10-K/A 1 cist10ka.htm FORM 10-K/A China Information Security Technology, Inc.: Form 10-K/A - Prepared by TNT Filings Inc.

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K/A
(Amendment
 No. 1)

(Mark One)

x  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934        
For the fiscal year ended: December 31, 2008

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 No. 000-53147

CHINA INFORMATION SECURITY TECHNOLOGY, INC.
(Name of Small Business Issuer in Its Charter)

NEVADA 98-0575209
(State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.)
   

21st Floor, Everbright Bank Building,
Zhuzilin, Futian District,
Shenzhen, Guangdong, 518040
People’s Republic of China

(Address of Principal Executive Offices)

(+86) 755 -8370-8333
(Registrant’s Telephone Number, Including Area Code)

Securities registered under Section 12(b) of the Exchange Act: NONE

Securities registered under Section 12(g) of the Exchange Act: Common stock, $0.01 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes o            No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes o            No x

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 past 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 x            No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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 definition for "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o Non-Accelerated Filer o Accelerated Filer x Smaller Reporting Company x

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Act).     Yes o            No x

The aggregate market value of the 18,671,366 shares of voting and non-voting common equity stock held by non-affiliates of the registrant was $105,679,900 as of June 30, 2008, the last business day of registrant’s most recently completed second fiscal quarter, based on the last sale price of the registrant’s common stock on such date of $ 5.66 per share, as reported by Quotemedia, Inc.

There were a total of 48,797,211 shares of the registrant’s common stock outstanding as of March 13, 2009.

Documents Incorporated by Reference: None

1


EXPLANATORY NOTE

This Amendment No. 1 on Form 10-K/A (this "Amendment") amends the China Information Security Technology, Inc. (the "Company") Annual Report on Form 10-K for the year ended December 31, 2008, previously filed with the Securities and Exchange Commission on March 16, 2009 (the "Original Filing"). This Amendment is being filed solely to amend Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations," primarily to remove the non-GAAP financial information contained in the text and graphic disclosure of the Company’s financial data for the years ended December 31, 2008 and 2007.

For purposes of this Form 10-K/A, and in accordance with Rule 12b-15 under the Securities Exchange Act of 1934, as amended, each item of the Original Filing that was affected by the inclusion of non-GAAP financial data has been amended and restated in its entirety. Unless otherwise indicated, this report speaks only as of the date that the original report was filed. No attempt has been made in this Form 10-K/A to update other disclosures presented in the Original Filing. This Form 10-K/A does not reflect events occurring after the filing of the Original Filing or modify or update those disclosures, including the exhibits to the Original Filing affected by subsequent events; however, this Form 10-K/A includes as exhibits 31.1, 31.2, 32.1 and 32.2 new certifications by the Company’s Chief Executive Officer and Chief Financial Officer as required by Rule 12b-15.

 



 

TABLE OF CONTENTS


  

PART I

  Page

  

  

  

ITEM 1.

BUSINESS.

4

ITEM 1A.

RISK FACTORS.

19

ITEM 1B.

UNRESOLVED STAFF COMMENTS.

30

ITEM 2.

DESCRIPTION OF PROPERTIES.

30

ITEM 3.

LEGAL PROCEEDINGS.

30

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

30

  

  

  

  

PART II

  

  

  

  

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

30

ITEM 6.

SELECTED FINANCIAL DATA.

32

ITEM 7.

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

32

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

43

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

43

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

43

ITEM 9A.

CONTROLS AND PROCEDURES.

43

ITEM 9B.

OTHER INFORMATION.

47

  

  

  

  

PART III

  

  

  

  

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

47

ITEM 11.

EXECUTIVE COMPENSATION.

50

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

53

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE.

55

ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES.

55

  

  

  

  

PART IV

  

  

  

  

ITEM 15.

EXHIBITS, FINANCIAL STATEMENT SCHEDULES.

56

 

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FORWARD-LOOKING STATEMENTS


This annual report contains forward-looking statements relating to us that are based on the beliefs of our management as well as assumptions made by, and information currently available to, our management. When used in this Report, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan” and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. These statements reflect management's current view of us concerning future events and are subject to certain risks, uncertainties and assumptions, including among many others: our potential inability to raise additional capital, the possibility that third parties hold proprietary rights that preclude us from marketing our products, the emergence of additional competing technologies, changes in domestic and foreign laws, regulations and taxes, changes in economic conditions, uncertainties related to China's legal system and economic, political and social events in China, a general economic downturn, a downturn in the securities markets, Securities and Exchange Commission regulations which affect trading in the securities of “penny stocks,” and other risks and uncertainties. Should any of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this Report as anticipated, estimated or expected.


USE OF CERTAIN DEFINED TERMS AND TREATMENT OF STOCK SPLIT

Except as otherwise indicated by the context, references in this report to:

“China” and “PRC” are references to the People’s Republic of China and references to “Hong Kong” are to the  Hong Kong Special Administrative Region of China;

“CIST”, “we,” “us,” or “our” and the “Company” are references to the combined business of China Information Security Technology, Inc. and its wholly-owned subsidiary, China Public Security Holdings Limited, a British Virgin Islands company, or CPSH, along with CPSH’s wholly-owned subsidiaries: Information Security Technology (China) Co., Ltd., a PRC company, or IST (formerly, Public Security Technology (PRC) Co., Ltd.); Public Security Technology (China) Co., Ltd., a Hong Kong Limited company; Information Security Software Investment Limited, a Hong Kong company,  or ISSI (formerly, Fortune Fame International Investment Limited), and its wholly-owned subsidiary, Information Security Software (China) Co., Ltd. a PRC company, or ISS, (formerly, Information Security Development Technology (Shenzhen) Co., Ltd.); Information Security International Investment and Development Limited, a Hong Kong company, or ISIID (formerly, Bocom Multimedia Display Co., Ltd.), and its operating PRC subsidiary Shenzhen Bocom Multimedia Display Technology Co., Ltd, or Bocom; iASPEC Software Co., Ltd., or iASPEC, to whose operations we succeeded on October 9, 2006 and who became our variable interest entity effective July 1, 2007, and its 57% majority owned subsidiary Wuhan Wuda Geoinformatics Co., Ltd., or Geo; and Kwong Tai International Technology Limited, or Kwong Tai, a Hong Kong Limited company, and its wholly-owned PRC subsidiary, Shenzhen Zhongtian Technology Development Company Ltd., or Zhongtian;

“RMB” are to Renminbi, the legal currency of China; and “U.S. dollar,” “$” and “US$” are to the legal currency of the United States; and

“Securities Act” are references to the Securities Act of 1933, as amended and references to “Exchange Act” are references to the Securities Exchange Act of 1934, as amended.

 

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PART I


ITEM 1.  DESCRIPTION OF BUSINESS

Overview of Our Business

China Information Security Technology, Inc. is a holding company that owns all of the issued and outstanding capital stock of China Public Security Holdings Limited, a British Virgin Islands holding company, or CPSH. We operate through our PRC mainland subsidiaries, IST, ISS, Bocom, Zhongtian and through our variable interest entity, or VIE, iASPEC and its subsidiary Geo. Through the operations of our China-based subsidiaries and the subcontracting services provided for in our Management Service Agreement, or MSA, with iASPEC, we are a provider of integrated solutions for the information security sector and full-service Geographic Information Systems, or GIS, solutions to the public security and civil-use markets in China, specializing in providing information security technology, GIS, and digital hospital information systems.  Through ISS, we also provide an e-Government application platform and solutions technology, and we are an exclusive Certificate Authority (CA) application provider for the PRC’s Shenzhen municipality. The CA certification allows ISS to issue digital certificates that contain a public key that can be used by the public to encrypt messages and protect the identity of the user.  The CA also certifies that the public key contained in the certificate belongs to the person, organization, server or other entity noted in the certificate. CAs are currently used in China’s e-Government industry and can be successfully integrated with our e-Government platforms and solutions to enhance customers’ applications.

Our customers are mostly public sector entities that use our products and services to improve the service quality and management level and efficiency of public security, traffic control, fire control, medical rescue, border control, and surveying and mapping. Our typical customers include some of the most important government departments in China, including the Ministry of Public Security of the People’s Republic of China, the Guangdong Province Public Security Department, the Fujian Province Public Security Department, the Shenzhen General Station of Exit and Entry Frontier Inspection, and other Public Security, Firefighting and Traffic Police Departments in Guangdong Province, Hainan Province, Shanxi Province, Shenzhen City, Shantou City, Zhuhai City, Beijing City, Tianjin City, Shijiazhuang City, Shanghai City, Jingmen City, Chongqing Municipality and Kunming City, and the Shenzhen Personnel Bureau, the Shenzhen Urban Planning Bureau, the Shenzhen Labor Bureau, the Shenzhen Civil Administration Bureau, the Shenzhen Health Bureau, the Dongguan Land Resource Bureau, the Dongguan Urban Planning Institute, the Nanchang Landscaping Bureau, the Wuhan Landscaping Bureau, the Nanjing Surveying and Mapping Bureau and the Inner-Mongolia Surveying and Mapping Bureau. In the future, we expect to continually expand our market and product offerings in the public sectors and other sectors, through active industry consolidation and technical capabilities reinforcement.

We generate revenues through the sale of our integrated hardware and software products and through the provision of related support services. In fiscal years 2008 and 2007, 48% and 68% of our revenues, respectively, were generated under our exclusive commercial arrangement with iASPEC. However, fulfillment of certain PGIS (Police-use Geographic Information Systems) contracts with PRC Government customers is restricted to entities possessing the necessary government licenses and approvals which IST does not have. The MSA anticipates that iASPEC will fulfill all obligations for PGIS contracts, IST will receive 100% of the net received profit of iASPEC, net of an annual fee of $180,000, and IST will reimburse iASPEC for all net losses incurred by iASPEC.

Our History and Background 


We were originally organized under the laws of the State of Florida, on September 19, 1979, under the name Mark Thomas Publishing Inc. and on April 29, 2003 we changed our name to Irish Mag, Inc.  From our inception through October 8, 2006, we provided consulting services in the offset printing industry, targeting individual retail consumers as well as small to mid-size companies. However, as a result of the transactions discussed below, we are now a provider of integrated solutions for the public security sector in China, specializing in providing public security information communication applications and Geographic Information Systems or GIS software services. On January 26, 2007, we changed our name to China Public Security Technology, Inc. to more accurately reflect our new business and commercial objectives, however, on April 2, 2008, we entered into an Agreement and Plan of Merger with China Information Security Technology, Inc., or CIST, a Nevada corporation and our wholly-owned subsidiary. Pursuant to the merger agreement, we agreed to merge with and into CIST, with CIST being the surviving entity. The merger became effective on April 7, 2008. As a result, our name is now China Information Security Technology, Inc., a Nevada corporation.


Reverse Merger Transaction


Between October 6, 2006 and January 31, 2007, our shareholders approved a series of transactions whereby we purchased all the issued and outstanding stock of CPSH from our current Chairman and Chief Executive Officer Jiang Huai Lin, for 25,500,000 shares of our common stock in the aggregate.  As a result of these transactions CPSH and its wholly-owned subsidiary, IST, became our wholly-owned subsidiaries, and Mr. Lin became the beneficial owner of 25,500,000 shares of our common stock in the aggregate, which, at January 31, 2007, constituted 80.8% of our issued and outstanding common stock. Mr. Lin has since transferred  3,749,920 of these shares and now holds 19,150,080 of these shares directly and 2,600,000 of these shares indirectly through Total Device Management Limited, an entity controlled by Mr. Lin.  

 

4


 

January 2007 Private Placement


On January 16, 2007, we entered into a securities purchase agreement, or January Purchase Agreement, with two accredited Investors, or the January Investors, led by Pinnacle China Fund, L.P., pursuant to which, as amended, we agreed to issue and sell to the January Investors up to 7,868,422 shares of our common stock equaling 19.96% of our issued and outstanding capital stock, for a purchase price, in the aggregate, of up to $14,950,001.80 or $1.90 per share, half of which was issued for one-half of the aggregate purchase price on January 31, 2007, and the remaining half of which was issued for the balance of the aggregate purchase price on February 6, 2007. We additionally represented and warranted in the January Purchase Agreement that, except for one contract, Shenzhen iASPEC Software Engineering Company Limited, or iASPEC, a company also controlled by our Chief Executive Officer and controlling stockholder, Mr. Jiang Huai Lin, would not require a certain governmental permit to perform under the Amended and Restated Turnkey Agreement, or Amended Turnkey Agreement, dated January 31, 2007, as amended, between iASPEC and our indirect Chinese Subsidiary, Information Security Technology (China) Co., Ltd. (formerly, Bo Hai Wen Technology (Shenzhen) Company Limited), and that IST’s performance of the services under the agreement does not conflict with or violate any laws or regulations of PRC.  In addition, the parties provided for a payment of liquidated damages to each of the January Investors, equal to the amount of each Investor’s pro rata share of the purchase price, if (a) any government agency of the PRC takes any action that materially or adversely affects the restructuring of our arrangements with iASPEC effected simultaneously with the closing of the January Purchase Agreement and (b) we cannot undo such government action or otherwise address such material adverse effect to the reasonable satisfaction of the January Investors within 60 days of such occurrence.


Roth Capital Partners, LLC acted as our placement agent, or Placement Agent, in connection with the offering of the shares to the January Investors under the January Purchase Agreement. As compensation for its services, the Placement Agent received a cash fee equal to $1,046,500, representing 7% of the gross proceeds received from the sale of the shares, of which a 20% cash fee was payable by us directly to Oppenheimer & Co., Inc., for its services as a finder, or Finder, in connection with the offering. The Placement Agent will also receive warrants to purchase 550,789 shares of our common stock, representing 7% of the gross proceeds received from the sale of the shares divided by the per share price of the shares, 20% of which was also payable by us directly to the Finder. The Placement Agent and Finder warrants have a term of five years, were exercisable immediately on issuance and have an exercise price equaling up to 120% of the per share purchase price of the shares purchased by the January Investors.  In addition, we reimbursed the Placement Agent for reasonable out-of-pocket expenses incurred in connection with the offering and for all road show related expenses.

 

Management Service Agreement


From October 9, 2006 through June 30, 2007, we operated under a Business Turnkey Agreement, or Turnkey Agreement, with iASPEC, pursuant to which iASPEC exclusively engaged IST as its subcontractor to provide iASPEC with outsourcing services (to the extent that those services do not violate any special governmental permits held by iASPEC and do not involve the improper transfer of any sensitive confidential governmental or other data). The Turnkey Agreement also provided for a revenue sharing arrangement between iASPEC and IST where IST was entitled to between 90% and 100% of the revenues actually received by iASPEC from servicing contracts involving any iASPEC business, but was obligated to pay for its own costs in providing these services and to pay iASPEC $180,000 per year throughout the term of the agreement.  


Effective July 1, 2007, iASPEC and iASPEC’s shareholders, Mr. Lin and Mr. Jin Zhu Cai agreed to terminate the Turnkey Agreement and replaced it on the same day with Management Service Agreement. Pursuant to the terms of the Management Service Agreement, iASPEC granted IST an exclusive, royalty-free, transferable, worldwide, license to use and install for a ten-year term, certain iASPEC software, along with copies of source and object code relating to such software, in any manner permitted by applicable laws, and IST licensed back to iASPEC a royalty-free, limited, non-exclusive license to the software, without right of sub-license, for the sole purpose of permitting iASPEC to carry out its business as presently conducted. IST will also have the right to designate two Chinese citizens to serve as senior managers of iASPEC, to serve on iASPEC’s Board of Directors and assist in managing the business and operations of iASPEC. In addition, both iASPEC and IST will require the affirmative vote of the majority of our Board of Directors, as well as at least one non-insider director, for certain material actions with respect to iASPEC, including, but not limited to: (a) the nomination, appointment, election or replacement of any board members; (b) the distribution of any dividend or profits; (c) any merger, division, change of corporate form, dissolution or liquidation; (d) any reimbursement of net losses or other payments or transfers of funds from IST to iASPEC; (e) the formation or disposition of a subsidiary or the acquisition or disposition of any interest in any other entity; and (f) the encumbrance of any assets under any lien not in the ordinary course of business. Furthermore, under the Management Service Agreement, IST will receive 100% of the net received profit of iASPEC and will reimburse iASPEC for all net losses incurred by iASPEC. The net profit of iASPEC will be paid to IST, and the net losses of iASPEC will be reimbursed by IST, no later than the last day of the month following the end of each calendar quarter, commencing on July 1, 2007.  IST is also obligated to pay iASPEC $180,000 per year, no later than the last day of the month following the end of each calendar year, commencing on July 1, 2007, and this amount may be retained by iASPEC out of any net received profit due and payable to IST as of such payment date.  IST may also advance to iASPEC, at IST’s sole discretion, amounts to be credited against IST’s future obligations to iASPEC, but any such advances will be treated as prepayments and not as loans.  iASPEC will have no obligation to repay any such advances except by crediting the amount of such advances against IST’s obligation to reimburse net losses, or by adding the amount thereof to net profit when and as requested by IST.   If iASPEC or any of the iASPEC shareholders materially breaches the Management Service Agreement and fails to remedy the breach within 60 days after notice from IST of such breach, they will be jointly and severally obligated to pay to IST liquidated damages in an amount equal to the higher of (a) eight times the annualized revenues of IST for the last completed fiscal quarter, or (b) US$50 million.

 

5


 

The Management Service Agreement contains a true-up provision which required iASPEC and IST, on or before September 30, 2007, to calculate all prior amounts owed to IST under the Turnkey Agreement, and required iASPEC to pay such amounts.  The parties were required to calculate the cumulative net profit/net losses of iASPEC from October 9, 2006, when iASPEC commenced its contractual relationship with IST, through the commencement date of the Management Service Agreement, and iASPEC was required to pay the amount due to IST, if there was a net received profit, while IST was obligated to reimburse any amount to iASPEC if there was a net loss.  “Net Received Profit” means the net received profit of iASPEC, calculated as follows: accrued accounts receivable plus net turnover (revenue), minus cost of sales, minus operating expenses, and minus accrued but not collected accounts receivable, but only if the result is a positive number. “Net Losses” means the net losses of iASPEC, calculated as follows: accrued accounts receivable plus net turnover (revenue), minus cost of sales, minus operating expenses, and minus accrued but not collected accounts receivable, but only if the result is a negative number.  The calculated true-up amount of $7,005,183 was paid by iASPEC to IST as of December 31, 2007.


In connection with the Management Service Agreement, IST also entered into a purchase option agreement, or Option Agreement, with iASPEC and its shareholders, effective as of July 1, 2007, pursuant to which the iASPEC shareholders granted IST, or its designee(s), an exclusive, irrevocable option to purchase from the iASPEC shareholders, from time to time, all or a part of iASPEC’s shares, pursuant to an equity transfer agreement, or all or a part of iASPEC’s assets, pursuant to an asset purchase and transfer agreement.  However, according to the Option Agreement, the option may not be exercised by IST if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated. Under the terms of the Option Agreement, the option is immediately exercisable at an exercise price of $1,800,000, in the aggregate, subject to regulatory approval.  In addition, iASPEC and the iASPEC shareholders agreed to use their best efforts to acquire all necessary government approvals and other consents to complete a share purchase under the Option Agreement. The Option Agreement may be rescinded by IST upon 30 days’ notice and will terminate on the date that we purchase all remaining shares or assets of iASPEC pursuant to the terms of the Option Agreement.  If any of the parties breaches the Option Agreement and fails to remedy the breach, the breaching party will pay a penalty of RMB5,000,000 (approximately $683,600) to the non-breaching party or parties, and compensate the non-breaching party or parties for any losses caused by the breach.


As a result of the restructuring of its relationship with iASPEC, iASPEC has become a variable interest entity of our Company. A variable interest represents a contractual or ownership interest in another entity that causes the holder to absorb the changes in fair value of the other entity’s net assets.  Potential variable interests include: holding economic interests, voting rights, or obligations to an entity; issuing guarantees on behalf of an entity; transferring assets to an entity; managing the assets of an entity; leasing assets from an entity; and providing financing to an entity.  In such cases FASB Interpretation 46(R), which interprets Accounting Research Bulletin (ARB) 51, Consolidated Financial Statement, requires consolidation of such entity by the enterprise that controls the economic risks and rewards of the entity, regardless of ownership. While we have held an economic interest in iASPEC since October 9, 2006, the Management Service Agreement and the Option Agreement have now given us control over the business and operations of iASPEC.  As a result, iASPEC’s financial data is subject to consolidation with our financial data in accordance with the provisions of FASB Interpretation 46(R), commencing July 1, 2007. For more details regarding the Management Service Agreement and Option Agreement, see our Current Report on Form 8-K filed with the SEC on August 6, 2007.


October, 2007 Private Placement


On October 25, 2007, we entered into a securities purchase agreement, or the October Purchase Agreement, with certain accredited investors, or Investors. Under the October Purchase Agreement, we agreed to issue and sell to the Investors up to 5,000,000 shares of our common stock, representing approximately 11% of our issued and outstanding capital stock on a fully-diluted basis as of and immediately after consummation of the transactions contemplated by the October Purchase Agreement, for an aggregate purchase price of up to $40,000,000, or $8.00 per share. On October 29, 2007, the 5,000,000 shares were issued and we received cash proceeds of $36,506,275.


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Pursuant to the October Purchase Agreement, we also entered into (i) a registration rights agreement (the “Registration Rights Agreement”) with the Investors, pursuant to which, among other things, we agreed to register the shares of its common stock issued to the Investors within a pre-defined period and (ii) a closing escrow agreement (the “Escrow Agreement”) with the Investors and our U.S. legal counsel, as escrow agent, pursuant to which the Investors agreed to deposit the Purchase Price into escrow to be released upon the occurrence of the events set forth in the Escrow Agreement. The funds were released in escrow on October 30, 2007, the closing date, and the registration statement covering these shares was declared effective on February 6, 2008.  We also agreed to use our reasonable best efforts to have our common stock listed and traded on any one of the New York Stock Exchange, the American Stock Exchange, the NASDAQ Global Select Market or the NASDAQ Capital Market by June 30, 2008.


In connection with the October Purchase Agreement, we issued warrants to Roth Capital Partners, LLC and Brean Murray, Carret & Co., LLC for the purchase of 300,000 and 100,000 shares of our common stock, respectively. The warrants are for a term of 5 years, have an exercise price of $9.60 per share, and include registration rights to register the shares issuable upon exercise of such warrants. For more details regarding the October Purchase Agreement and the Registration Rights Agreement, see our Registration Statement on Form S-1, filed with the SEC on February 6, 2008.


Acquisition of Fortune Fame


On November 7, 2007, we acquired 100% of the equity interests of Fortune Fame, and its operating PRC subsidiary, ISS, for which we paid approximately $7.1 million in cash and issued 883,333 shares of its common stock.  Of the 883,333 shares of common stock, 383,333 shares were issued to Cheer Crown International Investment Limited, or Cheer Crown, and 500,000 shares were issued to Mr. Gao, the Chairman of ISS’s Board of Directors. Under the terms of the acquisition agreement, Mr. Gao, agreed to continue on as the Chairman of ISS. Mr. Gao also agreed that he will return 250,000 shares of our common stock if Fortune Fame does not meet certain net income targets in 2008, and 250,000 shares if Fortune Fame does not meet certain net income targets in 2009.


Acquisition of Bocom Multimedia


On December 9, 2007, we entered into a Share Purchase Agreement (the “Bocom Purchase Agreement”), with Bocom Venture Inc. (“Bocom Venture”), a British Virgin Islands company, for the acquisition of 100% of the issued and outstanding capital stock of Bocom Multimedia and its wholly-owned Chinese subsidiary, Bocom, for a purchase price of approximately $18,000,000. We paid approximately $9,000,000 of the purchase price in cash which is included in deposit for business acquisition as of December 31, 2007. The remaining $9,000,000 of the purchase price was paid in 1,125,000 shares of our common stock.  On February 1, 2008, we completed our acquisition of Bocom Multimedia, and effective immediately, Bocom Multimedia and its subsidiary, Bocom, became our indirect wholly-owned subsidiary.


Bocom Multimedia was formed in Hong Kong on August 10, 2007, and is a leading provider of large screen digital light processing and integrated solutions in China. Their products have been widely applied in the fields of public security, communication and multimedia in China.  Bocom Multimedia has successfully completed over 100 digital light processing project installations for police bureaus and municipal governments in more than ten provinces in China, including Beijing, Shanghai, Chongqing, Sichuan, Hunan, Guangdong and Fujian.


Acquisition of Wuhan Wuda Geoinformatics


On April 7, 2008, our variable interest entity, iASPEC, acquired Wuhan Wuda Geoinformatics Co., Ltd., or Geo, pursuant to (1) a share purchase and increased capital agreement, or the Geo Agreement, dated as of February 16, 2008, by and among iASPEC, Wuhan Wuda Venture Capital Co., Ltd., or Wuhan Venture, Song Ai Hong and Geo, for the purchase of 46% of Geo for a purchase price of approximately $4,819,000, and to inject an additional approximately $1,388,900 to increase the registered capital of Geo to approximately $8,333,000 in the aggregate, and (2) a share purchase agreement, or the Li Agreement, dated as of February 16, 2008, between iASPEC and Li Wei, for the purchase of 2.4% of Geo, for a purchase price of approximately $666,700.


Geo was founded in 1999 by Wuhan University, a leading university in Asia for GIS-related studies. Geo develops and sells GIS software, contracts surveying and mapping projects, produces space measurement data and provides technical consulting and supervision services for GIS projects.  In addition to its research and development capabilities, Geo will provide us with direct access to numerous permits and mapping data that will further enhance our technological capabilities, lower project construction costs and enable us to price its products and services more competitively. Our ownership of the data will also provide licensing and recurring domestic and international revenue opportunities for us.


7


 

Move to Nasdaq


On May 21, 2008, we received approval to list our securities on The Nasdaq Global Select Market, or Nasdaq. The symbol for our common stock on Nasdaq is “CPBY.” We began trading under our new symbol on May 23, 2008.


Equity Transfer Agreement with iASPEC


On July 1, 2008, our Chairman and Chief Executive Officer, Mr. Jiang Huai Lin, entered into an equity transfer agreement, or Equity Transfer Agreement, with Mr. Jin Zhu Cai, the owner of a 24% minority interest in iASPEC, our variable interest entity, pursuant to which, Mr. Lin agreed to purchase Mr. Cai’s minority interest for a total consideration of RMB60 million (approximately $8.72 million).  The purchase price was payable in 1,527,855 restricted shares of our common stock owned by Mr. Lin, valued at $5.708 per share (based on a 5-day average of the Company’s share price during the week of June 23, 2008).  Mr. Lin was obligated to pay the purchase price on or before July 15, 2008. As a condition to the closing of the Equity Transfer Agreement, the parties obtained the consent of the Board of Directors of IST, our Chinese operating subsidiary, in accordance with the terms and conditions of the MSA. As a result of the Equity Transfer Agreement, Mr. Lin holds 100% of the equity interests of iASPEC.


Acquisition of Zhongtian


On October 31, 2008, we completed the acquisition of Kwong Tai International Technology Limited, a Hong Kong company, and its wholly-owned Chinese subsidiary, Shenzhen Zhongtian Technology Development Company Ltd., or Zhongtian, from Wide Peace International Investments Limited, a British Virgin Islands company, or Wide Peace, for a purchase price of $16,500,000,  $9,900,000 (approximately RMB67,617,000) of which was paid in cash, and the remaining $6,600,000 of which was paid in 1,280,807 shares of our common stock, valued at $5.153 per share (the average of the closing price of our common stock for the 20 trading days prior to September 23, 2008).

