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HARRIS INTERACTIVE INC

10-K

https://www.sec.gov/Archives/edgar/data/1094238/0000950152-03-008467.txt

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 000-27577 --------------------- HARRIS INTERACTIVE INC. (Exact Name of Registrant as Specified in its Charter) DELAWARE 16-1538028 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 135 CORPORATE WOODS, ROCHESTER, NY 14623 (Address of principal executive offices) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (585) 272-8400 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, par value $.001 per share (Title of Class) INDICATE BY CHECK MARK WHETHER THE REGISTRANT: (1) HAS FILED ALL REPORTS required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] INDICATE BY CHECKMARK IF DISCLOSURE OF DELINGUENT 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. [ ] INDICATE BY CHECKMARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] As of December 31, 2002, the aggregate market value of voting and non-voting common equity securities held by non-affiliates of the registrant was $92,293,526. On September 15, 2003, 55,448,763 shares of the Registrant's Common Stock, $.001 par value, were outstanding. DOCUMENTS INCORPORATED BY REFERENCE The information required by Part III of this Report, to the extent not set forth herein, is incorporated by reference from the Registrant's definitive proxy statement relating to the annual meeting of stockholders to be held in November 2003, which definitive proxy statement will be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Report relates. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- HARRIS INTERACTIVE INC. FORM 10-K FOR THE FISCAL YEAR ENDED JUNE 30, 2003 INDEX PAGE ---- PART I: "Safe Harbor" Statement under the Private Securities Litigation Reform 3 Act of 1995......................................................... Item 1: Business.................................................... 3 Item 2: Properties.................................................. 15 Item 3: Legal Proceedings........................................... 16 Item 4: Submission of Matters to a Vote of Security Holders......... 16 PART II: Item 5: Market for Registrant's Common Equity and Related Stockholder Matters......................................... 17 Item 6: Selected Consolidated Financial Data........................ 18 Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 19 Item 7A: Quantitative and Qualitative Disclosures About Market Risk........................................................ 37 Item 8: Financial Statements and Supplementary Data................. 38 Item 9: Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 62 Item 9A: Controls and Procedures..................................... 62 PART III: Item 10: Directors and Executive Officers of the Registrant.......... 62 Item 11: Executive Compensation...................................... 62 Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.................. 62 Item 13: Certain Relationships and Related Transactions.............. 62 Item 14: Principal Accountant Fees and Services...................... 62 PART IV: Item 15: Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................................................... 63 Signature............................................................. 68 2 PART I "SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 The discussion in this Form 10-K contains forward-looking statements that involve risks and uncertainties. The statements contained in this Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on the information available to Harris Interactive on the date hereof, and Harris Interactive assumes no obligation to update any such forward-looking statement. Actual results could differ materially from the results discussed herein. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the Risk Factors section of this Form 10-K. The Risk Factors set forth in other reports or documents Harris Interactive files from time to time with the Securities and Exchange Commission should also be reviewed. ITEM 1. BUSINESS Harris Interactive Inc. is a Delaware corporation that was incorporated in 1997. Harris Interactive Inc. and its subsidiaries (also herein referred to as "Harris Interactive", "we", "our", "us", or the "Company") is a worldwide market research and consulting firm best known for The Harris Poll(R), and for pioneering the Internet method to conduct scientifically accurate market research. Harris Interactive combines proprietary methodologies and technology with expertise in predictive, custom and strategic research. The Company conducts international research through its various U.S. offices, its wholly-owned subsidiaries: London- based HI Europe (www.hieurope.com) and Tokyo-based Harris Interactive Japan K.K. (www.hpol.co.jp) -- as well as through its Global Network of local market and opinion research firms. On November 1, 2001 Harris Interactive acquired all of the issued and outstanding shares of common stock, par value $.001 per share, of Total Research Corporation, a Delaware corporation, located in Princeton, New Jersey. The transaction was completed pursuant to the Agreement and Plan of Merger, dated as of August 5, 2001, among the Company, Total Merger Sub Inc., a Delaware corporation and direct, wholly owned subsidiary of the Company, and Total Research. Total Merger Sub was merged with and into Total Research (the "Merger"), with Total Research continuing as the surviving corporation and as a direct, wholly owned subsidiary of the Company. The Company has its corporate headquarters in Rochester, New York. The Company's fiscal year ends June 30th. Information about the Company's products and services, shareholder information, press releases, and SEC filings can be found on the Company's website at www.harrisinteractive.com. We make available free of charge through our website the documents and reports we file with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information on our website (or the websites of our subsidiaries) does not constitute part of this Report on Form 10-K. OVERVIEW The Company operates as one business segment, and services its clients through six distinct operating groups: - Business and Consumer Research, - Health Care & Policy Research, - Customer Loyalty Management, - HI Europe, - Harris Interactive Japan, and 3 - Harris Interactive Service Bureau. The operating groups conduct: - custom research -- internet-based and traditional studies conducted on specific issues for specific customers, - multi-client research -- internet-based studies conducted on issues of general interest and sold to numerous clients, and - service bureau research -- internet-based data collection conducted for other research firms. In 1997, the Company embarked on its mission to develop an Internet panel and the proprietary technology infrastructure necessary to conduct fast, comprehensive and accurate online market research. Accordingly, we have made, and will continue to make, significant expenditures to drive the transformation of the market research and polling industry to an Internet-based platform. We believe that Harris Interactive is the leading Internet-based market research and polling firm in the world, based on the size of our Internet panel, the number of online surveys that we have completed and the amount of revenue we derive from online research. The Company operates telephone data collection centers in Rochester, New York, London, England, and Tokyo, Japan. The Company's phone centers conduct interviews utilizing computer-based questionnaires. The data are immediately uploaded to the Company's central data-processing center, thereby enabling more efficient and effective analysis. The Company's phone centers have sufficient capacity to support reasonably predictable long-term needs. The Company also out-sources telephone data collection to support shorter-term project needs and others that exceed the Company's internal capacity. The Company maintains secure in-house data processing operations that provide rapid data management and analysis. The Company supports many platforms and file types both to exchange data and to provide clients with extensive database design and management capabilities. The Company also provides its clients with sample management services and survey data results using a variety of software applications. Harris Interactive and The Harris Poll are U.S. registered trademarks of Harris Interactive Inc. This Form 10-K also includes other trademarks, trade names and service marks of Harris Interactive and of other parties. OUR MARKET OPPORTUNITY GENERAL OVERVIEW Business is becoming more complex. Heightened competition, consolidation, globalization of product markets, accelerated product launch schedules, shortened product life and rapidly changing consumer preferences mark today's business environment. This complexity has escalated the value of accurate and timely information needed to make critical decisions. Business covets data about the preferences, needs, buying behavior and brand awareness of existing and potential clients. Well-managed companies also need to continuously track product performance and competitive position, monitor consumer satisfaction and loyalty, measure advertising effectiveness and determine price sensitivity. Historically, market research has been performed using traditional data collection methodologies: telephone, mail and in-person interviews. However, these methods are becoming increasingly less effective (and less affordable) due to high data collection costs, small sample sizes and the extensive time required to perform the research. Consequently, large traditional research projects can only be funded by organizations with significant resources. The Internet has dramatically changed the market research and polling industry, making it possible for the first time to survey a broad, diverse population at costs and speeds that were previously unattainable. This capacity has actually increased the amount of research that is being completed as much of our revenue is "new" research that had never been done before. 4 THE INTERNET AND ITS IMPACT ON THE MARKET RESEARCH AND POLLING INDUSTRY Since its conception in the early 1960s, the Internet has enabled hundreds of millions of people worldwide to gather and share information as well as conduct business electronically. The use of the Internet as a market research and polling tool is still in its relatively early stages, having only been practiced for the last five to seven years. Harris Interactive first began testing the Internet to conduct market research and polling in 1997. At that time, there were approximately 40 million people, or only about 16% of the U.S. population, who had Internet access. They were not representative of the general population. Harris Interactive had to perfect data weighting systems to correct for this bias. Today, the demographic composition of Internet users has become closer to the overall population and highly accurate weighting procedures have been developed, making the Internet a viable means to conduct market research -- with significant advantages, including: - FLEXIBILITY -- Internet-based market research is conducted on the respondent's schedule -- not the telephone researcher's schedule. Online questionnaires may be completed at home, work or anyplace with Internet access. Surveys can be created in multiple languages and administered around the world seven days a week, twenty-four hours a day. - VERSATILITY -- Motion and still pictures, graphics, advertising copy and other visual materials can be viewed over the Internet, a feature not available with telephone sampling. The images can be combined with sound as well as protected from being stolen, printed, forwarded, copied or saved. Internet-based methodology allows questions and their sequence in surveys to be modified as panelists respond. Mail surveys, in contrast, are limited to the order and content of the printed text of the survey. Online qualitative research