NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(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 (“company stores”) in Fujian Province.  All of the Company’s business operations are carried out by the Company’s subsidiary in China, Dong Rong (China) Co., Ltd. (“China Dong Rong”).  The Company also controls another company in China, Jinjiang Yinglin Jinduren Fashion Limited (“Yinglin Jinduren”), through contractual arrangements between Yinglin Jinduren and the Company’s subsidiary in Hong Kong, Dong Rong Capital Investment Limited (“HK Dong Rong”).  All of the Company’s business operations were conducted by Yinglin Jinduren until December 31, 2010.

 

As a result of the foregoing, the accompanying consolidated financial statements reflect the activities of the Company and each of the following entities:

(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.

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 owners of 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.   Since Yinglin Jinduren has no operations, the Company may dissolve it and exit from the contractual arrangements sometime in the future. Until then, however, the Company will continue operate its business through China Dong Rong while controlling Yinglin Jinduren through the contractual arrangements.

 

 (b)            Basis of presentation and consolidation

 

(c)            Use of estimates

(d)           Revenue recognition

Sales of goods - distributors

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

 

Returns within three 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.

 

In addition, the Company does not have any arrangements with its distributors to accept returns of obsolete or out-of-season stock.

 

Sales of goods - retail

In July 2011, the Company began operating company stores selling its products.  Revenue from retail sales is recognized at each point of sale.  During the three months ended March 31, 2013 and 2012, such sales accounted for 4.2% and 6.9% 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  consolidated statements 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 VAT, are unsecured, and are stated at the amount the Company expects to collect.  The Company maintains 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 receivables.  As of May 13, 2013, there was $5,106 in accounts receivable aged over 120 days at March 31, 2013 that had not been collected.  Management believes that the remaining accounts receivable are collectable.  As of March 31, 2013 and December 31, 2012, there was no allowance for uncollectible accounts receivable.

 

(g)            Trade deposits

The Company places trade deposits with third-party manufacturers in order to secure its ability to order products.  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 title transfers to the Company.

 

(h)           Inventories

 

Inventories are stated at the lower of cost, determined by the weighted average method, or market value.  For the company stores, the Company carries out 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. The Company also estimates an inventory allowance for excessive, slow moving and/or obsolete inventories as well as inventory which carrying value is in excess of net realizable value. As of March 31, 2013 and December 31, 2012, there was no allowance for inventory.  

 

(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:

 

Leasehold improvements	1 to 5 years (amortized over the shorter of their economic lives or the remaining lease terms)
Motor vehicles	5 years
Office equipment	3 to 5 years

 

(j)            Impairment of long-lived assets

 

(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.

 

There was no indication of impairment to goodwill as of March 31, 2013 and December 31, 2012.

(l)            Foreign currency translation

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 www.oanda.com, which are determined largely by supply and demand.  The rates of exchange quoted by www.oanda.com on March 31, 2013 and December 31, 2012 were $1.00 to RMB 6.27 and RMB 6.31, respectively.  The average translation rates of $1.00 to RMB 6.28 and RMB 6.31 were applied to the income statement accounts for the three months ended March 31, 2013 and 2012, respectively.

No representation is made that the RMB amounts could have been, or could be, converted into U.S. dollars at the above rates. The value of RMB against U.S. dollars and other currencies may fluctuate and is affected by, among other things, changes in China’s political and economic conditions. Any significant revaluation of RMB may materially affect the Company’s financial condition in terms of U.S. dollar reporting.

 

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 $ against RMB taking into account the demand and supply of RMB, as well as domestic and foreign economic and financial conditions.

(m)          Comprehensive income

The Company’s only component of other comprehensive income is foreign currency translation gains and losses.  Foreign currency translation gains for the three months ended March 31, 2013 and 2012 were $420,000 and $355,000, 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 China Dong Rong and Yinglin Jinduren for the years ended December 31, 2010 through 2012 are open to examination by the PRC central and local tax authorities.  The Company records interest and penalties as other expense on the consolidated statements of comprehensive income.  During the three months ended March 31, 2013 and 2012, 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 comprehensive income in the period in which the advertisements are first run.  Advertising expense for the three months ended March 31, 2013 and 2012 was approximately $1.57 million and $1.54 million, respectively.

(p)           Shipping and handling costs

Shipping and handling costs are expensed as incurred and included in selling expense. Such costs were insignificant for the three months ended March 31, 2013 and 2012.

(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 $0.53 million and $0.59 million for the three months ended March 31, 2013 and 2012, 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.

(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.

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

 

All of the Company’s customers are located in the PRC except for one distributor that sells the Company’s products in New York City.  The Company provides credit in the normal course of business.  The Company performs ongoing credit evaluations of its customers and maintains allowances for doubtful accounts based on factors surrounding the credit risk of specific customers, historical trends, and other information.  