 

Under the terms of the stock purchase agreement dated September 23, 2008, Wide Peace is obligated to return 355,164 of the purchased shares to us if Zhongtian does not attain an audited minimum after tax net income, or ATNI, of $2,200,000 for fiscal year 2009, and an additional 355,164 of the shares if Zhongtian does not attain an audited minimum ATNI of $2,860,000 for fiscal year 2010. If the audited ATNI of Zhongtian for either 2009 and 2010, as reflected in its audited accounts prepared in compliance with United States generally accepted accounting principles, meets the respective thresholds for 2009 and 2010, then the pledged shares for each such period will be released from the pledge whenever the applicable threshold is attained. However, if the audited ATNI for 2009 or 2010 fails to reach the applicable threshold, then Wide Peace is obligated to transfer title to and deliver such pledged shares to us. For more details regarding the Zhongtian transaction, see our Current Reports on Form 8-K filed with the SEC on September 29, 2008 and November 3, 2008.

Recent Developments

As part of our strategy to effectively deploy excess cash to improve shareholder value, our Board of Directors has approved a new share repurchase program of up to $5 million of our outstanding common shares, effective December 17, 2008.  Repurchases under the new program will be funded with available cash, and made from time to time in either the open market or through private transactions, and will terminate on December 17, 2009. The timing, volume, and nature of share repurchases will be at the discretion of management, dependent on market conditions, other priorities for cash investment, applicable securities laws, and other factors, and may be suspended or discontinued at any time. All or part of the repurchases may be implemented under a Rule 10b5-1 trading plan, effective as of February 11, 2009, which allows repurchases under pre-set terms at times when we are otherwise prevented from doing so under insider trading laws or because of self-imposed trading blackout periods. As of March 13, 2009, the Company had approximately $4.98 million remaining under the share repurchase program.  


Corporate Structure


The following chart reflects our current corporate organizational structure:

 

8


 

 

Our corporate headquarters are located at 21st Floor, Everbright Bank Building, Zhuzilin, Futian District, Shenzhen, Guangdong, 518040, People’s Republic of China. Our telephone number is (+86) 755 -8370-8333.  We maintain a website at www.chinacpby.com that contains information about our subsidiaries CPSH and Public Security, but that information is not a part of this report.

 

Our Industry


General


Over the past two decades, the PRC government has encouraged the development and use of new technologies for information and communication (or ICTs) and their application in all spheres of government, industry, education and culture. The term “Informatization” or “xinxihua” has been coined in China to describe the overall process of ICT application in China and has in recent years become a linchpin of central and many local economic development strategies.


As a part of the Informatization process, the PRC government has launched a series of online programs to accelerate its pace of implementing and using information technology to improve China’s current government information management systems, and help promote China’s economic development. The Informatization process has led to a growth in the use of information technology, such as e-Government platforms and GIS, for public security. An example of this has been the Government Online Project or GOP. The Government Online Project is a three-stage initiative: Stage One focused upon connecting 800-1,000 government offices and agencies to the Internet; Stage Two focused on having government offices and agencies move their information systems into compatible electronic form; and Stage Three focused on making government offices and agencies paperless. The purpose of the GOP is to create a centrally accessible administrative system that collects and transports data to and from users; users being the public and the enterprise system, as well as government departments.


On January 22, 1999, the GOP was formally launched by China Telecom and the State Economic and Trade Commission’s (SETCs) Economic Information Center along with the Information Offices of more than 40 central government departments. The project interconnects government offices of every province, autonomous region and municipality. The network will promote the establishment of formal government websites to provide information and services and then (in theory) also facilitate collaboration between the government and the nation’s growing number of IT enterprises. By developing the basic infrastructure and encouraging government agencies at all levels to incorporate Internet technologies, the government hopes to set the tone for online development and, ultimately, e-commerce. Our First Responder Coordination Platform, Intelligent Border Control System, Residence Card Information Management System are a part of the information technology implementation program of the public security sector in China.


9


 

Global GIS Industry


The GIS field is a rapidly growing field that incorporates geographical features with data in order to assess real world problems. In the strictest sense, a GIS is a computer system capable of capturing, storing, analyzing, and displaying geographically referenced information; that is, data identified according to location. The term GIS also includes the procedures, operating personnel, and spatial data that go into the system.


The power of a GIS comes from the ability to relate different information in a spatial context and reach a conclusion about this relationship. Most of the information we have about our world contains a location reference, placing that information at some point on the globe. However, GIS can be used to emphasize objects on a map, their absolute location on the Earth's surface and their spatial relationships, in a series of attribute tables—the “information” part of a GIS. For example, while a computer-aided mapping system may represent a road simply as a line, a GIS may also recognize that road as the boundary between wetland and urban development between two census statistical areas. A GIS, therefore, can reveal important new information (such as whether features intersect or whether they are adjacent) that leads to better decision making or solutions.


Data Capture and Integration – In order to utilize a GIS, data must be directly entered into (or captured by) a GIS in digital form, that is, in a form the computer can recognize.  A GIS can also convert existing digital information, which may not yet be in map form, into forms it can recognize and use.  Map data may also be created by (1) digitizing maps by hand-tracing with a computer mouse on the screen or on a digitizing tablet to collect the coordinates of features, (2) using electronic scanners to convert maps to digits, or (3) uploading coordinates from Global Positioning System or GPS receivers into a GIS. Once a time-consuming process, the data capture process is now made easier by the development in the GIS industry of software tools to automatically extract features from satellite images or aerial photographs and create databases in map form for use in a GIS.  


Information Retrieval and Data Output – With a GIS you can “point” at a location, object, or area on the screen and retrieve recorded information about it from off-screen files. For example, using scanned aerial photographs as a visual guide, you can ask a GIS about the location of a fire, analyze the area around the fire and determine conditions of adjacency (what is next to it), containment (what is enclosed by it) and proximity (how close is something to it).  


Another critical component of a GIS is its ability to produce graphics on the screen or on paper to convey the results of analyses to the people who make decisions about resources. Wall maps, Internet-ready maps, interactive maps and other graphics can be generated, allowing decision makers to visualize and thereby understand the results of analyses or simulations of potential events.


Components of GIS


Hardware – Hardware comprises the equipment needed to support the many activities ranging from data collection to data analysis. A central piece of the equipment is a workstation, which runs the GIS software and is the attachment point for the equipment. Data collection efforts can also require the use of a digitizer for conversion of hard copy data to digital data and a GPS data logger to collect the field. The use of handheld field technology is also becoming an important tool in GIS. With the advent of web-enabled GIS, web servers have become an important piece of equipment for GIS.


Software – Different software packages are important for GIS. Central to this is the GIS application package. Such software is essential for creating, editing and adding spatial and attributed data, therefore these packages contain a myriad of functions inherent to them. Extensions or add-ons are software that extends capabilities of the GIS software package. Component GIS software is the opposite of application software. Component GIS seeks to build software applications that meet a specific purpose and thus are limited in their spatial analysis capabilities. Utilities are stand-alone programs that perform a specific function. For example, a file format utility that converts from one type of GIS file to another. There is also web-GIS software that helps serve data through Internet browsers.


Data – Data is the core of any GIS.  There are two primary types of data that are used in GIS, data in geodatabases and attribute data. A geodatabase is a database that is in some way referenced to locations on the earth. Geodatabases are grouped into two different types: vector and raster. A vector image is stored as geometric objects, such as lines and arcs, which are drawn between specific coordinates. If you magnify a vector image you see the lines more accurately, and the line edges stay smooth. A raster image is made up from pixels, like the picture obtained from a scanner, or the screen image on a computer monitor, and has a finite amount of detail which is dependent upon the image size and resolution. However, the closer you look at a raster image the coarser it appears and you don't see any extra detail. Vector drawings are utilized in GIS and other applications where accuracy is important. Coupled with this data is usually data known as attribute data. Attribute data are data that relate to a specific, precisely defined location. The data are often statistical but may be text, images or multi-media. These are linked in the GIS to spatial data that define the location.


People - Well-trained people knowledgeable in spatial analysis and skilled in using GIS software are essential to the GIS process.


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Public Sector Use of GIS


GIS can be used by the public sector in the following ways:


Pubic Safety and Emergency Response Planning – GIS technology gives public safety personnel the ability to manage and analyze large amounts of location-based information. Data (including files from legacy systems) can be stored in a geodatabase and used to visualize spatial relationships and reveal trends critical to public safety response and planning. Computer-generated maps can be shared across a network or the Internet with multiple agencies to coordinate efforts and maximize resources.


Law Enforcement – GIS software uses geography and computer-generated maps as an interface for integrating and accessing massive amounts of location-based information. GIS allows law enforcement and criminal justice personnel to effectively plan for emergency response, determine mitigation priorities, analyze historical events, and predict future events. GIS can also be used to get critical information to emergency responders upon dispatch or while en route to an incident to assist in tactical planning and response. While law enforcement agencies collect vast amounts of data, only a very small part of this information can be absorbed from spreadsheets and database files. GIS provides a visual, spatial means of displaying data, allowing law enforcement agencies to integrate and leverage their data for more informed decision making.


Public Works and Development – Use of GIS software in public works improves efficiency and productivity to better serve citizens.  For example, GIS applications are in demand in connection with the construction of the Pan Asia Railway and development of the Meigong River and Tumen River in the Northwest of China. Such public works systems could use GIS to connect all divisions in a public works department from engineering to accounting, which streamlines work flows, asset management, operations, and planning. Using a GIS throughout the department allows all sections to share and easily access geographic data. GIS promotes data integrity and facilitates better communication and decision making throughout the organization.


Economic Development – GIS may be used to foster economic development. Agencies could work to advance the quality of life and strengthen the economic base of their region by retaining and growing existing businesses and attracting new investment.  


Urban Planning and Site Selection – Information regarding a proposed site for parcel zoning, transportation planning, waste disposal or other use may be combined and manipulated in a GIS to address planning and natural resource issues (such as the location of a water well near a proposed waste disposal site) to guarantee the quality of life for everyone in livable communities. Planning agencies have realized the power of enterprise GIS to identify problems, respond to them efficiently, and share the results with the public.


Public Security Information Technology in China

With the urbanization and fast economic growth along the coastal areas of China, the demands for information technology by government agencies has greatly increased, especially in the areas of urban planning, travel and land management. PRC government agencies face challenges, such as financial constraints and public safety, and must find ways to better manage resources and serve their citizens. For example, police departments explore methods to better protect the public by more effectively and efficiently analyzing crime patterns within specific geographic areas. Likewise, government authorities look to improve security by assessing threats across their geographic areas and departments and plan appropriate emergency responses.

In September 2003, China’s Ministry of Public Security, or the MPS, lunched the Golden Shield Program, and aimed to improve the IT infrastructure of China’s public security bureaus and customs. The program consists of two phases, with the first phase focusing on laying the infrastructure, and the second phase on the development of police-use applications, system integration, and multimedia communications. The first phase lasted for three years and was completed in late 2006 and the second phase is expected to last for several years. One of the important tasks of the Golden Shield Program is to implement the National PGIS Application Project, or the PGIS Project, to establish an integrated platform connecting all variations of PGIS systems throughout the country, to provide uniform standards, basic data, common technology as well as application mode characteristics, and to share information across different public service departments and police divisions. The ultimate goal of the PGIS Project is to upgrade the level of police-use technology and enhance quick response capabilities for public emergencies. When the PGIS Project is complete, it is expected that all PGIS systems in China will be standardized and interconnected. The MPS plans to standardize 100 provincial-level cities and municipalities over the next three years and then subsequently roll out these systems nationwide.

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Our Growth Strategy

Our objective is to be the leading provider of integrated solutions for information security technology and GIS solutions to the public security and civil-use markets in China. Our intelligence solutions can help organizations make more insightful decisions and improve the efficiency of their internal processes. Four key elements of our strategy are as follows:  

 

Continued Expansion Beyond Guangdong We plan to expand our geographic footprint to cover all major China markets.  Based on our successful track record and reputation, management sees significant opportunities to grow revenues from existing clients by winning follow-on contracts for subsequent phases of project implementation, capitalizing on our first mover advantage and related high cost of switching to other vendors. We plan to manage our national operations under six areas with centers located in Guangzhou, Beijing, Shanghai, Wuhan, Chongqing and Xi’an. So far we have set up offices in Guangzhou Beijing and Wuhan, and representatives in Changsha, capital city of Hunan Province, Nanning, capital city of Guangxi Province, Chengdu, capital city of Sichuan Province, Xi’an capital city of Shanxi Province, and Shanghai. And we now serve customers in 26 provinces and provincial cities. We plan to leverage our strong brand recognition and maintain a high contract bid/win ratio and follow on orders with our: (1) First Responder Coordination Platform, (2) Intelligent Border Control System (3)Residence Card Information Management System and Police-use GIS product lines.

 

Strengthen Our R&D Capability – We plan to enhance and expand our core products and further penetrate our customer base.  We expect to provide additional value-added services and add-ins to our current platform through continuous research and development, to enhance our product and service offerings and to maintain our leadership position in our core areas of focus.

 

Pursue Strategic Acquisitions to Support Strong Internal Growth – We expect that acquisitions will enable our geographic expansion, enhance our technological capabilities or competitive advantages, provide licensing and recurring revenue opportunities and propel our expansion into high growth enterprise class markets.

 

Leverage Existing Capabilities – We plan to leverage our PGIS strength and our recent acquisition of Wuda Geoinformatics to target planned expansion into Civil-use GIS, enterprise class information security markets and other government sectors. We also plan to continue providing our superior E-Government Platform and to maintain strong relationships with our current clients. Geo was founded in 1999 by Wuhan University, a leading university in Asia for GIS-related studies. Geo develops and sells GIS software, contracts surveying and mapping projects, produces space measurement data and provides technical consulting and supervision services for GIS projects.

 

We expect to execute these four elements of our growth strategy through a combination of investments in internal initiatives. Internal initiatives will focus typically on expanding capacity and enhancing our technology and services capabilities. We may also attempt to grow through acquisitions.


Our Products and Services


Through the operations of our China-based subsidiaries and the subcontracting services provided for in our MSA with iASPEC, we are a provider of integrated solutions for the information security sector and full-service GIS solutions to the public security and civil-use markets in China. Our products and services can be separated into three categories: (1) Information Security Technology, which is comprised of our First Responder Coordination Platform, our Intelligent Border Control System and our Residence Card Information Management System; (2) Geographic Information Systems (GIS) applications and services; and  (3) Product Sales and Services, which is comprised of Certificate Authority (CA) application, Multimedia Display and Control, and Digital Hospital Information System.


Public Security Information Technology


First Responder Coordination Platform – The First Responder Coordination Platform is a software program which integrates the contact numbers for general police, fire, traffic and other related government organizations into one contact number and enables these agencies to consolidate and improve their public emergency response. Through this platform, our public security customers are able to command and coordinate joint responses to provide the public with immediate, efficient and reliable assistance.


12


 

The PRC government, through its “Police Force Technology Reinforcement” initiative, has mandated the adoption of the first responder system to consolidate and improve public emergency response. Approximately 660 cities across China are expected to initiate the deployment of their coordinated emergency response platforms, creating significant opportunities for us.


Intelligent Border Control Systems – Our Intelligent Border Control product is used by the Ministry of Public Security for effective border control management. The Intelligent Border Control System stores biometric information, such as finger-prints and facial features from passengers in a database and integrates it with infrared and license plate recognition technologies to enable the automation of border control checkpoints for faster and more accurate processing of passengers, while at the same time helping to safeguard borders from stowaways, and greatly improving overall efficiency and the effectiveness of border control management.


The rapid development of China in recent years has also led to growing passenger traffic across its borders, which reached 318 million people in 2006. Shenzhen has 11 out of 64 Exit and Entry Frontier Stations controlled by the Ministry of Public Security in China, through which 167 million passengers crossed in 2006. The total market opportunity for the Intelligent Border Control System is currently estimated at $300 million. To address the increasing requirement and faster and more accurate checkpoint processing of passenger traffic, Exit and Entry Frontier Stations throughout China are in the process of implementing their own intelligent border control systems. These systems can also be used to strengthen port control and surveillance in China’s 288 air, sea and land ports and have many alternative private sector applications, including the management and control of stadium attendance, parking lot traffic, work attendance and toll road traffic.


Residence Card Information Management System – This system is designed to apply the latest information technology to automate the Shenzhen Residence Card System, and will integrate with police GIS systems. Through an integrated information transfer platform, the system will facilitate several social programs, including social welfare management, education management, and house rental service management. Various government and functional departments can access information regarding the immigrant population in the system to improve work efficiency and increase managing capability. In the near future, the system may be expanded to be compatible with other applications, such as medical, personal credit history, and driving records. If successful, the system may be extended to 660 cities across China. According to national statistics, there are over 150 million internal immigrants in China. In many mid-to-large cities, the population of recent immigrants from rural areas exceeds the resident population. As a key pilot project for the Ministry of China Public Security, our Residence Card information Management System will be deployed in Shenzhen first for evaluation.


GIS Software Services and Operations


We provide system management and support services in connection with our Police-Use GIS Platform, or PGIS Platform. The PGIS platform is a GIS that was developed by iASPEC and licensed exclusively to us, for use in creating, editing and adding data to our customers’ systems. The PGIS platform allows us to provide our law enforcement customers with different services, including specialized mapping services, positioning services, messaging services and services which monitor access to their GIS by users of different levels. We offer the PGIS platform with a full complement of services, including providing basic map image data from the GIS and specific data in connection with that map image (such as a bus stop), a consolidation of both basic data and specific data services for data inquiry services, and application system services, which is the application of consolidated services to a specific service requirement, such as the position of a police officer in the field.

 

We also provide application interface services which ensure that our PGIS platform is equipped to interact with other programs to the benefit of our customers. The data from different law enforcement command systems can be integrated with our PGIS platform to provide our law enforcement customers with more robust communication and location information. Typically, our platforms are integrated with the City Emergency Commanding System, the Police Resource Consolidated Management System, the Residence Management System, the Internet Surveillance System, the Traffic Commanding System, the Criminal Investigation System and the City Surveillance System. CIST’s Core PGIS Technology has been selected for use in the MPS’s PGIS Project, which when complete, is expected to standardize and interconnect all PGIS systems in China. The MPS plans to standardize 100 provincial-level cities and municipalities over the next three years and then subsequently roll out these systems nationwide. As a result, despite the current global economic crisis, management estimates the current market for PGIS in China to be worth approximately $346 million and that this market will grow at a 23% cumulative rate in the next five years.


In the Civil-use GIS sector, CIST has obtained the highest level of qualifications (some of them are mentioned in the sections under the heading “Competition – High Barriers to Entry”and “Regulation” below) with the widest range of applications, through its affiliation with Geo. In addition, Geo’s copyrighted GIS software, “Geostar”, has been widely applied in many mission-critical projects covering national defense, surveying and mapping, land resource, city planning and electricity. Management believes that these qualifications and intellectual property have positioned the Company to benefit for the next few years from the PRC government’s recent emphasis on and promulgation of favorable policies to encourage more applications of domestic-grown GIS software.

 

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Product Sales and Services


As a result of our acquisitions of ISS, Bocom and Zhongtian, we provide product sales and services related to CA application, Multimedia Display and Control, and Digital Hospital Information Systems. Also, through four commercial arrangements with iASPEC and our exclusive licenses to iASPEC’s 16 copyrighted applications, we have inherited iASPEC’s prior service line involving software sales and distribution and support services.


Product Warranty


Our Company usually offers a one-year service warranty for our system integration services. The warranty includes support services, minimal updates and system maintenance. In our experience the cost of providing this warranty has been immaterial.  We also offer warranties for our hardware sales, but the suppliers of such hardware provide the final warranty services.


Our Intellectual Property  


We currently have the following registered and copyrighted software products, as well as numerous software licenses from iASPEC under our Management Service Agreement with iASPEC:  


Registration Code

Year Issued

Name

Version

SHEN DGY-2007-0862

2007

IST Workflow Software

V1.0

SHEN DGY-2007-0861

2007

IST Search Engine Software

V1.0

SHEN DGY-2007-0361

2007

IST Short-message Service Platform Software

V1.0

101301

2008

IST General Office Automated System

V1.0

101300

2008

IST Content Management System

V3.0

2004SR09334

2004

iASPEC Case Tracking Management System

V 2.0

2004SR09335

2004

iASPEC Application Envelope System

V 2.1

2004SR09336

2004

iASPEC Quality System Document Management System

V 2.2

2004SR09337

2004

iASPEC e-Logistics Support Management System

V 2.0

2004SR09338

2004

iASPEC Secured and Audited Message Switching System

V 2.5

2004SR09084

2004

iASPEC Project e-Time Tracker Management System

V 2.0

2004SR09085

2004

iASPEC Application e-Monitor System

V 3.3

2004SR09086

2004

iASPEC Remote Administered Distributed Application Architecture System

V 2.1.3

2004SR09087

2004

iASPEC Community and Establishment Management System

V 1.1

2004SR09088

2004

iASPEC Document and Work Flow Management System

V 3.0

2004SR09089

2004

iASPEC e-Community Management and Service System

V 1.0

2006SR11589

2006

iASPEC Content Management System

V 1.0

2006SR11590

2006

iASPEC Three In One Police Computer Assistant Dispense System

V 1.0

2006SR11591

2006

iASPEC Police Force General Management System

V 1.0

2006SR11592

2006

iASPEC General Office Automation  System

V 1.0

2006SR11593

2006 

iASPEC Police Geographic Information System

V 1.0


14


 

Our newly acquired subsidiaries, ISS, Bocom and Zhongtian, have the following copyrighted software products:

 

Registration Code

Year Issued

Name

Version

SHEN DGY-2007-0857

2007

Bocom Multimedia Display Server Software

V 4.0

SHEN DGY-2007-0858

2007

Bocom Multimedia Screen Printing Software

V 4.0

SHEN DGY-2007-0859

2007

Bocom Multimedia Device Server Software

V 4.0

SHEN DGY-2007-0860

2007

Bocom Multimedia Customer End Software

V 4.0

SHEN DGY-2007-0761

2007

ISS Supplier Management Software

V 1.0

2007SR09783

2006

ISS GPS Terminal Security Management Software (XAGPS)

V 1.0

SHEN DGY-2007-0337

2007

ISS GPS Terminal Security Management Software

V 1.0

SHEN DGY-2007-0759

2007

ISS General Office Automation  System

V 1.0

SHEN DGY-2007-0759

2007

ISS Content Management Software

V 1.0

2006SR03209

2006

Zhongtian Doctor Work Station System

V1.0

2005SR03778

2005

Zhongtian Hospital Information Management System

V2.0

2008SR06203

2008

Zhongtian Mobile Diagnosis System

V1.0

2008SR06202

2008

Zhongtian Electronic Medical Record Software

V1.0

2008SR06204

2008

Zhongtian Picture Archiving & Communication System

V1.0

2008SR10992

2008

Zhongtian Hospitalization Management System (JAVA)

V1.0

2008SR10993

2008

Zhongtian Hospitalization Work Station System (JAVA)

V1.0

2008SR10994

2008

Zhongtian Outpatient Charging System

V1.0

2008SR10091

2008

Zhongtian Outpatient Work Station System

V1.0

2008SR10995

2008

Zhongtian Pharmacy Management System

V1.0

2008SR06205

2008

Zhongtian Office Application System

V1.0


All copyrighted software applications are effective 5 years or 15 years from the date of registration. We expect to renew all copyrighted software applications prior to their respective expiration date.


In addition, Bocom Multimedia and iASPEC own the following patents in China:

 

Patent No.

Effective Date

Description

Duration

ZL 2006 2 0014548.2

11/14/2007

Bocom Fiber Signal Access Device of Large Screen Display

10 years

ZL 2006 2 0014546.3

09/12/2007

Bocom General Cable  Signal Access Device of Large Screen Display

10 years

ZL 2006 2 0014549.7

09/12/2007

Bocom Bus Signal Access Device of Large Screen Display

10 years

ZL 2007 2 0119649.4

03/21/2008

Bocom Digital Light Display Back Projection Optical Reflector Structure

10 years

200610063434

05/20/2008

iASPEC Police Resource Management System

20 years

200810217553.7

11/07/2008

iASPEC Anti-Tagging Detection System

20 years

2008102177556.0

11/07/2008

iASPEC Intelligent Border Control System

20 years


We protect our know-how and technologies through confidentiality provisions in the employment contracts we enter into with our employees.  In addition, our engineers are generally divided into different project groups, each of which generally handles only a portion of the project. As a result, no one engineer generally has access to the entire design process and documentation for a particular product.


15


 

Sales and Marketing


We develop new business by identifying and contacting potential new customers and through referrals, or as a result of new customers contacting us because of our strong brand recognition and reputation in the industry. We strengthen our market presence through various types of marketing campaigns, such as participating in exhibitions, trade fairs and seminars, and presenting solutions to prospective customers.  We participate in several domestic and international trade fairs such as the China High-Tech Fair in Shenzhen and the e-Gov China Fair in Beijing.  We also participate in seminars held by ESRI, IBM etc. each year, to raise our recognition and promote our products. These trade fairs not only promote our reputation, but also our brand name.  


Our main marketing and business development focus is on public security information technology and GIS software services and operations, and software sales and distribution. We have a good reputation and brand recognition in this market. We expect to expand in the market and obtain more market shares through our mature products and quality services.


Our Major Customers

 

Our VIE, iASPEC serves 87 customers located in Guangdong, Sichuan, Xinjiang and Hainan Provinces in China. iASPEC has begun to explore markets outside these provinces in China. Our largest and second client, Shenzhen Municipal Government and Huipu Electronic (Shenzhen) Limited, both accounted for 13%, respectively, of our sales in 2008, and our five largest customers accounted for 43% of our revenue in 2008. The following table provides information on our major customers in 2008 and 2007, including revenues generated by us through iASPEC during the period from July 1, 2007 to December 31, 2007.
       

Year 2008

Name Revenues   Percentage of
  (in thousands   Total Sales
  of US dollars)    
Shenzhen Municipal Government $10,871   13%
Huipu Electronic (Shenzhen) Limited 10,663   13%
Shenzhen Dingzhi Information Technology Limited 5,453   6%
Hainan Xin Kerui Software Engineering Limited 5,410   6%
Shenzhen Ai Kemu Computer Technology Limited 4,112   5%
TOTAL $36,509   43%
       
Year 2007
Name Revenues   Percentage of
  (in thousands   Total Sales
  of US dollars)    
Shenzhen General Station of Exit and Entry Frontier Inspection of P.R.C. $7,756   26%
Shenzhen City Police Department 6,498   21%
Shantou City Police Department 2,171   7%
Shenzhen City Futian District Information Center 834   3%
Guangzhou Jieqing Computer Co., Ltd. 739   2%
TOTAL $17,998   59%


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Competition

The markets for public security information technology and GIS in China have developed in recent years but there are currently only a few software developers engaged in these fields, especially in the PGIS area, where we do not currently face any direct competition.  While there are barriers to accessing the PGIS market which give us a competitive advantage, there are many potential competitors in this area who could overcome these barriers and enter the market. For example, Beijing Founder Digital Company Limited and Beijing Creation Science & Technology Development Company Limited are two PRC-based software development companies who could pose a threat as potential market entrants in the public security information technology and GIS markets.  


However, we believe that we will be able to effectively compete with these companies should they enter the market for our product and service offerings in the future. We believe that our pioneering PGIS platform, our ongoing customer relationships and our reputation for success in the industry have enabled us to maintain this competitive advantage.  