techniques such as chat room or bulletin board focus groups provide substantial savings in time and travel costs. - SPEED -- In our experience, an average mail survey takes approximately six weeks from design to completion. In contrast, Internet surveys can generally be completed in two to seven days. As voicemail, caller ID, call screening answering machines, do-not-call protection, and a general aversion to telemarketing proliferate, call acceptance rates drop and telephone researchers must call more people to get the same number of completed surveys. Therefore, the speed (and cost) advantage of the Internet model actually becomes greater as the sample size increases. - VALUE -- Internet-based methodology offers significant cost benefits when compared to traditional market research methodologies. Traditional survey sample size is limited due to the high data collection costs per response. Internet-based market research methods can provide larger and more robust sample sizes for the same cost, or the same sample size can be gathered at a reduced cost. - PRODUCTIVITY -- Because online panelists can read questions faster than they can listen, more questions can be asked in the same amount of time. Respondents in qualitative sessions conducted online create their own transcripts, which can be immediately reviewed and analyzed by the market researcher- versus having to create transcriptions from audiotapes. THE HARRIS INTERACTIVE ADVANTAGE We believe that Harris Interactive is the global leader in online market research. We offer our clients a broad suite of Internet-based market research and polling products. We have several competitive advantages that we believe will enable us to maintain and expand our lead position in Internet-based research. Our key competitive advantages include: - HIGHLY SATISFIED AND LOYAL CLIENTS. Our intensive measurement of customer satisfaction and the associated process improvements have allowed us to greatly improve the quality of services that we deliver. All of our researchers and managers are evaluated on the customer satisfaction scores that they earn from their clients, and their bonus compensation is tied to customer satisfaction levels. Consequently, 5 our Company-wide client satisfaction scores (over 9.0 out of 10 in fiscal 2003) are among the best in the industry. - This high level of customer satisfaction provides us with a true competitive advantage in the marketplace by: - Monitoring and then responding to changing customer needs, - Increasing the loyalty of our customers, which generates a larger lifetime value earned from each client, - Improving our margins by softening price sensitivity, and - Decreasing our cost of sales due to the higher propensity for repeat business. - A PROPRIETARY PROPENSITY SCORE WEIGHTING SYSTEM. This system ensures very accurate online data collection results by correcting for data anomalies that occur due to sample bias - such as the difference in behavior between online respondents and offline respondents. We believe that no other online market research firm has an equal system to correctly weight data and project results to a larger population. The accuracy of this system was proven when Harris Interactive produced the most accurate forecast of the 2000 U.S. presidential election and state-by-state forecasts (72 races in total) that were approximately 2 times as accurate as those generated through telephone polls. - THE WORLD'S LARGEST INTERNET PANEL for conducting online market research. Currently, our panel consists of several million individuals from around the world who have been double opted-in and voluntarily agreed to participate in our various online research studies. We are currently adding thousands of additional names to our global panel on a daily basis. This large and diverse Internet panel enables us to: - conduct a broad range of customer-specific or multi-client research studies across a wide set of industries, - conduct very large surveys of the general population and studies of low-incidence, hard-to-find subsets, - market new research products and services through co-branded alliances that we historically could not develop alone, and - sell our online data collection services to other research firms through the Harris Interactive Service Bureau, enabling us to penetrate new markets and gain additional market share where we do not have relationships or specific expertise. - SPECIALTY-PANELS. During the past three years, we have performed additional screening of the respondents in our main panel in order to form specialty panels or groups of people with similar, hard to find characteristics. We have developed numerous specialty panels, including Affluent, Chronic Illness, Gay, Lesbian and Bisexual, Mothers and Expectant Mothers, Physicians, Pet Companion and Technology Decision Makers. Our clients highly value our ability to rapidly perform online surveying of these low incidence populations, and have even asked us to develop proprietary specialty panels exclusively for their use. Specialty panel research has become a key driver of high profit revenue growth for the Company. - PROPRIETARY TECHNOLOGY INFRASTRUCTURE. A significant amount of computer software and hardware is required to conduct Internet-based market research and polling. The key elements of our technology infrastructure include: - A HIGH SPEED CUSTOMIZED EMAIL SYSTEM, which enables us to rapidly format, target and send over one million customized email invitations per hour; - A SOPHISTICATED SURVEY ENGINE, which can process 240,000 five-minute incoming surveys per hour with a peak capacity of 20,000 surveys processed simultaneously; - SOFTWARE SYSTEMS with the ability to collect data in any language supported by Microsoft, including double-byte character sets (such as the Asian languages) and left to right reading languages; 6 - An advanced SURVEY DISPATCHER SYSTEM, which acts like an air traffic control system to monitor, control and balance all respondent activity across all of our servers - and to ensure that no respondent will get a "sorry - the system is busy" notice. In addition, our proprietary dispatcher system gathers real-time statistics on survey starts, suspensions and completions, shutting off the surveys when the contracted completion levels have been achieved, thereby reducing cost overruns. - A patented customizable MULTI-LANGUAGE REGISTRATION AND POLLING SYSTEM, which allows new and existing panel members to add, delete or update their registration information online, and which recognizes each panelist's language preference and delivers the survey in that language; - Flexible, AUTOMATED REAL TIME REPORTING TOOLS that allow online access to weighted survey data at any time and speed the process of data delivery to clients; - A SCALABLE TECHNOLOGY INFRASTRUCTURE. This infrastructure was designed with no theoretical upper limit and can easily and cheaply grow with the expansion of our business. Currently, we believe that we can double our existing capacity at a cost of less than $300,000. - A STRONG BRAND. We believe that The Harris Poll is one of the best-known polls operating in the United States today. For over 45 years, The Harris Poll has been recognized for providing trusted information to a broad range of companies, non-profit organizations and governmental agencies. We use a variety of marketing strategies to heighten awareness of and enhance brand recognition of The Harris Poll, Harris Interactive and our Internet-based products and services. OUR PRODUCTS AND SERVICES Our services are focused upon serving numerous vertical markets, which include, but are not limited to, pharmaceutical and health care, ecommerce, consumer packaged goods, automotive, financial services, technology, education, media and advertising and public policy. By aligning all of our support functions (e.g. sales, marketing, research staff, etc.) to specific vertical markets, we can effectively and efficiently deliver our services, while providing a high level of industry expertise and consultative support. Our three primary sources of revenue are: - custom research - multi-client research - service bureau research All multi-client and service bureau research is conducted via the Internet. We deliver custom research by employing both traditional and Internet-based methodologies. Currently, we are aggressively transitioning our custom research and polling products and services to Internet-based research. During fiscal 2003, 46% of our total revenue was derived from Internet-based products, up from 41% in fiscal 2002. We continue to dedicate a significant amount of our financial and management resources to developing and marketing new products and services that use our Internet-based methodologies. 7 The following table summarizes our products and services. PRODUCT TYPE DESCRIPTION METHODOLOGY ------------ ----------- ----------- Custom Research Market research and polling Traditional and Internet-based conducted on an issue specifically identified by a client. Multi-Client Research Studies developed for, and sold to, Internet-based a large number of clients who have a similar interest in a particular subject area -- like Equitrend(R) brand equity research and our annual Business School Reputation Rankings. Service Bureau Research Data Collection conducted for other Internet-based market research firms. CUSTOM RESEARCH For almost 50 years, we have provided custom research to a broad range of clients, ranging from business-to-business and business-to-consumer companies, to non-profit organizations and governmental agencies. This experience has served as our foundation to build the techniques used to conduct accurate Internet-based custom research. Our long history has also provided us with particular strong expertise in the following markets: - health care, - pharmaceuticals and medical devices, - office equipment and technology, - education and public policy, - transportation, - marketing communications and advertising, and - public relations. We conduct many types of custom research including customer satisfaction surveys, market share studies, new product introduction studies, brand recognition studies, reputation studies, ad concept testing and more. A custom research project has three distinct phases: - SURVEY DESIGN -- Initial meetings are conducted with the client to clearly define the objectives and reasons for the study which ensures that the data collected by the research will meet the customer's needs. Based on the requirements, we then determine the proper research procedure such as a mail, telephone or Internet survey, focus group meetings or personal interviews, identify the population to be surveyed, and design the survey questionnaire or focus group protocol. - DATA COLLECTION -- Field data collection is conducted through computer-aided Internet or telephone interviewing, by mail or in person, or by holding focus group meetings or any combination of the above. Quality procedures assure that surveys are returned and the correct number of interviews are completed. - WEIGHTING, ANALYSIS AND REPORTING -- We review the collected data for sufficiency and completeness, weight the data accordingly, and then analyze by desired demographic, business or industry characteristics. A comprehensive report that typically includes recommendations is then prepared and delivered to the client. Our proprietary sample design and questionnaire development techniques ensure that complete and accurate information is collected, and that this data will satisfy the specific inquiries of our clients. We have developed in-depth data collection techniques that enhance the integrity and reliability of our sample database. Our survey methodology ensures that responses are derived from the appropriate decision-makers in each category. As a result, we deliver the data that our clients need. 8 MULTI-CLIENT RESEARCH Multi-client research is sold on a one-time or subscription basis to a large number of customers that have an interest in a particular market segment or research application. Our multi-client products are developed