, 2011, respectively (liquidation preference $1,211,443 and $1,809,960)
   
602
     
900
 
Additional paid-in capital
   
10,479
     
9,718
 
Statutory reserve
   
913
     
913
 
Retained earnings
   
45,499
     
35,087
 
Accumulated other comprehensive income
   
3,445
     
3,171
 
Total stockholders' equity
   
60,939
     
49,790
 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
 
$
73,305
   
$
63,821
 

See accompanying notes to unaudited condensed consolidated financial statements
 
 
2

 
 
VLOV INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(Unaudited; amounts in thousands - except for share and per share data)

   
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Net sales
 
$
22,496
   
$
15,955
   
$
62,946
   
$
57,820
 
Cost of sales
   
12,370
     
9,445
     
33,568
     
32,690
 
Gross profit
   
10,126
     
6,510
     
29,378
     
25,130
 
                                 
Operating expenses:
                               
Selling expenses
   
4,382
     
3,153
     
10,272
     
9,375
 
General and administrative expenses
   
1,516
     
1,622
     
4,096
     
3,896
 
     
5,898
     
4,775
     
14,368
     
13,271
 
                                 
Income from operations
   
4,228
     
1,735
     
15,010
     
11,859
 
                                 
Other income (expenses):
                               
Change in fair value of derivative liability
   
96
     
258
     
663
     
837
 
Interest income
   
23
     
15
     
66
     
72
 
Interest expense
   
-
     
-
     
-
     
(8
)
     
119
     
273
     
729
     
901
 
                                 
Income before provision for income taxes
   
4,347
     
2,008
     
15,739
     
12,760
 
Provision for income taxes
   
1,295
     
400
     
5,327
     
2,950
 
                                 
Net income
   
3,052
     
1,608
     
10,412
     
9,810
 
                                 
Other comprehensive income:
                               
Foreign currency translation adjustment
   
(105
   
547
     
274
     
1,374
 
                                 
Comprehensive income
 
$
2,947
   
$
2,155
   
$
10,686
   
$
11,184
 
                                 
Allocation of net income for calculating basic earnings per share:
                               
Net income attributable to common shareholders
   
2,987
     
1,549
     
10,191
     
9,450
 
Net income attributable to preferred shareholders
   
65
     
59
     
221
     
360
 
Net income
 
$
3,052
   
$
1,608
   
$
10,412
   
$
9,810
 
                                 
Basic earnings per share- common
 
$
1.16
   
$
0.62
   
$
3.99
   
$
3.81
 
                                 
Diluted earnings per share
 
$
1.15
   
$
0.62
   
$
3.96
   
$
3.77
 
                                 
Weighted average number of common shares and participating preferred shares outstanding:
                               
                                 
Basic
   
2,583,841
     
2,485,057
     
2,552,524
     
2,478,231
 
                                 
Diluted
   
2,651,267
     
2,600,391
     
2,627,902
     
2,599,896
 

See accompanying notes to unaudited condensed consolidated financial statements
 
 
3

 
 
VLOV INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Amounts in thousands – except for share and per share data)
(Unaudited)
 
   
Common stock
   
Preferred stock
   
Additional
paid-in
   
Statutory
   
Accumulated
other
  comprehensive
   
Retained
   
Total
 
  
 
Shares
   
Amount
   
Shares
   
Amount
   
capital
   
reserve
   
income
   
earnings
   
equity
 
                             
                                                     
Balance at January 1, 2012
   
2,528,914
   
1
     
632,853
   
$
900
   
9,718
   
$
913
   
$
3,171
   
$
35,087
   
$
49,790
 
                                                                         
Net income
                                                           
10,412
     
10,412
 
Issuance of shares to officers/directors
   
8,482 
                             
164
                             
164
 
Issuance of shares to consultants
   
 34,000
                             
299
                             
299
 
Adjustment for 1-for-3 reverse split
   
21
                                                                 
Foreign currency translation adjustment
                                                   
274
             
274
 
Conversion of Preferred Stock to Common Stock
   
27,904
             
(209,275
)
   
(298
)
   
298
                             
-
 
                 
                                                                       
Balance at September 30, 2012
   
2,599,321
   
$
1
     
423,578
   
$
602
   
$
10,479
   
$
913
   
$
3,445
   
$
45,499
   
$
60,939
 

See accompanying notes to unaudited condensed consolidated financial statements
 
 
4

 
 
VLOV INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; amounts in thousands)

 
Nine months Ended
September 30,
 
 
2012
   
2011
 
             
Cash flows from operating activities:
           
Net income
 
$
10,412
   
$
9,810
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
   
852
     
336
 
Stock compensation expense
   
464
     
81
 
Loss on disposal of property, plant and equipment
   
510
     
15
 
Change in fair value of derivative liability
   
(663)
     
 (837)
 
(Increase) decrease in assets:
               
Accounts and other receivables
   
59
     
(2,203)
 
Trade deposits
   
3,505
     
(320)
 
Inventories
   
(7,744)
     
(3,358)
 
Prepaid expenses
   
26
     
110
 
Increase (decrease) in liabilities:
               
Accounts payable
   
559
     
(352)
 
Accrued expenses and other payables
   
(119)
     
824
 
Income and other taxes payable
   
(974)
     
(1,394)
 
                 
Net cash provided by operating activities
 
$
6,887
   
$
2,712
 
                 
Cash flows from investing activities:
               
Purchases of property, plant and equipment
   
(551)
     
(983)
 
Acquisition of a business
   
-
     
(6,684)
 
Proceeds from the sale of property, plant and equipment
   
-
     
1,188
 
Time deposits
   
-
     
3,020
 
Net cash used in investing activities
 
$
(551)
   
$
(3,459)
 
                 
Cash flows from financing activities:
               
Amount due to/from a director
   
(523)
     
1,026
 
Payment of short-term debt
   
-
     
(616)
 
Net cash provided by / (used in) financing activities
   
(523)
     
410
 
Effect of exchange rate changes
   
70
     
453
 
Net increase in cash and cash equivalents
   
5,883
     
116
 
Cash and cash equivalents, beginning of period
   
14,725
     
12,013
 
Cash and cash equivalents, end of period
 
$
20,608
   
$
12,129
 
                 
Supplemental disclosure of cash flow information:
               
Income taxes paid
 
$
5,151
   
$
4,345
 
 
See accompanying notes to unaudited condensed consolidated financial statements
 
 
5

 
 
VLOV INC.
NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2012

(1)           SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a)            Description of business and organization

VLOV Inc. (the “Company”) was incorporated on October 30, 2006 in the State of Nevada, under the name “Sino Charter, Inc.”  The Company changed its name to “VLOV Inc.” on March 20, 2009 in connection with the stock exchange transaction described below.

On February 13, 2009, the Company completed a stock exchange transaction with the stockholders of Peng Xiang Peng Fei Investments Limited (“PXPF”), whereby 1,941,334 restricted shares of common stock were issued to the stockholders of PXPF in exchange for 100% of the common stock of PXPF (the “Share Exchange”).  The completion of the Share Exchange resulted in a change of control.

The Share Exchange has been accounted for as a reverse acquisition and recapitalization of the Company whereby PXPF is deemed to be the accounting acquirer (legal acquiree) and the Company is the accounting acquiree (legal acquirer).  At the time of the Share Exchange, the Company had no assets or liabilities, and the 193,923 shares of its common stock outstanding immediately prior to the Share Exchange have been accounted for at their par value at the time of the Share Exchange.

The Company designs, markets and distributes “VLOV” brand men’s apparel and related products in the People’s Republic of China (“PRC” or “China”).  The Company also owns and operates retail stores in Fujian Province.  Through December 31, 2010, all of the Company’s business operations were conducted by a variable interest entity (“VIE”), Jinjiang Yinglin Jinduren Fashion Limited (“Yinglin Jinduren”), which is controlled by the Company’s wholly-owned subsidiary, Dong Rong Capital Investment Limited (“HK Dong Rong”), through a series of contractual arrangements.

In January 2011, however, the Company began transferring its business operations to Dong Rong (China) Co., Ltd.  (“China Dong Rong”), which is wholly-owned by HK Dong Rong, including all trademarks, sales contracts and design, marketing, sales and purchasing-related assets under Yinglin Jinduren.  As the Company’s manufacturing activities were discontinued and outsourced, such related assets, including manufacturing equipment, the building that housed such equipment and the land use right for the land on which the building sits, were sold to an unrelated third-party during the first quarter of 2011.  Such sales were completed, and all resulting proceeds were paid to Yinglin Jinduren during the first quarter of 2011, with the funds subsequently transferred to China Dong Rong.  All of the Company’s business operations are now carried out by China Dong Rong.