Our services are designed to provide our customers with integrated and innovative public safety and security solutions. Key advantages of our solutions include:   

 

Growing Portfolio of Software and Services We offer our customers location-based public security solutions through our growing portfolio of software and services offerings. Government agencies use our core products to incorporate location-based data into their decision-making processes to drive more effective results. Through our platforms, our customers can develop unique location-based applications, which can be extended across their agencies to support a variety of needs and generate more valuable intelligence. As a complement to these offerings, we offer related services, such as application development and systems integration, which help our customers quickly implement and customize our solutions.


Successful Implementation of High Profile Contracts Our management team has a proven track record of successful implementation of high profile government contracts in China. During 2007, we procured or completed several large-scale system integration contracts relating to our First Responder Coordination System, our Intelligent Border Control System, our Residence Card Management System and our Police-use GIS Platform. We have successfully implemented our First Responder Coordination Platform and Police-use GIS in Shenzhen City, Shantou City, Zhuhai City, Foshan City, Heyuan City, Dongfang City of Hainan Province, Chongqing Municipality, An’xi City of Fujian Province, Kashgar City of Xinjiang Province and Macao. Following the successful execution of the Residence Card Information Management System Phase I in Shenzhen City, in August, 2007 we were granted the Phase II project. The Shenzhen Residence Card Information Management System is designed to form an integrated information sharing platform to facilitate the management of different social functions by the Shenzhen Municipal Government, including public security, social welfare, education, industry and commerce, labor and house rental service management. Additional phases are expected to follow, pending successful completion of the Phase II roll-out. In 2008, we also successfully implemented many other high profile projects in the Police-use PGIS, Remote Sensing and Digital Hospital sectors.


High Barriers to EntryOur high qualifications, our successful contractual implementation record, the high cost of switching to other providers provides us with a “first mover” advantage in the PRC market and poses high barriers to entry for our potential competitors. We have a proven track record of contract implementation and our commercial partner, iASPEC holds the Computer Information System Integration Level 1 Qualification from the PRC Ministry of Information, the State Secret-related Computer Information System Integration Certification and the Computer Information System Security Service qualification from Guangdong Province. Geo, iASPEC’s subsidiary, holds the Level A Certificate for Surveying & Mapping, the highest qualification for providing the widest range of GIS services in China. In addition, after investing in our systems, our existing customers have a strong incentive to purchase follow-on phases with us in order to expedite implementation and save costs. Moreover, in February 2009, our PGIS technology was selected for use in the MPS’ Golden Shield Project and our GeoGlobe Software passed appraisal by China's National Bureau of Mapping and Surveying. Our management expects that these honors will significantly enhance our competitive position and reputation in the industry.


Scalability of Platform We have digitized detailed proprietary information systems data related to Shenzhen City and Guangdong Province that can be leveraged for future civil-use applications in logistics, insurance, and location based services across industries.


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Regulation


We are subject to the PRC’s foreign currency regulations. The PRC government has control over RMB reserves through, among other things, direct regulation of the conversion of RMB into other foreign currencies. Although foreign currencies which are required for “current account” transactions can be bought freely at authorized Chinese banks, the proper procedural requirements prescribed by Chinese law must be met. At the same time, Chinese companies are also required to sell their foreign exchange earnings to authorized Chinese banks and the purchase of foreign currencies for capital account transactions still requires prior approval of the Chinese government.


Our Chinese subsidiary IST, is a Shenzhen City Software Enterprise, holds ISO 9001:2000 Certification and Maturity Level 2 of Capability Maturity Model Integration. However, fulfillment of certain PGIS contracts with PRC Government customers is restricted to entities possessing the necessary government licenses and approvals which IST does not have. Through our exclusive commercial arrangements with iASPEC we benefit from the following governmental licenses and permits previously awarded and currently held by iASPEC:  


Name

Duration

Computer System Integration Level One Qualification from PRC Ministry of Information 

June 11, 2007 – June 10, 2010

State Secret related Computer Information System Integration Certificate

March 29, 2006 – March 29, 2009

Guangdong Province Computer Information System Security Service Qualification

July 22, 2004 (Grant Date, subject to annual renewal)

Shenzhen City High Technology Enterprise Certification

December 31, 2001 (Grant Date, subject to annual renewal)

Guangdong Province Security Technology Surveillance System Design, Implementation and Repair Qualification

October 31, 2007 – October 30, 2009

Maturity Level 3 of Capability Maturity Model Integration

September 2007 (Grant Date)

ISO 9001:2000 Certification

May 30, 2008 – May 29, 2011

Shenzhen Software Enterprise Certification

June 29, 2005 (Grant Date, subject to annual renewal)


In addition, Bocom Multimedia, ISS and Zhongtian hold the following certifications and qualifications:


Holder

Name

Duration

Bocom Multimedia

ISO 9001:2000 Certification from Universal Certification Service Co., Ltd.

November 08, 2004 – September 26, 2010

Bocom Multimedia

Certificate for China Compulsory Product Certification

August 14, 2007 (Grant Date)

ISS

ISO 9001:2000 Certification

June 05, 2008 – June 05, 2011

ISS

Shenzhen Software Enterprise Certification

April 09, 2008 (Grant Date, subject to annual renewal)

ISS

Maturity Level 3 of Capability Maturity Model Integration

(To provide)

ISS

Computer System Integration Level Three Qualification from PRC Ministry of Information 

August 15, 2008 – August 14, 2011

Zhongtian

Computer System Integration Level Four Qualification from PRC Ministry of Information 

(To provide)

Zhongtian

Shenzhen Software Enterprise Certification

April 29, 2008 (Grant Date, subject to annual renewal)

Zhongtian

Shenzhen High-tech Enterprise Certification

February 22, 2008 (Grant Date, subject to annual renewal)


Our Employees


As of December 31, 2008, we had approximately 732 full-time employees. The following table illustrates the allocation of these employees among the various job functions conducted at our company.


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Department

Number of Employees

Software Development

539

Sales & Marketing

60

Admin & Human Resources

64

Accounting

40

Corporate Finance

6

Management

23

Total

732


We believe that our relationship with our employees is good. Our Chinese subsidiaries have trade unions which protect employees’ rights, aim to assist in the fulfillment of our economic objectives, encourage employee participation in management decisions and assist in mediating disputes between us and union members. We have not experienced any significant problems or disruption to our operations due to labor disputes, nor have we experienced any difficulties in recruitment and retention of experienced staff. The remuneration payable to employees includes basic salaries and allowances. We also provide training for our staff from time to time to enhance their technical knowledge.  

As required by applicable Chinese law, we have entered into employment contracts with all of our officers, managers and employees.


Our employees in China participate in a state pension scheme organized by Chinese municipal and provincial governments.  We are required to contribute to the scheme at rates ranging from 13% to 18% of the average monthly salary. As of the date of this report, we have complied with the regulation and have paid the state pension plan as required by law. In addition, we are required by Chinese law to cover employees in China with various types of social insurance.  We have purchased social insurance for all of our employees.



ITEM 1A. RISK FACTORS

You should carefully consider the risks described below, which constitute the material risks facing us.  If any of the following risks actually occur, our business could be harmed.  You should also refer to the other information about us contained in this Form 10-K, including our financial statements and related notes

RISKS RELATED TO OUR BUSINESS

The global economic conditions and current credit crisis could impair the overall availability and cost of external financing for our operations and we may be forced to curtail or cease further business expansion or our operations.


We currently generate sufficient operating cash flows to support our working capital requirements, but our working capital requirements and the cash flow provided by future operating activities, if any, will vary greatly from quarter to quarter, depending on the volume of business during the period and payment terms with our customers.  Were rely on access to the financial markets to provide us with significant discretionary funding capacity.  However, the continuation or intensification of the current global economic crisis and turmoil in the global financial markets may adversely impact our potential sources of capital financing, and may impact our ability to manage normal relationships with our customers, suppliers and creditors.  In addition, the lack of availability of credit could lead to a further weakening of the Chinese and global economies and make capital financing of our operations more expensive for us or impossible altogether.  It is unclear whether and to what extent the economic stimulus measures and other actions taken or contemplated by the Chinese government and other governments throughout the world will mitigate the effects of the crisis on the industries that affect our business. Furthermore, deteriorating economic conditions including business layoffs, downsizing, industry slowdowns and other similar factors that affect our suppliers and creditors could have further negative consequences for our business operations. The economic situation also could harm our current or future suppliers and creditors, causing them to fail to meet their obligations to us.  No assurances can be given that the effects of the current crisis will not damage on our business, financial condition and results of operations.


If we are unable to raise additional financing or identify suitable merger or acquisition targets, we may be unable to implement our long-term business plan, develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures on a timely basis.


Our long-term business plan includes the identification of suitable targets for horizontal or vertical mergers or acquisitions, so as to enhance overall productivity and to benefit from economies of scale.  Due to the current global financial crisis, we may not be able to obtain adequate levels of additional financing, whether through equity financing, debt financing or other sources. To raise funds, we may need to issue new equities or bonds which could result in additional dilution to our shareholders, and additional financings could result in significant dilution to our earnings per share or the issuance of securities with rights superior to our current outstanding securities or contain covenants that would restrict our operations and strategy. In addition, we may grant registration rights to investors purchasing our equity or debt securities in the future. If we are unable to raise additional financing, we may be unable to implement our long-term business plan, develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures on a timely basis, if at all. In addition, a lack of additional financing could force us to substantially curtail or cease operations.


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We also may not be able to identify merger or acquisition targets or, after a merger or acquisition, may not be able to integrate the target’s business or operations successfully with ours. Such failure to execute our long-term business plan likely will negatively impact our results of operations.

If we are unable to develop competitive new products and service offerings our future results of operations could be adversely affected.

Our future revenue stream depends to a large degree on our ability to utilize our technology in a way that will allow us to offer new types of software applications and services to a broader client base. We will be required to make investments in research and development in order to continue to develop new software applications and related service offerings, enhance our existing software applications and related service offerings and achieve market acceptance of our software applications and service offerings. We may incur problems in the future in innovating and introducing new software applications and service offerings. Our development-stage software applications may not be successfully completed or, if developed, may not achieve significant customer acceptance. If we are unable to successfully define, develop and introduce competitive new software applications, and enhance existing software applications, our future results of operations would be adversely affected. Development schedules for software applications are difficult to predict. The timely availability of new applications and their acceptance by customers are important to our future success. A delay in new the development of new applications could have a significant impact on its results of operations.

A significant portion of our sales are derived from a limited number of customers, and results from operations could be adversely affected and stockholder value harmed if we lose any of these customers.

Historically, a significant portion of our revenues have been derived from a limited number of customers. For the years ended December 31, 2008 and 2007, 43% and 59% of our revenues, respectively, were derived from our five largest customers. The loss of any of these significant customers would adversely affect our revenues and stockholder value.

We depend heavily on key personnel, and turnover of key employees and senior management could harm our business.

Our future business and results of operations depend in significant part upon the continued contributions of our key technical and senior management personnel, including Jiang Huai Lin, our Chairman and Chief Executive Officer, Wendy Wang, our Chief Financial Officer and Zhi Xiong Huang, our Chief Technology Officer. They also depend in significant part upon our ability to attract and retain additional qualified management, technical, marketing and sales and support personnel for our operations. If we lose a key employee or if a key employee fails to perform in his or her current position, or if we are not able to attract and retain skilled employees as needed, our business could suffer. Significant turnover in our senior management could significantly deplete our institutional knowledge held by our existing senior management team. We depend on the skills and abilities of these key employees in managing the technical, marketing and sales aspects of our business, any part of which could be harmed by further turnover.

Investor confidence and the market price of our shares may be adversely impacted if we are unable to correct a material weakness or significant deficiency in our internal controls over our financial reporting identified by our management.

During its assessment of the effectiveness of our internal control over financial reporting as of December 31, 2008, our management concluded that we had significant deficiencies related to our supervision, monitoring and annual financial statement preparation and review processes, our identification, documentation and review of various reconciliations and related supporting documentation necessary to prepare financial statements in accordance with US GAAP, and our lack of sufficient accounting personnel qualified in US GAAP. Although we have taken steps to remediate this deficiency, including: (1) our establishment of an Audit Committee constituted of independent directors to oversee our accounting and financial reporting processes and the audits of our financial statements, one of whom also possesses the accounting or related financial management experience that qualifies him as financially sophisticated within the meaning of the Nasdaq Marketplace Rules and as an “audit committee financial expert” as defined by the rules and regulations of the SEC; and (2) our appointment of a new Chief Financial Officer with the relevant accounting experience, skills and knowledge in the preparation of financial statements and financial reporting disclosures in accordance with US GAAP and applicable SEC regulations, our failure to fully remediate it could result in losses in the future.

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We may be exposed to potential risks relating to our internal controls over financial reporting and our ability to have the operating effectiveness of our internal controls attested to by our independent auditors.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, or SOX 404, the SEC adopted rules requiring public companies to include a report of management on their internal controls over financial reporting in their annual reports, on Form 10-K. We are subject to this requirement commencing with our fiscal year ending December 31, 2008 and a report of our management is included under Item 9A of this Annual Report on Form 10-K. In addition, SOX 404 requires the independent registered public accounting firm auditing a company’s financial statements to also attest to and report on the operating effectiveness of such company’s internal controls. This annual report includes an attestation report since we are deemed to be an accelerated filer.  We can provide no assurance that we will comply with all of the requirements imposed thereby. There can be no assurance that we will receive a positive attestation from our independent registered public accountants. In the event we identify significant deficiencies or material weaknesses in our internal controls that we cannot remediate in a timely manner or we are unable to receive a positive attestation from our independent registered public accountants with respect to our internal controls, investors and others may lose confidence in the reliability of our financial statements.

Our holding company structure may limit the payment of dividends.

We have no direct business operations, other than our ownership of our subsidiaries. While we have no current intention of paying dividends, should we decide in the future to do so, as a holding company, our ability to pay dividends and meet other obligations depends upon the receipt of dividends or other payments from our operating subsidiaries and other holdings and investments. In addition, our operating subsidiaries, from time to time, may be subject to restrictions on their ability to make distributions to us, including as a result of restrictive covenants in loan agreements, restrictions on the conversion of local currency into U.S. dollars or other hard currency and other regulatory restrictions as discussed below. If future dividends are paid in RMB, fluctuations in the exchange rate for the conversion of RMB into U.S. dollars may reduce the amount received by U.S. stockholders upon conversion of the dividend payment into U.S. dollars.

Chinese regulations currently permit the payment of dividends only out of accumulated profits as determined in accordance with Chinese accounting standards and regulations. Our subsidiaries in China are also required to set aside a portion of their after tax profits according to Chinese accounting standards and regulations to fund certain reserve funds. Currently, our subsidiaries in China are the only sources of revenues or investment holdings for the payment of dividends. If they do not accumulate sufficient profits under Chinese accounting standards and regulations to first fund certain reserve funds as required by Chinese accounting standards, we will be unable to pay any dividends.

RISKS RELATING TO THE INDUSTRY IN WHICH WE OPERATE

Unfavorable economic conditions may affect the level of technology spending by our customers which could cause the demand for our products and services to decrease.

The revenue growth and profitability of our business depend on the overall demand for software products and related services, particularly within the private sector. Our strategy involves a sale of our products and services primarily to customers in the private sector, so our business depends on the overall economy and the economic and business conditions within this market. The current stock market decline and the global economic slowdown may affect the demand for our software products and related services and decrease technology spending of many of our customers and potential customers. These events could have a material effect on us in the future, including, without limitation, on our future revenue and earnings.

If we are unable to keep pace with the rapid technological changes in our industry, demand for our products and services could decline which would adversely affect our revenue.

Our industry is characterized by extremely rapid technological change, evolving industry standards and changing customer demands. These conditions require continuous expenditures on product research and development to enhance existing products, create new products and avoid product obsolescence. We believe that the timely development of new products and continuing enhancements to existing products is essential to maintain our competitive position in the marketplace. Our future success depends in part upon customer and market acceptance of our products and initiatives, which is uncertain. Any failure to achieve increased acceptance of these and other new product offerings could have a material adverse effect on our business and results of operations.

Our software products may contain defects or errors, which could decrease sales, injure our reputation or delay shipments of our products.

The software products that we develop are complex and must meet the stringent technical requirements of our customers. In addition, to keep pace with the rapid technological change in our industry and to avoid the obsolescence of our software products, we must quickly develop new products and enhancements to existing products. Because of this complexity and rapid development cycle, we cannot assure that our software products are free of errors, especially in newly released software products and new versions of existing software products. If our software is not free of errors, this could result in litigation, fewer sales, increased product returns, damage to our reputation and an increase in service and warranty costs, which would adversely affect our business.

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Our technology may become obsolete which could materially adversely affect our ability to sell our products and services.

If our technology, products and services become obsolete, our business operations would be materially adversely affected. The market in which we compete is characterized by rapid technological change, evolving industry standards, introductions of new products, and changes in customer demands that can render existing products obsolete and unmarketable. Our current products will require continuous upgrading or our technology will become obsolete. Our future success will depend upon our ability to address the increasingly sophisticated needs of our customers by supporting existing and emerging hardware, software, database, and networking platforms and by developing and introducing enhancements to our existing products and new products on a timely basis that keep pace with technological developments, evolving industry standards, and changing customer requirements. Research and development expenses were $2,596,430 and $797,580 for the years ended December 31, 2008 and 2007, respectively.

We face the risk of systems interruptions and capacity constraints, possibly resulting in adverse publicity, revenue loss and erosion of customer trust.

The satisfactory performance, reliability and availability of our network infrastructure are critical to our reputation and our ability to attract and retain customers and to maintain adequate customer service levels. We may experience temporary service interruptions for a variety of reasons, including telecommunications or power failures, fire, water damage, vandalism, computer bugs or viruses or hardware failures. We may not be able to correct a problem in a timely manner. Any service interruption that results in the unavailability of our system or reduces its capacity could result in real or perceived public safety issues that may affect customer confidence in our services and result in negative publicity that could cause us to lose customer accounts or fail to obtain new accounts. Any inability to scale our systems may cause unanticipated system disruptions, slower response times, degradation in levels of customer service, or impaired quality and speed of transaction processing. We are not certain that we will be able to project the rate or timing of increases, if any, in the use of our services to permit us to upgrade and expand our systems effectively or to integrate smoothly any newly developed or purchased modules with our existing systems.

If we are not able to adequately secure and protect our patent, trademark and other proprietary rights our business may be materially affected.

Under the Management Service Agreement, we license 16 copyrighted software applications from iASPEC on an exclusive basis. To protect the intellectual property underlying these applications and our other intellectual property, we rely on a combination of copyright, trademark, and trade secret laws. We also rely on non-disclosure agreements and other confidentiality procedures and contractual provisions to protect our intellectual property rights. Some of these technologies, other than the iASPEC copyrighted software applications, are very important to our business and are not protected by copyrights or patents. It may be possible for unauthorized third parties to copy or reverse engineer our products, or otherwise obtain and use information that we regard as proprietary. Further, third parties could challenge the scope or enforceability of our copyrights. In certain foreign countries, including China where we operate, the laws do not protect our proprietary rights to the same extent as the laws of the United States. Any misappropriation of our intellectual property could have a material adverse effect on our business and results of operations, and we cannot assure you that the measures we take to protect our proprietary rights are adequate.

Claims that we infringe the proprietary rights of third parties could result in significant expenses or restrictions on our ability to sell our products and services.

Third parties may claim that our products or services infringe their proprietary rights. Any infringement claim, with or without merit, would be time-consuming and expensive to litigate or settle and could divert our management’s attention from our core business. In the event of a successful infringement claim against us, we may have to pay significant damages, incur substantial legal fees, develop costly non-infringing technology, or enter into license agreements that require us to pay substantial royalties and that may not be available on terms acceptable to us, if at all.

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RISKS RELATING TO OUR COMMERCIAL RELATIONSHIP WITH IASPEC

Jiang Huai Lin’s association with iASPEC could pose a conflict of interest which may result in iASPEC decisions that are adverse to our business.

Jiang Huai Lin, our president and Chief Executive Officer and the beneficial owner of 49.4% of our common stock also beneficially owns 100% of the equity interests in iASPEC, from whom we derived 48% of our revenue in the fiscal year ended December 31, 2008 and 68% of our revenue in the fiscal year ended December 31, 2007, pursuant to existing commercial arrangements. As a result, conflicts of interest may arise from time to time and these conflicts may result in management decisions that could negatively affect our operations and potentially result in the loss of opportunities.

If iASPEC or its shareholders violate our contractual arrangements with it, our business could be disrupted and we may have to resort to litigation to enforce our rights which may be time consuming and expensive.

Our operations are currently dependent upon our commercial relationship with iASPEC. During the fiscal years ended December 31, 2008 and 2007 we derived 48% and 68% of our revenues, respectively, from the provision of services to iASPEC customers. A significant portion of these revenues have not yet been collected. Amounts owed by iASPEC under the Management Service Agreement for each quarter will be due and payable no later than the last day of the month following the end of each such quarter. If iASPEC or its shareholders are unwilling or unable to perform their obligations under our commercial arrangements with it, including payment of revenues under the Management Service Agreement as they become due each quarter, we will not be able to conduct our operations in the manner currently planned. In addition, iASPEC may seek to renew these agreements on terms that are disadvantageous to us. Although we have entered into a series of agreements that provide us with substantial ability to control iASPEC, we may not succeed in enforcing our rights under them. If we are unable to renew these agreements on favorable terms, or to enter into similar agreements with other parties, our business may not be able to operate or expand, and our operating expenses may significantly increase.

Uncertainties in the PRC legal system may impede our ability to enforce the commercial agreements that we have entered into with iASPEC or any arbitral award thereunder and any inability to enforce these agreements could materially and adversely affect our business and operation.

While disputes under the Management Service Agreement and the Option Agreement with iASPEC are subject to binding arbitration before the Shenzhen Branch of the China International Economic and Trade Arbitration Commission, or CIETAC, in accordance with CIETAC Arbitration Rules, the agreements are governed by PRC law and an arbitration award may be challenged in accordance with PRC law. For example, a claim that the enforcement of an award in our favor will be detrimental to the public interest, or that an issue does not fall within the scope of the arbitration would require us to engage in administrative and judicial proceedings to defend an award. China’s legal system is a civil law system based on written statutes and unlike common law systems, it is a system in which decided legal cases have little value as precedent. As a result, China’s administrative and judicial authorities have significant discretion in interpreting and implementing statutory and contractual terms, and it may be more difficult to evaluate the outcome of administrative and judicial proceedings and the level of legal protection available than in more developed legal systems. These uncertainties may impede our ability to enforce the terms of the Management Service Agreement, the Option Agreement and the other contracts that we may enter into with iASPEC. Any inability to enforce the Management Service Agreement and Option Agreement or an award thereunder could materially and adversely affect our business and operation.

If iASPEC fails to comply with the confidentiality requirements of certain of its customer contracts, then iASPEC could be subject to sanctions and could lose its business license which in turn would significantly disrupt or shut down our operations.

The business and operations of iASPEC, the owner and licensor to us of the copyrighted software applications and other intellectual property that are essential to the operation of our business, is subject to Chinese contractual obligations and laws and regulations that restrict its use of security information and other information that it obtains from its customers in the public security sector. For some of its contracts with government agencies, iASPEC has agreed to keep confidential all technical and commercial secrets obtained during the performance of services under the contract. iASPEC or its shareholders could violate these contractual obligations and laws and regulations by inadvertently or intentionally disclosing confidential information or by otherwise failing to operate its business in a manner that complies with these contractual and legal obligations. A violation of these agreements could result in the significant disruption or shut down of our business or adversely affect our reputation in the market. If iASPEC or its shareholders violate these contractual and legal obligations, we may have to resort to litigation to enforce our rights under our contractual obligations with iASPEC. This litigation could result in the disruption of our business, diversion of our resources and the incurrence of substantial costs.

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A majority of the share capital of iASPEC is held by our major shareholder, who may cause these agreements to be amended in a manner that is adverse to us.

Our major shareholder, Mr. Jiang Huai Lin, owns and controls iASPEC. As a result, Mr. Lin may be able to cause our commercial arrangements with iASPEC to be amended in a manner that will be adverse to our company, or may be able to cause these agreements not to be renewed, even if their renewal would be beneficial for us. Although we have entered into an agreement that prevents the amendment of these agreements without the approval of the members of our Board other than Mr. Lin, we can provide no assurances that these agreements will not be amended in the future to contain terms that might differ from the terms that are currently in place. These differences may be adverse to our interests.

Our arrangements with iASPEC and its shareholders may be subject to a transfer pricing adjustment by the PRC tax authorities which could have an adverse effect on our income and expenses.

We could face material and adverse tax consequences if the PRC tax authorities determine that our contracts with iASPEC and its shareholders were not entered into based on arm’s length negotiations. Although our contractual arrangements are similar to other companies conducting similar operations in China, if the PRC tax authorities determine that these contracts were not entered into on an arm’s length basis, they may adjust our income and expenses for PRC tax purposes in the form of a transfer pricing adjustment. Such an adjustment may require that we pay additional PRC taxes plus applicable penalties and interest, if any.

The shares purchased by the investors in our 2007 private placement transaction are subject to redemption in the event that the PRC government takes action that unwinds our restructuring transaction. Any such redemption would materially and adversely affect our liquidity and capital resources since we would have to return the funds raised in the private placement.

If any PRC governmental agency takes action that materially and adversely affects the transactions contemplated by the restructuring agreement and we are unable to reverse the adverse governmental action or otherwise address the material adverse effect to the reasonable satisfaction of the investors in the private placement transaction that closed on January 31, 2007 and February 5, 2007, within 60 days of the occurrence of such governmental action, then if asked, we are obligated, as liquidated damages, to redeem the shares purchased by such investors, within 30 days of their demand, for an amount equal to the investor’s entire investment amount without interest. If the PRC government takes action that triggers this redemption right, then our liquidity and capital resources would be materially adversely affected as we would be required to return the funds raised in the private placements. If we are required to return such funds we may required to sell assets or to seek financing on terms that are not favorable, if available at all, and our financial condition could be thereby materially and adversely affected.

The exercise of our option to purchase part or all of the equity interests in or assets of iASPEC under the Option Agreement might be subject to approval by the PRC government. Our failure to obtain this approval may impair our ability to substantially control iASPEC and could result in actions by iASPEC that conflict with our interests.

Our Option Agreement with iASPEC gives our Chinese operating subsidiary, IST, the option to purchase all or part of the equity interests in or assets of iASPEC, however, the option may not be exercised by IST if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated. Under the laws of China, if a foreign entity, through a foreign investment company that it invests in, acquires a domestic related company, China’s regulations regarding Mergers and Acquisitions would technically apply to the transaction. Application of these regulations requires an examination and approval of the transaction by China’s Ministry of Commerce, or MOFCOM, or its local counterparts. Also, an appraisal of the equity or assets to be acquired is mandatory. However, the Zhong Lun Law Firm, our local PRC counsel has advised us that Shenzhen and other local counterparts of MOFCOM hold the view that such a transaction would not require their approval. Therefore, we do not believe at this time that an approval and an appraisal are required for IST to exercise its option to acquire iASPEC in Shenzhen. In light of the different views on this issue, however, it is possible that the central MOFCOM office in Beijing will issue a standardized opinion imposing the approval and appraisal requirement. If we are not able to purchase the equity or assets of iASPEC, then we will lose a substantial portion of our ability to control iASPEC and our ability to ensure that iASPEC will act in our interests.

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Our right to elect a majority of the members on iASPEC’s Board of Directors and other provisions of the Management Service Agreement may be viewed by iASPEC’s customers as a change in control of iASPEC, which could subject iASPEC to sanctions and loss of its business license, which in turn would significantly disrupt or possibly terminate our operations.