 

 

 

Trade deposits consist of deposits made to third-party manufacturers in order for them to manufacture on behalf of the Company.  As of March 31, 2013, 100% of the balance was with the Company’s two top manufacturers. As of December 31, 2012, 100% of the balance was with the top three manufacturers.

   

The pre-existing distribution agreement recognized in conjunction with the acquisition 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 represents intangible values of the acquired store locations for their future profit potential that do not qualify for separate recognition, or other factors.

Depreciation expense was $152 and $207 for the three months ended March 31, 2013 and 2012, respectively.

 

 

  

  

(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.

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.

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

On October 27, 2009, the Company issued 1,446,105 shares of the Company’s series A convertible preferred stock (the “Preferred Shares”) to several accredited investors at $2.86 per share, as well as warrants to 96,407 purchase shares of the Company’s common stock.  On November 17, 2009, the Company issued an additional 1,350,616 Preferred Shares to several accredited investors, as well as warrants to purchase 90,041 shares of common stock.  The Company issued the Preferred Shares and warrants pursuant to a securities purchase agreement with the investors, and gross proceeds from both issuances amounted to $8.0 million in the aggregate (the “Preferred Shares Financing”).  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 Preferred Share also has a liquidation preference of $2.86 per share, plus any accrued but unpaid dividends.  

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 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 issued 87,138 shares of common stock to several accredited investor at $21.45 per share, as well as warrants to purchase 43,569 common shares.  The terms of these warrants are identical to those issued in the Preferred Shares Financing.  The Company issued the common stock and warrants pursuant to a securities purchase agreement with the investors, and gross proceeds from the issuance amounted to $1.87 million (the “Common Shares Financing,” and together with the Preferred Shares Financing, the “Financings”).  

 

In connection with the Financings, the Company timely filed a registration statement registering for resale the issued common shares and those underlying the Preferred Shares and warrants on December 17, 2009.  The registration statement, however, was not declared effective until March 30, 2011, thereby subjecting the Company to liquidated damages of $987,000, or 1% of the gross proceeds from the Financings per month, up to 10%.  As of March 31, 2013 and December 31, 2012, the Company accrued the full amount of the liquidated damages (Note 21).

 

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 were accounted for as derivative instrument liabilities (see Note 11). The warrants from both Financings expired during the fourth quarter of 2012.

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.

(11)        DERIVATIVE FINANCIAL INSTRUMENTS

Prior to their expiration, the Company used a binomial option pricing model to value the warrants issued in the Financing.  In valuing the warrants at the time they were issued and at March 31, 2012, 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 warrants could have been exercised by the holder at any time.

 

Because of the relatively limited historical trading period of the Company’s common stock, the expected volatility of its common stock over the then remaining life of the warrants, which was estimated at 77% as of March 31, 2012, was based on a review of the volatility of entities considered by management as comparable.  The risk-free rate of return used for the three months ended March 31, 2012 was 0.16%, based on constant maturity rates published by the U.S. Federal Reserve, applicable to the then remaining life of the warrants.  Dividend was estimated at 0% at March 31, 2012.

 

At March 31, 2013 and December 31, 2012, no derivative liabilities related to common stock warrants were outstanding as all the common stock warrants expired during the fourth quarter of 2012.

 

During the three months ended March 31, 2012, the Company recognized a gain of $318 from the change in fair value of the warrant liability.

  

(12)       COMMON STOCK

All amounts in this note are in thousands except for share data (shares, par value and price per share).  In addition, all common share and per share amounts, and exercise prices of warrants and options in these notes and the accompanying unaudited consolidated financial statements have been retroactively restated to reflect the reverse stock splits described below.

 

The Company is authorized to issue 13,333,334 shares of common stock, $0.00001 par value per share.  At March 31, 2013, 2,603,481 shares of common stock were issued and outstanding.

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 10).

  

During the year ended December 31, 2010, 1,100 warrants were exercised for, and 1,747,962 Preferred Shares were converted into, 1,100 and 233,062 shares of common stock, respectively.  In addition:

●

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 term of the service agreement was continued on March 10, 2013, with 1,334 shares of restricted common stock to be issued in four quarterly installments accordingly.  The fair value of the granted shares on March 10, 2013 and 2012 was $3.30 and $11.91 per share, respectively, for total values of $4 and $16, respectively.  $3 and $4 were recognized as compensation expense for the three months ended March 31, 2013 and 2012, respectively.

●

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 fair value of the granted shares on April 27, 2010 was $37.50 per share for a total value of $100.   $32 was recognized as compensation expense for the year ended December 31, 2011.