on an independent or co-branded basis and are marketed by us. We collaborate with other parties that have unique experience in a particular subject or market to produce co-branded multi-client products. Agreements for co-branded studies are negotiated on a case-by-case basis, with revenue generally applied to specified categories of expenses and any profits shared accordingly. Co- branded products typically enable our clients to conduct research that they could not conduct without our Internet panel and technology infrastructure. By combining their expertise with our vast database and research capabilities, we are able to develop and market products that benefit both parties. SERVICE BUREAU RESEARCH The Harris Interactive Service Bureau (HISB) conducts Internet-based data collection for other market research firms that either do not have the necessary resources to develop Internet-based market research capabilities or that have otherwise chosen not to develop such capabilities themselves. In addition to being a strong revenue source, HISB also enables us to penetrate markets or industries where we do not have current relationships or specific expertise. We also believe that HISB reduces the likelihood that those clients will invest significant financial and management resources to develop competitive Internet-based market research capabilities, and therefore serves as a barrier to entry to our competition Harris Interactive Service Bureau clients can utilize our data collection capabilities on a long-term, continuous basis or on a project-by-project basis. During fiscal 2003, 100 market research firms used HISB, up from 90 in fiscal 2002 and 74 at the end of fiscal 2001. OUR CLIENTS In fiscal 2003, approximately 42% of the Company's revenue was derived from Fortune 500 companies. The Company served approximately 1,070 clients, derived from the following lines of business: % FY2003 REVENUE -------- Customer Loyalty Management................................. 25 Health Care................................................. 19 Technology.................................................. 11 Harris Interactive Service Bureau (HISB).................... 7 Strategic Brands & Consulting............................... 7 Media & Public Relations.................................... 6 Automotive & Transportation................................. 5 Marketing Communications.................................... 4 Youth & Education........................................... 3 Customer Retention.......................................... 3 General Markets/Other....................................... 10 In fiscal 2003, no single client accounted for more than 10% of the Company's consolidated revenue. OUR SALES AND MARKETING PROGRAMS During fiscal 2003 the Company invested approximately $2.3 million to implement a broad range of sales and marketing programs, intended to: - raise awareness of the The Harris Poll, The Harris Poll Online, Harris Interactive, HI Europe and Harris Interactive Japan brands, - build specific product awareness, 9 - generate new sales leads, - expand our Internet panel, and - support our global network. Marketing activities are integrated and may contain elements of public relations, offline and online advertising and promotion, trade shows, industry event participation and speaking engagements, market research knowledge sharing conferences and direct marketing. - PUBLIC RELATIONS. We engage in comprehensive media relations and public relations on a full time basis. We regularly create and distribute, via national and international news wires, media releases for both our Company and our clients who desire to jointly release data from studies that we have conducted. During fiscal 2003, the Company created and distributed over 150 media releases, including the worldwide weekly distribution of The Harris Poll and The Harris Interactive Health Care News. Our public relations team also collaborated with our clients on over 250 joint releases of information, and responded to over 2,500 media inquiries from reporters, editors, authors and educational institutions who wanted to publish our data. The Harris Interactive name regularly appears in Business Week and Time magazines, and on CNN as a research provider for Time/CNN surveys. BRANDWEEK and The Wall Street Journal publish our brand and reputation research on a regular basis. Public Relations has been, and will remain, the main driver behind the rapid increase in the overall awareness of the Harris Interactive brand. - TRADE SHOWS AND SPEAKING ENGAGEMENTS. To further our position as a global leader in Internet-based research, Harris Interactive has participated and will continue to participate in a large number of industry tradeshows, seminars and expositions. Speakers from the Company have traveled the world to share their knowledge with many prestigious organizations, including the Congress of the United States. - OFFLINE ADVERTISING AND PROMOTION. We use print advertising in U.S., European and Japanese business and trade publications to raise awareness of our brand name and to generate leads for individual products and services. The weekly, public release of The Harris Poll is one of our most effective offline promotional activities. The Company also publishes The Harris Interactive Health Care News, containing recent health care research on a weekly schedule. We also regularly publish Trends and 'Tudes (youth and education research), Entree (food and beverage industry research) and @dvantage (HISB) newsletters to share knowledge with our current and potential customers. - ONLINE ADVERTISING AND PROMOTION. The Company has entered into numerous agreements with Internet portals, like The Wall Street Journal Online, which publishes the weekly editions of The Harris Poll and The Wall Street Journal-Harris Interactive Health Care Poll. The Company also purchases key word searches, global banner advertising and co-registration opportunities to generate leads and to recruit new members into The Harris Poll Online. Currently, these efforts are adding thousands of double-opted in panel members per day in the U.S., Canada, The United Kingdom, France, Germany, Italy, Spain and the Scandinavian countries. Other online promotions are undertaken from time to time to recruit special population segments into our panel such as senior citizens, teens, minorities, practicing physicians and information technology (IT) users. - DIRECT MARKETING. Direct marketing strategies are also used to generate leads for our specific products and services. Campaigns that incorporate dimensional mail in combination with outbound telemarketing calls conducted by the inside sales force, have yielded the greatest response. These campaigns are scheduled on a rotating basis throughout the year to support all major lines of business and to maximize the productivity of the inside sales force. - SALES FORCE AUTOMATION. At the end of fiscal 2003, a major effort to implement a web-based, Customer Relationship Management (CRM) system was launched for internal use. We expect that by the end of December 2003, more than 200 employees in the U.S. and Europe will be wired into this integrated system to share customer data, manage leads and contacts as well as track sales proposals, RFP's and contracts sold. 10 OUR COMPETITION We compete with numerous market research firms, as well as corporations and individuals that perform market research studies on an isolated basis, many of whom have market shares larger than our own. Consolidation in the industry continues to create larger and larger global firms, some with billions of dollars in annual revenue. Industry analysts at Inside Research estimate that traditional market research and polling revenue in the U.S. will grow at about 1.9% (compounded annual growth rate, "CAGR", adjusted for inflation) in calendar year 2003, while the Internet-based market research and polling segment of the industry will grow at about 17% (CAGR adjusted for inflation) in calendar year 2003 -- down from 60% (CAGR adjusted for inflation) in CY2002 and 53% (CAGR adjusted for inflation) in CY2001. Although barriers to entry are high, we expect that competition will intensify as existing market research firms continue to invest in building their online research capabilities. We will likely also face competition in the future from other traditional market research firms who move into Internet-based technologies or other companies with access to large databases of individuals with whom they can communicate on the Internet. These companies may, either alone or in alliances with other firms, attempt to penetrate this market. Many of our current and potential competitors have longer operating histories or significantly greater financial and marketing resources. These competitors may be able to undertake more extensive marketing campaigns for their services, adopt more aggressive pricing policies and make more attractive offers to potential employees, partners and potential customers. Further, our competitors and potential competitors may develop technologies that are superior to ours or that achieve greater market acceptance than our own. We believe, however, that we can and will remain highly competitive due to the knowledge of our people and our ability to excel in: - proprietary sample design techniques, - questionnaire development, - in-depth data collection, and - the ability to accurately deliver data that represents the desired demographics. We also believe that we have additional competitive advantages such as: - our expanding global footprint - our ability to project results to the required universe, - our large Internet panel, diverse in geographic scope and demographic depth, - our scalable proprietary Internet technology platform, - our quality, and the depth and breadth of our products and services, - our brand recognition and strong reputation, - our values, and - our very high levels of customer satisfaction OUR INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS Our success in becoming the leader in Internet-based market research has been largely driven not only by our investment in our database but also by our proprietary software technology, research methodology, data weighting and analysis techniques, and the internal processes that we developed to conduct online research. This intellectual property is essential to our continued success, and to protect it, we rely on a combination of patent, 11 copyright, trademark and trade secret laws, plus confidentiality and license agreements. In October 2001, we received a patent for a system to conduct surveys over a network, including the Internet, to multiple respondents in multiple countries in different languages. This system only allows the respondent to participate once. It can also dynamically generate surveys from a database as well as immediately show and compare the results of the surveys. The patent will expire February 2, 2019. We also have two additional patents pending: - For ConceptLoc(TM) -- a proprietary suite of online security products that protect non-animated graphics interchange format and Joint Photographic Expert Group images, prevent printing of protected images, disable screen print capability, disable save, save as, drag and drop, and copy capabilities and defeat third-party capture applications; and - Harris Interactive Configurator -- a system to conduct "build your own" product configuration research over a network. Our success and ability to compete substantially depend on our internally developed technologies and trademarks. We have trademark registrations for a number of our trademarks, including Harris Interactive, HI Europe, and The Harris Poll. If we were prevented from using The Harris Poll name, our brand recognition and business would likely suffer. We would have to make substantial financial investments to rebuild our brand identity. Effective trademark, service mark, copyright and trade secret protection may not be available in every country in which our services are made available. Under the terms of our 1996 acquisition