Our new commercial arrangement with iASPEC gives us the right to designate two Chinese citizens to serve as senior managers of iASPEC, serve on iASPEC’s Board of Directors and assist in managing the business and operations of iASPEC. In addition, iASPEC will require the affirmative vote of the majority of the our Board of Directors, as well as at least one non-insider director, for completing certain material actions with respect to iASPEC, including, but not limited to: (a) the nomination, appointment, election or replacement of any board members; (b) the distribution of any dividend or profits; (c) any merger, division, change of corporate form, dissolution or liquidation; (d) any reimbursement of net losses or other payments or transfers of funds from IST to iASPEC; (e) the formation or disposition of a subsidiary or the acquisition or disposition of any interest in any other entity; and (f) the encumbrance of any assets under any lien not in the ordinary course of business. However, fulfillment of certain PGIS contracts with PRC Government customers is restricted to entities, such as iASPEC, that possess the necessary PRC government licenses and approvals, and any change in control may be viewed under PRC law as creating a new entity. If iASPEC’s government customers view these Management Service Agreement provisions as a change in control of iASPEC or as evidence of iASPEC’s failure to operate its business in a manner that complies with its contractual obligations or with related laws and regulations. Such a perception could result in the cancellation or invalidation of iASPEC’s licenses and permits. A loss by iASPEC of its licenses and permits could result in the significant disruption or possible termination of our business or adversely affect our reputation in the market.

RISKS RELATED TO DOING BUSINESS IN CHINA

Changes in China’s political or economic situation could harm us and our operational results.

Economic reforms adopted by the Chinese government have had a positive effect on the economic development of the country, but the government could change these economic reforms or any of the legal systems at any time. This could either benefit or damage our operations and profitability.  Some of the things that could have this effect are:

 

Level of government involvement in the economy;

 

Control of foreign exchange;

 

Methods of allocating resources;

 

Balance of payments position;

 

International trade restrictions; and

 

International conflict.

 

The Chinese economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD, in many ways. As a result of these differences, we may not develop in the same way or at the same rate as might be expected if the Chinese economy were similar to those of the OECD member countries.

Our business is largely subject to the uncertain legal environment in China and your legal protection could be limited.

The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which precedents set in earlier legal cases are not generally used. The overall effect of legislation enacted over the past 20 years has been to enhance the protections afforded to foreign invested enterprises in China. However, these laws, regulations and legal requirements are relatively recent and are evolving rapidly, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to foreign investors, such as the right of foreign invested enterprises to hold licenses and permits such as requisite business licenses. In addition, all of our executive officers and our directors are residents of China and not of the U.S., and substantially all the assets of these persons are located outside the U.S. As a result, it could be difficult for investors to affect service of process in the U.S., or to enforce a judgment obtained in the U.S. against us or any of these persons.

The Chinese government exerts substantial influence over the manner in which we must conduct our business activities which could have an adverse effect on our ability to operate in China.

China only recently has permitted provincial and local economic autonomy and private economic activities. The Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of these jurisdictions may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations.

25


 

Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof, and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures.

Future inflation in China may inhibit our ability to conduct business in China.

In recent years, the Chinese economy has experienced periods of rapid expansion and high rates of inflation. During the past ten years, the rate of inflation in China has been as high as 20.7% and as low as -2.2%. These factors have led to the adoption by the Chinese government, from time to time, of various corrective measures designed to restrict the availability of credit or regulate growth and contain inflation. High inflation may in the future cause the Chinese government to impose controls on credit and/or prices, or to take other action, which could inhibit economic activity in China, and thereby harm the market for our products.

Any future outbreak of severe acute respiratory syndrome or avian flu in China, or similar adverse public health developments, may severely disrupt our business and operations.


From December 2002 to June 2003, China and certain other countries experienced an outbreak of a new and highly contagious form of atypical pneumonia now known as severe acute respiratory syndrome, or SARS. On July 5, 2003, the World Health Organization declared that the SARS outbreak had been contained. However, following this declaration, a number of isolated new cases of SARS have been reported, mostly recently in central China in April 2004. During May and June of 2003, many businesses in China were closed by the PRC government to prevent transmission of SARS. In addition, during 2005 and 2006 China reported cases of humans becoming infected with a strain of avian influenza or bird flu known as H5N1, which is often fatal to humans. This disease, which is spread through poultry populations, is capable in some circumstances of being transmitted to humans and is often fatal. A new outbreak of SARS or an outbreak of avian flu may reduce the level of economic activity in affected areas and deter people from congregating in public places, which may lead to a reduction in our advertising revenue as our clients may cancel existing contracts or defer future advertising expenditures. In addition, health or other government authorities may require temporary closure of our offices, or the offices, where we provide our advertising services. All these will severely disrupt our business operations and have a material adverse effect on our financial condition and results of operations.

Restrictions on currency exchange may limit our ability to receive and use our revenues effectively.

The majority of our revenues will be settled in RMB, and any future restrictions on currency exchanges may limit our ability to use revenue generated in RMB to fund any future business activities outside China or to make dividend or other payments in U.S. dollars. Although the Chinese government introduced regulations in 1996 to allow greater convertibility of the RMB for current account transactions, significant restrictions still remain, including primarily the restriction that foreign-invested enterprises may only buy, sell or remit foreign currencies after providing valid commercial documents, at those banks in China authorized to conduct foreign exchange business. In addition, conversion of RMB for capital account items, including direct investment and loans, is subject to governmental approval in China, and companies are required to open and maintain separate foreign exchange accounts for capital account items. We cannot be certain that the Chinese regulatory authorities will not impose more stringent restrictions on the convertibility of the RMB.

Failure to comply with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident stockholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC subsidiaries, limit our PRC subsidiaries’ ability to distribute profits to us or otherwise materially adversely affect us.

In October 2005, the PRC State Administration of Foreign Exchange, or SAFE, issued the Notice on Relevant Issues in the Foreign Exchange Control over Financing and Return Investment Through Special Purpose Companies by Residents Inside China, generally referred to as Circular 75, which required PRC residents to register with the competent local SAFE branch before establishing or acquiring control over an offshore special purpose company, or SPV, for the purpose of engaging in an equity financing outside of China on the strength of domestic PRC assets originally held by those residents. Internal implementing guidelines issued by SAFE, which became public in June 2007 (known as Notice 106), expanded the reach of Circular 75 by (1) purporting to cover the establishment or acquisition of control by PRC residents of offshore entities which merely acquire “control” over domestic companies or assets, even in the absence of legal ownership; (2) adding requirements relating to the source of the PRC resident’s funds used to establish or acquire the offshore entity; (3) covering the use of existing offshore entities for offshore financings; (4) purporting to cover situations in which an offshore SPV establishes a new subsidiary in China or acquires an unrelated company or unrelated assets in China; and (5) making the domestic affiliate of the SPV responsible for the accuracy of certain documents which must be filed in connection with any such registration, notably, the business plan which describes the overseas financing and the use of proceeds. Amendments to registrations made under Circular 75 are required in connection with any increase or decrease of capital, transfer of shares, mergers and acquisitions, equity investment or creation of any security interest in any assets located in China to guarantee offshore obligations, and Notice 106 makes the offshore SPV jointly responsible for these filings. In the case of an SPV which was established, and which acquired a related domestic company or assets, before the implementation date of Circular 75, a retroactive SAFE registration was required to have been completed before March 31, 2006; this date was subsequently extended indefinitely by Notice 106, which also required that the registrant establish that all foreign exchange transactions undertaken by the SPV and its affiliates were in compliance with applicable laws and regulations. Failure to comply with the requirements of Circular 75, as applied by SAFE in accordance with Notice 106, may result in fines and other penalties under PRC laws for evasion of applicable foreign exchange restrictions. Any such failure could also result in the SPV’s affiliates being impeded or prevented from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation to the SPV, or from engaging in other transfers of funds into or out of China.

26


 

We believe that our stockholders, who are PRC residents as defined in Circular 75, have registered with the relevant branch of SAFE, as currently required, in connection with their equity interests in us and our acquisitions of equity interests in our PRC subsidiaries. However, we cannot provide any assurances that their existing registrations have fully complied with, and they have made all necessary amendments to their registration to fully comply with, all applicable registrations or approvals required by Circular 75. Moreover, because of uncertainty over how Circular 75 will be interpreted and implemented, and how or whether SAFE will apply it to us, we cannot predict how it will affect our business operations or future strategies. For example, our present and prospective PRC subsidiaries’ ability to conduct foreign exchange activities, such as the remittance of dividends and foreign currency-denominated borrowings, may be subject to compliance with Circular 75 by our PRC resident beneficial holders. In addition, such PRC residents may not always be able to complete the necessary registration procedures required by Circular 75. We also have little control over either our present or prospective direct or indirect stockholders or the outcome of such registration procedures. A failure by our PRC resident beneficial holders or future PRC resident stockholders to comply with Circular 75, if SAFE requires it, could subject these PRC resident beneficial holders to fines or legal sanctions, restrict our overseas or cross-border investment activities, limit our subsidiaries’ ability to make distributions or pay dividends or affect our ownership structure, which could adversely affect our business and prospects.

We may be unable to complete a business combination transaction efficiently or on favorable terms due to complicated merger and acquisition regulations which became effective on September 8, 2006.

On August 9, 2006, six PRC regulatory agencies, including the CSRC, promulgated the Regulation on Mergers and Acquisitions of Domestic Companies by Foreign Investors, which became effective on September 8, 2006. This new regulation, among other things, governs the approval process by which a PRC company may participate in an acquisition of assets or equity interests. Depending on the structure of the transaction, the new regulation will require the PRC parties to make a series of applications and supplemental applications to the government agencies. In some instances, the application process may require the presentation of economic data concerning a transaction, including appraisals of the target business and evaluations of the acquirer, which are designed to allow the government to assess the transaction. Government approvals will have expiration dates by which a transaction must be completed and reported to the government agencies. Compliance with the new regulations is likely to be more time consuming and expensive than in the past and the government can now exert more control over the combination of two businesses. Accordingly, due to the new regulation, our ability to engage in business combination transactions has become significantly more complicated, time consuming and expensive, and we may not be able to negotiate a transaction that is acceptable to our stockholders or sufficiently protect their interests in a transaction.

The new regulation allows PRC government agencies to assess the economic terms of a business combination transaction. Parties to a business combination transaction may have to submit to the Ministry of Commerce and other relevant government agencies an appraisal report, an evaluation report and the acquisition agreement, all of which form part of the application for approval, depending on the structure of the transaction. The regulations also prohibit a transaction at an acquisition price obviously lower than the appraised value of the PRC business or assets and in certain transaction structures, require that consideration must be paid within defined periods, generally not in excess of a year. The regulation also limits our ability to negotiate various terms of the acquisition, including aspects of the initial consideration, contingent consideration, holdback provisions, indemnification provisions and provisions relating to the assumption and allocation of assets and liabilities. Transaction structures involving trusts, nominees and similar entities are prohibited. Therefore, such regulation may impede our ability to negotiate and complete a business combination transaction on financial terms that satisfy our investors and protect our stockholders’ economic interests.

27



The value of our securities will be affected by the foreign exchange rate between U.S. dollars and RMB.

The value of our common stock will be affected by the foreign exchange rate between U.S. dollars and RMB, and between those currencies and other currencies in which our sales may be denominated. For example, to the extent that we need to convert U.S. dollars into RMB for our operational needs and should the RMB appreciate against the U.S. dollar at that time, our financial position, the business of the company, and the price of our common stock may be harmed. Conversely, if we decide to convert our RMB into U.S. dollars for the purpose of declaring dividends on our common stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent of our earnings from our subsidiaries in China would be reduced.

We may be exposed to liabilities under the Foreign Corrupt Practices Act, and any determination that we violated the Foreign Corrupt Practices Act could have a material adverse effect on our business.

We are subject to the Foreign Corrupt Practice Act, or FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute, for the purpose of obtaining or retaining business. We have operations, agreements with third parties and we make sales in China. Our activities in China create the risk of unauthorized payments or offers of payments by the employees, consultants, sales agents or distributors of our Company, even though they may not always be subject to our control. It is our policy to implement safeguards to discourage these practices by our employees. However, our existing safeguards and any future improvements may prove to be less than effective, and the employees, consultants, sales agents or distributors of our Company may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition. In addition, the U.S. government may seek to hold our Company liable for successor liability FCPA violations committed by companies in which we invest or that we acquire.

Under the New Enterprise Income Tax, or EIT, Law, we may be classified as a “resident enterprise” of China. Such classification will likely result in unfavorable tax consequences to us and our non-PRC stockholders.


China passed the New EIT Law and its implementing rules, both of which became effective on January 1, 2008. Under the New EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a “resident enterprise,” meaning that it can be treated in a manner similar to a Chinese enterprise for enterprise income tax purposes. The implementing rules of the New EIT Law define de facto management as “substantial and overall management and control over the production and operations, personnel, accounting, and properties” of the enterprise. Because the New EIT Law and its implementing rules are new, no official interpretation or application of this new “resident enterprise” classification is available. Therefore, it is unclear how tax authorities will determine tax residency based on the facts of each case.


If the PRC tax authorities determine that China Information Security Technology, Inc. is a “resident enterprise” for PRC enterprise income tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to the enterprise income tax at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. In our case, this would mean that income such as interest on offering proceeds and non-China source income would be subject to PRC enterprise income tax at a rate of 25%. Second, although under the New EIT Law and its implementing rules dividends paid to us from our PRC subsidiaries would qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to a 10% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes. Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC stockholders and with respect to gains derived by our non-PRC stockholders from transferring our shares. We are actively monitoring the possibility of “resident enterprise” treatment for the 2008 tax year and are evaluating appropriate organizational changes to avoid this treatment, to the extent possible.


In addition, under the New EIT Law, dividends payable by a FIE to any of its foreign non-resident enterprise investors shall be subject to a 10% withholding tax, unless such foreign non-resident enterprise investor’s jurisdiction of incorporation has signed a tax treaty or arrangement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income with China that provides for a reduced rate of withholding tax on dividends. Since the PRC and Hong Kong have signed the above-mentioned tax arrangement for the avoidance of double taxation, and Shenzhen Bocom, Information Security Software and Information Security Technology are wholly owned by China Information Security Technology, the dividends payable by each of Shenzhen Bocom, Information Security Software and Information Security Technology to its foreign non-resident enterprise investors are expected to be subject to a 5% withholding tax pursuant to the China-Hong Kong double tax arrangement. However, dividends declared and paid from pre-January 1, 2008 distributable profits are grandfathered under the New EIT Law and are not subject to withholding tax.


28


 

RISKS RELATED TO THE MARKET FOR OUR STOCK

We are subject to penny stock regulations and restrictions which may affect our ability to sell our securities on the secondary market.

The SEC has adopted regulations which generally define so-called “penny stocks” to be an equity security that has a market price less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exemptions. Trading in our common stock is volatile and our stock price fluctuates: between December 1, 2007 and December 31, 2008, our stock price has fluctuated from a low of $3.00 to a high of $10.80.  When our stock price trades under $5.00 per share it may be designated a “penny stock.” As a “penny stock,” our common stock may become subject to Rule 15g-9 under the Exchange Act, or the “Penny Stock Rule.” This rule imposes additional sales practice requirements on broker-dealers that sell such securities to persons other than established customers and “accredited investors” (generally, individuals with a net worth in excess of $1,000,000 or annual incomes exceeding $200,000, or $300,000 together with their spouses). For transactions covered by Rule 15g-9, a broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transaction prior to sale. As a result, this rule may affect the ability of broker-dealers to sell our securities and may affect the ability of purchasers to sell any of our securities in the secondary market.

For any transaction involving a penny stock, unless exempt, the rules require delivery, prior to any transaction in a penny stock, of a disclosure schedule prepared by the SEC relating to the penny stock market. Disclosure is also required to be made about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Finally, monthly statements are required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock.

There can be no assurance that our common stock will qualify for exemption from the Penny Stock Rule. In any event, even if our common stock were exempt from the Penny Stock Rule, we would remain subject to Section 15(b)(6) of the Exchange Act, which gives the SEC the authority to restrict any person from participating in a distribution of penny stock, if the SEC finds that such a restriction would be in the public interest.

Market volatility may affect our stock price, and the value of our common stock may experience sudden decreases.

There has been, and will likely continue to be, significant volatility in the market price of securities in general and of technology companies in particular, including ours. These fluctuations can be unrelated to the operating performance of these companies. Factors such as the following could cause the market price of our common stock to fluctuate substantially:

general economic conditions and trends;

stock market price and volume fluctuations of other publicly traded companies and, in particular, those that are in the technology industry;

investor perceptions of the stock market in general and our industry or company in particular;

shortfalls in our actual financial results compared to our guidance or results previously forecasted by stock market analysts

quarterly fluctuations in our financial results or other software companies’ financial results;

acquisitions or strategic alliances or announcements of new products by us or our competitors;

any stock repurchase program;

significant developments relating to our relationships with our customers or suppliers;

litigation involving our Company or any of our officers and directors; and

general conditions in the software industry and conditions in the financial markets.

A decline in the market price of our common stock may adversely impact our ability to attract and retain employees. In addition, stockholders may initiate securities class action lawsuits if the market price of our stock drops significantly, which may cause us to incur substantial costs and could divert the time and attention of our management.

29


 

Our controlling stockholder holds a significant percentage of our outstanding voting securities, which could hinder our ability to engage in significant corporate transactions without his approval.

Mr. Jiang Huai Lin, our Chairman, President and Chief Executive Officer, beneficially owns 45.8% of our outstanding voting securities as at December 31, 2008. As a result, he possesses significant influence, giving him the ability, among other things, to elect a majority of our Board of Directors and to authorize or prevent proposed significant corporate transactions. His ownership and control may also have the effect of delaying or preventing a future change in control, impeding a merger, consolidation, takeover or other business combination or discourage a potential acquirer from making a tender offer.  

ITEM 1B.  UNRESOLVED STAFF COMMENTS


We have no outstanding or unresolved comments from the Securities and Exchange Commission staff.


ITEM 2.  DESCRIPTION OF PROPERTY


All land in China is owned by the state or collectives.  Individuals and companies are permitted to acquire rights to use land or land use rights for specific purposes.  In the case of land used for industrial purposes, the land use rights are granted for a period of 50 years.  This period may be renewed at the expiration of the initial and any subsequent terms according to the relevant Chinese laws.  Granted land use rights are transferable and may be used as security for borrowings and other obligations.


Prior to June 2007, our subsidiary IST occupied space in offices pursuant to a six month rental agreement.  In June 2007, we moved into our new executive offices located on the 21st Floor of the Everbright Bank Bldg., Zhuzilin, Futian District, Shenzhen, China, for which IST currently has land use rights.  Our new executive offices, consist of approximately 1,200 square meters, all of which are dedicated to administrative office space.  We have fully paid the land use fees.  Our other property primarily consists of computer equipment, servers, licensed software, some furniture and fixtures.  There is no lien on any of our property and we currently do not have any intention to make large scale improvements or developments with respect to these properties.  

iASPEC and Bocom lease offices, employee dormitories and factory space in Shenzhen, Guangzhou, Beijing and Dongguan in the PRC, pursuant to lease agreements that will expire on various dates through June 2011. Rent expense for the years ended December 31, 2008 and 2007, was approximately $337,000 and $46,300, respectively.

We believe that all our properties have been adequately maintained, are generally in good condition, and are suitable and adequate for our business.


ITEM 3.  LEGAL PROCEEDINGS


From time to time, we may become involved in various lawsuits and legal proceedings in the ordinary course of our business.  We are currently not aware of any legal proceedings the ultimate outcome of which, in our judgment based on information currently available, would have a material adverse affect on our business, financial condition or operating results.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


There were no matters that were submitted during the fourth quarter of 2008 to a vote of security holders that has not already been disclosed in a Current Report on Form 8-K during the period.


PART II


ITEM 5.  MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES


Market Information


Our common stock is quoted under the symbol “CPBY” on the Nasdaq Global Select Market. Our CUSIP number is 16944F101.


The following table sets forth, for the periods indicated, the high and low bid prices of our common stock.  These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.

 

30



 

Sales Prices (1)

 

High

Low

Year Ended December 31, 2009

1st Quarter (through March 3, 2009)

$3.99

$2.00

 

 

 

Year Ended December 31, 2008

1st Quarter

$8.50

$4.10

2nd Quarter

$7.99

$4.80

3rd Quarter

$5.61

$3.61

4th Quarter  

$4.89

$3.00

 

 

 

Year Ended December 31, 2007

1st Quarter

$9.50

$3.98

2nd Quarter

$8.25

$4.00

3rd Quarter

$9.00

$4.11

4th Quarter

$10.80

$7.05

 

 

 

________________________

(1) The above tables set forth the range of high and low sales prices per share of our common stock as reported by quotemedia.com for the periods indicated.


Holders


As of December 31, 2008, there were 201 stockholders of record of our common stock.


Dividend Policy


We have never declared or paid cash dividends.  Any future decisions regarding dividends will be made by our Board of Directors.  We currently intend to retain and use any future earnings for the development and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.  


Our Board of Directors has complete discretion on whether to pay dividends, subject to the approval of our shareholders.  Even if our Board of Directors decides to pay dividends, the form, frequency and amount will depend upon our future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and other factors that the Board of Directors may deem relevant.


Securities Authorized for Issuance under Equity Compensation Plans


The following table includes the information as of the end of 2008 for each category of our equity compensation plan:


Plan category

Number of securities to be issued upon exercise of outstanding options, warrants and rights

(a)

Weighted-average exercise price of outstanding options, warrants and rights

(b)

Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))

(c)

Equity compensation plans approved by security holders

8,000,000 (1)

$9.48

7,530,000(2)

Equity compensation plans not approved by security holders

-

-

-

Total

8,000,000

 

7,530,000


(1)  On June 13, 2007, our Board of Directors authorized the establishment of the China Information Security Technology, Inc. Equity Incentive Plan, or Plan, whereby we are authorized to issue shares of our common stock to certain employees, consultants and directors.  At that time we reserved 8,000,000 shares of our common stock for issuance under the Plan.  


(2)  On November 27, 2007, we issued 70,000 shares of common stock to our senior management and an outside consultant as bonus awards and we included stock-based compensation of $609,000 in our administrative expenses for the year ended December 31, 2007. On November 30, 2007, our Board of Directors authorized the grant of options to certain employees to purchase 490,000 shares of our common stock, par value $0.01, subject to ratification of the Plan by our stockholders. The options had an exercise price of $9.48 per share, were to vest on December 5, 2008 and to expire on December 5, 2011. The respective stock-based compensation, amounting to $68,891 was charged into administrative expenses in the Consolidated Statements of Income and Comprehensive Income. On March 3, 2008, our Board of Directors voided and canceled the grant of the stock options to the employees, and on March 20, 2008 approved the grant of 400,000 shares stock awards to them at price of $4.30 per share. These newly granted shares vested quarterly at 1/4 over a one-year period following the grant. Since the cancellation and grant of the replacement award occurred concurrently, they were treated as a modification of the terms of the cancelled award in accordance with SFAS 123R.  

 

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ITEM 6.  SELECTED FINANCIAL DATA


Not applicable.


ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 

  

Overview


We are a holding company that owns all of the issued and outstanding capital stock of China Public Security Holdings Limited, a British Virgin Islands holding company, or CPSH. We operate through our PRC mainland subsidiaries, IST, ISS, Bocom and Zhongtian, and through our variable interest entity, or VIE, iASPEC and its subsidiary Geo. Through the operations of our China-based subsidiaries and the subcontracting services provided for in our MSA with iASPEC, we are a provider of integrated solutions for the information security sector and full-service GIS solutions to the public security and civil-use markets in China, specializing in providing information security technology, GIS, and digital hospital information systems. Through ISS, we also provide an e-Government application platform and solutions technology, and we are an exclusive CA application provider for the PRC’s Shenzhen municipality. The CA certification allows ISS to issue digital certificates that contain a public key that can be used by the public to encrypt messages and protect the identity of the user. The CA also certifies that the public key contained in the certificate belongs to the person, organization, server or other entity noted in the certificate. CAs are currently used in China’s e-Government industry and can be successfully integrated with our e-Government platforms and solutions to enhance customers’ applications.


Our customers are mostly public sector entities that use our products and services to improve the service quality and management level and efficiency of public security, traffic control, fire control, medical rescue, border control, and surveying and mapping. Our typical customers include some of the most important government departments in China, including the Ministry of Public Security of People’s Republic of China, the Guangdong Province Public Security Department, the Fujian Province Public Security Department, the Shenzhen General Station of Exit and Entry Frontier Inspection, and other Public Security, Firefighting and Traffic Police Departments in Guangdong Province, Hainan Province, Shanxi Province, Shenzhen City, Shantou City, Zhuhai City, Beijing City, Tianjin City, Shijiazhuang City, Shanghai City, Jingmen City, Chongqing Municipality and Kunming City, and the Shenzhen Personnel Bureau, the Shenzhen Urban Planning Bureau, the Shenzhen Labor Bureau, the Shenzhen Civil Administration Bureau, the Shenzhen Health Bureau, the Dongguan Land Resource Bureau, the Dongguan Urban Planning Institute, the Nanchang Landscaping Bureau, the Wuhan Landscaping Bureau, the Nanjing Surveying and Mapping Bureau and the Inner-Mongolia Surveying and Mapping Bureau In the future, we expect to continually expand our market and product offerings in the public sectors and other sectors, through active industry consolidation and technical capabilities reinforcing.


Fiscal Year 2008 Financial Performance Highlights


We continued to experience strong demand for our products and services during the fiscal year ended December 31, 2008, which resulted in revenue and net income growth. The following are some financial highlights for the period:


Revenue: Revenue increased $55 million, or 181.5%, to $85.3 million for the fiscal year ended December 31, 2008, from $30.3 million for the same period in 2007.

Income from operations: Income from operations increased $10.6 million, or 79.7%, to $23.9 million for the fiscal year ended December 31, 2008, from $13.3 million for the same period in 2007.

Net income: Net income increased $10.5 million, or 78.9%, to $23.8 million for the fiscal year ended December 31, 2008, from $13.3 million for the same period in 2007.

Fully diluted net income per share: Fully diluted net income per share was $0.51 for the fiscal year ended December 31, 2008, as compared to $0.33 for the same period in 2007.

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Our net income for the fiscal years ended December 31, 2008 and 2007 was approximately $23.8 million and $13.3 million, respectively. For the fiscal years ended December 31, 2008 and 2007, our net income was impacted by a stock-based compensation cost recognized pursuant to SFAS 123 (R). 


The following table represents the impact of our stock-based compensation cost for the fiscal years ended December 31:

 

 

 

2008

 

 

2007

           

Net income

$

23,786,976

 

$

13,331,452

Stock-based compensation (“SBC”)

 

1,604,741

   

677,891

           

Weighted average number of shares outstanding

         

Basic

 

46,398,600

 

 

39,718,967

Diluted

 

46,852,827

   

40,152,855


Together with new contracts won from other provinces and our acquisition of Bocom, Geo and Zhongtian, we have become a full service, national provider of public security information technology and we are on our way to achieving our goal to be the leading provider of integrated solutions for public security information technology and GIS software service operations in China.