As a result of the foregoing, the accompanying consolidated financial statements reflect the activities of the Company and each of the following entities:
Name
 
Background
 
Ownership
PXPF
 
A British Virgin Islands limited liability company
   
100%
   
Incorporated on April 30, 2008
     
             
HK Dong Rong
 
A Hong Kong limited liability company
   
100%
   
Incorporated on January 5, 2005 originally under the name “Korea Jinduren International Dress Limited”
     
   
Acquired by PXPF from the majority shareholders of PXPF on September 22, 2008
     
             
China Dong Rong
 
A PRC limited liability company and deemed a wholly foreign owned enterprise (“WFOE”)
   
100% 
   
Incorporated on November 19, 2009
     
   
Registered capital of $8 million fully funded
     
             
Yinglin Jinduren
 
A PRC limited liability company
   
VIE by
   
Incorporated on January 19, 2002
   
contractual
   
Registered capital of RMB 10,000,000 ($1,237,000) fully paid by the majority shareholders of PXPF, Qingqing Wu and Zhifan Wu.
   
arrangements (1)
   
65.91% of equity interests held by Qingqing Wu, the Company’s Chief Executive Officer and Chairman of the Board of Directors, and 34.09% by his brother Zhifan Wu
     
  
 
(1)
On December 28, 2005, HK Dong Rong (then known as Korea Jinduren International Dress Limited) entered into certain exclusive agreements with Yinglin Jinduren and its equity owners.  Pursuant to these agreements, HK Dong Rong provides exclusive consulting services to Yinglin Jinduren in return for a consulting services fee which is equal to Yinglin Jinduren’s net profits.  Prior to the Share Exchange, however, certain dividends were declared and paid from Yinglin Jinduren’s net income to the equity owners of Yinglin Jinduren.  In addition, Yinglin Jinduren’s equity owners have pledged their equity interests in Yinglin Jinduren to HK Dong Rong, irrevocably granted HK Dong Rong an exclusive option to purchase all or part of the equity interests in Yinglin Jinduren and agreed to entrust all the rights to exercise their voting power to the person(s) appointed by HK Dong Rong.
 
 
6

 
 
   
Through these contractual arrangements, HK Dong Rong has the ability to control Yinglin Jinduren’s daily operations and financial affairs, appoint its senior executives and approve all matters requiring shareholder approval.  As part of these contractual arrangements, HK Dong Rong and Yinglin Jinduren entered into an operating agreement which, amongst other matters, precludes Yinglin Jinduren from borrowing money, selling or acquiring assets, including intellectual property rights, providing guarantees to third parties or assigning any business agreements, without the prior written consent of HK Dong Rong.  HK Dong Rong also agreed that, if any guarantee for Yinglin Jinduren’s performance of any contract or loan was required, HK Dong Rong would provide such guarantee to Yinglin Jinduren.
 
As a result of these contractual arrangements, HK Dong Rong is entitled to receive the expected residual returns of Yinglin Jinduren.  Additionally, although Yinglin Jinduren has been profitable, in the event that Yinglin Jinduren were to incur losses, HK Dong Rong would be obligated to absorb a majority of the risk of loss from Yinglin Jinduren’s activities as a result of its inability to receive payment for its accumulated consulting fees that are equal to Yinglin Jinduren’s net income.
 
The Company believes that the equity investors in Yinglin Jinduren do not have the characteristics of a controlling financial interest, and that the Company is the primary beneficiary of the operations and residual returns of Yinglin Jinduren and, in the event of losses, would be required to absorb a majority of such losses.  Accordingly, the Company consolidates Yinglin Jinduren’s results, assets and liabilities in the accompanying financial statements.  Due to the contractual arrangements, the net income and interest allocable to the non-controlling interest is zero.
 
The Company’s consolidated assets do not include any collateral for Yinglin Jinduren’s obligations.  The creditors of Yinglin Jinduren do not have recourse to the general credit of the Company.
 
Once Yinglin Jinduren's annual filing for 2011 is filed with, and receives no comment from, the State Administration for Industry and Commerce, the Company intends to exit from the contractual arrangements with, and to dissolve, Yinglin Jinduren.  Until then, however, the Company will operate its business through China Dong Rong (as it currently does) while continuing to control Yinglin Jinduren through the contractual arrangements.
 
(b)           Basis of presentation and consolidation

The accompanying unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America.

The condensed consolidated financial statements include the financial statements of the Company, its subsidiaries and the variable interest entity (VIE), Yinglin Jinduren.  Yinglin Jinduren is considered a VIE because the Company is deemed to be its primary beneficiary by virtue of the contractual arrangements between HK Dong Rong and Yinglin Jinduren.  Because the Company and Yinglin Jinduren are under common control, the initial measurement of the assets and liabilities of Yinglin Jinduren for the purpose of consolidation by the Company is at book value.  All significant inter-company transactions and balances between the Company, its subsidiaries and the VIE are eliminated upon consolidation.  As of September 30, 2012, Yinglin Jinduren has no operations.
 
In the opinion of management, the accompanying unaudited consolidated financial statements of the Company contain all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the consolidated balance sheets as of September 30, 2012 and December 31, 2011, the consolidated statements of operations and comprehensive income for the three and nine months ended September 30, 2012 and 2011, and the consolidated statements of cash flows for the nine months ended September 30, 2012 and 2011.  The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to Rule 10-01 of Regulation S-X of the Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results of operations to be expected for the full fiscal year.  These financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2011.
 
(c)           Use of estimates

The preparation of consolidated financial statements in conformity with GAAP requires the Company’s management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements.  The reported amounts of revenues and expenses during the reporting period may be affected by the estimates and assumptions that the management is required to make.  Estimates that are critical to the accompanying consolidated financial statements relate primarily to returns, sales allowances and customer chargebacks, the identification and valuation of derivative instruments, and the recoverability of the carrying amounts of property, plant and equipment and goodwill. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the period that they are determined to be necessary.  Actual results could differ from these estimates.
 
 
7

 

(d)           Revenue recognition

Sales of goods - distributors

All of the Company’s products sold to its distributor customers are manufactured on its behalf by third parties, based on orders for the Company’s products received from such customers.  The Company is responsible for product design, product specification, pricing to such customers, the choice of third-party manufacturer, product quality and credit risk associated with such customers’ receivable.  As such, the Company acts as a principal and records revenue from its distributors on a gross basis.

The Company recognizes revenue when (a) the price to the customer is fixed or determinable, (b) persuasive evidence of an arrangement exists, (c) delivery has occurred and (d) collectability of the resulting receivable is reasonably assured.   Revenue from the sales of goods is recognized on the transfer of significant risks and rewards of ownership, which generally coincides with the time when the goods are delivered and the title has passed to the customer.  Revenue excludes value-added tax (“VAT”) and is stated after deduction of trade discounts and allowances.

Sales of goods - retail

In July 2011, the Company began operating retail stores selling its products.  Revenue from retail sales is recognized at each point of sale.  During the three and nine months ended September 30, 2012, such sales accounted for 4.6% and 4.8% of the Company’s total revenue, respectively. During the three and nine months ended September 30, 2011, such sales accounted for 8.1% and 2.2% of the Company’s total revenue, respectively.

The Company’s retail revenue is net of VAT collected on behalf of PRC tax authorities in respect of the sale of merchandise.  VAT collected from customers, net of VAT paid for purchases, is recorded as a liability in the accompanying consolidated balance sheets until it is paid to the relevant PRC tax authorities.

Retail sales returns within seven days of purchase are accepted only for quality reasons.  The Company has not yet had the experience to estimate and provide for such returns at the time of sale, and returns have been minimal to date.

(e)            Cash and cash equivalents

For purposes of the statement of cash flows, the Company considers all highly liquid instruments with original maturities of three months or less to be cash equivalents.  Cash and cash equivalents comprise cash at bank and on hand and demand deposits with banks.

(f)            Accounts receivable
 
Accounts receivable, including associated VATs, are unsecured, and are stated at the amount the Company expects to collect.  The Company may maintain allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments.  The Company evaluates the collectability of its accounts receivable based on a combination of factors, including customer credit-worthiness and historical collection experience.  Management reviews the receivable aging and adjusts the allowance based on historical experience, financial condition of the customer and other relevant current economic factors.   Interest is not normally charged on accounts receivable.   As of November 1, 2012, there were $3,390 in accounts receivable aged over 120 days from September 30, 2012 that had not been collected.  However, management believes that these accounts receivable are collectable and has therefore determined that no allowance for uncollectible amounts is necessary.
 
(g)           Trade deposits

The Company places trade deposits with new third-party manufacturers in order to secure its ability to order production.  The trade deposits are recorded at the amount paid to the manufacturers.  Trade deposits are applied against the manufacturers’ invoices for inventory purchases.  Inventory is recorded when received or when title transfers to the Company.
 
(h)           Inventories

Inventories are stated at the lower of cost or market value, determined by the weighted average method.  The Company performs physical inventory counts on a monthly basis to ensure that the amounts reflected in the consolidated financial statements at each reporting period are properly stated and valued.  The Company records write-downs to inventories for shrinkage losses and damaged merchandise that are identified during the inventory counts.  To date, such amounts have not been material to the consolidated financial statements.
 