of Louis Harris and Associates, we purchased the HARRIS name including The Harris Poll, for global use except for use in Europe and the European portion of the former Soviet Union (the "Territory"). The prior owner of Louis Harris and Associates sold the HARRIS name for use in the Territory, and those rights are now owned by Taylor Nelson Sofres plc. ("TNS"). In February 2000, we entered into a trademark license agreement with TNS, which provides us with a non-transferable license to use the names HARRIS ONLINE, HARRIS POLL ONLINE, HARRIS INTERACTIVE, and HARRIS POLL INTERACTIVE within the Territory. Our use of these trademarks is permitted only in connection with market research services involving use of the Internet and with reference to the license. We may not otherwise use the HARRIS name in the Territory. The agreement prohibits TNS from using HARRIS ONLINE, HARRIS POLL ONLINE, HARRIS INTERACTIVE and HARRIS POLL INTERACTIVE, or confusingly similar marks within the Territory, and provides that TNS will not contest our use of "HPOL" within the Territory. TNS retains the right to use the HARRIS name within the Territory unless such use indicates a connection with the Internet and is confusingly similar to the marks licensed to us. TNS also retains the right to terminate the license in the event of (i) our insolvency or our breach of the agreement, (ii) the termination of separate agreements between us and TNS relating to our providing TNS with access to our panelist database, and/or (iii) a change of control or sale of substantially all of the business or assets of Harris Interactive in favor of a competitor of TNS; provided however, in the latter two cases we may purchase perpetual rights to the names. We have licensed in the past, and expect to license in the future, certain of our proprietary rights, such as trademarks or copyrighted material, to third parties. While we attempt to ensure that the quality of our brand is maintained by these licenses, licensees may take actions that might harm the value of our proprietary rights or reputation. The steps taken by us to protect our proprietary rights may not be adequate and third parties may infringe or misappropriate our copyrights, trademarks and similar proprietary rights. In addition, other parties may assert claims of infringement of intellectual property or other proprietary rights against us. In addition, there can be no assurance that third parties will not independently develop functionally equivalent or superior systems, software or procedures. We believe that our systems, software and procedures and other proprietary rights do not infringe on the proprietary rights of third parties. There can be no assurance, however, that third parties will not assert infringement claims against us in the future or that any such claim will not require us to enter into materially adverse license agreements or result in protracted and costly litigation, regardless of the merits of such claims. 12 FINANCIAL INFORMATION ABOUT GEOGRAPHIC AREAS During fiscal 2003 and 2002, approximately 77% and 78%, respectively, of our total consolidated revenue was derived from our U.S. operations and approximately 23% and 22%, respectively, of our total consolidated revenue was derived from our non-U.S. operations. Further financial information about the geographic areas in which the Company operates is included in Note 8, "Business Segment and Geographic Information," to our Audited Consolidated Financial Statements contained in this Form 10-K. BACKLOG As of June 30, 2003, we had a revenue backlog of approximately $36 million, as compared to a backlog of approximately $40 million at June 30, 2002. It is estimated that substantially all of the backlog as of June 30, 2003 will be recognized during the fiscal year ending June 30, 2004. EMPLOYEES As of June 30, 2003, we employed a total of 731 persons on a full-time basis worldwide, 561 of which were employed in the United States. In addition, we employed 1,003 part-time and hourly individuals on a worldwide basis, for data gathering and processing activities, 199 of which were employed in the United States. None of our employees are represented by a collective bargaining agreement. We have not experienced any work stoppages. We consider our relationship with our employees to be good. EXECUTIVE OFFICERS OF HARRIS INTERACTIVE The following table sets forth the name, age and position of each of the persons who were serving as executive officers of the Company as of September 15, 2003. These individuals have been elected by and are serving at the pleasure of our board of directors: NAME AGE POSITION ---- --- -------- Gordon S. Black 62 Chairman of the Board, Chief Executive Officer Albert Angrisani 54 President, Chief Operating Officer Leonard R. Bayer 53 Executive Vice President, Chief Technology Officer Bruce A. Newman 49 Chief Financial Officer, Secretary and Treasurer Dennis K. Bhame 55 Executive Vice President, Human Resources Peter J. Milla 44 Executive Vice President, Chief Information Officer Gregory T. Novak 41 President, U.S. Operations Arthur E. Coles 60 Group President, Health Care & Policy Research Theresa A. Flanagan 42 President, Customer Loyalty Management Ronald Knight 64 Group President, Harris Interactive Service Bureau and Chief of Staff George Terhanian 39 President, Harris Interactive Europe Minoru Aoo 59 Managing Director, Harris Interactive Japan David Vaden 32 Senior Vice President, Business Development & Internet Services James Fredrickson 42 Senior Vice President, Research Operations The following is a brief account of the business experience of each of the above executive officers: Gordon S. Black PhD. has served as Chairman of the Board and Chief Executive Officer of Harris Interactive since he founded Gordon S. Black Corporation in July 1975. From July 1968 to June 1978, Dr. Black was a member of the faculty of the University of Rochester, where he was an Associate Professor with tenure. Dr. Black received a Ph.D. in Political Science from Stanford University and a B.A. degree in Political Science from Washington University. 13 Albert Angrisani has served as President and Chief Operating Officer, and as a director of Harris Interactive since November 2001. Mr. Angrisani was elected to serve as President and Chief Operating Officer and as a director of Harris Interactive pursuant to the terms of the Agreement and Plan of Merger dated August 5, 2001 between Harris Interactive Inc., Total Research Corporation and Total Merger Sub Inc. From July 1998 to November 2001, Mr. Angrisani served as President and Chief Executive Officer of Total Research Corporation and as director of Total Research Corporation from November 1994 to November 2001. Prior to July 1998, Mr. Angrisani acted as a consultant to Total Research Corporation, and from January 1993 to April 1998, Mr. Angrisani served as the President of the Princeton-Potomac Management Company, a consulting and financial services firm. Mr. Angrisani earned an A.P.C. from New York University, an M.B.A. from Fairleigh Dickinson University and a B.A. from Washington & Lee University. Leonard R. Bayer has served as Executive Vice President and Chief Technology Officer, and as a director of Harris Interactive, since July 1978. From August 1976 to July 1978, Mr. Bayer worked for Practice Development Corporation where he served as Vice President of Research and Development. From September 1975 to August 1976, Mr. Bayer was a member of the faculty of the University of Rochester School of Medicine where he taught mathematical statistics. Mr. Bayer received an M.A. degree in Statistics, a B.S. degree in Astrophysics and a B.A. degree in Mathematics from the University of Rochester. Bruce A. Newman has served as our Chief Financial Officer, Secretary and Treasurer since January 1986. From July 1980 to January 1986, Mr. Newman served as Treasury Manager of The Case-Hoyt Corporation, a national printer. From July 1975 to August 1979, Mr. Newman worked for PricewaterhouseCoopers LLP. Mr. Newman received a B.S. in Accounting from the State University of New York at Albany and is a Certified Public Accountant. Dennis K. Bhame has served as the Executive Vice President of Human Resources since April 2000. Prior to joining our company, Mr. Bhame spent 16 years at Bausch & Lomb Inc., most recently as Vice President, Global Human Resources, Eyeware Division. He worked as a human resource professional at Burroughs Corporation and Moore Business Forms prior to joining Bausch & Lomb. Mr. Bhame holds a B.S. in Business Management from New Hampshire College. Peter J. Milla has served as our Executive Vice President, Chief Information Officer since September 1999. From 1985 until 1999, Mr. Milla was the Senior Vice President and Chief Information Officer at Response Analysis Corporation and following its acquisition, at Roper Starch Worldwide, where he was responsible for all information technology and data processing activities. From 1983 until 1985, Mr. Milla was on the staff of the National Opinion Research Center (NORC) at the University of Chicago and was responsible for managing the data processing activities on research projects for academic institutions and government agencies. Mr. Milla is currently a member of the Board of Directors of the Council of American Survey Research Organizations (CASRO). He also serves as chair of CASRO's Technology Committee. Mr. Milla holds a B.A. and M.A. from Queens College of the City University of New York. Arthur E. Coles has served as our Group President, Health Care & Policy Research, since July 2000. From June 1999 to June 2000, Mr. Coles was our Executive Vice President of Marketing and Business Development. Mr. Coles was President and Chief Executive Officer of our largest subsidiary from June 1997 to June 1999. Prior to joining the Company, Mr. Coles worked for Eastman Kodak Company, where he served as Vice President of Strategic Planning for the Digital Imaging Division. Prior to this, he spent over 30 years at Xerox Corporation in a variety of general management, marketing, and operational roles. Mr. Coles received an M.B.A. from the Rochester Institute of Technology and a B.S. in Mathematics from the State University of New York at Albany. Theresa A. Flanagan has served as President of the Customer Loyalty Management division of Harris Interactive since November 2001. Ms. Flanagan became President of the Customer Loyalty Management division of Total Research Corporation in July 1996. She joined Total Research Corporation in 1983 and served as Senior Vice President from June 1993 to July 1996. Ronald B. Knight has served as Group President, Harris Interactive Service Bureau and Chief of Staff since July 2001. He served as Group President, Business and Consumer Services; Consulting & Brand Management from July 2000 until July 2001. Prior to joining the Company, Mr. Knight was the Chief Operating Officer for 14 The Sutherland Group from September 1998 through July 2000. He is the former Vice President and Chief of Staff of Business Operations for Xerox Corporation's Production Systems Group (PSG) where he worked for 30 years. He served as a Lieutenant in the U.S. Navy and worked as a financial analyst for General Motors prior to joining Xerox Corporation. Mr. Knight holds a B.S. in Business Administration from the University of Rochester, and an M.B.A. from the University of Rhode Island. Gregory T. Novak has served as President, U.S. Operations, since July 2003, and prior to that he was Group President, Strategic Marketing Solutions and Business and Consulting since July 2001. He served as Group President, Strategic Marketing Solutions, from July 2000 to July 2001. From June 1999 through June 2000, Mr. Novak was the President of our Internet Division. From August 1996 to June 1999, Mr. Novak was Vice President/General Manager of Lightnin America's, a unit of GSX. Mr. Novak received an M.S. in Management from Purdue University's Krannert Business School and a B.S. in Mechanical Engineering from the University of Pittsburgh. Mr. Novak is also a graduate of General Electric's