The total value of our backlog of contracts is estimated to be approximately $30.68 million. The following table shows our backlog information as of December 31, 2008:

Revenue recognized in the fiscal year of 2008

$

85.30 million

Backlog of uncompleted contracts

$

22.09 million

Backlog of contracts newly signed, but not yet implemented

$

8.59 million


Principal Factors Affecting Our Financial Performance


Demand for Software Products and Services


The revenue growth and profitability of our business depend on the overall market demand for software products and related services. Our products and services in the public security sector are considerably mature. However, if we fail to quickly expand our market share in the public security sector, our financial results could be adversely affected. Under the Management Service Agreement, we license 16 copyrighted software applications from iASPEC on an exclusive basis. To protect the intellectual property underlying these applications and our other intellectual property, we rely on a combination of copyright, trademark, and trade secret laws worldwide. We also rely on non-disclosure agreements and other confidentiality procedures and contractual provisions under the laws of various jurisdictions to protect our intellectual property rights.  Some of these technologies, other than the iASPEC copyrighted software applications, are very important to our business and are not protected by copyrights or patents. It may be possible for unauthorized third parties to copy or reverse engineer our products, or otherwise obtain and use information that we regard as proprietary. Further, third parties could challenge the scope or enforceability of our copyrights. In certain foreign countries, including China where we operate, the laws do not protect our proprietary rights to the same extent as the laws of the United States. Any misappropriation of our intellectual property could have a material adverse effect on our business and results of operations. See our Risk Factors under the headings “Risks Related to our Business” and “Risks Related to Doing Business in China” to read about significant risk factors related to our intellectual property and our ability to protect them under PRC law.


33


 

Taxation  


Our subsidiaries, ISS, iASPEC, Bocom and Zhongtian, are all governed by the Income Tax Laws of the PRC and are subject to the PRC enterprise income tax, or EIT, at 18% in 2008.


Before January 1, 2008, foreign invested enterprises, or FIEs, established in the PRC were generally subject to an enterprise income tax, or EIT, rate of 33.0%, which included a 30% state income tax and a 3.0% local income tax. FIEs established in Shenzhen Special Economic Zone were subject to reduced tax rate. On March 6, 2007, the China Unified Corporate Income Tax Law, or the EIT Law, was released and on November 28, 2007, the State Council of China passed the Implementing Rules for the EIT Law, or Implementing Rules, both of which became effective on January 1, 2008, and resulted in an increase in the PRC federal statutory tax rate to 25%. The EIT Law gives foreign investment enterprises, or the FIEs, established before March 16, 2007, or Old FIEs, a five-year grandfather period during which they can continue to enjoy their existing preferential tax treatments. During this five-year grandfather period, Old FIEs that enjoyed tax rates lower than 25% under the original EIT Law can gradually increase their EIT rate by 2% per year until their tax rate reaches 25%. In addition, the Old FIEs that are eligible for the “two-year exemption and three-year half reduction” or “five-year exemption and five-year half-reduction” under the original EIT Law, are allowed to continue enjoying their preference until these holidays expire. The discontinuation of any such special or preferential tax treatment or other incentives would have an adverse effect on any organization's business, fiscal condition and current operations in China.

 

In addition to the changes to the current tax structure, under the EIT Law, an enterprise established outside of China with “de facto management bodies” within China is considered a resident enterprise and will normally be subject to an EIT of 25.0% on its global income. The Implementing Rules define the term “de facto management bodies” as “an establishment that exercises, in substance, overall management and control over the production, business, personnel, accounting, etc., of a Chinese enterprise.” If the PRC tax authorities subsequently determine that the Company should be classified as a resident enterprise, then the organization's global income will be subject to PRC income tax of 25%


As a wholly-owned FIE, our PRC subsidiary, IST, was approved by PRC tax authorities on August 10, 2007, to enjoy a two-year tax exemption, followed by a 50% exemption for three years, retroactive to as of January 1, 2007. Since the EIT Law permits companies, such as IST, that were previously exempt from taxes or that had concessional rates to retain their preferences until the original expiration date the EIT Law does not impact IST’s income tax qualification to enjoy a tax exemption in fiscal year 2008 and IST will continue to qualify for a 50% tax exemption for the two years thereafter. EIT exemptions claimed by IST may become payable if IST were to dissolve within the next 10 years. However, management believes that the PRC tax authorities will not request payment of any such amounts. As a high-tech enterprise, Geo was subject to EIT at a 15% rate in 2008, and will be subject to EIT at the same rate in 2009.


34


 

Results of Operations

The following tables set forth key components of our results of operations for the periods indicated, both in dollars and as a percentage of sales revenue and key components of our revenue for the periods indicated in dollars.

 

2008

2007

 

 

Year ended 31-December

 

Year ended 31-December

Revenue-Third Parties

$

85,235,887

$

24,800,750

Revenue-Related party

 

65,297

 

5,541,959

Total Revenue

 

85,301,184

 

30,342,709

 

 

 

 

 

Cost of revenue

 

(46,222,320)

 

(12,373,370)

Gross profit

 

39,078,864

 

17,969,339

 

 

 

 

 

Administrative expenses

 

(10,158,863)

 

(3,288,657)

Research and development expenses

 

(2,596,430)

 

(797,580)

 

 

 

 

 

Fee to iASPEC under the Turkey Agreement

 

-

 

(92,160)

Selling expenses

 

(2,440,689)

 

(480,465)

Income from operations

 

23,882,882

 

13,310,477

 

 

 

 

 

Other income, net

 

938,921

 

79,435

Interest income

 

214,850

 

138,840

Interest expenses

 

(179,130)

 

 

Minority interest

 

(241,197)

 

(90,000)

 

 

 

 

 

Income from discontinued operations

 

718,159

 

-

 

 

 

 

 

Income taxes

 

(1,547,509)

 

(107,300)

Net income

$

23,786,976

$

13,331,452

 

 

 

 

 

Weighted average number of shares

 

 

 

 

Basic

 

46,398,600

 

39,718,967

Diluted

 

46,852,827

 

40,152,855

 

 

 

 

 

Earnings per share

 

 

 

 

Basic

$

0.51

$

0.34

Diluted

$ 

0.51

$ 

0.33


35


 

AS A PERCENTAGE OF REVENUE

       
   

2008

 

2007

           
   

Year ended

 

Year ended

 
 

31-December

 

31-December

 

Revenue-third parties

 

99.9%

 

81.7%

 

Revenue-related party

 

0.1%

 

18.3%

 

Cost of revenue

 

54.2%

 

40.8%

 

Gross profit

 

45.8%

 

59.2%

 

Administrative expenses

 

11.9%

 

10.8%

 

Research and development expenses

 

3.0%

 

2.6%

 

Fee to iASPEC under the Turnkey Agreement

 

-

 

0.3%

 

Selling expenses

 

2.9%

 

1.6%

 

Income from operations

 

28.0%

 

43.9%

 

Other income

 

1.1%

 

0.3%

 

Interest income

 

0.3%

 

0.5%

 

Minority interest

 

0.3%

 

0.3%

 

Income taxes

 

1.8%

 

0.4%

 

Net income

 

27.9%

 

43.9%

 


Revenue

Our revenue is generated from our integrated hardware and software products and through the related after-sales services. In 2008 we experienced solid growth in revenues. Revenue for the year ended December 31, 2008 increased $54.9 million, or 181%, to $85.3 million, as compared to $30.3million for 2007. The increase in our revenue was mainly due to the addition of new product lines, our procurement of several large-scale system integration projects in 2008 and our expansion into new territory.

In 2008, we completed the acquisition of our operating subsidiaries, Bocom, Geo and Zhongtian. Our consolidation of the revenues of these three companies in our 2008 financial statements, resulted in a $12 million increase of our revenues for the period. The consolidation of Bocom accounted for $7.3 million, Geo accounted for $4.4 million and Zhongtian accounted for 0.5 million of this increase. The acquisitions also enriched our product and service offerings to our customers.

Our increase in revenues during the 2008 period was also attributable to the Company’s win of 235 new system integration or software development contracts that contributed approximately $69 million to the Company’s 2008 revenues. Of these contracts, 118 integration/software development contracts contributed $35 million in sales, 75 software development contracts contributed $10 million in sales, and 42 new software development contracts contributed approximately $24 million in sales. The completion of existing contracts also contributed about $5.4 million in sales to the Company.

Some of our new contract wins also signaled our expansion into new territories. Of these 235 new contracts, 15 contracts were won from provinces outside of our usual market in Guangdong Province, including Beijing, Hainan, Tianjin, Liaoning, Guangxi, Xinjiang and Xi'an. These contracts, in the aggregate, contributed approximately $16.5 million to our revenues.

Cost of Revenue


Our cost of revenues increased $33.8 million, or 273%, to $46.2 million, for the fiscal year ended December 31, 2008, from $12.4 million in 2007. The increase was mainly due to the consolidation of ISS, Bocom, Geo and Zhongtian who collectively contributed approximately $15.8 million in 2008, compared to $1.7 million in 2007 which only included ISS. As a percentage of revenues, our cost of revenue increased to 54.2% during the year ended December 31, 2008, from 40.8% in 2007. During the 2008 period, we were engaged in several large-scale system integration projects which involved higher costs for procured hardware and other subcontracting costs. The cost for accomplishing those projects is generally much higher than pure software development services and, therefore, led to an increase in our cost of revenues.


Gross Profit

Gross profit as a percentage of revenue was 45.8% for the year ended December 31, 2008, a decrease of 13.4%, from 59.2% in 2007. The decrease in our gross profit ratio is the combined effect of an increase in the gross profit ratio of our software sales by 1%, and a decrease in the gross profit ratio of our system integration sales by 7%, net of a decrease in the gross profit ratio of our product sales by 10%, as shown in the following table:

    2008   2007
    Revenue   Cost   GP%   Revenue   Cost   GP%
Products   26,822,325   25,049,072   7%   2,007,800   1,669,410   17%
Software   34,958,401   5,628,436   84%   13,131,578   2,233,493   83%
System integration   19,328,312   12,196,185   37%   15,194,314   8,470,467   44%
Others   4,192,146   3,348,627   20%   9,017   -   100%
Subtotal   85,301,184   46,222,320   46%   30,342,706   12,373,370   59%

The increase in gross profit, or GP, ratio of software sales results from management’s cost control procedures and processes to enhance efficiency. Management has taken a series of measures to reduce software development costs, such as reducing purchases of out-sourced services and enhancing reliance on the work of the Company’s own technicians. The decrease in the GP ratio of system integration and product sales is mainly due to the increase in the purchase price of manufacturing materials.

Administrative Expenses


Administrative expenses consist primarily of compensation and benefits to our general management, finance and administrative staff, professional advisor fees, audit fees and other expenses incurred in connection with general operations. We expect the dollar amount of our general and administrative expenses will increase as our business grows and we continue to incur increased costs for being a public reporting company.


36


 

Our administrative expenses increased $6.9 million, or 209%, to $10.2 million for the year ended December 31, 2008, from $3.3 million in 2007. The increase in administrative expenses was mainly attributable to an increase in our administrative staff and increased administrative costs in connection with the expansion of our operations. The number of our employees increased from 460 in 2007 to 732 in 2008. In addition, we issued 70,000 bonus shares to our senior management and a consulting service company on November 27, 2007. On November 30, 2007, we also granted options to purchase 490,000 shares of our common stock to certain employees which resulted in $0.68 million of stock-based compensation cost charged into administrative expenses in 2007. On March 3, 2008, the Company canceled the grant of the stock options, and on March 20, 2008 approved the grant of 400,000 shares of restricted common stock to the employees under our 2007 Equity Incentive Plan. In 2008, $1.6 million of stock-based compensation was charged to administrative expenses in connection with the Plan. As a percentage of revenue, administrative expenses increased to 11.9% for the year ended December 31, 2008 from 10.8% in 2007. We believe the increase was generally in line with the increase in our revenue.


Research and Development Expenses


Research and development expenses consist primarily of personnel-related expenses as well as costs associated with new software product development and enhancement. For the year ended December 31, 2008, research and development expenses increased to $2.6 million, from $0.8 million for the same period of 2007, a $1.8 million, or 226% increase, from period to period. Increases related to iASPEC and IST reflect our efforts to address the increasingly sophisticated needs of our customers for the support of existing and emerging hardware, software, database and networking platforms, and for the development and introduction of enhancements to our existing products and new products on a timely basis in order to keep pace with technological developments. We capitalize costs that are incurred to produce finished products after technological feasibility is established.


Selling Expenses


Selling expenses consist primarily of compensation and benefits to our sales and marketing staffs, business travels after-sale support, transportation costs and other sales related costs. Our selling expenses increased $1.9 million, or 408%, to $2.4 million for the year ended December 31, 2008, from $0.5 million in 2007. The increase was mainly due to the consolidation of ISS, Bocom, Geo and Zhongtian collectively contributed $1.3 million in 2008, compared to $0.04 million, the result of consolidation in the same period of 2007 which only included ISS. As a percentage of revenue, our selling expenses increased to 2.9% for the year ended December 31, 2008, from 1.6% in 2007. We believe such increase was generally in line with the increase in our revenue.  


Income from Operations


Income from operations increased $10.7 million, or 80%, to $23.9 million for the year ended December 31, 2008, from $13.2 million in 2007. Income from operations as a percentage of revenue decreased to 28.0% during the year ended December 31, 2008, from 43.9% in 2007. This decrease was due to the lower margins reported by recent acquisitions, as well as the significantly higher costs for procured hardware and other subcontracting costs related to the implementation of several large-scale systems integration projects.


Interest Income


Interest income increased $76,010, or 55%, to $214,850 for the year ended December 31, 2008, from $138,840 in 2007. Such increase was mainly attributable to the increased cash balances from our fundraising activities during 2008. As a percentage of revenue, our interest income decreased to 0.3% for the year ended December 31, 2008, from 0.5% in 2007.


Minority Interest


Compared with $0.09 million for the same period in 2007, minority interest increased $0.15 million, or 168%, to $0.24 million for the year 2008. Consolidation of iASPEC for the twelve months in 2008, compared to six months in 2007, resulted in an increase of $0.09 million in minority interest, and the consolidation of Geo from April 1, 2008 contributed $0.06 million.


Discontinued Operations


In December 2008, we terminated our involvement in two joint venture projects, the leasing of LED screens and the manufacture and sale of LCD screens. Our termination resulted in income from discontinued operations of $ 0.72 million.


Provision for Income Taxes


Our subsidiaries, ISS, Bocom, Zhongtian, and our VIE, iASPEC (exclusive of Geo), are all governed by the Income Tax Laws of the PRC and are subject to the PRC’s enterprises income tax, or EIT, at a rate of 18% of assessable profits in 2008. Geo is subject to EIT at a rate of 15% of assessable profits as a High-Tech Enterprise. However, after offsetting accumulated losses from prior years, Geo had no assessable profit subject to EIT for the year of 2008. In addition, as a software company, IST was entitled to a two-year exemption from EIT followed by a 50% tax exemption for the next 3 years. On August 10, 2007, IST was granted the EIT exemption by PRC tax authorities, retroactive to as of January 1, 2007. Income tax expenses for the years 2008 and 2007, was $1.55 million, and $0.11 million, respectively.


37



Net Income


Net income increased $10.5 million, or 78%, to $23.8 million during the year ended December 31, 2008, from $13.3 million in 2007. The increase in net income was primarily attributable to the increase in revenue and other factors described above.


Liquidity and Capital Resources 


Cash Flow and Working Capital 

As of December 31, 2008, we had cash and cash equivalents of $ 9.6 million.  We believe that our currently available working capital should be adequate to sustain our operations at our current levels through at least the next twelve months. Due to the current state of the credit markets, we are not able to predict with any certainty whether we could obtain debt or equity financing to provide additional sources of liquidity, should the need arise, at favorable rates.

The following table provides the statements of net cash flows for the years ended December 31, 2008 and 2007:

 CASH FLOW

   

Years Ended December 31

   

 

2008

 

 

2007

Net Cash Provided by Operating Activities

 

$

4,547,977

 

$

1,607,191

 

 

 

 

 

 

 

Net Cash Used in Investing Activities

 

 

(21,045,087)

 

 

(31,964,909)

 

 

 

 

 

 

 

Net Cash Provided by Financing Activities

 

 

5,228,098

 

 

49,535,182

 

 

 

 

 

 

 

Effect of Exchange Rate Change on Cash

 

 

1,079,082

 

 

405,402

 

 

 

 

 

 

 

Net (decrease) increase in Cash and Cash Equivalents

 

 

(10,189,930)

 

 

19,582,866

 

 

 

 

 

 

 

Cash and Cash Equivalents – Beginning of Period

 

 

19,755,182

 

 

172,316

 

 

 

 

 

 

 

Cash and Cash Equivalents – End of Period

 

$

9,565,252

 

$

19,755,182

Operating Activities

Cash provided by operating activities increased $2.9 million, 183%, from $1.6 million in 2007 to $4.5 million in 2008. This increase was primarily the result of increased cash receipts from customers in 2008, which was driven by a $55 million, or 181%, increase in revenue. The increase was partially offset by an increase in accounts receivable and an increase in cash payments for purchases and operating expenses.

Accounts receivable of $42.9 million as of December 31, 2008 include $25.72 of unbilled amounts, which consist of estimated future billings for work performed but not yet invoiced to customers. Unbilled amounts are usually expected to be billed within three months, and unbilled accounts receivable has the same impact on our liquidity and operating cash flows as normal accounts receivable.

In May 2008, our wholly-owned subsidiary, IST, entered into a contractual joint venture agreement with Huipu Electronic (Shenzhen) Co., Ltd., or Huipu, to set up a joint venture project in the manufacturing and sales of LCD screens. In May 2008, IST also entered into a contractual joint venture agreement with Lianchengwen Technology (Shenzhen) Co., Ltd. ("LTS"), to set up a joint venture project in leasing LED screens. According to the contracts, the Company provided funds to the projects for equipment acquisition, repayable by the other parties if certain revenue and income targets were not met. This contractual arrangement also resulted in the creation of a variable interest under FIN 46R, as the Company is the primary beneficiary of the project. Under the terms of the contract, we agreed to provide funds to the projects for equipment acquisition, and the other parties agreed to repay such equipment costs if certain revenue and income targets are not met. Effective December 31, 2008, the contractual joint venture arrangements were terminated and IST received approximately $718,000, representing its agreed-upon share of the joint venture project’s net income from inception through termination. As a result of the termination, the cash flows of the joint ventures have been eliminated from IST’s ongoing operations and IST has no continuing involvement in the projects. Accordingly, the assets and liabilities and revenues and expenses of the two joint ventures are no longer included in the Company’s consolidated financial statements and the $718,000 has been recorded as income from discontinued operations.

During December, 2008, IST received a Bills Receivable from Huipu, in the amount of RMB 30,716,000 (approximately $4,481,340) that will mature on March 31, 2009.

Investing Activities

For the fiscal year ended December 31, 2008, net cash used in investing activities was $21.05 million, which included $0.71 million, $2.44 million and $0.23 million of cash acquired from Bocom, Geo and Zhongtian, respectively, compared to cash used of $31.96 million for 2007. Cash provided by and used in investing activities during the fiscal year ended December 31, 2008 consisted of the $15.0 million in cash collected from the sale of our investment in marketable securities and from the honor of a guarantee by our Chief Executive Officer and controlling shareholder, Mr. Jiang Huai Lin in connection with this investment, offset by the price paid of $7.0 million and $9.9 million, respectively, in connection with the acquisition for Geo and Zhongtian, a $5.66 million short-term investment made in June 2008 and $8.57 million cash paid for the investment in the two joint ventures during the year. The company also spent $8.9 million on the purchase of property and equipment, and received $1.14 million in cash proceeds from sales of property and equipment.

On October 31, 2008, we completed the acquisition of Kwong Tai and its wholly-owned PRC subsidiary, Zhongtian, from Wide Peace International Investments Limited, a British Virgin Islands company, for a purchase price of $16,500,000, of which $9,900,000 (approximately RMB67,617,000) was paid in cash on the closing date.

38


 

On June 25, 2008, we invested RMB40 million (approximately $5.71 million) in currency–linked capital protected investment products, or CPI Products. These products have a term of one year and matured on June 25, 2009. The potential return rate on these investments is 4.1975% or 5.2722% per annum, based upon the quoted exchange rate between Hong Kong Dollars (HK$) and Chinese RMB on June 23, 2008, however, these return rates are dependent on the exchange rate market fluctuations which may dilute performance. We expect to hold these CPI Products to maturity in order to realize the full potential return.

In May 2008, IST entered into contractual joint venture agreements with Huipu Electronic (Shenzhen) Co., Ltd. to set up a joint venture project in manufacturing and sales of LCD screens, and with Lianchengwen Technology (Shenzhen) Co., Ltd. ("LTS"), to set up a joint venture project in leasing LED screens. According to the contracts, the Company provided funds to the project for RMB 60,000,000 (approximate $8.57 million). In December 2008, we terminated these two joint venture projects.

On February 15, 2008, our Board of Directors approved our VIE, iASPEC’s entry into a share purchase and increased capital agreement, dated as of February 16, 2008, for the purchase of approximately 57% of Geo for RMB 49,500,000 (approximately $6,999,000), which is reflected in consideration paid for business acquisition of Geo in our condensed consolidated financial statements.

In order to facilitate iASPEC’s expansion and also to provide financing for iASPEC to complete the acquisition of Geo, the Company advanced RMB38 million to iASPEC (approximately $5.4 million) to increase iASPEC’s registered capital. In order to comply with PRC laws and regulations, the advance was made to Mr. Lin, iASPEC’s majority shareholder, who, upon authority and direction of the Board of Directors, forwarded the funds to iASPEC. The Company has recorded the advance of these funds as an interest-free loan to iASPEC, which was eliminated against additional capital of iASPEC in consolidation. The increase in iASPEC’s registered capital does not affect IST’s exclusive option to purchase iASPEC’s assets and shares under the MSA.

On November 9, 2007, we invested in three equity-linked notes, or ELNs, for HKD176,814,000 (approximately $22,654,000). The ELNs were linked to three different equity securities traded on the Hong Kong Stock Exchange. Our Chief Executive Officer and controlling shareholder, Mr. Jiang Huai Lin, provided a guarantee against any losses sustained as a result of the our investment in the ELNs. On December 28, 2007, the maturity date of the ELNs, one of the ELNs was redeemed by the issuer for cash of HKD 60,000,000 (approximately $7,687,000) and with a gain of HKD906,000 (approximately $116,000). The other two ELNs were redeemed by the issuer’s surrender of the underlying equity securities to us. On March 25, 2008, when we sold the remaining equity securities, the market value of the underlying securities was HKD85,009,123 (approximately $10,897,000). To honor his guarantee, on March 28, 2008, Mr. Lin consummated a private sale to certain accredited investors of 1,070,000 restricted shares of our Common Stock owned by him, for an aggregate price of $4.28 million, or $4.00 per share, and delivered the proceeds from the sale of his shares to us. Mr. Lin will not receive any shares of our common stock, other security or other consideration for this capital contribution and has waived any and all rights that he may have to make a claim against us for any such shares, securities or other consideration in the future. In connection with this private sale transaction, we entered into a registration rights agreement with the purchasers of Mr. Lin’s shares, pursuant to which, among other things, we agreed to register within a predefined period, shares of its common stock transferred to them by Mr. Lin. There are no liquidated damages associated with the failure to timely register these shares.

As a result of Mr. Lin’s actions, the transactions did not have any impact on our operating results or financial condition for the fiscal year 2008. All of our cash is currently invested in interest bearing bank accounts. In addition, management and our Board of Directors have reviewed our cash management practices and have now put in place strict controls to ensure that going forward, our cash will only be invested in straight interest bearing instruments that ensure the liquidity of these funds and the preservation of capital.

39


 

Financing Activities

For the fiscal year ended December 31, 2008 and 2007, net cash provided by financing activities was $5.1 million and $49.5 million, respectively. For the fiscal year ended December 31, 2008, financing activities included the repayment of a $1.09 million bank loan and securing a $6.3 million bank loan. During 2007, net cash provided by financing activities was mainly attributable to the net proceeds of $49.8 million raised in our private placement during January and February 2007.

On July 8, 2008, the Company's subsidiary, ISIID, drew a term loan for HK$40 million (approximately $5.1 million) from a bank. The loan is payable in 12 monthly installments of principal and interest, has an interest rate at Hong Kong Interbank Offer Rate (“HIBOR”) plus 2.75% (4.57% as of July 8, 2008) per annum and matures on July 8, 2009. The loan is guaranteed by Mr. Lin, iASPEC, Bocom, CPSH and the Company, and is collateralized by the Company's short-term investments.


Obligations under Material Contracts

 

During the first half of 2007, our wholly-owned subsidiary, IST, was a party to the Turnkey Agreement with iASPEC, pursuant to which IST was exclusively engaged as a subcontractor providing iASPEC’s customers with certain outsourcing services (to the extent that those services did not violate any special governmental permits held by iASPEC and did not involve the transfer of any sensitive confidential governmental or other data), and IST was obligated under the terms of the Turnkey Agreement to pay for its own costs in providing these services and to pay iASPEC $180,000 per year throughout the term of the agreement.

 

IST, iASPEC and iASPEC’s shareholders, Mr. Lin and Mr. Jin Zhu Cai, terminated the Turnkey Agreement, effective as of July 1, 2007, and replaced it on the same day with the Management Services Agreement, or MSA. Pursuant to the terms of the MSA, iASPEC granted IST an exclusive, royalty-free, transferable, worldwide, license to use and install for a ten-year term, certain iASPEC software, along with copies of source and object code relating to such software, in any manner permitted by applicable laws, and IST licensed back to iASPEC a royalty-free, limited, non-exclusive license to the Software, without right of sub-license, for the sole purpose of permitting iASPEC to carry out its business as presently conducted. IST also has the right to designate two Chinese citizens to serve as senior managers of iASPEC, to serve as a majority on iASPEC’s Board of Directors and assist in managing the business and operations of iASPEC. In addition, both iASPEC and IST will require the affirmative vote of the majority of our Board of Directors, as well as at least one non-insider director, for certain material actions with respect to iASPEC, including, but not limited to: (a) the nomination, appointment, election or replacement of any board members; (b) the distribution of any dividend or profits; (c) any merger, division, change of corporate form, dissolution or liquidation; (d) any reimbursement of net losses or other payments or transfers of funds from IST to iASPEC; (e) the formation or disposition of a subsidiary or the acquisition or disposition of any interest in any other entity; and (f) the encumbrance of any assets under any lien not in the ordinary course of business.

 

Under the MSA, IST receives 100% of the net received profit of iASPEC, and reimburses iASPEC for all net losses incurred by iASPEC, as such terms are defined in the MSA, and iASPEC is permitted to retain $180,000 per year out of net received profits. The MSA also provides that IST may advance to iASPEC, at IST’s sole discretion, amounts to be credited against IST’s future obligations to iASPEC. Any such advances are treated as prepayments and not as loans and iASPEC has no obligation to repay any such advances except by crediting the amount of such advances against IST’s obligation to reimburse net losses, or by adding the amount thereof to net received profit when and as requested by IST. The parties to the MSA also agreed to the calculation of a true-up amount, consisting of the cumulative net profit or net losses of iASPEC from October 9, 2006, when iASPEC commenced its contractual relationship with IST, through the date of the MSA, and iASPEC will pay such true-up amount to IST if there is a net received profit, while IST is obligated to reimburse such true-up amount to iASPEC if it is there is a net loss.