 
8

 
 
(i)            Property, plant and equipment

Property, plant and equipment are stated at cost less accumulated depreciation and impairment losses.  Depreciation of property, plant and equipment is computed using the straight-line method based on the following estimated useful lives:
Motor vehicles
 
5 years
Office equipment
 
3 to 5 years
Leasehold improvements
  
1 to 4 years (amortized over the shorter of their economic lives or the remaining lease terms)

(j)            Long-lived assets

The Company estimates the future undiscounted cash flows to be derived from an asset to assess whether or not a potential impairment exists when events or circumstances indicate the carrying value of a long-lived asset may be impaired.  If the carrying value exceeds the Company’s estimate of future undiscounted cash flows, the Company then calculates the impairment as the excess of the carrying value of the asset over the Company’s estimate of its fair market value.
 
(k)           Goodwill

In September 2011, the Financial Accounting Standards Board (“FASB”) issued an authoritative pronouncement related to testing goodwill for impairment.  The guidance permits the Company to first assess qualitative factors to determine whether it is “more likely than not” that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test.  The Company adopted this pronouncement as of the first quarter of 2012.  If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, goodwill is then tested following a two-step process.  The first step compares the fair value of each reporting unit to its carrying amount, including goodwill.  If the fair value of each reporting unit exceeds its carrying amount, goodwill is not considered to be impaired and the second step will not be required.  If the carrying amount of a reporting unit exceeds its fair value, the second step compares the implied fair value of goodwill to the carrying value of a reporting unit’s goodwill.  The implied fair value of goodwill is determined in a manner similar to accounting for a business combination with the allocation of the assessed fair value determined in the first step to the assets and liabilities of the reporting unit.  The excess of the fair value of the reporting unit over the amounts assigned to the assets and liabilities is the implied fair value of goodwill.  An impairment loss is recognized for any excess in the carrying value of goodwill over the implied fair value of goodwill.
 
Management has performed an assessment and determined that there was no indication of impairment to goodwill during the three and nine months ended September 30, 2012.
 
(l)            Foreign currency translation

The Company’s functional currency is the Renminbi (“RMB”), China’s currency.  The accompanying unaudited consolidated financial statements are translated from RMB into U.S. Dollars (“US$” or “$”).  Accordingly, all assets and liabilities are translated at the exchange rates prevailing at the balance sheet dates, all income and expenditure items are translated at the average rates for each of the periods and equity accounts, except for retained earnings, are translated at the rate at the transaction date.  Retained earnings reflect the cumulative net income (loss) translated at the average rates for the respective periods since inception, less dividends translated at the rate at the transaction date.
  
RMB is not a fully convertible currency.  All foreign exchange transactions involving RMB must take place either through the People's Bank of China (the “PBOC”) or other institutions authorized to buy and sell foreign exchange.  The exchange rates adopted for the foreign exchange transactions are the rates of exchange quoted by the PBOC, which are determined largely by supply and demand.  The rates of exchange quoted by the PBOC on September 30, 2012 and December 31, 2011 were US$1.00 to RMB6.33 and RMB6.36, respectively.  The average translation rates of US$1.00 to RMB6.33 and RMB6.40 were applied to the income statement accounts for the three months ended September 30, 2012 and 2011, respectively.  The average translation rates of US$1.00 to RMB6.32 and RMB6.49 were applied to the income statement accounts for the nine months ended September 30, 2012 and 2011, respectively.
 
Translation adjustments are recorded as other comprehensive income in the consolidated statement of income and comprehensive income and as a separate component of stockholders' equity.

Commencing from July 21, 2005, China adopted a managed floating exchange rate regime based on market demand and supply with reference to a basket of currencies.  Since then, the PBOC administers and regulates the exchange rate of US$ against RMB taking into account the demand and supply of RMB, as well as domestic and foreign economic and financial conditions.
 
 
9

 
 
(m)          Comprehensive income

The Company’s only component of other comprehensive income is foreign currency translation gains and losses.  The foreign currency translation gain (loss) for the three months ended September 30, 2012 and 2011 were ($105,000) and $547,000 respectively.  The foreign currency translation gains for the nine months ended September 30, 2012 and 2011 were $274,000 and $1,374,000 respectively.   Accumulated other comprehensive income is recorded as a separate component of stockholders’ equity.

(n)           Income taxes

The Company accounts for income taxes under the liability method.  Deferred income taxes are recognized for the estimated tax consequences in future years, as differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted tax laws and statutory rates applicable to the periods in which the differences are expected to affect taxable income.  Valuation allowances are established to reduce deferred tax assets to the amount expected to be realized when, in management’s opinion, it is more likely than not that some portion of the deferred tax assets will not be realized.  The provision for income taxes represents current taxes payable net of the change during the period in deferred tax assets and liabilities.
    
The Company’s income tax returns are subject to examination by the Internal Revenue Service (“IRS”) and other tax authorities in the locations where it operates.  The Company assesses potentially unfavorable outcomes of such examinations based on the criteria of FASB ASC 740-10-25-5 through 740-10-25-7 and 740-10-25-13 .  The interpretation prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken (or expected to be taken) in a tax return.  This interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures.
 
According to the PRC Tax Administration and Collection Law, the statute of limitations is three years if the underpayment of taxes is due to computational or other errors made by the taxpayer or the withholding agent.  The statute of limitations extends to five years under special circumstances.  In the case of transfer pricing issues, the statute of limitations is ten years.  There is no statute of limitations in the case of tax evasion.  Accordingly, the income tax returns of the Company’s PRC operating subsidiaries for the years ended December 31, 2009 through 2011 are open to examination by the PRC state and local tax authorities.  The Company records interest and penalties as other expense on the consolidated income and other comprehensive income statements.  During the three and nine months ended September 30, 2012 and 2011, the Company did not recognize any amount in interest and penalties.

(o)           Advertising costs
 
Advertising costs are expensed and reflected in selling expenses on the consolidated statements of income and comprehensive income in the period in which the advertisements are first run.  Advertising expense for the three months ended September 30, 2012 and 2011 was approximately $1.47 million and $1.45 million, respectively.  Advertising expense for the nine months ended September 30, 2012 and 2011 was approximately $4.48 million and $4.30 million, respectively.

(p)           Shipping and handling costs
 
Shipping and handling costs are expensed as incurred and included in selling expenses.  Shipping and handling costs for the three and nine months ended September 30, 2012 and 2011 were insignificant.

(q)           Research and development costs

The Company charges all product design and development costs to expense when incurred, and such costs are reflected in general and administrative expenses on the consolidated statements of income and comprehensive income.  Such costs were approximately $0.76 million and $0.94 million for the three months ended September 30, 2012 and 2011, respectively, and approximately $2.26 million and $2.14 million for the nine months ended September 30, 2012 and 2011, respectively.

(r)            Operating leases

Leases where substantially all the risks and rewards of ownership of assets remain with the lessor are accounted for as operating leases.  Annual rentals applicable to such operating leases are charged to expense on a straight-line basis over the lease terms except where an alternative basis is more representative of the pattern of benefits to be derived from the leased assets.  Lease incentives received are recognized as an integral part of the aggregate net lease payments made.  Contingent rentals are charged to expense in the accounting period in which they are incurred.
 
 
10

 
 
(s)           Derivative financial instruments

The Company does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks.

The Company reviews the terms of convertible debt or convertible preferred stock that it issues to determine whether there are embedded derivative instruments, including the embedded conversion option, that are required to be bifurcated and accounted for separately as a derivative financial instrument.  Also, in connection with the sale of convertible debt or equity instruments, the Company may issue freestanding warrants that may, depending on their terms, be accounted for as derivative instrument liabilities, rather than as equity.

Derivative financial instruments are initially measured at their fair value.  For derivative financial instruments that are accounted for as liabilities, each such derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income.  For option-based derivative financial instruments, the Company uses a binomial option pricing model to value the derivative instruments.
  
(t)            Fair value of financial instruments

The carrying amounts of the Company’s financial instruments, which principally include cash and cash equivalents, time deposits, accounts receivable and accounts payable, approximate their fair values due to the relatively short maturity of such instruments.

Warrants that are recorded as derivative instrument liabilities are carried at their fair value, with changes in the fair value reported as charges or credits to income each period.
 
(u)           Earnings per share

Basic net income per share is computed by dividing net income attributable to common shareholders by the weighted average number of shares of common stock outstanding during the period.  Diluted earnings per share is calculated by dividing net income by the weighted-average number of common shares used in the basic earnings per share calculation plus the number of common shares that would be issued assuming exercise or conversion of all potentially dilutive common stock equivalents outstanding.  Equity instruments are excluded from the calculation of diluted earnings per share if the effect of including such instruments is anti-dilutive.
 
(v)           Recent accounting pronouncements
 
In July 2012, the FASB issued ASU No. 2012-02 Intangibles — Goodwill and Other (Topic 350).   The amendments in this update will allow an entity to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. Under these amendments, an entity would not be required to calculate the fair value of an indefinite-lived intangible asset unless the entity determines, based on qualitative assessment, that it is not more likely than not, the indefinite-lived intangible asset is impaired. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment.  The amendments are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment tests performed as of a date before July 27, 2012, if a public entity’s financial statements for the most recent annual or interim period have not yet been issued.  The adoption of the provisions in this update is not expected to have a significant impact on the Company’s consolidated financial statements.
 