Nuclear Power Engineering Program and Corporate Analyst's Training and Development Program. Minoru Aoo has served as Managing Director of Harris Interactive Japan since February 2000. He has also served as Managing Director of Adams Communications and M&A Create Limited since August 1995. From March 1987 to July 1995, Mr. Aoo worked for Dow Jones and Co. as a Managing Director/North Asia in the International Marketing Services Department. Mr. Aoo joined Nihon Keizai Shimbun after receiving a Bachelor of Commercial Science from Keio University in Tokyo. George Terhanian PhD has served as President, Harris Interactive Europe, since July 2003 and continues to serve as President of Global Internet Research. Dr. Terhanian has directed the Company's online research activities since they began in 1997. Prior to joining the Company in 1996, Dr. Terhanian taught in elementary and secondary schools in the United States and was an analyst for the Inspector General's Office of the United States Department of Education. He has also served an appointment as an American Educational Research Association Fellow at the National Center for Educational Statistics. Dr. Terhanian received his B.A. from Haverford College, his Masters degree from Harvard University, and his Ph.D. from the University of Pennsylvania. David Vaden has served as Senior Vice President, Business Development and Internet Services since January 2002. Mr. Vaden is responsible for direction of the Company's acquisition and alliance program, strategic planning, and global management of the Company's Internet research panel and specialty subpanels. He served as Vice President, Finance from January 2000 to December 2001. Prior to joining the Company, Mr. Vaden served as a Manager in the Audit and Business Advisory Services division at PricewaterhouseCoopers LLP (PwC). While at PwC, David was selected as one of fifty employees among thirty seven thousand personnel in the United States to participate in the PwC Scholars Program. David received an M.B.A. with distinction from Columbia University Business School, a B.S. in Accounting with honors from St. John Fisher College and is a Certified Public Accountant. James Fredrickson has served as Senior Vice President, Research Operations, since May 2002. In this role, Mr. Fredrickson is responsible for all of the firm's operational activities associated with providing market research services in support of client studies. Mr. Fredrickson was Vice President, Harris Interactive Service Bureau from its inception in March 1999 to April 2002. From 1987 to 1999, Mr. Fredrickson served in a variety of operational roles. Mr. Fredrickson received a B.S. in Mathematics from the State University of New York at Brockport. ITEM 2. PROPERTIES The Company's headquarters and principal United States operating facility is located at 135 Corporate Woods, Rochester, New York, 14623, under a lease that expires in June 2008. In addition, we lease data collection centers, in which we operate telephone interviewing centers in Rochester, New York, London, England, and Tokyo, Japan, and we lease service offices to house our project staff, administrative staff and processing staff, in New York, New York, Princeton, New Jersey, Norwalk, Connecticut, Minneapolis, Minnesota, Claremont, California, London, England and Tokyo, Japan. 15 We lease all of our facilities and believe our current facilities are adequate to meet our needs for the foreseeable future. We believe additional or alternative facilities can be leased to meet our future needs on commercially reasonable terms. ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Company is at times subject to pending and threatened legal actions and proceedings. After reviewing pending and threatened actions and proceedings with counsel, management believes that the outcome of such actions or proceedings is not expected to have a material adverse effect on our business, financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2003. 16 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION Our common stock is traded on the Nasdaq National Market system under the symbol "HPOL". The following quotations reflect inter-dealer quotations that do not include retail markups, markdowns or commissions and may not represent actual transactions. The following table shows, for the periods indicated, the high and low bid prices per share of our common stock. PRICE RANGE OF COMMON STOCK --------------- HIGH LOW ------ ------ Year ending June 30, 2003: Fourth Quarter............................................ 6.9500 4.0000 Third Quarter............................................. 5.6000 2.9200 Second Quarter............................................ 3.5800 2.0000 First Quarter............................................. 3.5000 2.0800 Year ending June 30, 2002: Fourth Quarter............................................ 3.9900 3.0700 Third Quarter............................................. 4.1000 2.4500 Second Quarter............................................ 3.1800 1.6500 First Quarter............................................. 3.2100 1.6500 HOLDERS At September 15, 2003, the Company's common stock was held by approximately 5,400 stockholders, reflecting stockholders of record or persons holding stock through nominee or street name accounts with brokers. DIVIDENDS We have never declared nor paid any cash dividends on our common stock. We currently anticipate that we will retain any future earnings for the development and operations of our business. Accordingly, we do not anticipate paying any cash dividends on our capital stock in the foreseeable future. CHANGES IN SECURITIES AND USE OF PROCEEDS The Company issued and sold an aggregate of 414,299 shares of its common stock to employees during the fourth quarter of fiscal 2003, upon the exercise of options granted under the Company's 1997 stock option plan, at exercise prices ranging from $0.35 per share to $3.70 per share, for an aggregate cash consideration of $753,524. As to each employee of the Company who was issued the common stock described in this paragraph, the Company relied on the exemption from registration provided by Rule 701 under the Securities Act of 1933, as amended. Each person was granted an option to purchase shares of the Company's common stock pursuant to a written contract between such person and the Company, and the Company was eligible to use Rule 701 at the time the options herein reported as exercised were originally granted in accordance with Rule 701(b). On June 30, 2003, the Company issued an aggregate of 33,209 shares of its common stock as the Company's matching contribution under its 401(k) Plan for an aggregate consideration of $214,530, which did not constitute a sale under Section 2(3) of the Securities Act of 1933, as amended. During the fourth quarter of fiscal 2003, the Company issued and sold an aggregate of 134,420 shares of its common stock to individuals who exercised options to acquire shares received in connection with their investment in Total Research in 1998, which options were assumed by the Company as part of the Merger. The shares were issued at an exercise price of $1.84 per share for an aggregate cash consideration of $247,333. As to 17 each person who was issued common stock described in this paragraph, the Company relied on an exemption from registration provided under Section 4(2) of the Securities Act of 1933. On December 6, 1999, the Company completed an initial public offering of 6,670,000 shares of its common stock. Proceeds to the Company from the offering totaled approximately $85.5 million. During the period from December 6, 1999 through June 30, 2003, the Company used portions of the proceeds from its public offering as follows: (i) approximately $56.2 million of net cash used for working capital and general corporate purposes, including capital expenditures (ii) approximately $11.4 million of net cash used for the expansion of our Internet panel (iii) approximately $11.3 million of net cash used for acquisitions and (iv) $4.0 million of net cash used in connection with the repayment of short-term and long-term borrowings. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data of Harris Interactive should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and the notes to those statements and other financial information appearing elsewhere in this Form 10-K. FOR THE YEARS ENDED JUNE 30, --------------------------------------------------- 2003 2002 2001 2000 1999 -------- -------- -------- -------- ------- (IN THOUSANDS, EXCEPT PER SHARE AND SALES GROWTH) STATEMENT OF OPERATIONS DATA: Revenue from services.............................. $130,551 $100,048 $ 60,061 $ 51,289 $28,965 Cost of services................................... 66,852 53,470 30,764 28,600 19,086 -------- -------- -------- -------- ------- Gross profit....................................... 63,699 46,578 29,297 22,689 9,879 OPERATING EXPENSES: Sales and marketing expenses....................... 9,542 9,720 8,475 8,665 1,316 General and administrative expenses................ 47,507 46,708 48,537 37,856 17,590 Restructuring (credits) charges and asset write-downs...................................... (997) 6,222 -- -- -- -------- -------- -------- -------- ------- Operating income (loss)............................ 7,647 (16,072) (27,715) (23,832) (9,027) Interest and other income.......................... 563 1,412 3,721 3,100 206 Interest expense................................... (57) (95) (26) (160) (26) -------- -------- -------- -------- ------- Income (loss) before income taxes.................. 8,153 (14,755) (24,020) (20,892) (8,847) -------- -------- -------- -------- ------- Income tax (benefit) expense....................... (2,954) 38 -- 50 -- -------- -------- -------- -------- ------- Net income (loss).................................. 11,107 (14,793) (24,020) (20,942) (8,847) Accrued dividends on preferred stock............... -- -- (738) (1,176) -------- -------- -------- -------- ------- Net income (loss) available to holders of common stock............................................ $ 11,107 $(14,793) $(24,020) $(21,680) (10,023) ======== ======== ======== ======== ======= Basic net income (loss) per share.................. $ 0.21 $ (0.32) $ (0.70) $ (0.93) $ (1.01) ======== ======== ======== ======== ======= Diluted net income (loss) per share................ $ 0.20 $ (0.32) $ (0.70) $ (0.93) $ (1.01) ======== ======== ======== ======== ======= Weighted average shares outstanding -- basic...... 52,984 46,136 34,239 23,318 9,955 Weighted average shares outstanding -- diluted.... 54,639 46,136 34,239 23,318 9,955 SELECTED OPERATING DATA: Sales Growth....................................... 30% 67% 17% 77% 10% Capital Expenditures............................... 2,178 2,841 7,606 12,092 4,372 BALANCE SHEET DATA (AT THE END OF THE PERIOD): Cash and cash equivalents.......................... 20,391 10,787 10,585 23,932 108 Marketable securities.............................. 18,693 17,070 31,906 48,960 Working capital.................................... 41,321 27,799 45,394 78,698 552 Total Assets....................................... 145,242 135,463 85,221 104,452 14,785 Long-term debt, excluding current installment...... -- 314 -- -- -- Mandatory redeemable preferred stock............... -- -- -- -- 15,876 Total stockholders' equity (deficit)............... 118,489 103,300 71,174 94,350 (8,496) The selected consolidated financial data reported above includes the financial results of the following entities which we acquired as of the dates indicated: Total Research Corporation (November 2001), Market Research Solutions Limited (August 2001), M&A Create Limited (August 2001) and the custom research division of Yankelovich Partners (February 2001). 