 

40


 

In connection with the MSA, IST also entered into an Option Agreement with iASPEC and its shareholders, effective as of July 1, 2007, pursuant to which the iASPEC shareholders granted the Company or its designee(s) an exclusive, irrevocable option to purchase, from time to time, all or a part of iASPEC’s shares or iASPEC’s assets from the iASPEC shareholders. However, according to the Option Agreement, the option may not be exercised by IST if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated. Under the terms of the Option Agreement, the option is immediately exercisable at an exercise price of $1,800,000 in the aggregate, subject to regulatory approval. In addition, iASPEC and the iASPEC shareholders agreed to use their best efforts to acquire all necessary government approvals and other consents to complete a share purchase under the Option Agreement. The Option Agreement may be rescinded by the Company upon 30days’ notice and will terminate on the date that the Company purchases all remaining shares or assets of the Company pursuant to the terms of the Option Agreement. If any of the parties breaches the Option Agreement and fails to remedy the breach, the breaching party will pay a penalty of RMB5,000,000 (approximately $712,000) to the non-breaching party or parties, and compensate the non-breaching party or parties for any losses caused by the breach. For more details regarding the MSA and Option Agreement, see our Report on Form 8-K filed with the SEC on August 6, 2007.


Seasonality of our Sales

 

Our operating results and operating cash flows historically have not been subject to seasonal variations. This pattern may change, however, as a result of new market opportunities or new product introductions.

 

Inflation

 

Inflation has not materially affected our business or the results of our operations to date.


Critical Accounting Policies


The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires our management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements, including the notes thereto, and related disclosures of commitments and contingencies, if any.  We consider our critical accounting policies to be those that require the more significant judgments and estimates in the preparation of financial statements, including the following:


Goodwill-Goodwill represents the excess of the purchase price over the net of the fair value of the identifiable tangible and intangible assets acquired and the fair value of liabilities assumed upon the acquisition of Information Security Software Investment Limited, or ISSI (formerly Fortune Fame International Limited) in 2007, Information Security International Investment and Development Limited, Shenzhen or ISIID (formerly Bocom Multimedia Display Technology Co., Ltd.), Wuda Geoinformatics Co., Ltd or Geo, Shenzhen Zhongtian Technology Development Company Ltd, and Kwong Tai International Technology Limited, or Kwong Tai. In accordance with Statement of Financial Accounting Standards or “SFAS” No. 142, Goodwill and Other Intangible Assets, our management evaluates the carrying value of goodwill annually or when a possible impairment is indicated. We perform our impairment annually during the fourth quarter of the fiscal year and determined that there was no impairment of goodwill as of December 31, 2008.


Revenue Recognition-Revenues from products are recognized only when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price to the customer is fixed or determinable, and collectability is reasonably assured. Generally, revenue is recognized (1) upon shipment for equipment and software, (2) as work is performed for professional services and (3) in equal periodic amounts over the term of the contract for software and hardware maintenance. Our revenue recognition policies are in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition,” and AICPA Statement of Position No. 97-2, “Software Revenue Recognition.


The majority of revenues are generated from fixed-price contracts, which provide for licenses to software products, and services to customize such software to meet customers' use. Generally, when the services are determined to be essential to the functionality of the delivered software, revenue is recognized using the percentage of completion method of accounting in accordance with SOP 97-2 and SOP 81-1 “Accounting for Long-term Construction Type Contracts.” The percentage of completion for each contract is estimated based on the ratio of direct labor hours incurred to total estimated direct labor hours. We review accounts receivables for allowances whenever events or changes in circumstances indicates that the related carrying amounts may not be recoverable, losses on accounts receivables are provided when they become evident


Foreign Currency Translation-The functional currency of our wholly- owned PRC subsidiaries, IST, ISS, Bocom,  Zhongtian and our VIE, iASPEC and its holding subsidiary, Geo is the Chinese Renminbi Yuan, (“RMB”). RMB is not freely convertible into foreign currencies. Our PRC subsidiaries’ financial statements are maintained in the functional currency. Monetary assets and liabilities denominated in currencies other than the functional currency are translated into the functional currency at rates of exchange prevailing at the balance sheet date. Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchange rates prevailing at the dates of the transactions. Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods.


41


 

The exchange rates adopted are as follows:


 

December 31, 2008

December 31, 2007

Year end exchange rate

6.8542

7.3141

Average yearly exchange rate

6.9623

7.6172


No representation is made that the RMB amounts could have been, or could be, converted into United States dollars at the rates used in translation.


Income Taxes - Income tax expense is based on reported income before income taxes. Deferred income taxes reflect the effect of temporary differences between assets and liabilities that are recognized for financial reporting purposes and the amounts that are recognized for income tax purposes. In accordance with SFAS No. 109 , “Accounting for Income Taxes,”  these deferred taxes are measured by applying currently enacted tax laws.


Earnings per Share - Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, or resulted in the issuance of common stock that shared in the earnings of the entity. For the year ended December 31, 2008, dilutive securities represent outstanding warrants to acquire 400,000 shares of common stock, and contingently issuable common stock of 970,479 shares.

Recent Accounting Pronouncements

On September 15, 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, which defines fair value, establishes a new framework for measuring that values and expands disclosures about fair value measurements. The standard applied prospectively to new fair value measurements performed after January 1, 2008, for measurements of the fair values of financial instruments and recurring fair value measurements of non-financial assets and liabilities; on January 1, 2009, the standard applies to all remaining fair value measurements, including non-recurring valuations of non-financial assets and liabilities such as those used in measuring impairments of goodwill, other intangible assets and other long-lived assets. It also applies to fair value measurements of non-financial assets acquired and liabilities assumed in business combinations consummated after January 1, 2009.

On December 4, 2007, the FASB issued SFAS No. 141(R), “Business Combinations”, which is effective for the Company on January 1, 2009. This standard will significantly change the accounting for business acquisitions both during the period of the acquisition and in subsequent periods. Among the more significant changes in the accounting for acquisitions are the following

In-process research and development (IPR&D) will be accounted for as an asset, with the cost recognized as the research and development is realized or abandoned. IPR&D is presently expensed at the time of the acquisition.

Contingent consideration will generally be recorded at fair value with subsequent adjustments recognized in operations. Contingent consideration is presently accounted for as an adjustment of purchase price.

Decreases in valuation allowances on acquired deferred tax assets will be recognized in operations. Such changes previously were considered to be subsequent changes in consideration and were recorded as decreases in goodwill.

Transaction costs will generally be expensed. Certain such costs are presently treated as costs of the acquisition.

Generally, the effects of SFAS No. 141(R) will depend on future acquisitions. In December 2008, the FASB issued (FSP FAS 141(R)-a, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies,” a proposed FSP which would amend the accounting in SFAS 141(R) for assets and liabilities arising from contingencies in a business combination. The proposed FSP would require that pre-acquisition contingencies be recognized at fair value, if fair value can be reasonably determined. If fair value cannot be reasonably determined, the proposed FSP requires measurement based on the best estimate in accordance with SFAS 5, Accounting for Contingencies.

42


 

On December 4, 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements”, an amendment of ARB No. 51, which is effective for the Company on January 1, 2009. This standard will significantly change the accounting and reporting related to noncontrolling interests in the Company’s consolidated financial statements. After adoption, noncontrolling interests (approximately $14 million and $10 million at December 31, 2008 and 2007, respectively) will be classified as stockholders’ equity, a change from its current classification between liabilities and stockholders’ equity. Earnings attributable to minority interests (approximately $241,000 in 2008 and $90,000 in 2007) will be included in net earnings, although such earnings will continue to be deducted to measure earnings per share. Purchases and sales of minority interests will be reported in equity similar to treasury stock transactions.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 allows companies the choice to measure many financial instruments and certain other items at fair value. This gives a company the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. This standard did not have any material impact on the Company’s consolidated operating results and financial position upon adoption.

Off-Balance Sheet Arrangements


We do not have any off-balance arrangements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Not Applicable


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


See the index to our financial statements and our financial statements following the Signature Page at the end of this Annual Report on Form 10-K.


ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.


ITEM 9A. CONTROLS AND PROCEDURES


Disclosure Controls and Procedures


(a) Evaluation of Disclosure Controls and Procedures


We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  

As required by Rule 13a-15(e), our management has carried out an evaluation, with the participation and under the supervision of our Chief Executive Officer, Mr. Jiang Huai Lin and our Chief Financial Officer, Ms. Wendy Wang, of the effectiveness of the design and operation of our disclosure controls and procedures, as of December 31, 2008.  Based upon, and as of the date of this evaluation, Mr. Lin and Ms. Wang, determined that, for the reasons disclosed below, as of December 31, 2008, and as of the date of this Report, our disclosure controls and procedures were not effective.

(b) Management's Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal controls over our financial reporting as defined in Rule 13a-15(f) under the Exchange Act. The Exchange Act defines internal control over financial reporting as a process designed by, or under the supervision of, the a company’s principal executive and principal financial officers and effected by a company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that: (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, or US GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.


43


 

There are inherent limitations in the effectiveness of any system of internal controls, including the possibility of human error and the circumvention or overriding of controls, such that internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.  A material weakness is a deficiency, or a combination of deficiencies, in internal controls over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of our financial reporting.

Management, with the participation and under the supervision of our Chief Executive Officer, Mr. Jiang Huai Lin and our Chief Financial Officer, Ms. Wendy Wang, assessed the effectiveness of our internal control over financial reporting as of December 31, 2008.  Management excluded from this assessment, two of the three businesses that we acquired in 2008, because it was not possible to conduct an assessment of the two acquired businesses’ internal control over financial reporting in the period between the consummation date and the date of management’s assessment. With respect to excluding these companies, we are required to (1) formally note that management is excluding these acquired business from management’s report on internal control over financial reporting; (2) clearly identify the acquired businesses excluded and have indicated the significances of the acquired businesses in our company’s consolidated financial statements; and (3) disclose material changes, if any, to our internal control over financial reporting due to the acquisition of these businesses.  We have excluded Geo, iASPEC’s PRC subsidiary, and Zhongtian, our PRC indirect subsidiary, from our assessment of internal control over financial reporting as of December 31, 2008 because these companies were acquired on April 1, 2008 and October 31, 2008, respectively, and qualified under current SEC regulations for exclusion from our assessment of internal control over financial reporting. Geo and Zhongtian’s financial statements constitute 12% and 8%, respectively, of our total assets, 5% and less than 1% respectively of total revenues, and less than 1% each of net income of our consolidated financial statements amounts, as of and for the year ended December 31, 2008. In assessing the effectiveness of our internal controls over financial reporting as of December 31, 2008, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on our assessment, we determined that, for the reasons disclosed below, as of December 31, 2008, our internal controls over financial reporting were not effective based on those criteria.  


During its audit of our consolidated financial statements for the fiscal year ended December 31, 2008, our independent registered public accounting firm reported material weaknesses in our internal controls over financial reporting. Our independent registered public accounting firm reported material weakness in our financial statement reporting process, including:

(i)

lack of sufficient accounting personnel qualified in US GAAP;

(ii)

deficiencies in the supervision, monitoring, and annual financial statements preparation and review processes; and

(iii)

insufficient identification, documentation and review of various reconciliations and related supporting documentation necessary to prepare financial statements in accordance with US GAAP.

Management believes that the material weaknesses identified above were the direct result of our changes in both junior and senior accounting personnel during the 2008 period and our lack of audit committee oversight during a part of this period. We have taken the measures below and plan to continue taking measures to remediate these material weaknesses as soon as practicable.  


44


 

On April 8, 2008, our Board of Directors established an audit committee consisting of Mr. Yun Sen Huang, Mr. Qiang Lin, and Mr. Sean Shao (Chair), each of whom our board determined to be “independent” as that term is defined by Rule 4200(a)(15) of the Marketplace Rules of The Nasdaq Stock Market, Inc., and one of whom (Mr. Shao) possesses the accounting or related financial management experience that qualifies him as financially sophisticated within the meaning of Rule 4350(d)(2)(A) of the Nasdaq Marketplace Rules and that he is an “audit committee financial expert” as defined by the rules and regulations of the SEC.  Our Audit Committee now oversees our accounting and financial reporting processes and the audits of our financial statements, and is responsible for, among other things:


selecting our independent auditors and pre-approving all auditing and non-auditing services permitted to be performed by our independent auditors;

reviewing with our independent auditors any audit problems or difficulties and management’s response;

reviewing and approving all proposed related-party transactions;

discussing the annual audited financial statements with management and our independent auditors;

reviewing major issues as to the adequacy of our internal controls and any special audit steps adopted in light of significant internal control deficiencies;

annually reviewing and reassessing the adequacy of our audit committee charter;

such other matters that are specifically delegated to our Audit Committee by our Board of Directors from time to time;

meeting separately and periodically with management and our internal and independent auditors; and

reporting regularly to the full Board of Directors.

These functions were previously being performed by the Board of Directors. However, we believe that an independent audit committee performing these functions will help to remediate the material weaknesses identified above.

On November 17, 2008, our Board of Directors appointed Ms. Wendy Wang to serve as our Chief Financial Officer. Ms. Wang has over ten years experience in financial reporting, cost accounting, financial planning, forecasting and analysis, internal controls and tax planning in sizeable organizations. Prior to joining us, Ms. Wang served from September 2004 to October 2008 as the China regional financial controller for the Industrial Operations Division of Amphenol Corp. (NYSE: APH), one of the world’s largest manufacturers of interconnect products; and from August 2000 to June 2003, as Assistant Manager with Pacific Quorum Property Inc. in Vancouver, Canada. Ms. Wang has also served as a financial controller with several other companies in multiple industries and is knowledgeable in PRC GAAP, US GAAP, IFRS and China taxation standards. She holds a Chinese Accountant Certificate and a Master’s degree in International Accounting from the City University of Hong Kong.  Our management is confident that, in light of Ms. Wang’s professional history and background, she has the relevant accounting experience, skills and knowledge in the preparation of financial statements and financial reporting disclosures in accordance with US GAAP and applicable SEC regulations.

In addition to the foregoing measures, we plan to take the following measures to remediate the material weaknesses identified:

(i)

hire additional financial reporting and accounting personnel with relevant accounting experience, skills and knowledge in the preparation of financial statements under the requirements of US GAAP and financial reporting disclosure under the requirement of SEC rules;

(ii)

engage a qualified external consultant with extensive experience in US GAAP reporting and accounting to assist us in  the supervision of the financial reporting process; and

(iii) fine tune our processes for collecting and reviewing information required for the preparation of the financial statements and related footnotes.

When implemented, management believes that these proposed controls will operate effectively for a sufficient period of time to reduce to a less than reasonably possible likelihood the possibility of a material misstatement and remediate the material weakness reported by our independent registered public accounting firm.

Our management does not believe that these material weaknesses had a material effect on our financial condition or results of operations or caused our financial statements as of and for the year ended December 31, 2008 to contain a material misstatement.

We do not believe that the costs of remediation for the above material weaknesses will have a material effect on our financial position, cash flows, or results of operations and we expect to implement these corrective measures by the end of fiscal year 2009.

(c) Changes in Internal Controls over Financial Reporting

We regularly review our system of internal control over financial reporting and make changes to our processes and systems to improve controls and increase efficiency, while ensuring that we maintain an effective internal control environment. Changes may include such activities as implementing new, more efficient systems, consolidating activities, and migrating processes.


Except as described above, there were no changes in our internal controls over financial reporting during the fourth quarter of fiscal 2008 that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

45


 

(d) Audit Report of the Independent Registered Public Accounting Firm

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Board of Directors and Stockholders
China Information Security Technology, Inc. and subsidiaries

We have audited China Information Security Technology, Inc. and subsidiaries’ (the “Company’s”) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing under Item 9A(b) of the Company’s December 31, 2008 annual report on Form 10-K. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control over financial reporting based on that risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America (“US GAAP”). A company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with US GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A(b) of the Company’s December 31, 2008 annual report on Form 10-K, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include two business acquisitions during 2008 because it was not possible to conduct an assessment of the acquired businesses’ internal control over financial reporting in the period between the consummation date and the date of management’s assessment.  The two businesses’ comprise 20%, 5% and less than 1% of total assets, total revenue and net income, respectively, included in the consolidated financial statements of the Company as of December 31, 2008.  Our audit of internal control over financial reporting of the Company also did not include an evaluation of the internal control over financial reporting of these two acquired businesses.

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Material weaknesses have been identified in the financial statement reporting process, including maintaining sufficient accounting and finance personnel qualified in US GAAP; the supervision, monitoring and annual financial statement preparation and review processes; and the identification, documentation and review of various reconciliations and related supporting documentation necessary to prepare financial statements in accordance with US GAAP.  These material weaknesses are included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A(b) of the Company’s December 31, 2008 annual report on Form 10-K.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the Company’s consolidated financial statements as of and for the years ended December 31, 2008 and 2007, and this report does not affect our report on such consolidated financial statements.


46


 

In our opinion, because of the effects of the material weaknesses identified above on the achievement of the objectives of the control criteria, the Company did not maintain effective internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company as of and for the years ended December 31, 2008 and 2007, and our report dated March 15, 2009 expressed an unqualified opinion on those consolidated financial statements.

/s/ GHP Horwath, P.C.

Denver, Colorado

March 15, 2009


ITEM 9B.  OTHER INFORMATION


There is no information required to be disclosed in a report on Form 8-K during the fourth quarter of the year covered by this Form 10-K but not reported.


PART III


ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE


Directors and Executive Officers

 

Set forth below are the names of our current directors, officers and significant employees, their ages, all positions and offices that they hold with us, the period during which they have served as such, and their business experience during at least the last five years.


NAME

AGE

POSITION

Jiang Huai Lin

38

President, Chief Executive Officer, and Chairman of the Board

Wendy Wang

42

Chief Financial Officer

Zhi Xiong Huang

38

Chief Technology Officer

Yifu Liu

35

Chief Operating Officer

Zhiqiang Zhao

37

Director and Chief Administrative Officer

Yun Sen Huang

61

Director

Qiang Lin

61

Director

Sean Shao

51

Director


Mr. Jiang Huai Lin.  Mr. Lin has been a member of our Board of Directors since September 6, 2006 and he became our President and Chief Executive Officer on October 3, 2006. Mr. Lin has also served as the Chairman and Chief Executive Officer of our subsidiary, IST, since its incorporation in January 2006. During the period from September 2000 to June 2004, Mr. Lin served as the President and Chief Executive Officer of Hong Kong United Development Group, a consolidated enterprise engaging in investment, high technology and education. Before that, during the period from February 1995 through August 2000, Mr. Lin was a Director and the General Manager of Fujian Wild Wolf Electronics Limited, a company engaged in the business of manufacturing electrical consumer products. Mr. Lin holds a Bachelor’s degree in Industrial Accounting from Xiamen University.


Ms. Wendy Wang.  Ms. Wang has been our Chief Financial Officer since November 17, 2008. Ms. Wang has over ten years experience in financial reporting, cost accounting, financial planning, forecasting and analysis, internal controls and tax planning in sizeable organizations. Prior to joining us, Ms. Wang served from September 2004 to October 2008 as the China regional financial controller for the Industrial Operations Division of Amphenol Corp. (NYSE: APH), one of the world’s largest manufacturers of interconnect products; and from August 2000 to June 2003, as Assistant Manager with Pacific Quorum Property Inc. in Vancouver, Canada. Ms. Wang has also served as a financial controller with several other companies in multiple industries and is knowledgeable in PRC GAAP, US GAAP, IFRS and China taxation standards. She holds a Chinese Accountant Certificate and a Master’s degree in International Accounting from the City University of Hong Kong.


Mr. Zhi Xiong Huang.  Mr. Huang has been our Chief Technology Officer since September 1, 2008.  Prior to that, he served as our Chief Operating Officer from May 10, 2007 and as a member of our Board of Directors from November 28, 2006. Mr. Huang has also served as the Vice-President of IST since its incorporation in January 2006. Since September 2002, he has also been a Vice President of iASPEC, where he supervises iASPEC’s research and development activities and consults on various types of sophisticated, technical issues. Between July 2001 and March 2002, Mr. Huang served as the General Manager of product development of Shenzhen Runsheng Information Systems Company Ltd. and was responsible for overseeing general operations. He holds a B.S. in computer science from Hehai University in China and has over fifteen years’ experience in information systems. Mr. Huang is currently a Director of the Shenzhen Computer Association and is an Expert with the Shenzhen Expert Association, a nonprofit organization.


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Mr. Yifu Liu.  Mr. Liu has been our Chief Operating Officer since September 1, 2008.  Mr. Liu has over ten years’ experience in corporate operations, strategy management and market development.  Mr. Liu has served as Deputy General Manager of iASPEC since August 2002, and has been the General Manager of iASPEC since November 2006.  Prior to that, Mr. Liu served, from August 1997 to July 2002, as a Senior Sales Manager for Shenzhen Jingpinjia Electronics Company Ltd.. Mr. Liu holds a Bachelor’s degree in Electronics Engineering from Zhejiang University.


Mr. Zhiqiang Zhao.  Mr. Zhao has been our Chief Administrative Officer and a member of our Board of Directors since September 1, 2008. Mr. Zhao has extensive experience in corporate administration and human resources management.  Mr. Zhao has served as iASPEC’s Human Resource Manager since April 2005, and as its Deputy General Manager since July 2006. Prior to that, Mr. Zhao served, from March 2003 to March 2005, as Supervisor of Human Resources for Foxconn Technology Group.  Mr. Zhao holds a Bachelor’s degree in Mechanical and Electrical Engineering from Inner Mongolia University.


Mr. Yun Sen Huang.  Mr. Huang has been a member of our Board of Directors since August 10, 2007. Mr. Huang has been a Professor in the School of Information Engineering at Shenzhen University since September 1984. He has been involved in many computer application projects, and has received many awards, including a First Grade Award of Technology Advancement from Sichuan Province, a Second Grade Award of Technology Advancement from Guangdong Province, and a Third Grade Award of Technology Advancement from the Chemical Ministry. Mr. Huang has published eight books in the field of Networks and Multimedia Applications. In addition, Mr. Huang was a founder of the International Software Development (Shenzhen) Co., Ltd, a co-partnership company incorporated by IBM, East Asia Bank, and Shenzhen SDC Company, and its Chairman between 2001-2006. Currently, Mr. Huang is a Director of the Shenzhen Computer Academy, a Vice Director of the Guangdong Province Computer Academy, as well as Executive Director of the China University Computer Basic Education Committee. Mr. Huang holds a Bachelor’s Degree of Electronics Engineering from Tsinghua University. There is no relationship between Mr. Huang and our Chief Operating Officer, Zhi Xiong Huang.


Mr. Qiang Lin.  Mr. Lin has been a member of our Board of Directors since August 10, 2007. Mr. Lin has been a Professor in the School of Information Engineering at Shenzhen University since September 2002. From July 1997 to September 2002, Mr. Lin served as the Director of Computer Science and Technology Department at Shenzhen University. Mr. Lin has been engaged in teaching and research in the Computer Applications field for many years. Presently, he is a postgraduate advisor and teacher and focuses his research in the fields of Computer Networks, Information Systems, Databases, and ERP systems. Mr. Lin has published many research papers in China’s Computer Science . He is also the editor-in-chief of Electrical Business Foundation . Mr. Lin has significant research experience in information systems, electronic business, logistics, and image disposal and has successfully developed many computer application systems as a project principal. He has been awarded with a First Grade Award of Software Development from the Chinese Chemical Ministry and a Third Grade Award of Science and Technology Development by Guangdong Province. Mr. Lin holds a Master Degree of Computing Mathematics from Zhongshan University .  There is no relationship between Mr. Lin and our Chief Executive Officer, Jiang Huai Lin.


Mr. Sean Shao.  Mr. Shao has been a member of our Board of Directors since April 1, 2008. Mr. Shao has been serving as Chief Financial Officer of Trina Solar Limited since August 2006, where he assisted it in listing on the NYSE in December 2006. Previously he was the Chief Financial Officer of ChinaEdu Corporation, a Chinese educational service provider, from September 2005 to August 2006 and was the Chief Financial Officer of Watchdata Technologies Ltd., a Chinese security software company, from August 2004 to September 2005. He was previously a senior manager at Deloitte Touche Tohmatsu CPA Ltd., Beijing from October 1998 to July 2004 and an assistant manager at Deloitte & Touche Toronto from December 1994 to November 1997. Mr. Shao received his Master’s degree in Health Care Administration from the University of California at Los Angeles in 1988 and his Bachelor’s degree in Art from East China Normal University in 1982. Mr. Shao is an associate member of the American Institute of Certified Public Accountants.

Family Relationships

There are no family relationships among our directors or officers.

Involvement in Certain Legal Proceedings

To the best of our knowledge, except as set forth in our discussion below in “Certain Relationships and Related Transactions,” none of our directors, director nominees or executive officers has been involved in any transactions with us or any of our directors, executive officers, affiliates or associates which are required to be disclosed pursuant to the rules and regulations of the SEC. None of the directors, director designees or executive officers to our knowledge has been convicted in a criminal proceeding, excluding traffic violations or similar misdemeanors, or has been a party to any judicial or administrative proceeding during the past five years that resulted in a judgment, decree or final order enjoining the person from future violations of, or prohibiting activities subject to, federal or state securities laws, or a finding of any violation of federal or state securities laws, except for matters that were dismissed without sanction or settlement.

48


 

Promoters and Certain Control Persons

We did not have any promoters at any time during the past five fiscal years.

Compliance with Section 16(a) of the Exchange Act

Section 16(a) of the Exchange Act requires our executive officers and directors, and persons who beneficially own more than ten percent of our equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Officers, directors and greater than ten percent shareholders are required by SEC regulation to furnish us with copies of all Section 16(a) forms they file. Based on its review of the copies of such forms received by us all such filing requirements applicable to its officers and directors were complied with during the fiscal year ended December 31, 2008.

Code of Ethics

On December 25, 2007, our Board of Directors amended and restated our current code of ethics, or Code of Ethics, so that it conforms to the rules and regulations of The Nasdaq Stock Market, Inc. The Code of Ethics applies to all of our directors, officers and employees, including our principal executive officer, principal financial officer and principal accounting officer, and addresses, among other things, honesty and ethical conduct, conflicts of interest, compliance with laws, regulations and policies, including disclosure requirements under the federal securities laws, confidentiality, trading on inside information, and reporting of violations of the code.  A copy of the Code of Ethics has been filed as Exhibit 14 to our annual report on Form 10-K, filed on March 31, 2008.  Our Code of Ethics is also posted on the Corporate Governance page of our website at www.chinacpby.com.  


Material Changes to Director Nomination Procedures  


There have been no material changes to the procedures by which stockholders may recommend nominees to our Board of Directors since such procedures were last disclosed.


Shareholder Communications


Shareholders who wish to communicate with the Board may write to it at our address given above. These communications will be reviewed by one or more employees of the Company designated by the Board, who will determine whether they should be presented to the Board. The purpose of this screening is to allow the Board to avoid having to consider irrelevant or inappropriate communications.


Committees and Meetings

Our Board currently has three standing committees which, pursuant to delegated authority, perform various duties on behalf of and report to the Board: (i) Audit Committee, (ii) Compensation Committee and (iii) Corporate Governance and Nominating Committee.  Each of the Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee are comprised entirely of independent directors.  From time to time, the Board may establish other committees.

Each of our three standing committees were formed on April 8, 2008.  During the fiscal year ended December 31, 2008, each of our four committees met 4 times.  Copies of the charters for each of our four standing committees may be obtained from our website at www.chinacpby.com.

Audit Committee and Audit Committee Financial Expert


Our Board of Directors established an Audit Committee on April 8, 2008 and appointed Mr. Yun Sen Huang, Mr. Qiang Lin, and Mr. Sean Shao to serve as members of the committee, each of whom our board determined to be “independent” as that term is defined by Rule 4200(a)(15) of the Marketplace Rules of The Nasdaq Stock Market, Inc.  Mr. Shao was appointed as the Chair of the audit committee.      