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company’s consolidated financial statements upon adoption.
    
(2)           INVENTORIES

Inventories consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
 
 
September 30,
 
December 31,
 
 
2012
 
2011
 
 
(unaudited)
     
Finished goods
 
$
9,624
   
$
1,880
 
                 
   
$
9,624
   
$
1,880
 
 
 
11

 
 
(3)           TRADE DEPOSITS

Trade deposits consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):

 
September 30,
 
December 31,
 
 
2012
 
2011
 
 
(unaudited)
     
Trade deposits
 
$
-
   
$
3,482
 
                 
   
$
-
   
$
3,482
 
   
Trade deposits consist of deposits made to third-party manufacturers in order for them to manufacture on behalf of the Company.  As of December 31, 2011, the Company had trade deposits with 16 manufacturers. 86.0% of the balance as of December 31, 2011 was with the top seven manufacturers.

(4)           BUSINESS COMBINATION

In May 2011, the Company entered into an agreement with its Fujian distributor to acquire the distributor’s retail network of 13 stores for $6,684,000 (RMB 44,100,000) in cash.  The Company believes that operating certain points of sale directly can facilitate the promotion of its brand and brand image, and the Company can benefit at the same time from the higher margins for retail sales.  The Company believes that the Fujian distributor’s retail network is ideal as the Company is headquartered in, and operates from, the same province.  The Company completed this acquisition on June 30, 2011 and has reported its retail operations since July 1, 2011.  This acquisition resulted in a new segment, “company stores,” as further disclosed in Note 15.  Pro forma results of operations that include the acquired business for the three and nine months ended September 30, 2012 are not presented because the effects of the acquisition were not material to the Company’s financial results.
The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

Total purchase price:
 
$
6,684
 
         
Allocation of the purchase price to assets and liabilities at fair value:
       
Inventories
   
151
 
Prepaid rent
   
98
 
Leasehold improvements
   
469
 
Property, plant and equipment
   
17
 
Net assets acquired at fair value
   
735
 
         
Pre-existing distribution agreement
   
919
 
Goodwill
   
5,030
 
Total intangible assets acquired
 
$
5,949
 

The pre-existing distribution agreement recognized in conjunction with the acquisition on June 30, 2011 represents the intangible value of the reacquisition of the distribution license that was granted by the Company to its Fujian distributor.  The value assigned to the pre-existing distribution agreement has been fully amortized as of December 31, 2011.

The goodwill recognized in conjunction with the acquisition on June 30, 2011 represents intangible values of the acquired store locations for their future profit potential that do not qualify for separate recognition, or other factors.
(5)           PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):

   
September 30,
2012
   
December 31,
2011
 
   
(unaudited)
       
Leasehold improvements
 
$
2,396
   
$
2,826
 
Motor vehicles
   
56
     
56
 
Office equipment
   
67
     
66
 
                 
Total property, plant and equipment
   
2,519
     
2,948
 
Less: accumulated depreciation
   
(1,119
   
(751)
 
                 
Property, plant and equipment, net
 
$
1,400
   
$
2,197
 
 
 
12

 
 
Depreciation expense was $206 and $312 for the three months ended September 30, 2012 and 2011, respectively, and $852 and $336 for the nine months ended September 30, 2012 and 2011, respectively.
 
During the nine months ended September 30, 2012, the Company closed five company stores.  The leasehold improvements for these five store locations were disposed of for no consideration and had an unamortized value of $128 at September 30, 2012, resulting in a loss of $128.

During the three months ended September 30, 2012, the Company entered into a lease agreement for new office space, and expensed the remaining $382 of unamortized leasehold improvement for its old office space as the Company does not expect to receive any consideration from disposing such improvement.
 
During the nine months ended September 30, 2011, the Company disposed of its manufacturing equipment with a net book value of $145 on December 31, 2010, for $154, resulting in a gain of $9.

During the nine months ended September 30, 2011, the Company disposed of the building that housed its discontinued manufacturing activities and the land use right for the land on which the building sits, which collectively had a net book value of $1,013 on December 31, 2010, for $989, resulting in a loss of $24.
 
(6)           GOODWILL
 
Goodwill (see Note 4) consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):
 
   
September 30, 2012
   
December 31, 2011
 
   
(unaudited)
       
Beginning of period
 
$
5,219
   
$
-
 
Goodwill on stores acquired
   
-
     
5,030
 
Exchange realignment
   
28
     
189
 
                 
End of period
 
$
5,247
   
$
5,219
 
(7)            ACCRUED EXPENSES AND OTHER PAYABLES

Accrued expenses and other payables consisted of the following as of September 30, 2012 and December 31, 2011 (in thousands):

   
September 30, 2012
   
December 31, 
2011
 
   
(unaudited)
       
Accrued salaries and wages
 
$
81
   
$
79
 
Accrued liquidated damages (Note 9)
   
987
     
987
 
Accrued expenses
   
570
     
699
 
Advertising subsidies payable
   
203
     
202
 
   
$
1,841
   
$
1,967
 
   
(8)           RELATED PARTY TRANSACTIONS

Amount due to related parties consisted of the following as of September 30, 2012 and December 31, 2011  (in thousands):

   
September 30, 2012
   
December 31, 
2011
 
   
(unaudited)
       
Mr. Qingqing Wu (1)
 
$
581
   
$
1,144
 
Mr. Bennet Tchaikovsky (2)
   
28
     
5
 
Ms. Ying (Teresa) Zhang (3)
   
90
     
67
 
   
$
699
   
$
1,216
 
 
(1)  
The amount due to this director is unsecured, interest-free and repayable on demand.
(2)  
Represents compensation and reimbursable expenses owed.
(3)  
Represents cash compensation owed.
 
 
13

 
 
Mr. Qingqing Wu currently has four trademarks registered in his name that were intended to be transferred to Yinglin Jinduren for no consideration prior to the closing of the Share Exchange on February 13, 2009.  As such transfers could not be timely effected, Mr. Wu entered into trademark license contracts with Yinglin Jinduren on February 12, 2009, pursuant to which he perpetually granted Yinglin Jinduren the rights to use these trademarks for no consideration.  Mr. Wu is also in the process of transferring the trademarks to Yinglin Jinduren for no consideration as originally intended, although such transfers have not been completed.  To date, Yinglin Jinduren has not utilized these trademarks, and the Company considers the value of these trademarks to be de minimis.  Upon completion of the transfer to Yinglin Jinduren, the trademarks will be transferred to China Dong Rong.

(9)           SALE OF PREFERRED STOCK, COMMON STOCK AND WARRANTS

On October 27, 2009, the Company entered into a securities purchase agreement (the “Purchase Agreement”) with several accredited investors (collectively the “Purchasers”) pursuant to which the Company agreed to sell to the Purchasers shares of the Company’s series A convertible preferred stock (the “Preferred Shares”) at $2.86 per share and to issue warrants to purchase shares of the Company’s common stock (the “Preferred Shares Financing”).  At the initial closing on October 27, 2009, the Company issued 1,446,105 Preferred Shares and Warrants to purchase 96,407 shares of common stock for gross proceeds of approximately $4.1 million.  At the final closing on November 17, 2009, the Company issued an additional 1,350,616 Preferred Shares and Warrants to purchase 90,041 shares of common stock for gross proceeds of approximately $3.9 million.  The 1,446,105 Preferred Shares issued on October 27, 2009 and the 1,350,616 Preferred Shares issued on November 17, 2009 are convertible into 192,814 common shares and 180,082 common shares, respectively.

The designation, rights, preferences and other terms and provisions of the Preferred Shares are set forth in the Certificate of Designation filed with the Nevada Secretary of State on October 23, 2009 (the “Certificate”).  The Preferred Shares are convertible into 0.1333 shares of common stock at $21.45 per share (subject to certain adjustments) at any time at the holder’s option, and will automatically convert when the Company’s common stock is qualified for listing on either the NASDAQ Capital Market or the NYSE Amex Equities.  The Preferred Shares are entitled to participate in any dividends declared and paid on the Company’s common stock on an as-converted basis.  Holders of the Preferred Shares are also entitled to notice of any stockholders’ meeting and vote together with common stock holders on an as-converted basis.  Additionally, as long as any Preferred Shares are outstanding, the Company cannot, without the affirmative vote of the holders of a majority of the then outstanding Preferred Shares, (a) alter or change adversely the powers, preferences, or rights given to the Preferred Shares or alter or amend the Certificate, (b) authorize or create any class of stock ranking as to dividends, redemption or distribution of assets upon a Liquidation (as defined in Section 5 of the Certificate) senior to or otherwise pari passu with the Preferred Shares, (c) amend its charter documents in any manner that adversely affects any rights of the holders of Preferred Shares, (d) increase the number of authorized shares of Preferred Shares, or (e) enter into any agreement with respect to any of the foregoing.
Each warrant entitles its holder to purchase one share of common stock at an exercise price of $25.725 per share (subject to certain adjustments) for a period of three years.  The Company is also entitled to redeem the warrants for the then applicable exercise price (currently $25.725) if the volume-weighted average price of the common stock for 20 consecutive days exceeds 200% of the then applicable exercise price.