18 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Harris Interactive provides market research, polling and consulting services to a broad range of companies, non-profit organizations and governmental agencies. Since 1956, we have provided these services utilizing traditional market research and polling methodologies, such as direct mail, telephone-based surveys, mall intercepts, focus groups and in-person interviews. In September 1997, we began developing our Internet panel and building the technology infrastructure to provide online market research and polling services. In November 1997, we introduced our first Internet-based market research and polling services. We generally perform traditional and Internet-based custom research services on a fixed fee basis in response to client-generated requests. We sell our multi-client research services on a periodic subscription basis, typically annually. Harris Interactive Service Bureau also performs research for other market research firms on a project-by-project basis in response to requests from those firms. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported therein. The most significant of these areas involving difficult or complex judgments made by management with respect to the preparation of the Company's financial statements for fiscal 2003 include: - Revenue recognition, - Provision for uncollectible accounts, - Valuation of intangible assets and other long-lived assets, - Valuation of goodwill - Realizability of deferred tax assets, and - HIpoints(TM) loyalty program. In each situation, management is required to make estimates about the effects of matters or future events that are inherently uncertain. Revenue under fixed fee arrangements is recognized on a proportional performance basis based on the ratio of costs incurred to total estimated costs. This revenue includes amounts billed to our clients to cover subcontractor costs and other direct expenses. Provisions for estimated contract losses, if any, are made in the period such losses are determined. Subscription revenue is recognized upon delivery of the research results. Revisions to estimated costs and differences between actual contract losses and estimated contract losses would affect both the timing of revenue allocated and the results of operations of the Company. The Company maintains provisions for uncollectible accounts and estimated losses resulting from the inability of its customers to remit payments. If the financial condition of customers were to deteriorate, thereby resulting in an inability to make payments, additional allowances may be required. The Company assesses the carrying value of its identifiable intangible assets and long-lived assets, excluding goodwill, whenever events or changes in circumstances indicate that the carrying amount of the underlying asset may not be recoverable. Certain factors which may occur and indicate that an impairment exists include, but are not limited to: a significant decrease in the market price of a long-lived asset; significant under-performance relative to historical or projected future operating results; significant changes in the manner of the Company's use of the underlying assets or their physical condition; and significant adverse industry or market trends. In the event that the carrying value of an asset is determined to be unrecoverable, the Company would record an adjustment to the respective carrying value. With respect to goodwill, the Company completes an impairment test on an annual basis. In performing this annual test, the Company compares the fair value of its reporting units with each reporting unit's carrying amount, including goodwill. In the event that a reporting unit's carrying value exceeds its fair value, the Company would record an adjustment to the respective reporting unit's goodwill for the difference between the implied fair value of goodwill and the carrying value. In addition to the annual impairment analysis, the Company also 19 assesses the carrying value of goodwill whenever events or changes in circumstances indicate that the carrying amount of the underlying asset may not be recoverable. The Company evaluates the valuation allowance and potential realization of its deferred tax assets on an ongoing basis. In the determination of the valuation allowance, the Company has considered future taxable income. As a result of the Company's operating performance in fiscal 2003 and the more favorable near term outlook for profitability, a portion of the valuation allowance was reversed with the resultant benefit to income and goodwill. Should the Company determine that it is more likely than not that it will realize additional deferred tax assets in the future, an additional adjustment would be required to reduce the existing valuation allowance, with the resultant benefit to income, goodwill and additional paid in capital. Further financial information about income taxes is included in Note 11, "Income Taxes," to our Audited Consolidated Financial Statements contained in this Form 10-K. Since July 2001, the Company has had a loyalty program (HIpoints(TM)), whereby points are awarded to market survey respondents who register for the Company's online panel, complete online surveys and refer others to join the online panel. The earned points, which are non-transferable, may be redeemed for gifts from a specific product folio. The Company maintains a reserve for its obligations with respect to future redemption of outstanding points, calculated based on the expected redemption rate of the points. This expected redemption rate is estimated based on research from other loyalty and retention programs and the Company's actual redemption rates to date. An actual redemption rate that differs from this estimated redemption rate may have a material impact on the results of operations of the Company. BUSINESS COMBINATIONS On November 1, 2001 the Company acquired all of the issued and outstanding shares of common stock, par value $.001 per share, of Total Research Corporation ("Total Research"), a Delaware corporation, headquartered in Princeton, New Jersey, pursuant to the Agreement and Plan of Merger, dated as of August 5, 2001, among the Company, Total Merger Sub Inc., a Delaware corporation and direct, wholly owned subsidiary of the Company, and Total Research. Pursuant to the merger agreement, Total Merger Sub was merged with and into Total Research (the "Merger"), with Total Research continuing as the surviving corporation and as a direct, wholly owned subsidiary of the Company. Harris Interactive and Total Research are engaged in complementary businesses in the market research and polling industry. The acquisition has created revenue growth, cost savings and other synergies including the ability to convert Total Research traditional-based clients to the Internet, sell to one another's customers, offer customers more comprehensive and diverse services, and use a combined worldwide network. For example, the Company was able to build on Total Research's prior relationship with a key customer to win unrelated Internet-based work in excess of $1 million over the past year. Upon consummation of the Merger, each outstanding share of Total Research common stock was converted into the right to receive 1.222 shares of Harris Interactive common stock, par value $.001 per share. An aggregate of approximately 16,610,000 shares of common stock, with an estimated fair value of $41.3 million, was issued to the stockholders of Total Research Corporation. The value was determined using the average fair market value of the stock for the range of trading days beginning August 2, 2001 and ending August 8, 2001. Additionally, pursuant to the merger agreement, all outstanding options to purchase shares of Total Research common stock were, upon consummation of the Merger, fully vested and converted into an option to purchase 1.222 shares of Harris Interactive common stock. As a result, the former option holders of Total Research received from Harris Interactive options to purchase approximately 2,899,000 shares of Harris Interactive common stock, with an estimated fair value of $3.6 million. The acquisition was accounted for as a purchase in accordance with FAS 141 and is included in the Company's financial statements commencing on November 1, 2001. The Company has recorded approximately $50.5 million in goodwill and intangibles related to the acquisition in accordance with the provisions of SFAS 141. In September, 2001, the Company acquired all of the issued and outstanding stock of M&A Create Limited, a privately owned company headquartered in Tokyo, Japan, in consideration of a combination of cash and shares of Harris Interactive common stock. Additionally, in August, 2001, the Company acquired all of the issued and outstanding stock of Market Research Solutions Limited, a privately owned UK company, headquartered in 20 Oxford, England, in consideration of a combination of cash and shares of Harris Interactive common stock, and in February, 2001 the Company acquired all of the assets of the custom research group of Yankelovich Partners, Inc., headquartered in Norwalk, Connecticut. RESTRUCTURING AND ASSET IMPAIRMENT CHARGE During the second quarter of fiscal 2002, the Company recorded a restructuring and asset write-down charge of $6.2 million directly related to the operational integration of Harris Interactive and Total Research. Management developed a formal plan that included a 5% reduction in Harris Interactive staff of the full-time workforce in Rochester, NY; New York, NY; Norwalk, CT and a few other outlying locations. The affected employees were mainly support staff with overlapping functions in the combined Company. Other integration actions included the closing of our telephone center located in Youngstown, OH and offices in New York, NY and Chicago, IL, which resulted in asset write- downs and a reserve for lease commitments at these locations. The plan was formally communicated to the affected employees during the second fiscal quarter of 2002. The Company realized approximately $1.1 million in non-cash savings and $1.9 million in cash savings in fiscal 2002. In fiscal 2003 the Company realized non-cash savings of approximately $2.1 million and cash savings of approximately $5.6 million. The following table summarizes activity with respect to the restructuring and asset impairment charge for the period ended June 30, 2003: (IN THOUSANDS) ---------------------------------------------- ASSET LEASE SEVERANCE WRITE-DOWNS COMMITMENTS TOTAL --------- ----------- ----------- ------ Net charge fiscal 2002............................ $1,169 $2,792 $2,261 $6,222 Asset write-offs during fiscal 2002............. 0 (2,792) 0 (2,792) Cash payments during fiscal 2002................ (1,098) 0 (160) (1,258) ------ ------ ------ ------ Remaining reserve at June 30, 2002................ 71 0 2,101 2,172 Cash payments during fiscal 2003................ (71) 0 (954) (1,025) Fiscal 2003 adjustments......................... (997) (997) ------ ------ ------ ------ Remaining reserve at June 30, 2003................ $ 0 $ 0 $ 150 $ 150 ====== ====== ====== ====== As of June 30, 2002, all actions were completed, however cash payments for lease commitments have been, and will continue to be, made on a longer-term basis according to the contractually scheduled payments of such commitments and will continue through 2005. During fiscal 2003, the Company adjusted the reserve for restructuring charges by $997,000 for lease commitments that were no longer required. The adjustments were due to the Company obtaining a release from its obligations under lease obligations previously included in restructuring charges. The total number of employees included in the charge and ultimately terminated was 82. 21 RESULTS OF OPERATIONS The following table sets forth for the periods indicated our results of operations expressed as a percentage of revenue: YEAR ENDED JUNE 30, -------------------- 2003 2002 2001 ---- ---- ---- Revenue from services....................................... 100% 100% 100% Cost of services............................................ 51 53 51 --- --- --- Gross profit................................................ 49 47 49 --- --- --- Operating expenses: Sales and marketing......................................... 7 10 14 General and administrative.................................. 