49


 

Our Audit Committee oversees our accounting and financial reporting processes and the audits of our financial statements. Our Audit Committee is responsible for, among other things:


selecting our independent auditors and pre-approving all auditing and non-auditing services permitted to be performed by our independent auditors;

reviewing with our independent auditors any audit problems or difficulties and management’s response;

reviewing and approving all proposed related-party transactions;

discussing the annual audited financial statements with management and our independent auditors;

reviewing major issues as to the adequacy of our internal controls and any special audit steps adopted in light of significant internal control deficiencies;

annually reviewing and reassessing the adequacy of our audit committee charter;

such other matters that are specifically delegated to our Audit Committee by our Board of Directors from time to time;

meeting separately and periodically with management and our internal and independent auditors; and

reporting regularly to the full Board of Directors.

Our Board of Directors has determined that Mr. Shao possesses the accounting or related financial management experience that qualifies him as financially sophisticated within the meaning of Rule 4350(d)(2)(A) of the Nasdaq Marketplace Rules and that he is an “audit committee financial expert” as defined by the rules and regulations of the SEC.


Compensation Committee


Our Compensation Committee consists of Mr. Yun Sen Huang, Mr. Qiang Lin, and Mr. Sean Shao, each of whom “independent” as that term is defined under the Nasdaq listing standards. Our Compensation Committee assists the board in reviewing and approving the compensation structure of our directors and executive officers, including all forms of compensation to be provided to our directors and executive officers. Our Chief Executive Officer may not be present at any committee meeting during which his compensation is deliberated.  Mr. Huang was appointed as Chair of the Compensation Committee.


The Compensation Committee is responsible for, among other things:

approving and overseeing the compensation package for our executive officers;  

reviewing and making recommendations to the Board with respect to the compensation of our directors;  

reviewing and approving corporate goals and objectives relevant to the compensation of our Chief Executive Officer, evaluating the performance of our Chief Executive Officer in light of those goals and objectives, and setting the compensation level of our Chief Executive Officer based on this evaluation; and  

reviewing periodically and making recommendations to the Board regarding any long-term incentive compensation or equity plans, programs or similar arrangements, annual bonuses, employee pension and welfare benefit plans.  

The Compensation Committee has sole authority to retain and terminate outside counsel, compensation consultants retained to assist the Compensation Committee in determining the compensation of the Chief Executive Officer or senior executive officers, or other experts or consultants, as it deems appropriate, including sole authority to approve the firms' fees and other retention terms.  The Compensation Committee may also form and delegate authority to subcommittees and may delegate authority to one or more designated members of the Compensation Committee.  The Compensation Committee may from time to time seek recommendations from the executive officers of the Company regarding matters under the purview of the Compensation Committee, though the authority to act on such recommendations rests solely with the Compensation Committee.


Corporate Governance and Nominating Committee


Our Corporate Governance and Nominating Committee consists of Mr. Yun Sen Huang, Mr. Qiang Lin, and Mr. Sean Shao, each of whom is “independent” as that term is defined under the Nasdaq listing standards. The Corporate Governance and Nominating Committee assists the Board of Directors in identifying individuals qualified to become our directors and in determining the composition of the Board and its committees.  Mr. Lin was appointed as Chair of the Corporate Governance and Nominating Committee.


50


 

The Corporate Governance and Nominating Committee is responsible for, among other things:

identifying and recommending to the Board nominees for election or re-election to the Board, or for appointment to fill any vacancy;  

reviewing annually with the Board the current composition of the Board in light of the characteristics of independence, age, skills, experience and availability of service to us;  

identifying and recommending to the Board of Directors to serve as members of the Board’s committees; and  

monitoring compliance with our code of business conduct and ethics.


ITEM 11.  EXECUTIVE COMPENSATION

Summary Compensation Table

The following table sets forth information concerning all cash and non-cash compensation awarded to, earned by or paid to the named persons for services rendered in all capacities during the noted periods.  No other executive officers received total annual salary and bonus compensation in excess of $100,000.


Name and Principal Position

Year

Salary

($)

Bonus

($)

Stock
Awards ($)

Option
Awards ($)

Non-Equity Incentive Plan  Compensation Earnings

($)

Non-

Qualified Deferred Compensation

Earnings

($)

All Other

Compensation

($)

Total

($)

Jiang Huai Lin,
Chairman, CEO,
and President (1)

2007

45,949

-

261,000 (3)

-

-

-

108,000 (2)

414,949

2008

82,732

-

-

-

-

-

-

82,732

Zhi Xiong Huang,
Chief Technology Officer (4)

2007

27,359

-

174,000 (5)

-

-

-

-

201,359

2008

52,282

-

-

-

-

-

-

52,282

Zhi Qiang Zhao,
Director and
Chief Administrative Officer (6)

2007

-

-

-

-

-

-

-

-

2008

47,686

-

60,150 (7)

-

-

-

-

107,836


Narrative Disclosure to Summary Compensation Table


(1)        

On September 6, 2006, Mr. Lin became our Chairman and on October 3, 2006 he became our President and Chief Executive Officer. Prior to that, Mr. Lin was (and continues to be) the Chairman and Chief Executive Officer of our subsidiary, IST. The annual, long term and other compensation shown in this table include the amount Mr. Lin received from IST during the applicable periods.

(2)        

This amount constitutes amounts due to iASPEC under a license agreement between iASPEC and IST. Mr. Lin controls 100% of the equity interests of iASPEC.

(3) 

Represents the Fair Market Value of 30,000 shares of our common stock, par value $0.01, awarded to Mr. Lin on November 27, 2007, pursuant to the Plan.

(4)      

Mr. Huang resigned from the posts of Chief Operating Officer and Board of Director on September 1, 2008 and was appointed as Chief Technology Officer. Mr. Huang has also served as the Vice-President of our subsidiary, IST since its incorporation in January 2006.

(5)  

Represents the Fair Market Value of 20,000 shares of our common stock, par value $0.01, awarded to Mr. Huang on November 27, 2007, pursuant to the Plan.

(6)        

Mr. Zhao was appointed as Board of Director and Chief Administrative Officer on September 1, 2008. Mr. Zhao served as Human Resource Manager of iASPEC since April 2005 and as Deputy General Manager of iASPEC since July 2006.

(7)        

The dollar amount reported represents the Fair Market Value of 15,000 shares of our common stock, par value $0.01, awarded to Mr. Zhao, for his services as our Chief Administrative Officer after he assumed that role.

 

51


 

Outstanding Equity Awards at Fiscal Year End

 

Other than as set forth below, none of our executive officers received unexercised options, stock that has not vested or equity incentive plan awards that remained outstanding as of the end of the fiscal year ended December 31, 2008.

 

We use the Black-Scholes option pricing model to measure the fair value of stock options, granted in 2008. The determination of the fair value of stock-based compensation awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including the expected volatility of our stock price over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

 

Employment Agreements

 

All our employees, including Messrs Lin, Huang, Liu and Zhao and Ms Wang, have executed our form of employment agreement and non-disclosure agreement. Mr. Lin earns RMB 40,000 per month (approximately $5,700) for his services as our Chief Executive Officer and as IST’s Chief Executive Officer.  Mr. Huang earned RMB8, 000 per month (approximately $1,149) for his services as our Board of Director and earns RMB30,000 per month (approximately $4,300) as our Chief Technology Officer and as IST’s Vice President. Mr. Liu earns RMB 35,000 (approximately $5,030) per month for his services as our Chief Operating Officer.  Ms. Wendy Wang earns RMB 35,000 (approximately $5,030) per month for her services as our Chief Financial Officer.  Mr. Zhao earns RMB 35,000 per month (approximately $5,030) for his services as our Chief Administrative Officer. In addition, on June 20, 2008, Mr. Zhao was granted 5,000 shares of our common stock, for his services as iASPEC's management and he subsequently transferred all 5,000 of those shares in July 2008.  On September 20, 2009 and December 20, 2009 respectively, 5,000 and 15,000 shares of our common stock were granted to Mr. Zhao for his services as our Chief Administration Officer, pursuant to our 2007 Equity Incentive Plan.  No other benefits have been granted by us to officers at this time.


Director Compensation


The following table sets forth certain information concerning the compensation paid to our directors for services rendered to us during the fiscal year ending December 31, 2008:


Name

Fees Earned or Paid in Cash

($)

Stock Awards

($)

Option Awards

($)

Non-Equity Incentive Plan Compensation

($)

Nonqualified Deferred Compensation Earnings

($)

All  Other Compensation

($)

Total

($)

Jiang Huai Lin

13,788

-

-

-

-

-

13,788

Zhi Qiang Zhao

4,596

-

-

-

-

-

4,596

Zhi Xiong Huang

9,192

-

-

-

-

-

9,192

Qiang Lin

3,879

-

-

-

-

-

3,879

Yun Sen Huang

3,879

-

-

-

-

-

3,879

Sean Shao

13,500

-

-

-

-

-

13,500


Narrative to Director Compensation Table


Mr. Jiang Huai Lin earns RMB 8,000 per month (approximately $1,149) for his services as the Chairman of our Board of Directors and Mr. Zhao earns RMB 8,000 per month (approximately $1,149) for his services as a member of our Board of Directors. Mr. Zhi Xiong Huang, who served as a member of our Board of Directors until September 1, 2008, earned RMB 8,000 per month (approximately $1,149) until his resignation.

Our independent directors, Messrs Yun Sen Huang, Qiang Lin and Sean Shao, have all entered into our form of independent director agreement.  Under the terms of their agreements, Mr. Yun Sen Huang earns RMB 3,000 per month (approximately $431), Mr. Qiang Lin earns RMB 3,000 per month (approximately $431), and Mr. Shao earns $18,000 per year as compensation for their services as independent directors.  

All of our directors are reimbursed for pre-approved reasonable business-related expenses incurred in good faith in the performance of their duties for our Company.


52


 

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


The following table sets forth, as of March 13, 2009, certain information with respect to the beneficial ownership of our common stock by (i) each director and executive officer, (ii) each person known by us to be the beneficial owner of five percent or more of the outstanding shares of common stock, and (iii) all directors and executive officers as a group.  Unless otherwise indicated, the person or entity listed in the table is the beneficial owner of, and has sole voting and investment power with respect to, the shares indicated.  


Unless otherwise specified, the address of each of the persons set forth below is in care of China Information Security Technology, Inc., 21st Floor, Everbright Bank Building, Zhuzilin, Shenzhen, China 518040.


Name & Address of Beneficial Owner

Office, If Any

Title of Class

Amount and Nature of Beneficial Ownership(1)

Percent of Class(2)

Officers and Directors

Jiang Huai Lin

President, CEO and Chairman

Common Stock, $0.01 par value

21,750,080 (3)

44.57%

Wendy Wang

Chief Financial Officer

Common Stock, $0.01 par value

0

*

Zhi Xiong Huang

Chief Technology Officer

Common Stock, $0.01 par value

20,000

*

Yifu Liu

Chief Operating Officer

Common Stock, $0.01 par value

15,000

*

Zhiqiang Zhao

Director and Chief Administrative Officer

Common Stock, $0.01 par value

15,000

*

Yun Sen Huang

Director

Common Stock, $0.01 par value

0

*

Qiang Lin

Director

Common Stock, $0.01 par value

0

*

Sean Shao

Director

Common Stock, $0.01 par value

0

*

All officers and directors as a group (8 persons named above)

 

Common Stock, $0.01 par value

21,800,080

44.67%

5% Security Holders

Jiang Huai Lin

 

Common Stock, $0.01 par value

19,150,080

39.24%

Total Devices Management, Ltd.

 

Common Stock, $0.01 par value

2,600,000

5.33%

Barry M. Kitt (4)
4965 Preston Park Blvd.
Suite 240
Plano, TX 75093

 

Common Stock, $0.01 par value

6,840,958

14.02%

The Pinnacle Fund, L.P. (4)
4965 Preston Park Blvd.
Suite 240

Plano, TX 75093

 

Common Stock, $0.01 par value

3,420,479  

7.01%

Pinnacle China Fund, L.P.(4)
4965 Preston Park Blvd.
Suite 240
Plano, TX 75093

 

Common Stock, $0.01 par value

3,420,479

7.01%

Adam Benowitz(5)

20 West 55th Street, 5th Floor

New York, New York 10019

 

Common Stock, $0.01 par value

3,474,069

7.12%

 

*Less than 1%


(1)

Beneficial Ownership is determined in accordance with the rules of the SEC and generally includes voting or investment power with respect to securities.  Each of the beneficial owners listed above has direct ownership of and sole voting power and investment power with respect to the shares of our common stock.

 (2)

As of March 13, 2009, a total of 48,803,211 shares of our common stock are considered to be outstanding pursuant to SEC Rule 13d-3(d)(1).  For each Beneficial Owner above, any options exercisable within 60 days have been included in the denominator.

(3)

Includes 2,600,000 shares of our common stock held by Mr. Lin indirectly through Total Devices Management, Ltd., an entity that is wholly-owned by Mr. Lin.

(4)

Includes 3,420,479 shares of our common stock held by Pinnacle China Fund, L.P. and 3,420,479 shares of our common stock held by The Pinnacle Fund, L.P. Barry M. Kitt exercises investment discretion and control over the shares held by Pinnacle China Fund, L.P. and The Pinnacle Fund, L.P. and may be deemed to be the beneficial owner thereof. Mr. Kitt hereby disclaims beneficial ownership of the shares of common stock held by Pinnacle China Fund, L.P. and by The Pinnacle Fund, L.P. to the extent of his direct or indirect pecuniary interest therein.

(5)

Includes 1,400,000 shares of our common stock held by Vision Opportunity Master Fund, Ltd., a Cayman Islands company and 2,074,069 shares of our common stock held by Vision Opportunity China LP, a limited partnership organized under the laws of Guernsey.  Mr. Benowitz exercises investment discretion and control over these shares and may be deemed to be the beneficial owner thereof.

 

53


 

Changes in Control


There are currently no arrangements which may result in a change in control of the Company.


Securities Authorized for Issuances under Equity Compensation Plans


The following table includes the information as of the end of 2008 for each category of our equity compensation plan:

 

 

Plan category

Number of securities to be issued upon exercise of outstanding options, warrants and rights

(a)

Weighted-average exercise price of outstanding options, warrants and rights

(b)

Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))

(c)

Equity compensation plans approved by security holders(1)

8,000,000 (1)

$4.30

    7,530,000(2)

Equity compensation plans not approved by security holders

-

-

-

Total

8,000,000

 

7,530,000

_________________________

(1)  On June 13, 2007, our Board of Directors authorized the establishment of the China Information Security Technology, Inc. Equity Incentive Plan, or Plan, whereby we are authorized to issue shares of our common stock to certain employees, consultants and directors. At that time we reserved 8,000,000 shares of our common stock for issuance under the Plan.  


(2)  On November 27, 2007, we issued 70,000 shares of common stock to our senior management and an outside consultant as bonus awards and we included stock-based compensation of $609,000 in our administrative expenses for the year ended December 31, 2007. On November 30, 2007, our Board of Directors authorized the grant of options to certain employees to purchase 490,000 shares of our common stock, par value $0.01, subject to ratification of the Plan by our stockholders. The options had an exercise price of $9.48 per share, were to vest on December 5, 2008 and to expire on December 5, 2011. The respective stock-based compensation, amounting to $68,891 was charged into administrative expenses in the Consolidated Statements of Income and Comprehensive Income. On March 3, 2008, our Board of Directors voided and canceled the grant of the stock options to the employees, and on March 20, 2008 approved the grant of 400,000 shares stock awards to them at price of $4.30 per share. These newly granted shares have been vested quarterly at 1/4 over a one-year period following the grant. Since the cancellation and grant of the replacement award occurred concurrently, they will be treated as a modification of the terms of the cancelled award in accordance with SFAS 123R.


54


 

ITEM 13.  CERTAIN RELATIONSHIPS AND TRANSACTIONS AND DIRECTOR INDEPENDENCE

Certain Relationships and Transactions with Related Persons

The following includes a summary of transactions since the beginning of the 2008 fiscal year, or any currently proposed transaction, in which we were or are to be a participant and the amount involved that exceeded or exceeds the lesser of $120,000 or one percent of the average of our total assets at year-end for the last two completed fiscal years, and in which any related person had or will have a direct or indirect material interest (other than compensation described under Item 11. Executive Compensation).  We believe the terms obtained or consideration that we paid or received, as applicable, in connection with the transactions described below were comparable to terms available or the amounts that would be paid or received, as applicable, in arm’s-length transactions.

 

On March 28, 2008, Mr. Jiang Huai Lin, our Chairman, Chief Executive Officer and President, consummated a private sale to certain accredited investors of 1,070,000 restricted shares of our common stock owned by him, for an aggregate purchase price of $4.28 million, or $4.00 per share. Mr. Lin delivered the proceeds from the sale of his shares to honor the guarantee that he had provided that we would not suffer any loss incurred from our investment in ELNs. See Management’s Discussion and Analysis of Financial Condition and Results of Operation – Liquidity and Capital Resources – Investing Activities. In connection with this private sale transaction, we entered into a registration rights agreement with the purchasers of Mr. Lin’s shares, pursuant to which, among other things, we agreed to register within a predefined period, shares of our common stock transferred to them by Mr. Lin. Mr. Lin will not receive any shares of our common stock, other securities or other consideration for this capital contribution and has waived any and all rights that he may have to make a claim against us for any such shares, securities or other consideration in the future.

  

Approximately 9% of Wuhan Geo Navigation and Communication Technology Co., Ltd. (“Geo Navigation”) is owned by Geo. Prior to our acquisition of Geo, Geo Navigation made non-interest bearing cash advances to Geo and at December 31, 2008, a balance of $486,136 remained outstanding.  The Company intends to repay this balance as soon as practicable.


Shenzhen Kewen Information Technology Co., Ltd., or Kewen, is private a company owned by Mr. Qi Danfeng, who is Chief Executive Officer of Zhongtian, our new indirect subsidiary.  Prior to our purchase of Zhongtian, Kewen routinely purchased software from Zhongtian and at December 31, 2008, Accounts receivable from Kewen was $95,120. Kewen intends to repay this balance as soon as practicable.


Except as set forth in our discussion above, none of our directors, director nominees or executive officers has been involved in any transactions with us or any of our directors, executive officers, affiliates or associates which are required to be disclosed pursuant to the rules and regulations of the SEC.


Director Independence


Our Board of Directors is currently composed of 5 members, Messrs. Jiang Huai Lin, Zhiqiang Zhao, Yun Sen Huang, Qiang Lin and Sean Shao.  Each of Messrs. Zhao, Huang, Lin and Shao qualify as an “independent director” as defined by Rule 4200(a)(15) of the Marketplace Rules of The Nasdaq Stock Market, Inc.


ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES


Audit Fees


The aggregate fees billed for each of the fiscal years ended December 31, 2008 and 2007 for professional services rendered by the principal accountant for the audit of our annual financial statements and review of the financial statements included in our quarterly financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for the fiscal years ended December 31, 2008 and 2007 were approximately $831,000 and $390,000, respectively.


55


 

Audit-Related Fees


The aggregate fees billed in each of the fiscal years ended December 31, 2008 and 2007 for assurance and related services by the principal accountant that are reasonably related to the performance of the audit or review of our financial statements and are not reported under the paragraph captioned “Audit Fees” above are $0 and $100,000, respectively.


Tax Fees

 

The aggregate fees billed in each of the fiscal years ended December 31, 2008 and 2007 for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning were $15,358 and $1,000, respectively.  


Pre-Approval Policies and Procedures


On September 22, 2008, our Board of Directors adopted resolutions in accordance with the Sarbanes-Oxley Act of 2002 requiring pre-approval of all auditing services and all audit related, tax or other services not prohibited under Section 10A(g) of the Securities Exchange Act of 1934, as amended, to be performed for us by our independent auditors, subject to the de minimus exception described in Section 10A(i)(1)(B) of the Exchange Act.  These resolutions authorized our independent auditor to perform audit services required in connection with the annual audit relating to the fiscal year ended December 31, 2008 and the quarterly reviews for the subsequent fiscal quarters of 2009 through the review for the quarter ended September 30, 2009 at which time additional pre-approvals for any additional services to be performed by our auditor would be sought from the Board. Our Board of Directors also appointed and authorized Mr. Lin to grant pre-approvals of other audit, audit-related, tax and other services requiring Board approval to be performed for us by our independent auditor, provided that the designee, following any such pre-approvals, thereafter reports the pre-approvals of such services at the next following regular meeting of the Board.


The percentage of audit-related, tax and other services that were approved by the Board of Directors is 100%.


ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES


(a)  The following documents are filed as part of this report:

 

(1)  Financial Statements

 

The financial statements filed as part of this Form 10-K are located as set forth in the index on page F-1 of this report.

 

(2)  Financial Statement Schedules

 

Not applicable.

 

(3)  Exhibits

 

The following exhibits are filed as part of this report or incorporated by reference:


56


   
Exhibit No. Description
   
2.1

Agreement and Plan of Merger, dated April 2, 2008, between China Public Security Technology, Inc. and China (incorporated by reference to Exhibit 2.1 of the current report on Form 8-K filed by the Company on April 7, 2008).

   
3.1

Amended and Restated Articles of Incorporation of the Company, as filed with the Secretary of State of Nevada on February 13, 2008 (incorporated by reference to Exhibit 3.1 of the current report on Form 8-K filed by the Company on April 7, 2008).

   
3.2

Bylaws of China Information Security Technology, Inc., adopted on February 13, 2008 (incorporated by reference to Exhibit 3.2 of the registration statement on Form 8-K filed by the Company on April 7, 2008).

   
4.1

Form of Registration Rights Agreement, dated October 25, 2007 (incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed by the Company on October 25, 2007).

   
4.2

Common Stock Purchase Warrant issued to Roth Capital Partners, LLC, dated October 29, 2007 (incorporated by reference to Exhibit 4.2 to the current report on Form 8-K filed by the Company on October 30, 2007).

   
4.3

Common Stock Purchase Warrant issued to Brean Murray, Carret & Co., LLC, dated October 29, 2007 (incorporated by reference to Exhibit 4.3 to the current report on Form 8-K filed by the Company on October 30, 2007).

   
4.4

Registration Rights Agreement, dated January 31, 2007, among the Company and the investors signatory thereto (incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed by the Company on February 1, 2007).

   
4.5

Amendment No. 1 to Registration Rights Agreement, dated March 9, 2007, among the Company and the investors signatory thereto (incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed by the Company on March 20, 2007).

   
4.6

China Information Security Technology, Inc. 2007 Equity Incentive Plan (incorporated by reference to Exhibit 10.1 to the current report on Form 8-K filed by the Company on June 13, 2007).

   
4.7

Registration Rights Agreement, dated March 26, 2008, among the Company and the investors signatory thereto (incorporated by reference to Exhibit 4.1 to the current report on Form 8-K filed by the Company on March 28, 2008).

   
10.1

Form of Securities Purchase Agreement, dated October 25, 2007 (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on October 25, 2007).

   
10.2

Form of Closing Escrow Agreement, dated as of October 25, 2007 (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on October 25, 2007).

   
10.3

Securities Purchase Agreement, dated January 16, 2007, among the Company and the investors signatory thereto (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on January 17, 2007).

   
10.4

Amendment No. 1 to the Securities Purchase Agreement, dated January 31, 2007, among the Company and the investors signatory thereto (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on February 1, 2007).

   
10.5

Make Good Escrow Agreement, dated January 31, 2007, among the Company, Mr. Jiang Huai Lin, the investors signatory thereto, Roth Capital Partners, LLC and Securities Transfer Corporation, as escrow agent (incorporated by reference to Exhibit 10.3 of the current report on Form 8-K filed by the Company on February 1, 2007).

   
10.6

Lockup Agreement, dated January 31, 2007, among the Company and the stockholders signatory thereto (incorporated by reference to Exhibit 10.4 of the current report on Form 8-K filed by the Company on February 1, 2007).

   
10.7

Rescission; Termination and Share Exchange Agreement, dated January 31, 2007, among Shenzhen iASPEC Software Engineering Company Limited, the shareholders of iASPEC who are signatories thereto, including Jiang Huai Lin, Public Security Technology (PRC) Co., Ltd., China Information Security Holdings Limited and the Company (incorporated by reference to Exhibit 10.5 of the current report on Form 8-K filed by the Company on February 1, 2007).

   
10.8

Amended and Restated Business Turnkey Agreement, dated as of January 31, 2007, by and between Public Security Technology (PRC) Co., Ltd. and Shenzhen iASPEC Software Engineering Company Limited and the shareholders of iASPEC party thereto (incorporated by reference to Exhibit 10.6 of the current report on Form 8-K filed by the Company on February 1, 2007).

   
10.9

Management Service Agreement, dated as of August 1, 2007, among Public Security Technology (PRC) Co., Ltd., Shenzhen iASPEC Software Engineering Company Limited, Jiang Huai Lin and Jin Zhu Cai (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on August 6, 2007).

   

 

57


   
10.10

Guaranty, dated August 1, 2007, by Jiang Huai Lin and Jin Zhu Cai (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on August 6, 2007).

   
10.11

Purchase Option Agreement, dated August 1, 2007, among Public Security Technology (PRC) Co., Ltd., Shenzhen iASPEC Software Engineering Company Limited, Jiang Huai Lin and Jin Zhu Cai (incorporated by reference to Exhibit 10.3 of the current report on Form 8-K filed by the Company on August 6, 2007).

   
10.12

Notice of Termination, dated August 1, 2007, among Public Security Technology (PRC) Co., Ltd., Shenzhen iASPEC Software Engineering Company Limited, Jiang Huai Lin and Jin Zhu Cai (incorporated by reference to Exhibit 10.4 of the current report on Form 8-K filed by the Company on August 6, 2007).

   
10.13

Letter Agreement, dated as of September 12, 2007, among Public Security Technology (PRC) Co., Ltd., Shenzhen iASPEC Software Engineering Company Limited, Jiang Huai Lin and Jin Zhu Cai.

   
10.14 English Translation of Form of China Public Security Technology, Inc. Employment Agreement (incorporated by reference to Exhibit 10.7 of the annual report on Form 10-KSB filed by the Company on April 16, 2007).
   
10.15 English Translation of Form of China Public Security Technology, Inc. Non-Disclosure Agreement (incorporated by reference to Exhibit 10.8 of the annual report on Form 10-KSB filed by the Company on April 16, 2007).
   
10.16 Letter Agreement, dated March 29, 2007, among the Company and the investors and stockholder signatory thereto (incorporated by reference to Exhibit 10.9 of the annual report on Form 10-KSB filed by the Company on April 16, 2007).
   
10.17 Form of China Public Security Technology, Inc. Independent Director Agreement (incorporated by reference to Exhibit 10.1 of the current report on Form 8- K filed by the Company on August 16, 2007).
   
10.18 Form of China Public Security Technology, Inc. Indemnification Agreement (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on August 16, 2007).
   
10.19 Share Purchase Agreement, dated as of November 7, 2007, by and among China Public Security Holdings Limited, Cheer Crown International Investment Limited, the Company, and Dongwei Gao (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on November 9, 2007).
   
10.20 Share Purchase Agreement, dated as of December 9, 2007, by and among China Public Security Holdings Limited, Bocom Venture Inc., and the Company. (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on December 13, 2007).
   
10.21 Share Purchase and Increase Capital Agreement, dated as of February 16, 2008, by and among iASPEC Software Engineering Co., Ltd., Wuhan Wuda Venture Capital Co., Ltd., Wuhan Wuda Geoinformatics Co., Ltd. and Song Ai Hong (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on February 19, 2008).
   
10.22 Share Purchase and Increase Capital Agreement, dated as of February 16, 2008, by and among iASPEC Software Engineering Co., Ltd. and Li Wei (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on February 19, 2008).
   