The conversion price of the Preferred Shares and the exercise price of the warrants are subject to anti-dilution adjustments in the event that the Company issues additional equity, equity linked securities or securities convertible into common stock at a purchase price less than the then applicable conversion or exercise price (other than shares issued to the Company’s officers, directors, employees or consultants pursuant to any stock or option plan duly adopted by a majority of the Company’s non-employee directors, or issued upon the conversion or exercise of any securities outstanding as of the closing date of the Preferred Shares Financing, or for acquisitions or strategic transactions approved by a majority of the Company’s directors).  The conversion and exercise prices are also subject to customary adjustments for stock dividends, stock splits, reverse stock splits or other similar transactions.
 
In connection with the Purchase Agreement, certain of the Company’s shareholders entered into a lock-up agreement (the “Lock-up Agreement”) whereby they agreed not to offer, sell, or other dispose of (a) 50% of their common stock holdings for nine months from the initial closing of the Preferred Shares Financing, and (b) the remaining 50% of their common stock holdings for twelve months from the initial closing.

In connection with the Preferred Shares Financing, the Company agreed to place $150,000 of its gross proceeds and Warrants to purchase up to 40,000 shares of common stock in an escrow account to be expended for investor relations, pursuant to the terms of an escrow agreement.

Gilford Securities, Incorporated acted as the placement agent in connection with the Preferred Shares Financing. 
 
On December 1, 2009, the Company entered into a second securities purchase agreement (the “Second Purchase Agreement”) with several accredited investors, including some of the Purchasers (the “Common Shares Purchasers”) pursuant to which the Company issued to the Common Shares Purchasers 87,138 shares of common stock at $21.45 per share and warrants to purchase 43,569 shares of Common Stock, for gross proceeds of approximately $1.87 million (the “Common Shares Financing”).  The terms of the warrants issued in connection with the Second Purchase Agreement are identical to the warrants issued in connection with the Purchase Agreement.
 
 
14

 
 
The Company is required to file a registration statement to register the common stock underlying the Preferred Shares and Warrants from the Preferred Shares Financing, and the common stock issued in and underlying the warrants from the Common Shares Financing, for resale on or before December 17, 2009, and have it declared effective within 90 days thereafter (or 150 days if the registration statement receives a full review).  If the registration statement is not timely filed or declared effective, the Company is subject to liquidated damages of 1% of the gross proceeds from both financings per month, up to 10%, and pro-rated for partial periods.  The registration statement was filed on December 17, 2009, and was declared effective on March 30, 2011.  Accordingly, as of September 30, 2012 and December 31, 2011, the Company accrued the full amount of the liquidated damages or $987,000.

Because the warrants contain provisions that would reduce their exercise price in the event that the Company issues additional equity, equity linked securities or securities convertible into common stock at a purchase price less than the then applicable conversion or exercise price, and because the Warrants are denominated in a currency that is different from the Company’s functional currency, they have been accounted for as derivative instrument liabilities (see Note 10).

The Preferred Shares are not subject to redemption (except on liquidation), are entitled to participate in any dividends declared and paid on the Company’s common stock on an as-converted basis, and the holders of the Preferred Shares are entitled to vote together with common stock holders on an as-converted basis.  The Preferred Shares, excluding the embedded conversion option, are considered to be an equity instrument and accordingly, the embedded conversion option has not been separated and accounted for as a derivative instrument liability.  However, the Company has recognized a beneficial conversion feature related to the Preferred Shares, to the extent that the conversion feature, based on the proceeds allocated to the Preferred Shares, was in-the-money at the time they were issued.  Such beneficial conversion feature amounted to approximately $1.973 million and $2.030 million related to the initial closing and the final closing of the Preferred Shares Financing, respectively.  Because the Preferred Shares do not have a stated redemption date and may be converted by the holder at any time, the discount recognized by the allocation of proceeds to the beneficial conversion feature has been immediately amortized through retained earnings as a deemed dividend to the holders of the Preferred Shares.

(10)         DERIVATIVE FINANCIAL INSTRUMENTS

The Company uses a binomial option pricing model to value the common stock purchase warrants issued in connection with the Preferred Shares Financing and the Common Shares Financing (see Note 9).  In valuing these warrants at the time they were issued and at September 30, 2012 and December 31, 2011, the Company used the market price of its common stock on the date of valuation, an expected dividend yield of 0% and the remaining period to the expiration date of the warrants.  All of the warrants can be exercised by the holder at any time.

Because of the limited historical trading period of the Company’s common stock, the expected volatility of its common stock over the remaining life of the warrants, which has been estimated between 67% to 80% at September 30, 2012 and 75% at December 31, 2011, respectively, is based on a review of the volatility of entities considered by management as comparable.  The risk-free rates of return used of 0.06% to 0.08% at September 30, 2012 and 0.10% to 0.11% at December 31, 2011 are based on constant maturity rates published by the U.S. Federal Reserve, applicable to the remaining life of the warrants. Dividend is estimated at 0% at September 30, 2012 and December 31, 2011.

At September 30, 2012 and December 31, 2011, the following derivative liabilities related to the warrants were outstanding (in thousands except price per share and number of warrants):
Issue Date
 
Expiration Date
 
# of
Warrants
   
Exercise Price
 Per Share
   
Value -
December 31,
2011
   
Value -
September 30,
2012
 
                         
(unaudited)
 
October 27, 2009
 
October 27, 2012
   
96,407
   
$
25.725
   
$
271
   
$
2
 
                                     
November 17 2009
 
November 17, 2012
   
88,941
     
25.725
     
266
     
4
 
                                     
December 1, 2009
 
December 1, 2012
   
43,569
     
25.725
     
136
     
4
 
                                     
         
228,917
           
$
673
   
$
10
 
 
 
15

 
 
During the three months ended September 30, 2012 and 2011, the Company recognized gains of $96 and $258, respectively, from the change in fair value of its warrant liability.  During the nine months ended September 30, 2012 and 2011, the Company recognized gains of $663 and $837, respectively, from the change in fair value of its warrant liability.

Assets and liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their fair value measurement.  The Company’s derivative financial instruments which are required to be measured at fair value on a recurring basis are measured at fair value using Level 3 inputs.  Level 3 inputs are unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

The following represents a reconciliation of the changes in fair value of financial instruments measured at fair value using Level 3 inputs during the nine months ended September 30, 2012 and 2011 (in thousands):
   
Warrants
 
       
Balance – January 1, 2011
 
$
1,312
 
Issued
   
-
 
Exercised
   
-
 
Fair value adjustments
   
(837
Balance- September 30, 2011
   
475
 
Issued
   
-
 
Exercised
   
-
 
Fair value adjustments
   
198
 
Balance- December 31, 2011
   
673
 
Issued
   
-
 
Exercised
   
-
 
Fair value adjustments
   
(663
)
Balance- September 30, 2012
 
$
10
 
 
Estimating the fair values of derivative financial instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors.  In addition, valuation techniques are sensitive to changes in the trading market price of our common stock, which may exhibit significant volatility.  Because derivative financial instruments are initially and subsequently carried at fair values, the Company’s income will reflect the volatility in these estimate and assumption changes.

(11)        COMMON STOCK

Amounts in the following discussion are in thousands except for share data (shares, par value and price per share):

The Company is authorized to issue 13,333,334 shares of common stock, $0.00001 par value per share.  The Company had 193,923 common shares outstanding prior to the Share Exchange with PXPF, and, as described in Note 1, issued 1,941,334 common shares to the shareholders of PXPF in connection with the Share Exchange.  For accounting purposes, the shares issued to the shareholders of PXPF are assumed to have been outstanding on January 1, 2008, and the 193,923 shares held by the existing shareholders of the Company prior to the Share Exchange on February 13, 2009 are assumed to have been issued on that date in exchange for the net assets of the Company.

On December 1, 2009, the Company sold 87,138 shares of common stock to certain accredited investors (see Note 9).

During the year ended December 31, 2010, 1,100 warrants were exercised for, and 1,747,962 shares of convertible preferred stock were converted into 1,100 and 233,062 shares of common stock, respectively.

During the year ended December 31, 2011, 415,906 shares of convertible preferred stock were converted into 55,454 shares of common stock.

During the nine months ended September 30, 2012, 209,275 shares of convertible preferred stock were converted into 27,904 shares of common stock.
 
On March 10, 2010, the Company entered into a service agreement with a non-executive director and agreed to issue 1,334 shares of restricted common stock in four quarterly installments for her annual service.  The terms of the service agreement was continued on March 10, 2011 and 2012, with 1,334 shares of restricted common stock to be issued in four quarterly installments accordingly.  The trading value of the Company’s common stock on March 10, 2012 and 2011 was $11.91 and $11.79, respectively, and the total to be recognized for each these issuances over the year of service is $16 and $16, respectively. Compensation expense of $3 and $4 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $13 and $20 for the nine months ended September 30, 2012 and 2011, respectively.
 