37 47 81 Restructuring (credits) charges and asset write-downs....... (1) 6 -- --- --- --- Operating income (loss)..................................... 6 (16) (46) Interest and other income, net.............................. 1 1 6 --- --- --- Net income (loss) before taxes.............................. 7 (15) (40) --- --- --- Income tax (benefit) expense................................ (2) -- -- --- --- --- Net income (loss)........................................... 9 (15) (40) === === === FISCAL 2003 AS COMPARED TO FISCAL 2002 REVENUE FROM SERVICES. Total fiscal 2003 revenue increased 30%, from $100.0 million in fiscal 2002 to $130.6 million in fiscal 2003. This increase in revenue was primarily driven by the $22.6 million increase in U.S. revenue, or 29%, to $101.1 million for fiscal 2003. The increased U.S. revenue was partially attributable to the incremental revenue generated from the acquisition of Total Research as well as overall growth in several U.S. markets, most prominently healthcare and customer loyalty management. Additionally, excluding the Total Research acquisition, the Company recognized a modest increase in U.S. revenue related to our expanding Internet client base and Internet-based market research services, which contributed $59.3 million in total U.S. Internet-based revenue for fiscal 2003, as compared to $40.6 million for the prior fiscal year. Revenue for the United Kingdom increased from the prior year by $6.6 million, or 40%, to $23.0 million in fiscal 2003. Revenue for Japan increased $1.3 million, or 26%, to $6.5 million in fiscal 2003. The increase in U.K. revenue was primarily attributable to the incremental revenue generated from the acquisition of Total Research in November 2001. Revenue from Japan increased due to the continued benefit we derived from new contracts with selected customers throughout fiscal 2003. GROSS PROFIT. Gross profit was $63.7 million, or 49% of revenue, for fiscal 2003, compared with $46.6 million, or 47% of revenue, for fiscal 2002. The improvement in gross margin percentage resulted primarily from the growth in Internet-related business relative to overall revenue growth. Revenue from Internet-based services was $60.1 million, or 46% of total revenue, in fiscal 2003, compared with $40.6 million, or 41% of revenue, for fiscal 2002. This increase in Internet revenue was due in part to the acquisition of new Internet-based projects as well as the conversion of existing, traditional work to the Internet. Additionally, through increasing the level of Internet related work, the Company has been able to use our existing panel for research in place of more expensive outsourcing and telephone costs. HISB has also played a significant role in the growth of Internet revenue. HISB projects generate higher gross margins due to the fact that they are data collection only and typically do not include as much professional time as customer Internet-based research work. SALES AND MARKETING. Sales and marketing expenses in fiscal 2003 were $9.5 million, or 7% of revenue, compared with $9.7 million, or 10% of revenue, for fiscal 2002. As a percentage of revenue, sales and marketing expenses decreased three percentage points. The decrease is attributable to reductions in headcount and related expenses, reflecting the Company's continuing efforts to reduce costs, as well as productivity improvements from 22 the increased experience level of the Company's sales force with Harris Interactive sales and marketing strategies. The Company has been able to maintain a consistent level of sales and marketing costs as a percentage of sales throughout the fiscal year despite increased fiscal 2003 fourth quarter expenditures for incentive compensation and severance related costs. The severance related costs were associated with reorganizing our U.K. management team and the closing of one of our four U.K. offices. The additional incentive compensation expense resulted from increased full year revenue results as compared to budget that led to increased commissions and bonuses to employees in accordance with the Company's compensation plans. In total annual expenditures in fiscal 2003 continue to support the Company's overall business model established in the prior year. GENERAL AND ADMINISTRATIVE. General and administrative expenses were $47.5 million, or 37% of revenue, in fiscal 2003 compared with $46.7 million, or 47% of revenue, for fiscal 2002. The ten percentage point decrease in such expenses as a percentage of revenue reflects reductions in headcount and related expenses, rent expense and depreciation expense, and reflects the Company's continuing efforts to reduce costs. Depreciation and equipment rental and maintenance expenses decreased by a combined $1.1 million, or 15%, to $6.3 million in fiscal 2003 primarily as a result of the fixed asset write-offs in connection with the Company's fiscal 2002 second quarter restructuring charge which reduced the level of gross fixed assets. The 2002 restructuring plan also reduced fiscal 2003 rent expense by $0.7 million as a result of the closing of three of our telephone centers. As part of its cost savings efforts, the Company has eliminated all but two telephone centers in the United States and the United Kingdom, retaining one in each country primarily to support committed projects with longer-term, predictable needs. The balance of telephone data collection has been migrated to lower cost providers, including some in foreign countries. The cost savings from the prior year restructuring plan were partially offset by increased database development costs related to the establishment of our Western European panel as well as the continued expansion of our U.S. panel, which are expected to continue in fiscal 2004. INTEREST AND OTHER INCOME, NET. Net interest and other income totaled $0.5 million for fiscal 2003 compared with $1.3 million for fiscal 2002. The decrease was primarily attributable to a lower average marketable securities balance and interest rates for fiscal 2003 compared to fiscal 2002. INCOME TAX BENEFIT. The Company recorded an income tax benefit of $3.0 million in fiscal 2003 as compared to a minimal expense in fiscal 2002. For financial reporting purposes, in fiscal 2003 the Company was able to utilize net operating loss carryforwards to apply against current year net income, resulting in substantially no current income tax expense. The recorded benefit in 2003 was as a result of the partial reversal of the valuation allowance on the Company's deferred tax assets. Since the deferred tax assets were substantially comprised of net operating loss carryforwards and it was determined that it is more likely than not that we will utilize additional net operating losses in the near future, as required by GAAP a portion of the valuation allowance was reversed in 2003. Due to operating losses in fiscal 2002 no benefit was recognized in that fiscal year. FISCAL 2002 AS COMPARED TO FISCAL 2001 REVENUE FROM SERVICES. Revenue increased 67% from $60.1 million in fiscal 2001 to $100.0 million in fiscal 2002. The revenue growth was mainly due to the acquisitions of Total Research in November of fiscal 2002, the Yankelovich custom research group in February of fiscal 2001, and Market Research Solutions Limited and M&A Create Limited in August of fiscal 2002. In fiscal 2002, the Company also increased Internet-based revenue to $40.6 million, from $32.6 million in fiscal 2001. Acquiring new Internet-based revenue as well as converting existing, traditional work to the Internet drove this 25% increase. GROSS PROFIT. Gross profit decreased to 47% in fiscal 2002, from 49% in fiscal 2001. The margins declined primarily because a large majority of the revenue derived from acquisitions was generated from traditional research as opposed to Internet-based research. SALES AND MARKETING. Sales and marketing expenses were $9.7 million for fiscal 2002, or 10% of revenue, compared with $8.5 million, or 14% of revenue for fiscal 2001. The absolute dollar increase is primarily attributable to an increase in salaries and related expenses resulting from the acquisition of Total Research and an increase in sales commission expense. The improvement as a percentage of revenue is attributable to the Company's continuing efforts to reduce overall costs. 23 GENERAL AND ADMINISTRATIVE. General and administrative expenses were $46.7 million, or 47% of revenue in fiscal 2002, compared with $48.5 million, or 81% of revenue in fiscal 2001. Similar to sales and marketing expenses, general and administrative expenses excluding database development costs have increased in absolute dollars due to increased personnel and related costs, including rent and depreciation expense, resulting from the acquisition of Total Research. The decrease as a percentage of revenue was directly attributable to continuing cost reduction efforts including the fiscal 2002, second quarter restructuring plan. Internet database development costs declined $7.0 million, or 95%, to $0.4 million in fiscal 2002 from $7.4 million in fiscal 2001. This decrease was primarily due to significant expenditures to build our U.S. database in fiscal 2001, the decreased price to acquire double opt-in names for database replenishment in fiscal 2002, the termination of our panel recruitment agreement with during fiscal 2002, and the elimination of costs associated with The Planet Project Global Poll conducted in November 2000. INTEREST AND OTHER INCOME, NET. Net interest and other income totaled $1.3 million for fiscal 2002, compared with $3.7 million for fiscal 2001. The decrease is primarily attributable to a lower average marketable securities balance for fiscal 2002 as compared to fiscal 2001. SIGNIFICANT FACTORS AFFECTING COMPANY PERFORMANCE In the past, the Company has reported EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), which is a non-GAAP financial measure as defined under SEC Regulation G. The Company has reported EBITDA because management believes that EBITDA, although not a GAAP measurement, is widely understood and is an additional tool that assists investors in evaluating current operating performance of the business without the effect of the non-cash depreciation and amortization expenses. Management internally monitors EBITDA to monitor cash flow unencumbered by non-cash items. While instructive, EBITDA should be considered in addition to, rather than as a substitute for, operating income, net income or cash flows from operations or any other GAAP measure of performance or liquidity. Globally, for fiscal 2003, EBITDA was $13.3 million, or 10% of revenue, compared to the fiscal 2002 and 2001 EBITDA losses of $9.6 million and $21.3 million, or 10% and 35% of revenue, respectively, as reconciled with the most directly comparable financial measure calculated in accordance with GAAP within the following table. YEAR ENDED JUNE 30, ----------------------------- 2003 2002 2001 ------ -------- ------- Net income (loss)....................................... 11,107 (14,793) (24,020) Less: interest and other income, net.................... (506) (1,317) (3,695) Plus: income tax (benefit) expense...................... (2,954) 38 -- Plus: depreciation and amortization..................... 5,676 6,515 6,441 ------ ------- ------- EBITDA.................................................. 13,323 (9,557) (21,274) ------ ------- ------- Net income (loss) as a % of revenue..................... 9% (15%) (40%) ------ ------- ------- EBITDA as a % of revenue................................ 10% (10%) (35%) ====== ======= ======= By comparison, a published index reports average EBITDA as a percentage of revenue of 5.9% for the U.S. market research industry as a whole for the calendar year ended December 31, 2002. The primary factors driving the growth in the Company's gross profit, EBITDA and net income (loss) are growth in revenue and the mix of the revenue derived from Internet versus traditional work. The Company's model is based upon the premise that Internet work is more profitable than traditional work, due to the 24 comparatively low variable data collection cost of Internet work. The model, which the Company believes reasonably represents comparability of traditional and Internet-based projects, is as follows: TRADITIONAL INTERNET-BASED ----------- -------------- Revenue..................................................... 