10.23 Purchase Agreement, dated as of March 26, 2008, by and among Jiang Huai Lin, the Company and the investors signatory thereto (incorporated by reference to Exhibit 10.1 of the current report on Form 8-K filed by the Company on March 28, 2008).
   
10.24 Equity Transfer Agreement, dated August 1, 2008, by and between Jiang Huai Lin and Jin Zhu Cai (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on August 3, 2008).
   

58


   
10.25** Purchase Contract between iASPEC Software Co., Ltd. and Huipu Electronic (Shenzhen) Co., Ltd., dated September 15, 2008.
   
10.26* Purchase Contract between Dell (China) Company Limited and Information Security Software Company Ltd., dated January 1, 2008.
   
10.27** General Purchase Contract between Huipu Electronics (Shenzhen) Co., Ltd. and iASPEC Software Co., Ltd., dated August 26, 2008.
   
10.28** Sales Contract for Digital Court Storage System between the Shenzhen Intermediate People’s Court and iASPEC Software Co., Ltd., dated April 3, 2008.
   
10.29* Employment Agreement, dated January 25, 2007, between the Company and Jiang Huai Lin
   
10.30* Employment Agreement, dated November 17, 2008, between the Company and Wendy Wang
   
10.31* Employment Agreement, dated August 12, 2008, between the Company and Yi Fu Liu
   
10.32* Employment Agreement, dated August 12, 2008, between the Company and Zhi Xiong Huang
   
10.33* Employment Agreement, dated August 12, 2008, between the Company and Zhi Qiang Zhao
   
10.34 Share Purchase Agreement, dated as of September 23, 2008, by and among China Public Security Holdings Limited, Wide Peace International Investments Limited, and the Company (incorporated by reference to Exhibit 10.2 of the current report on Form 8-K filed by the Company on July 3, 2008).
   
14 Amended and Restated Code of Ethics, adopted on December 25, 2007.
   
21 List of Subsidiaries
   
23 Consent of GHP Horwath, P.C. (incorporated by reference to Exhibit 23 of the annual report on Form 10-K filed by the Company on March 16, 2009).
   
31.1* Certification of Principal Executive Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
31.2* Certification of Principal Financial and Accounting Officer filed pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
   
32.1* Certification of Principal Executive Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
32.2* Certification of Principal Financial and Accounting Officer furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

* Filed herewith

 

** Registrant has omitted portions of the referenced exhibits and filed such exhibits separately with the Securities and Exchange Commission, pursuant to a request for confidential treatment under Rule 406 promulgated under the Securities Act.


59


 

SIGNATURES


In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC. 

   

Dated: August 12, 2009

/s/ Jiang Huai Lin                                                                       

Jiang Huai Lin

Chairman and Chief Executive Officer

(Principal Executive Officer)

   

Dated: August 12, 2009

/s/ Wendy Wang                                                                         

Wendy Wang

Chief Financial Officer

(Principal Financial and Accounting Officer)


Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on December 12, 2008.


SIGNATURE

CAPACITY

DATE

 

 

 

/s/ Jiang Huai Lin                            

 Jiang Huai Lin

President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)

August 12, 2009

 

 

 

/s/Wendy Wang                                

Wendy Wang

Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

August 12, 2009

     

s/ Zhiqiang Zhao                           

Zhiqiang Zhao

Director and Chief Administrative Officer

August 12, 2009

     

s/ Qiang Lin                                    

Qiang Lin

Director

August 12, 2009

     

s/ Sean Shao                                    

Sean Shao

Director

August 12, 2009

     

s/ Yun Sen Huang                           

Yun Sen Huang

Director

August 12, 2009


60


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2008 AND 2007

 


Contents

  

Page(s)

  

  

  

Report of Independent Registered Public Accounting Firm

  

F-2

  

  

  

Consolidated Balance Sheets as of December 31, 2008 and 2007

  

F-3

  

  

  

Consolidated Statements of Operations and Comprehensive Income for the years ended December 31, 2008 and 2007

  

F-4

  

  

  

Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2008 and 2007

  

F-5

  

  

  

Consolidated Statements of Cash Flows for the years ended December 31, 2008 and 2007

  

F-6

  

  

  

Notes to the Consolidated Financial Statements

  

F-8


  


F-1


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Board of Directors and Stockholders

China Information Security Technology, Inc. and subsidiaries

 

We have audited the accompanying consolidated balance sheets of China Information Security Technology, Inc. and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive income, stockholders’ equity and cash flows for the each of the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.


We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2008 and 2007, and the results of its operations and cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America.


We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 15, 2009 expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of material weaknesses.


/s/ GHP Horwath, P.C.

Denver, Colorado

March 15, 2009

 

F-2


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC.

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2008 AND 2007

 


 

NOTES

2008

2007

ASSETS

     
       

CURRENT ASSETS

     
           

Cash and cash equivalents

 

$

9,565,252

$

19,755,182

Short-term investments

5

 

5,835,838

 

14,966,752

Accounts receivable, net of allowance for doubtful accounts of $399,800 and $0, respectively

 

 

42,857,108

 

11,721,306

Bills receivable

   

4,481,340

 

-

Advances to suppliers

   

8,469,976

 

1,791,440

Amount due from related parties, net of allowance for doubtful accounts of $73,000 and $0, respectively

6

 

131,594

 

-

Inventories

7

 

7,107,537

 

4,779,930

Other receivables and prepaid expenses

 

 

6,251,484

 

974,475

TOTAL CURRENT ASSETS

   

84,700,129

 

53,989,085

           

Deposit for business acquisition

4

 

-

 

8,989,022

Long-term investments

8

 

3,078,405

 

-

Property and equipment, net

9

 

23,555,603

 

13,826,896

Intangible assets, net

10

 

13,115,151

 

4,894,397

Goodwill

4

 

24,018,894

 

7,154,395

TOTAL ASSETS

 

$

148,468,182

$

88,853,795

           

LIABILITIES AND STOCKHOLDERS' EQUITY

         
           

CURRENT LIABILITIES

         
           

Short-term bank loans

11

$

6,327,992

$

-

Accounts payable

 

 

10,707,728

 

3,079,304

Advances from customers

   

2,476,335

 

394,383

Amount due to related parties

6

 

486,136

 

-

Accrued payroll and benefits

   

1,319,386

 

386,699

Other payables and accrued expenses

 

 

2,553,019

 

600,784

Income tax payable

12

 

1,592,459

 

326,026

TOTAL CURRENT LIABILITIES

 

 

25,463,055

 

4,787,196

           

MINORITY INTEREST

3 

 

13,907,347

 

10,060,657

           

STOCKHOLDERS' EQUITY

         
           

Common stocks, par $0.01; authorized capital, 200,000,000 shares;

         

Shares issued and outstanding (2008: 47,462,404; 2007:45,639,396 shares)

14

 

209,121

 

190,891

Additional paid-in capital

 

 

64,127,339

 

57,421,150

Reserve

13

 

4,964,597

 

1,755,552

Retained earnings

 

 

33,748,480

 

13,170,549

Accumulated other comprehensive income

   

6,048,243

 

1,467,800

TOTAL STOCKHOLDERS' EQUITY

 

 

109,097,780

 

74,005,942

           

TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY

 

$

148,468,182

$

88,853,795

The accompanying notes are an integral part of these consolidated financial statements

F-3


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

YEARS ENDED DECEMBER 31, 2008 AND 2007

 

 

NOTES

 

2008

 

2007

     


 


Revenue - Products

 

$

26,822,325

$

2,007,800

Revenue - Software

   

34,958,401

 

13,131,578

Revenue - System integration

 

 

19,328,312

 

15,194,314

Revenue - Others

   

4,192,146

 

9,017

TOTAL REVENUE

 

 

85,301,184

 

30,342,709

     


 


Cost - Products sold

   

25,049,072

 

1,669,410

Cost - Software sold

 

 

5,628,436

 

2,233,493

Cost - System integration

   

12,196,185

 

8,470,467

Cost - Others

 

 

3,348,627

 

-

TOTAL COST

   

46,222,320

 

12,373,370

     


 


GROSS PROFIT

 

 

39,078,864

 

17,969,339

     


 


Administrative expenses

   

(10,158,863)

 

(3,288,657)

Research and development expenses

 

 

(2,596,430)

 

(797,580)

Management fee

   

-

 

(92,160)

Selling expenses

 

 

(2,440,689)

 

(480,465)

     


 


INCOME FROM OPERATIONS

 

 

23,882,882

 

13,310,477

     


 


Other income, net

16

 

938,921

 

79,435

Interest income

 

 

214,850

 

138,840

Interest expense

   

(179,130)

 

-

     


 


INCOME BEFORE INCOME TAXES AND MINORITY INTEREST

 

 

24,857,523

 

13,528,752

     


 


Income tax expense

12

 

(1,547,509)

 

(107,300)

Minority interest

3

 

(241,197)

 

(90,000)

     


 


INCOME FROM CONTINUING OPERATIONS

   

23,068,817

 

13,331,452

     


 


INCOME FROM DISCONTINUED OPERATIONS

(NET OF TAX OF $0)

   

718,159

 

-

     


 


NET INCOME

   

23,786,976

 

13,331,452

     


 


Foreign currency translation gain

 

 

4,580,443

 

1,467,800

     


 


COMPREHENSIVE INCOME

 

 $

28,367,419

14,799,252

     


 


WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING

 


 


Basic

 

 

46,398,600

 

39,718,967

Diluted

   

46,852,827

 

40,152,855

     

 

 


EARNINGS PER SHARE

   

 

 


Basic - From continuing operations

 

 $

0.50

$ 

0.34

Basic - From discontinued operations

   

0.01

 

- 

 

 

 $  $

0.51

$

0.34

     

 

 

 

Diluted - From- continuing operations

 

 $

0.49

$

0.33

Diluted - From discontinued operations

 

 

0.02

 

- 

   

 $

0.51

$

0.33

The accompanying notes are an integral part of these consolidated financial statements

F-4


CHINA INFORMATION SECURITY TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2008 AND 2007


                     

Accumulated

   
 

Common stock

 

Additional

         

other

   
 

par value $0.01

 

paid-in

     

Retained

 

comprehensive

   
 

Shares

 

Amount

 

capital

 

Reserve

 

earnings

 

income

 

Total

                           

BALANCE AS AT January 1, 2007

31,550,298

$

50,000

$

-

$

159,465

$

1,435,184

$

-

$

1,644,649

                 

 

       

Issuance of common stock in private placements

12,868,422

 

128,684

 

49,688,802

 

-

 

-

 

-

 

49,817,486

Common stock issued upon the cashless exercise of warrants

267,343

 

2,674

 

(2,674)

 

-

 

-

 

-

 

-

Common stock issued for business acquisition (Note 4 )

883,333

 

8,833

 

7,057,831

 

-

 

-

 

-

 

7,066,664

Stock-based compensation (Note 14 )

70,000

 

700

 

677,191

 

-

 

-

 

-

 

677,891

Net income for the year

-

 

-

 

-

 

-

 

13,331,452

 

-

 

13,331,452

Foreign currency translation gain

-

 

-

 

-

 

-

 

-

 

1,467,800

 

1,467,800

Transfer to reserve (Note 13)

-

 

-

 

-

 

1,596,087

 

(1,596,087)

 

-

 

-

BALANCE AS AT DECEMBER 31, 2007

45,639,396

 

190,891

 

57,421,150

 

1,755,552

 

13,170,549

 

1,467,800

 

74,005,942

         

 

     

 

       

Common stock issued upon the cashless exercise of warrants (Note 14)

298,008

 

2,980

 

(2,980)

 

-

 

-

 

-

 

-

Common stock issued and  to be issued for business acquisitions (Note 4)

1,125,000

 

11,250

 

5,108,428

 

-

 

-

 

-

 

5,119,678

Stock-based compensation (Note 14)

400,000

 

4,000

 

1,600,741

 

-

 

-

 

-

 

1,604,741

Net income for the year

-

 

-

 

-

 

-

 

23,786,976

 

-

 

23,786,976

Foreign currency translation gain

-

 

-

 

-

 

-

 

-

 

4,580,443

 

4,580,443

Transfer to reserve (Note 13)

-

 

-

 

-

 

3,209,045

 

(3,209,045)

 

-

 

-

BALANCE AS AT DECEMBER 31, 2008

47,462,404

$

209,121

$

64,127,339

$

4,964,597

$

33,748,480

$

6,048,243

$

109,097,780

 

The accompanying notes are an integral part of these consolidated financial statements

 

F-5


 

 CHINA INFORMATION SECURITY TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, 2008 AND 2007

 

   

2008

 

2007

OPERATING ACTIVITIES

       

Net income

$

23,786,976

$

13,331,452

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

Operating cash flows from discontinued operations

 

(718,153)

 

 

Depreciation (Note 9)

 

2,991,266

 

1,274,768

Amortization of intangible assets (Note 10)

 

1,354,567

 

168,747

Stock-based compensation (Note 14)

 

1,604,741

 

677,891

Minority interest (Note 3)

 

241,197

 

90,000

Gain on disposition of property and equipment

 

2,533

 

-

Provisions for losses on accounts receivable

 

472,750

 

-

   

 

 

 

Changes in operating assets and liabilities, net of effects of business acquisitions

 

 

 

 

Increase in inventories

 

(472,829)

 

(1,399,838)

Increase in accounts receivable

 

(30,169,244)

 

(4,115,867)

(Increase) decrease in other receivables, advances to suppliers and prepaid expenses

 

(553,400)

 

592,182

Decrease in receivables from and advances to iASPEC prior to VIE consolidation

 

-

 

(10,660,988)

(Increase) in amount due from related parties

 

(109,422)

 

-

Increase in amount due to related parties

 

481,813

 

-

Increase in accounts payable

 

4,633,198

 

903,475

(Decrease) increase in advances from customers

 

(801,288)

 

54,830

Increase in other payables and accrued expenses

 

896,447

 

643,953

Increase in income tax payable

 

906,825

 

46,586

   

 

 

 

Net cash provided by operating activities

 

4,547,977

 

1,607,191

   

 

 

 

INVESTING ACTIVITIES

 

 

 

 

Increase in cash from VIE consolidation (Note 4)

 

-

 

4,731,140

Cash acquired from ISSI (Note 4)

 

-

 

326,831

Cash acquired in Geo acquisition (Note 4)

 

2,443,677

 

-

Cash acquired in Bocom acquisition (Note 4)

 

713,876

 

-

Cash acquired in Kwongtai and Zhongtian acquisition (Note 4)

 

233,243

 

-

Consideration paid for acquisition of ISSI (Note 4)

 

-

 

(7,051,469)

Consideration paid for acquisition of Geo (Note 4)

 

(7,049,073)

 

-

Consideration paid for acquisition of Kwongtai and Zhongtian (Note 4)

 

(9,852,455)

 

-

Purchase of  Equity Linked Notes (Note 5)

 

-

 

(22,654,230)

Proceeds from sale of marketable securities (Note 5)

 

14,966,752

 

7,687,478

Purchased short-term investments (Note 5)

 

(5,655,605)

 

-

Proceeds from sales of property and equipment

 

1,146,671

 

-

Advances to third parties

 

-

 

332,479

Advances from related parties

 

-

 

115,312

Purchases of property and equipment

 

(8,928,057)

 

(6,452,450)

Capitalized and purchased software development costs

 

(487,541)

 

-

Deposit for acquisition of Bocom

 

-

 

(9,000,000)

Investing cash flows from discontinued operations

 

(8,576,575)

 

 

   

 

 

 

Net cash used in investing activities

 

(21,045,087)

 

(31,964,909)

(Continued)


F-6


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, 2008 AND 2007 (CONTINUED)


FINANCING ACTIVITIES

 

 

 

 

Advances repaid to a third party company

 

-

 

(200,000)

Amount repaid to a stockholder

 

-

 

(82,304)

Cash received from private placement of common stock

 

-

 

49,817,486

Borrowings under short-term loans (Note 11 )

 

6,314,410

 

-

Repayment of bank loan  (Note 11)

 

(1,086,312)

 

-

Net cash provided by financing activities

 

5,228,098

 

49,535,182

   

 

 

 

Effect of exchange rate changes on cash and cash equivalent

 

1,079,082

 

405,402

   

 

 

 

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS

 

(10,189,930)

 

19,582,866

CASH AND CASH EQUIVALENTS, BEGINNING

 

19,755,182

 

172,316

CASH AND CASH EQUIVALENTS, ENDING

$

9,565,252

$

19,755,182

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

Cash paid during the year

 

 

 

 

     Income taxes, net of refund

$

650,648

$

24,574

     Interest paid

$

158,650

$

-


Supplemental disclosure of non-cash investing and financing activities:


Acquired businesses


In 2007, 883,333 shares of common stock were issued in satisfaction of the equity portion of the purchase price of approximately $7,067,000 of ISS.


In 2008, 1,125,000 shares of common stock were issued and a further 1,280,807 were reserved for issuance for the equity portion of the purchase price of approximately $5,120,000 of Bocom and Zhongtian.


Property and equipment transfers from inventory

$

78,784

$

-


The accompanying notes are an integral part of these consolidated financial statements.


F-7


 

CHINA INFORMATION SECURITY TECHNOLOGY, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007


1. ORGANIZATION AND PRINCIPAL ACTIVITIES


China Information Security Technology Inc (the "Company" or “CIST”), and its subsidiaries, is a provider of integrated solutions for the information security sector,  and full-service Geographic Information Systems (“GIS”) solutions to the public security and civil-use markets in the People's Republic of China ("PRC"), specializing in providing information security technology, Geographic Information Systems (GIS), and digital hospital information systems, as well as the sale of computer hardware and software, and the provision of Certificate Authority, or CA, an application platform and e-Government solution technology. These services are provided through the Company’s wholly-owned PRC subsidiaries, Information Security Technology (PRC) Co., Ltd ("IST"), Information Security Software (China) Co., Ltd (formerly, Information Security Development Technology Co., Ltd), or "ISS," Shenzhen Bocom Multimedia Display Technology Co., Ltd ("Bocom"), and Shenzhen Zhongtian Development Company Ltd (“Zhongtian”), and through the Company’s variable interest entity ("VIE"), iASPEC Software Co, Ltd ("iASPEC"), and its subsidiary, Wuda Geoinformatics Co., Ltd ("Geo").


On April 2, 2007, China Public Security Technology, Inc. ("CPST") entered into an Agreement and Plan of Merger (the "Merger Agreement") with CIST, a Nevada corporation and wholly-owned subsidiary of CPST. Pursuant to the Merger Agreement, CPST agreed to merge with and into CIST, with CIST being the surviving entity (the "Reincorporation Merger"). The Reincorporation Merger became effective on April 7, 2008 The Reincorporation Merger was effected by an exchange of shares of CPST into shares of CIST on a one-for-one basis. As a result of the Reincorporation Merger, CPST became domiciled in Nevada its name was changed to China Information Security Technology, Inc. All assets, liabilities, contracts and obligations of CPST became the assets, liabilities, contracts and obligations of CIST. References to the Company are to CIST as successor to CPST and its subsidiaries.


Business Turnkey Agreement


On October 9, 2006, IST, entered into a Business Turnkey Agreement, as amended (the “Turnkey Agreement”) with iASPEC Software Company Limited, (formerly Shenzhen iASPEC Software Engineering Company Limited) (“iASPEC”), a PRC company controlled by Mr. Lin, the Company’s Chairman and Chief Executive Officer. iASPEC is a software development company that provides public security information technology, Police-Use Geographic Information Systems (“PGIS”) and Civil-Use Geographic Information Systems (“CGIS”) operating services to government and private customers in the PRC. Under the Turnkey Agreement, IST was to pay an annual fee of $180,000 to iASPEC and was to perform all services necessary for iASPEC to fulfill its customer contracts in exchange for 100% or 90% of the revenues from such contracts, depending on the contract. In addition, under the Turnkey Agreement, iASPEC granted IST an exclusive, royalty-free, transferable, worldwide perpetual license to use and install iASPEC’s proprietary software. No other tangible assets or liabilities were transferred to IST under the Turnkey Agreement.


Effective July 1, 2007, IST, iASPEC and iASPEC’s shareholders, Mr. Lin and Mr. Jin Zhu Cai, terminated the Turnkey Agreement, and replaced it with a Management Service Agreement (“MSA”).


Management Service Agreement


Pursuant to the terms of the MSA, iASPEC granted IST a ten-year, exclusive, royalty-free, transferable worldwide license to use and install certain iASPEC software, along with copies of source and object codes relating to such software. In addition, IST licensed back to iASPEC a royalty-free, limited, non-exclusive license to the software, without right of sub-license, for the sole purpose of permitting iASPEC to carry out its business as presently conducted. IST has the right to designate two Chinese citizens to serve as senior managers of iASPEC, to serve as a majority on iASPEC’s Board of Directors, and to assist in managing the business and operations of iASPEC. In addition, both iASPEC and IST will require the affirmative vote of a majority of the Company’s Board of Directors, including at least one non-insider director, for certain material actions, as defined, with respect to iASPEC.


Under the MSA, IST receives 100% of the net received profit of iASPEC, and reimburses iASPEC for all net losses incurred by iASPEC, as such terms are defined in the MSA, and iASPEC is permitted to retain $180,000 per year out of the net received profits. The MSA also provides that IST may advance to iASPEC, at its sole discretion, amounts to be credited against IST’s future obligations to iASPEC. Any such advances are treated as prepayments and not as loans and iASPEC has no obligation to repay any such advances except by crediting the amount of such advances against IST’s obligation to reimburse net losses, or by adding the amount thereof to net received profit when and as requested by IST. The parties to the MSA also agreed to the calculation of a true-up amount, consisting of the cumulative net profit or net losses of iASPEC from October 9, 2006 to June 30, 2007, when iASPEC commenced its contractual relationship with IST, through the date of the MSA.

 

F-8



1. ORGANIZATION AND PRINCIPAL ACTIVITIES (CONTINUED)


In connection with the MSA, IST also entered into an immediately exercisable purchase option agreement (“Option Agreement”) with iASPEC and its shareholders, pursuant to which the iASPEC shareholders granted the Company or its designee(s) an exclusive, irrevocable option to purchase, from time to time, all or a part of iASPEC’s shares or iASPEC’s assets from the iASPEC shareholders for $1,800,000 in the aggregate. The option may not be exercised if the exercise would violate any applicable laws and regulations in China or cause any license or permit held by, and necessary for the operation of iASPEC, to be cancelled or invalidated.


The substance of the MSA and the Option Agreement is to:


Allow the Company to utilize the business licenses, contacts, permits and other resources of iASPEC in order for the Company to be able to expand its operations and business model;


Provide the Company with effective control over all of iASPEC's operations;


Allow the shareholders of iASPEC an opportunity to monetize a portion of their investment through the $1.8 million purchase option.


The Company has adopted Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46R, “ Consolidation and Variable Interest Entities”  (“VIEs”), (“FIN 46R”), an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46R requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE’s residual returns. As a result of the MSA and the Option Agreement, on July 1, 2007 iASPEC became a VIE of the Company and iASPEC’s results are consolidated in the Company’s financial statements. To comply with PRC laws and regulations that restrict foreign ownership of companies that provide public security information technology and Geographic Information Systems software operating services to certain government and other customers, the Company operates the restricted aspect of its business through iASPEC.  

In May 2008, IST entered into a contractual joint venture agreement with Huipu Electronic (Shenzhen) Co., Ltd. to set up a joint venture project in manufacturing and sales of LCD screens. According to the contract, the Company provided funds to the project for equipment acquisition, repayable by the other parties if certain revenue and income targets were not met. This contractual arrangement resulted in a variable interest under FIN 46R, as the Company was the primary beneficiary of the project.  

In May 2008, IST also entered into a contractual joint venture agreement with Lianchengwen Technology (Shenzhen) Co., Ltd. ("LTS"), to set up a joint venture project in leasing LED screens. According to the contract, the Company provided funds to the project for equipment acquisition, repayable by LTS if certain revenue and income targets were not met. This contractual arrangement also resulted in the creation of a variable interest under FIN 46R, as the Company is the primary beneficiary of the project.

Effective December 31, 2008, the contractual joint venture agreements were terminated and, in December 2008, IST received bills receivable from Huipu Electronic (Shenzhen) Co., Ltd. for a full refund of its original investments of  approximately $4.48 million. The Company expects LTS to refund its $4.1 million investment by March 31, 2009. Bills receivable represent bank undertakings that essentially guarantee payment of amounts thereunder. The undertakings are provided by banks upon receipt of collateral deposits from the Company’s customers or debtors. Bills receivable can be sold at a discount before maturity, which is typically within three months. In addition, IST received approximately $718,000, representing its agreed-upon share of the VIEs’ net income from inception through termination. The cash flows of these two VIE’s has been eliminated from IST’s ongoing operations and IST has no continuing involvement in the VIE’s. Accordingly, the assets and liabilities and revenues and expenses of this joint venture are no longer included in the Company’s consolidated financial statements and the $718,000 has been recorded as income from discontinued operations.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


(a) Basis of Consolidation


The consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles. The consolidated financial statements include the accounts of the Company, its subsidiaries and its VIE for which the Company is the primary beneficiary. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

F-9



2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

 

(b) Use of Estimates


The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Management makes these estimates using the best information available at the time the estimates are made; however actual results could differ from those estimates.


(c) Economic and Political Risks


The majority of the Company’s operations are conducted in the PRC. Accordingly, the Company’s business, financial condition and results of operations may be influenced by the political, economic and legal environment in the PRC, and by the general state of the PRC economy. The Company's operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company's results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, and rates and methods of taxation.


(d) Cash and Cash Equivalents


The Company considers all highly liquid investments purchased and cash deposits with financial institutions with original maturities of three months or less to be cash equivalents.


The Company maintains its cash accounts at credit worthy financial institutions and closely monitors the movements of its cash positions. At December 31, 2008, approximately $9.56 million was held in bank accounts in the PRC.


(e) Short-term Investments


The Company’s short-term investments are accounted for as either available-for-sale or trading securities. Investments accounted for as available for sale are stated at fair market value, with unrealized gains and losses (net of deferred income tax assets (liabilities)) reported as a component of stockholders’ equity. Investments accounted for as trading securities are stated at fair market value with unrealized holding gains and losses reported in income. The cost of securities sold is determined based on the specific identification method for purposes of recording realized gains and losses.


(f) Accounts Receivable and Concentration of Risk

 

During the normal course of business, the Company extends unsecured credit to its customers. The Company regularly evaluates and monitors the creditworthiness of each customer on a case-by-case basis. The Company includes any account balances that are determined to be uncollectible in an allowance for doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance.


Bills receivable represent bank undertakings that essentially guarantee payment of amounts thereunder.  The undertakings are provided by banks upon receipt of collateral deposits from the Company’s customers or debtors.  Bills receivable can be sold at a discount before maturity, which is typically within three months.


Accounts receivable include $25.72 million and $6.4 million of unbilled accounts receivable at December 31, 2008 and 2007, respectively. Unbilled accounts receivable consist of estimated future billings for work performed but not yet invoiced to the customer. Unbilled accounts receivable are generally invoiced upon the completion of work orders, which is estimated to be within one year.


F-10


 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

 

(g) Accounts Receivable and Concentration of Risk (Continued)

 

The Company’s top five customers accounted for 47.3 % of accounts receivable as of December 31, 2008, of which two customers accounted for 13.9% and 10.8% of accounts receivable. No other customers accounted for greater than 10% of accounts receivable. As of December 31, 2007, the Company’s top five customers accounted for 40.5% of accounts receivable, of which two customers accounted for 20% and 10% of accounts receivable. No other customers accounted for greater than 10% of accounts receivable.


For the year ended December 31, 2008, two customers accounted for 12.8% and 12.5% of the third party revenue and no other customer contributed gre