 
16

 
 
On April 27, 2010, the Company entered into an agreement to issue 2,667 shares of restricted common stock to Worldwide Officers Inc.  (“WOI”) for the services of its chief financial officer for one year, which would vest as follows: 475 shares on June 30, 2010, 672 shares on September 30, 2010, 672 shares on December 31, 2010, 658 shares on March 31, 2011 and 190 shares on April 26, 2011.  The trading value of the granted shares on April 27, 2010 was $37.50 per share for a total value of $100.  Compensation expense of $0 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $0 and $32 for the nine months ended September 30, 2012 and 2011, respectively.
 
On September 28, 2011, the Company entered into an agreement to issue 2,648 shares of restricted common stock to WOI for the chief financial officer’s services from April 27, 2011 through September 27, 2011.  The trading value of the granted shares on September 28, 2011 was $9.75 for a total value of $26.  Compensation expense of $0 and $26 was recognized for the three and nine months ended September 30, 2012 and 2011, respectively.  
 
On September 28, 2011, the Company entered into an agreement to grant WOI a restricted stock award of $200 of its common stock for each one-year term of the chief financial officer, $100 of which is calculated based on the closing price of the common stock on the first day of such term, and the other $100 calculated based on the closing price on the first day immediately after the initial 6-month period of such term.  In connection therewith, 10,256 shares were granted to WOI for the initial 6-month period term (“First Issuance”), and 8,482 shares for the subsequent 6-month term (“Second Issuance”), calculated based on the closing prices of the Company’s common stock as quoted on the OTC Bulletin Board on September 28, 2011 of $9.75, and on March 28, 2012 of $11.79, respectively.  The terms of agreement were continued on September 28, 2012 with 12,049 shares granted to WOI for the 6-month period of the renewal term (“Third Issuance”), calculated based on the closing prices of the Company’s common stock as quoted on the OTC Bulletin Board on September 28, 2012 of $8.30.  The First Issuance vested in two installments of 5,128 shares each on December 27, 2011 and March 27, 2012.  The Second Issuance vested in two installments of 4,241 shares each on June 27 and September 27, 2012.  The Third Issuance will vest in two installments of 6,025 shares on December 27, 2012 and 6,024 shares on March 27, 2013.  For the First Issuance and Second Issuance, compensation expense of $48 and $2 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $149 and $2 for the nine months ended September 30, 2012 and 2011, respectively.  For the Third Issuance, compensation expense of $2 and $0 was recognized for the three and nine months ended September 30, 2012 and 2011, respectively.

On May 25, 2012, the Company’s Board of Directors ratified an agreement with a consultant to provide one year of strategic public relations services from May 4, 2012 to May 3, 2013 in exchange for 22,334 shares of its common stock to be issued under the Company’s 2012 Stock Plan.  The trading value of such shares on May 25, 2012 was $10.20, for a total value of $227.  Compensation expense of $0 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $227 and $0 for the nine months ended September 30, 2012 and 2011, respectively.  The shares were issued in July 2012.
 
On July 25, 2012, the Company’s Board of Directors ratified an agreement with a consultant to provide the Company with general advice and consulting services regarding the Company’s expansion into the Taiwan market from July 20, 2012 to July 19, 2013 in exchange for 11,667 shares of its common stock to be issued under the Company’s 2012 Stock Plan.  The trading value of such shares on July 25, 2012 was $6.15, for a total value of $72.  Compensation expense of $72 and $0 was recognized for the three months ended September 30, 2012 and 2011, respectively, and $72 and $0 for the nine months ended September 30, 2012 and 2011, respectively. The shares were issued in July 2012.

A summary of the status of the Company’s non-vested shares as of September 30, 2012, and changes during the year ended December 31, 2011, is presented below:
Non-vested shares
 
Shares
   
Weighted-
Average
Grant Date
Fair Value
 
Non-vested at January 1, 2011
   
1,181
   
$
39.96
 
Granted
   
14,237
     
9.98
 
Vested
   
(4,495
)
 
$
18.00
 
Forfeited
   
-
     
-
 
Non-vested at September 30, 2011
   
10,923
   
$
9.90
 
Granted
   
-
   
$
-
 
Vested
   
(5,462
)
 
$
9.87
 
Forfeited
   
-
     
-
 
Non-vested at December 31, 2011
   
5,461
   
$
9.93
 
Granted
   
55,865
     
9.23
 
Vested
   
(48,889
)
 
$
9.50
 
Forfeited
   
-
     
-
 
Non-vested at September 30, 2012
   
12,437
   
$
8.47
 
 
 
17

 
 
As of September 30, 2012, there was $105 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted by the board of directors.  This cost is expected to be recognized by March 27, 2013.  The total fair value of shares vested during the three months ended September 30, 2012 and 2011 was $124 and $31, respectively.  The total fair value of shares vested during the nine months ended September 30, 2012 and 2011 was $464 and $79, respectively.
 
On December 12, 2011, the Company effected a 1-for-2.5 reverse stock split of its issued and outstanding shares of common stock and a proportional reduction of its authorized shares of common stock.   On September 24, 2012, the Company effected a 1-for-3 reverse stock split of its issued and outstanding shares of common stock and a proportional reduction of its authorized common stock.  All common share and per share amount, and exercise prices of common stock purchase warrants and options disclosed herein and in the accompanying consolidated unaudited financial statements have been retroactively restated to reflect both reverse stock splits.

At September 30, 2012, there were 2,599,321 shares of common stock issued and outstanding.
 
(12)         PREFERRED STOCK

The following amounts are in thousands except for share data (shares, par value and price per share):

The Company is authorized to issue 100,000,000 shares of preferred stock, $0.00001 par value, of which 2,800,000 shares have been designated as series A convertible preferred stock (the “Preferred Share”).

On October 27 and November 17, 2009, the Company sold 1,446,105 and 1,350,616 Preferred Shares to certain accredited investors in connection with the Preferred Shares Financing, respectively (see Note 9).  Up to December 31, 2011, 2,163,868 Preferred Shares were converted, and at December 31, 2011, 632,853 Preferred Shares were outstanding, with an aggregate liquidation preference of $1,810.  During the nine months ended September 30, 2012, 209,275 Preferred Shares were converted into 27,904 shares of common stock, and at September 30, 2012, 423,578 Preferred Shares were outstanding, with an aggregate liquidation preference of $1,211.
 
(13)         EARNINGS PER SHARE
 
The following amounts are in thousands except for share data (shares and earnings per share):
 
(a)            Basic

“Basic earnings per share - common” is calculated by dividing the net income attributable to common shareholders of the Company by the weighted average number of common shares.  Using the two class method pursuant to ASC 260-10-45, the Company allocated its net income to preferred and common shareholders during the three and nine months ended September 30, 2012 and 2011, based on the number of common shares outstanding during the periods shown (taking into account the number of preferred shares converted into common shares at the end of such periods on a 1-for-0.1333 common share basis), and participating preferred shares outstanding during the periods shown.
   
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
  
 
2012
   
2011
   
2012
   
2011
 
Income attributable to common shareholders of the Company
   
2,987
     
1,549
     
10,191
     
9,450
 
Income attributable to preferred shareholders of the Company
   
65
     
59
     
221
     
360
 
Net income
 
$
3,052
   
$
1,608
   
$
10,412
   
$
9,810
 
Weighted average number of common shares outstanding
   
2,583,841
     
2,485,057
     
2,552,524
     
2,478,231
 
 
 
18

 
 
(b)           Diluted

Diluted earnings per share is calculated by adjusting the weighted average number of common shares outstanding to assume conversion of all dilutive potential common shares.  The Company has two categories of dilutive potential common shares: the Preferred Shares issued in October and November 2009 in connection with the Preferred Shares Financing, and the Warrants issued in connection with both the Preferred Shares Financing and the Common Shares Financing in December 2009.  The Warrants are assumed to have been converted into common shares and the calculation is done to determine the number of shares that could have been acquired at fair value (determined as the average annual market share price of the Company’s common stock) based on the monetary value of the subscription rights attached to outstanding Warrants.  The Preferred Shares that were outstanding at the end of the respective periods are assumed to have been converted into common shares on a 1-for-0.1333 basis.  Since the Preferred Shares are included in the diluted calculation, net income (attributable to both common and preferred shareholders) is used.  The number of shares calculated as above is compared with the number of shares that would have been issued assuming the exercise of the Warrants.
  
 
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
  
 
2012
   
2011
   
2012
   
2011
 
Net income
 
$
3,052
   
$
1,608
   
$
10,412
   
$
9,810
 
Weighted average number of common shares outstanding
   
2,583,841
     
2,485,057
     
2,552,524
     
2,478,231
 
                                 
Adjustment for: 
                               
Preferred stock
   
67,426
     
115,334
     
75,378
     
121,665
 
     
2,651,267
     
2,600,391
     
2,627,902
     
2,599,896
 

For the three and nine months ended September 30, 2012 and 2011, 228,917 common stock purchase warrants are excluded from the calculation of diluted earnings per share as they are anti-dilutive.
(14)         INCOME TAXES

The provisions for income tax expense were as follows (in thousands):

  
 
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
PRC enterprise income tax- current
 
$
1,295
   
$
400
   
$
5,327
   
$
2,950
 

As of September 30, 2012 and December 31, 2011, the Company did not have any significant temporary differences and carry forwards that may result in deferred tax.