During the year ended December 31, 2011, 415,906 Preferred Shares were converted into 55,454 shares of common stock.  In addition:

●

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 fair value of the granted shares on September 28, 2011 was $9.75 for a total value of $26.  $26 was recognized as compensation expense for the year ended December 31, 2011.

●

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, 10,257 shares were granted to WOI for the initial 6-month period term (the “First Issuance”), and 8,482 shares for the subsequent 6-month term (the “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 term of the agreement was continued on September 28, 2012 with 12,049 shares granted to WOI for the initial 6-month period of the renewal term (the “Third Issuance”) and 22,223 shares for the second 6-month period (the “Fourth Issuance”), calculated based on the closing prices of $8.30 on September 28, 2012, and $4.50 on March 28, 2013, respectively.  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 vested in two installments of 6,025 shares each on December 27, 2012 and March 27, 2013.  The Fourth Issuance will vest in two installments of 11,111 shares each on June 27 and September 27, 2013.   For the First Issuance and Second Issuance, compensation expense of $0 and $50 was recognized for the three months ended March 31, 2013 and 2012, respectively.  For the Third Issuance, compensation expense of $47 and $0 was recognized for the three months ended March 31, 2013 and 2012, respectively.  For the Fourth Issuance, compensation expense of $2 and $0 was recognized for the three months ended March 31, 2013 and 2012, respectively.

 

 

●	On December 9, 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.

During the year ended December 31, 2012, 238,375 Preferred Shares were converted into 31,784 shares of common stock.  In addition:

●	On May 21, 2012, the Company’s Board of Directors (the “Board”) approved a stock plan pursuant to which up to 266,667 shares of common stock may be issued to officers, directors, employees and consultants (the “2012 Stock Plan”).

●

On May 25, 2012, the Board 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 22,333 shares of common stock to be issued under the Company’s 2012 Stock Plan.  The fair value of such shares on May 25, 2012 was $10.20, for a total value of $228.  Compensation expense of $228 and $0 was recognized for years ended December 31, 2012 and 2011, respectively.  The shares were issued in July 2012.

●

On July 25, 2012, the Board ratified an agreement with a consultant to provide the Company with general advice and consulting services from July 20, 2012 to July 19, 2013, regarding the Company’s expansion into the Taiwan, in exchange for 11,667 shares of common stock to be issued under the Company’s 2012 Stock Plan.  The fair 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 years ended December 31, 2012 and 2011, respectively. The shares were issued in July 2012.

●	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 shares of common stock.

A summary of the status of the Company’s non-vested shares as of March 31, 2013 and changes during the year ended December 31, 2012, is presented below:

 

As of March 31, 2013, there was $104 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted by the Board.  Such cost is expected to be recognized by March 9, 2014.  The total fair value of shares vested during the three months ended March 31, 2013 and 2012 was $53 and $54, respectively.

 

(13)       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 (see Note 10). As of December 31, 2012 and March 31, 2013, 394,478 Preferred Shares were outstanding, with an aggregate liquidation preference of $1.13 million.

No Preferred Shares were converted during the three months ended March 31, 2013.

 

(14)       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 months ended March 31, 2013 and 2012, 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.

 

(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 and the warrants issued in connection with the Financings.  For the three months ended March 31, 2012, the warrants were 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 warrants expired during the fourth quarter of 2012. 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 for the three months ended March 31, 2012.

 

 

Warrants were excluded from the calculation of diluted earnings per share for the three months ended March 31, 2013 as all warrants were expired during the fourth quarter of 2012. Warrants were also excluded from such calculation for the three months ended March 31, 2012 as their effects were anti-dilutive .

(15)       INCOME TAXES

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

		Three Months  Ended March 31,
		2013 (unaudited)				2012 (unaudited)
PRC enterprise income tax - current		$	1,921			$	2,191

As of March 31, 2013 and December 31, 2012, 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 2013 and 2012 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 March 31, 2013.

 

The following table reconciles the theoretical tax expense calculated at the statutory rates to the Company’s effective tax expense for the three months ended March 31, 2013 and 2012 (in thousands):

 

Tax adjustment for 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 relevant tax authority subsequent to the Company's filing of its annual report on Form 10-K on April 12, 2012. Therefore a provision was made for the additional income tax during the three months ended March 31, 2012. Non-deductible expenses for the three months ended March 31, 2013 and 2012 primarily consisted of expenses incurred outside of the PRC which are not deductible in computing the income tax for the PRC.

 

(16)       SEGMENT INFORMATION

 

ASC Topic 280 requires use of the “management approach” model for segment reporting.  Such 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 months ended March 31, 2013 and 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 March 31, 2013 the Company’s distributors operated 404 points of sale, and the Company operated 17 company stores.

 

Condensed information with respect to the two reportable business segments for the three months ended March 31, 2013 and 2012 is as follows (in thousands):

(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.