The applicable rate of Hong Kong profits tax for 2012 and 2011 is 16.5%.  No provision for Hong Kong profits tax has been made, however, as the Company does not carry on any business that generates profits chargeable to Hong Kong profits tax.

PXPF is a company incorporated in the BVI and is fully exempt from Domestic Corporate Tax of the BVI.

The Company’s subsidiary and VIE in China are subject to a statutory income tax rate of 25% in the PRC.

The Company has analyzed the tax positions taken or expected to be taken in its tax filings and has concluded it has no material liability related to uncertain tax positions or unrecognized tax benefits as of September 30, 2012.

The following table reconciles the theoretical tax expense calculated at the statutory rates to the Company’s effective tax expense for the three and nine months ended September 30, 2012 and 2011, respectively (in thousands):
 
   
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
  
 
2012
   
2011
   
2012
   
2011
 
Theoretical tax expense calculated at PRC statutory Enterprise income tax rate of 25%
   
1,087
     
502
     
3,935
     
3,190
 
Tax adjustment for prior year
   
-
     
-
     
1,056
     
-
 
Tax effect of non-deductible expenses
   
232
     
(38)
     
553
     
(31
)
Other
   
(24
   
(64)
     
(217
)
   
(209
Effective tax expense
 
$
1,295
   
$
400
   
$
5,327
   
$
2,950
 
 
The tax adjustment for the prior year represents a change in management’s estimate of the prior year income tax provision.  Certain expenses that the Company believed were deductible were deemed non-deductible by the PRC tax bureau subsequent to the Company's filing of its annual report on Form 10-K on April 12, 2012.  A provision was therefore made for the additional income tax during 2012.  Non-deductible expenses for the three and nine months ended September 30, 2012 and 2011 primarily consisted of expenses incurred outside of the PRC which are not deductible in computing the income tax for the PRC.
 
The New Tax Law imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China for distribution of earnings generated after January 1, 2008. Under the New Tax Law, the distribution of earnings generated prior to January 1, 2008 is exempt from the withholding tax. As management does not anticipate that the subsidiaries in the PRC will distribute their earnings to the Company for the year ending December 31, 2012, and no dividends were distributed in the years ended December 31, 2011 and 2010, no deferred tax liability has been recognized for the undistributed earnings of these PRC subsidiaries through September 30, 2012. Total undistributed earnings of these PRC subsidiaries at September 30, 2012 was RMB340,477,569 ($53,829,595).
 
 
19

 
 
(15)       SEGMENT INFORMATION
 
ASC Topic 280 requires use of the “management approach” model for segment reporting.  The management approach model is based on the way a company’s management organizes segments within the company for making operating decisions and assessing performance.  Reportable segments are based on products and services, geography, legal structure, management structure, or any other manner in which management disaggregates a company.  During the three and nine months ended September 30, 2012, the Company operated in two reportable business segments: (1) sales to its distributors, and (2) retail sales at company stores.  These reportable segments represent the two ways that the Company sells its products: (1) to its distributors who then sell the products to consumers, and (2) directly to consumers (via company stores).  These segments share certain costs that are allocated on the basis of revenues: advertising within the PRC and research and development.  Company stores, however, require different types of management focus and as such are managed separately.  As of September 30, 2012, the Company’s distributors operated 435 points of sale, and the Company operated 19 company stores.
 
Condensed information with respect to the two reportable business segments for the three and nine months ended September 30, 2012 and 2011 is as follows (in thousands):
 
   
Three Months Ended
September 30,
   
Nine months Ended
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net sales:
                       
Distributors
   
21,458
     
14,668
     
59,894
     
56,533
 
Company stores
   
1,038
     
1,287
     
3,052
     
1,287
 
     
22,496
     
15,955
     
62,946
     
57,820
 
                                 
Cost of sales:
                               
Distributors
   
12,020
     
9,029
     
32,521
     
32,274
 
Company stores
   
350
     
416
     
1,047
     
416
 
     
12,370
     
9,445
     
33,568
     
32,690
 
                                 
Selling expenses:
                               
Distributors
   
3,708
     
2,581
     
8,145
     
8,828
 
Company stores
   
674
     
572
     
2,127
     
547
 
     
4,382
     
3,153
     
10,272
     
9,375
 
                                 
General and administrative expenses:
                               
Distributors
   
727
     
863
     
2,152
     
2,096
 
Company stores
   
35
     
362
     
110
     
334
 
Other
   
754
     
397
     
1,834
     
1,466
 
     
1,516
     
1,622
     
4,096
     
3,896
 
Income (loss) before provision for income taxes
                               
Distributors
   
5,003
     
2,195
     
17,076
     
13,335
 
Company stores
   
(21
)
   
(63
)
   
(232
)
   
(10
)
Other (a)
   
(635
)
   
(124
)
   
(1,105
)
   
(565
)
     
4,347
     
2,008
     
15,739
     
12,760
 
 
 (a)  
The Company does not allocate its general and administrative expenses from its activities in the United States, or the fair value changes of its derivative liabilities, to its reportable segments, as they are managed at the corporate level. 
     
 
September 30,
2012
 
December 31,
2011
 
 
(unaudited)
     
Identifiable long lived assets at September 30, 2012 and December 31, 2011 (net of depreciation and amortization):
       
Corporate
  $
555
    $ 54  
Distributors
    -       -  
Company stores
   
6,092
      7,362  
    $ 6,647     $ 7,416  
 
 
20

 
 
(16)       STATUTORY RESERVES

Under PRC regulations, Yinglin Jinduren may pay dividends only out of its accumulated profits, if any, determined in accordance with PRC GAAP.  In addition, it is required to set aside at least 10% of its after-tax net profits each year, if any, to fund the statutory reserves until the balance of the reserves reaches 50% of its registered capital.  The statutory reserves are not distributable in the form of cash dividends to the Company but can be used to make up prior year cumulative losses.  As of December 31, 2011, the registered capital was RMB 10,000,000 ($1,517,036), and the statutory reserves have been fully funded.

Like Yinglin Jinduren, China Dong Rong is also required to set aside at least 10% of its annual after-tax net profit, if any, to fund government-mandated statutory reserves until the balance of such reserves reach 50% of its registered capital, or $4 million (based on its registered capital of $8 million).  The funds in the statutory reserves can only be used for certain purposes, such as to increase its registered capital or to eliminate its future losses as determined under PRC generally acceptable accounting principles.  As of December 31, 2011 and September 30, 2012, the statutory reserves were not funded as China Dong Rong only commenced operations in December 2010.  The Company plans to start funding the statutory reserves by the end of 2012.
 
(17)      LEASE COMMITMENTS

Company leases : (in thousands)

For its administrative operations, the Company leases certain premises under long-term, non-cancelable leases and year-to-year leases.  These leases are accounted for as operating leases.  Rent expense for such leases amounted to $28 and $10 for the three months ended September 30, 2012 and 2011, respectively, and $87 and $78 for the nine months ended September 30, 2012 and 2011, respectively.

Store leases : (in thousands)
 
As of September 30, 2012, the Company operated 19 company stores, including the 9 initially acquired on June 30, 2011 and 10 opened thereafter.  Of the leases for these stores, 7 require fixed rent payments.  The remaining 12 have rental payments based on store revenue with no minimum rental payment, and are thus not listed below.  Instead, rent expense for such leases is recorded as sales are made.  Rent expense for fixed-rent leases amounted to $42 and $76 for the three months ended September 30, 2012 and 2011, respectively, and $390 and $76 for the nine months ended September 30, 2012 and 2011, respectively.  Rent expense for leases based on store revenues was $126 and $201 for the three months ended September 30, 2012 and 2011, respectively, and $411 and $201 for the nine months ended September 30, 2012 and 2011, respectively.
 
Future minimum payments under long-term, non-cancelable leases as of September 30, 2012, are as follows (in thousands):
 
 
   
Future
minimum
payments -
Corporate
   
Future
minimum
payments-
Stores
   
Total 
future
minimum
payments
 
Three months Ending December 31,
                 
2012
 
$
62
   
$
92
   
$
154
 
Year ending December 31,
                       
2013
 
$
151
   
$
339
   
$
490
 
2014
   
136
     
140
     
276
 
2015
   
143
     
-
     
143
 
2016
   
150
     
-
     
150
 
                         
   
$
642
   
$
571
   
$
1,213
 
 
(18)       BUSINESS AND CREDIT CONCENTRATIONS

The Company operates in the fashion apparel industry and generates all of its sales in the PRC.  The fashion apparel industry is impacted by the general economy.  Changes in the marketplace would significantly affect management’s estimates and the Company’s performance.

The Company had distribution agreements with 11 and 12 distributors at September 30, 2012 and 2011, respectively.  The Company had the following concentrations of business with each distributor (customer) constituting greater than 10% of the Company’s sales:
 
   
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Distributors
                       
Distributor A
   
19.8
%
   
16.9
%
   
20.5
%
   
18.9
%
Distributor B
   
15.0
%
   
10.9
%
   
14.8
%
   
10.8
%
Distributor C
   
13.5
%
   
*
     
14.1
%
   
10.7
%
Distributor D
   
16.2
%
   
*
     
16.1
%
   
*
 
 
           * Denotes concentration of less than 10%
 
 
21

 

The Company’s concentrations of accounts receivable by distributors (customers) constituting greater than 10% of the Company's accounts receivable were as follows:
 
   
September 30,
 
   
2012
   
2011
 
Distributors
           
Distributor A
   
27.0
%
   
25.1
%
Distributor B
   
13.2
%
   
11.7
%
Distributor C
   
21.1
%
   
11.2
%
Distributor D
   
*
     
10.6
 %
Distributor E
   
19.8
%
   
*
 
 
* Denotes concentration of less than 10%

The Company had the following concentrations of business with each vendor constituting greater than 10% of the Company’s purchases:
   
Three Months Ended 
September 30,
   
Nine months Ended 
September 30,
 
   
2012
   
2011
   
2012
   
2011
 
Vendors
                       
Vendor A
   
*
     
13.2
%
   
16.5
%
   
12.6
Vendor B
   
28.2
%
   
13.8
%
   
20.3
%
   
*
 
Vendor C
   
11.4
   
16.6
%
   
10.2
   
*
 
Vendor D
   
10.2
   
15.4
%
   
22.0
   
*
 

* Denotes concentration of less than 10%

The Company had the following concentrations of business with each creditor constituting greater than 10% of the Company’s trade payables:
 
   
September 30,
 
   
2012
   
2011
 
   
(unaudited)
   
(unaudited)
 
Creditors
           
Creditor A
   
*
     
16.2
%
Creditor B
   
*
     
12.6
%
Creditor C
   
*
     
10.8
%
Creditor D
   
*
     
11.4
%
Creditor E
   
19.3
%
   
11.3
Creditor F
   
48.8
%
   
*
 
Creditor G
   
10.7
%
   
*
 
Creditor H
   
12.4
%
   
*
 
 
* Denotes concentration of less than 10%

The above concentrations make the Company vulnerable to a near-term severe impact should the relationships be terminated.
 
 
22

 

(19)       BENEFIT PLAN

Pursuant to the relevant regulations of the PRC government, China Dong Rong participates in a local municipal government retirement benefits scheme (the “Scheme”), whereby China Dong Rong is required to contribute a certain percentage of the basic salaries of its employees to the Scheme to fund their retirement benefits.  Contributions under the Scheme are charged to the income statement as incurred.  Contributions to the Scheme were $23,000 and $22,000 for the three months ended September 30, 2012 and 2011 respectively, and $73,000 and $40,000 for the nine months ended September 30, 2012 and 2011, respectively.
 
 
23

 
 
ITEM 2.  
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following management’s discussion and analysis should be read in conjunction with our consolidated financial statements and the notes thereto that are included elsewhere in this report.  In addition to historical information, the following discussion contains certain forward-looking statements within the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.  These statements relate to our future plans, objectives, expectations and intentions.  These statements may be identified by the use of words such as “may, “will,” “could,” “expect,, “anticipate,” “intend,” “believe, “estimate,” “plan,” “predict” and similar terms or terminology, or the negative of such terms or other comparable terminology.  Although we believe the expectations expressed in these forward-looking statements are based on reasonable assumptions within the bound of our knowledge of our business, our actual results could differ materially from those discussed in these statements.  Factors that could contribute to such differences include, but are not limited to, those discussed in the “Risk Factors” section of our annual report on Form 10-K for the year ended December 31, 2011 and filed with the SEC on April 12, 2012.  We undertake no obligation to update publicly any forward-looking statements for any reason even if new information becomes available or other events occur in the future.

Our financial statements are prepared in U.S.  Dollars and in accordance with accounting principles generally accepted in the United States.  See “Foreign Currency Translation” below for information concerning the exchanges rates at which Renminbi were translated into U.S. Dollars at various pertinent dates and for pertinent periods.

Overview

We design, market and distribute men’s apparel and related products targeted at 20-45 years old Chinese men under the “VLOV” brand.  We currently carry three product lines represented by different label colors: (1) the purple label for business; (2) the black label for business casual; and (3) the white label for casual.

We primarily sell our products to our independent distributors, each of whom is granted rights to market and sell our products in a defined market or territory.  Our distributors sell our products at points of sale, or POS, that they establish within their territories and operate either directly or through third-party retail operators, including counters, concessions, store-in-stores and stand-alone stores.  To better showcase our brand, however, we acquired the retail network of our Fujian distributor in June 2011 to operate the stores on our own.  As of September 30, 2012, our products were sold at 19 POS that we operate directly (“company stores”) and 435 POS that our distributors operate.
 
We maintain and exercise control over advertising and marketing activities from our headquarters in Fujian Province, China, where we set the tone for integrity, consistency and direction of the VLOV brand image throughout China.  Additionally, we set guidelines for our distributors as to how our products are to be advertised and displayed.

Our goal is to provide stylish, fashion-forward clothing, to our target customer.  We pride ourselves on our brand image and our ability to convey a successful and exclusive lifestyle brand.  Given our significantly increased marketing efforts in the past year, our distributors have shifted their POS from counters and concessions to stand-alone store and store-in-store locations.  Ultimately, our goal is for our distributors to move towards operating stand-alone stores and store-in-stores as we believe that this will further enhance our brand value amongst our target consumer base.

All our manufacturing activities are carried out by third-party manufacturers.  After we design and create samples, they are presented to our distributors at our biannual previews for their selection and purchase based on what they believe will sell most effectively in their POS.  After our distributors place their purchase orders with us, the manufacturers make and deliver the products to our distributors.

During 2010, all of our business operations were carried out by Jinjiang Yinglin Jinduren Fashion Limited (“Yinglin Jinduren”), which we control through contractual arrangements between Yinglin Jinduren and our wholly-owned subsidiary Dong Rong Capital Investment Limited (“HK Dong Rong”).  We completed the transfer of all sales contracts and design, marketing, sales and purchasing-related assets from Yinglin Jinduren to our wholly-owned subsidiary Dong Rong (China) Co., Ltd. (“China Dong Rong”) in the first quarter of 2011, and all of our business activities are currently conducted by China Dong Rong.

As Yinglin Jinduren has not conducted any operations since early 2011, we made Yinglin Jinduren’s annual filing for 2011 with the State Administration of Industry and Commerce (“SAIC”) in the first half of 2012.  Once the SAIC has no comment to our filing, we will proceed to dissolve, and exit from the contractual arrangements with, Yinglin Jinduren.  Until then, we will continue to operate our business through China Dong Rong (as we currently do) while continuing to control Yinglin Jinduren through the contractual arrangements.
 
 
24

 
 
Critical Accounting Policies

Our management’s discussion and analysis of our financial condition and results of operations are based on our unaudited consolidated financial statements included with this report that have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported net sales and expenses during the reporting periods.  On an ongoing basis, we evaluate our estimates and assumptions.  We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 1 to our unaudited consolidated financial statements accompanying this report.  Our critical accounting policies are those where we have made the most difficult, subjective or complex judgments in making estimates, and/or where these estimates can significantly impact our financial results under different assumptions and conditions.  Our critical accounting policies are:

Basis of presentation and consolidation

As discussed above and in Note 1 to our unaudited consolidated financial statements accompanying this report, we transferred our operations from Yinglin Jinduren to China Dong Rong during the first quarter of 2011.  Previously, our operations were conducted by Yinglin Jinduren, in which the equity interests are held by Mr.  Qingqing Wu, our chief executive officer, and his brother Mr.  Zhifan Wu.  Through contractual arrangements, we control the daily operations of Yinglin Jinduren, as well as all matters requiring shareholder approval.  We received a fee equal to Yinglin Jinduren’s net income and, in the event it were to incur losses, would be expected to absorb those losses through our inability to collect the accumulated net income due to us.  As a result, we are considered to be the primary beneficiary of Yinglin Jinduren’s operations and accordingly consolidated its assets, liabilities and results of operations in our consolidated financial statements.  All of our operations are now conducted by China Dong Rong.

Revenue Recognition
 
Sales of goods - distributors

Products for our distributors are manufactured by third parties based on orders that we receive from our distributors.  We are responsible for product design, product specification, pricing to the customer, the choice of third party manufacturers, product quality and credit risk associated with the customer receivable.  As such, we act as a principal, not as an agent, and records revenues on a gross basis.

We recognize revenue when (a) the price to the customer is fixed or determinable, (b) persuasive evidence of an arrangement exists, (c) delivery has occurred and (d) collectability of the resulting receivable is reasonably assured.  Revenue from the sales of goods is recognized on the transfer of significant risks and rewards of ownership, which generally coincides with the time when the goods are delivered and title has passed to the customer.  Revenue excludes value-added tax and is stated after deduction of trade discounts and allowances.

Sales of goods - retail