100% 100% Less: Cost of Services (as a % of revenue) Direct Payroll............................................ 25% 30% Variable Data Collection.................................. 40% 5% - 10% --- --------- Variable Gross Profit (as a % of revenue)................... 35% 60% - 65% === ========= In addition to the Variable Data Collection Costs, the Internet-Based model has additional fixed costs associated with the development and maintenance of underlying databases and Internet technology. Such costs decrease Net Income and EBITDA for Internet-based work. In general, however, due to the interplay between the variable and fixed components of cost, the premise is that, as the percentage of Internet work increases, and assuming that project professional service components and pricing are comparable and operating expenses continue to be managed in the ordinary course, Net Income and EBITDA as a percentage of revenue should also increase. Based upon the operation of the model, the Company believes that net operating margins of its business can grow steadily over a period of years with a potential as high as EBITDA in the range of high teens to 20%. Such growth is predicated upon the Company's global mix of Internet-based versus traditional work, continued growth of revenue with the ability to continue to achieve reasonable pricing, controlled growth of operating expenses, and maintenance and continued growth of the respondent database sufficient to support the Company's business at reasonable per-unit costs. The model should be viewed as illustrative and not as an actual measure or predictor of any particular project or the Company's projects as a whole at any given point in time. Regarding the Company's ability to continue to generate revenue, the Company must constantly develop new business, both for growth and to replace non-renewed projects. Although work for no one client constitutes more than 10% of the Company's revenue, the Company has had to, and in the future will likely have to, find significant amounts of replacement and additional revenue as customer relationships and work for continuing customers change. The Company's ability to generate revenue is dependent not only on execution of its business plan but also on general market factors outside of its control. Many of our clients treat all or a portion of their market research expenditures as discretionary. As a result, as economic conditions decline in any of our markets, our ability to generate revenue is adversely impacted. The Company believes that its ability to continue to sustain and grow revenue is significantly affected by client satisfaction with completed work, and that improved client satisfaction ratings have had and will continue to have a positive impact on the growth of the Company's business. We have instituted what we believe are among the most comprehensive systems to measure client satisfaction in our industry. We use information provided by our clients to improve the quality of our products, services, and relationships, and therefore to improve future satisfaction levels. As the Company matured in the conversion of its business model to the Internet, we have been able to improve client satisfaction scores to over 9.0 out of 10.0, among the top in our industry. We believe that such improvements have had a direct result in greater customer loyalty and an increased rate of customer acceptance of our proposals. Regarding the mix of work, for fiscal 2003, the Company's actual Internet mix was 46% on a global basis and 59% in the United States alone. The Company considers all of the revenue from a project to be Internet-based whenever 50% or more of the surveys were completed over the Internet. Although the Company continues to work to convert projects to the Internet in the United States, the primary new growth opportunity is in Europe, where the ability to change the Internet mix is dependent upon the Company's success in expanding the size of its respondent panel and increase customer acceptance of Internet-based work. The globalization of the Internet portion of the Company's business has commenced and we believe that it is expected to ramp up over the next several years. The Company's global database of more than 4 million Internet survey respondents continues to be a critical component of its success. The Company believes that its multi-million participant U.S. database, to which it is 25 adding between 3,500 and 4,000 names per day on average, continues to be adequate to service its Internet-based business. In fiscal 2003, the Company launched an initiative to build a European database as well. To that end, it has entered into name acquisition agreements with a major Internet portal and others. Names are being added regularly to the European database, which included approximately 350,000 names as of July 2003, and the Company is now conducting Internet-based projects in Europe. The Company intends to continue to expand the European panel in fiscal 2004 and beyond in order to support growth of Internet-based research in Europe and is currently adding more than 1,000 names per day. Additionally, in both the U.S. and in Europe, the Company intends to continue efforts to enhance existing and build new specialty panels. For example, it has entered into joint development activities with IMS Health, Inc. to build physician specialty panels. The amount of the Company's investments in names for its databases will continue to vary, particularly quarter by quarter, based upon factors such as panel availability, opportunities that arise for acquisition or development of panels in specialty or under-represented groups, and attrition. Internet databases by their nature experience participant attrition. There are no standard measurement systems for such attrition, particularly in the Internet survey response field. Measurement involves complex variables. For example, determining attrition, by lack of response from a panelist for a set length of time since last contact, is not necessarily reflective of expected long-term attrition. The panelist may not have had an interest in responding regarding particular survey topics offered over a period of time but may, after an absence, respond to a later survey covering a topic of particular interest to the respondent. Thus, percentage rates of attrition may not be comparable or meaningful within the industry. When the Company first developed its Internet model, it expected attrition of panel members to be in the range of 20% annually. With the Company's increased expertise gained from several years of investment in panel management techniques, it monitors panel fatigue and attrition in multiple ways. Its overall attrition rates by most measures, however, are significantly less than originally anticipated. LIQUIDITY AND CAPITAL RESOURCES Prior to fiscal 2003 we financed our operations primarily through the $85.5 million of net proceeds generated from our December 1999 initial public offering. Consequently, cash and cash equivalents and marketable securities were $42.5 million at June 30, 2001, and $27.9 million at June 30, 2002. In fiscal 2003 the Company generated positive cash flows for the first time in recent years and as a result our cash and cash equivalents and marketable securities were $39.1 at June 30, 2003. Net cash provided by operating activities was $11.9 million for fiscal 2003 as compared to net cash used in operating activities of $5.5 million and $15.5 million for fiscal 2002 and 2001, respectively. The positive cash flow in fiscal 2003 was primarily as a result of the Company generating net income in fiscal 2003 as compared to the funding of net losses in fiscal 2002 and 2001. Net cash used in investing activities was $3.9 million in fiscal 2003 as compared with net cash provided by investing activities of $8.0 million and $2.1 million for fiscal 2002 and fiscal 2001, respectively. During fiscal 2003 the Company's investing activities included the net purchase of additional marketable securities of approximately $1.9 million as well as capital expenditures of $2.2 million. During fiscal 2002, net proceeds from sales and maturities of marketable securities of $14.6 million were partially offset by capital expenditures of $2.8 million and the $3.8 million cash outflow for transaction related costs to acquire Total Research in November 2001. During fiscal 2001, net proceeds from sales and maturities of marketable securities of $17.9 million were partially offset by capital expenditures of $7.6 million and the $8.2 million cash outflow to purchase the custom research division of Yankelovich Partners, Inc. in February 2001. Fiscal 2003, 2002 and 2001 capital expenditures primarily supported the development of our Internet infrastructure in the U.S. In fiscal 2003 the Company had net cash provided by financing activities of $1.8 million. The Company received cash of $4.1 million in fiscal 2003 as a result of issuances of common stock and stock option exercises; this was offset by the repayment of $2.3 million in short and long term borrowings. Net cash used in financing activities of $1.7 million in fiscal 2002 was primarily related to the repayment of long-term debt of $2.3 million and the repurchase of 422,900 shares of common stock for $0.9 million, these cash outflows were partially offset by $1.7 million provided by the issuance of common stock and stock option exercises. Net cash provided by 26 financing activities was $0.1 million in fiscal 2001, resulting from issuances of common stock and stock options of $0.9 million, offset by the repurchase of common stock of $0.8 million. Our capital requirements depend on numerous factors, including market acceptance of our services, the resources we allocate to the continuing development of our Internet infrastructure and Internet panel, marketing and selling of our services, our promotional activities, our acquisition activities and other factors. Management anticipates continuing expenditures for property, plant and equipment and working capital requirements throughout fiscal 2004 at levels consistent with fiscal 2003. As of June 30, 2003 the Company had no short-term or long-term borrowings. At June 30, 2002, the Company had short-term and long-term borrowings of $0.8 million and $1.5 million, respectively, limited to operations in the United Kingdom and Japan. Interest rates related to the borrowings ranged from 1.8% to 3.0%. There were no restrictive covenants associated with these borrowings. In fiscal 2003 and 2002, the Company had, and continues to maintain, a line of credit with a commercial bank providing borrowing availability up to $5.0 million, at the prime interest rate. The prime rate in effect at June 30, 2003 was 4.0%. Borrowings under this arrangement are due upon demand. There were no borrowings under this agreement at June 30, 2003 and June 30, 2002. The line of credit is collateralized by the assets of the Company. Based on current plans and business conditions, we believe that our existing cash, cash equivalents and short-term investments will be sufficient to satisfy our anticipated cash requirements to support the Company's planned operations for the foreseeable future. We cannot be certain, however, that our underlying assumed levels of revenue and expenses will be accurate. If our operating results were to fail to meet our expectations, or if accounts receivable or other assets were to require a greater use of cash than is currently anticipated, we could be required to seek additional funding through public or private financing or other arrangements. In such event, adequate funds may not be available when needed or may not be available on favorable terms, which could have a negative effect on our business and results of operations. CONTRACTUAL CASH OBLIGATIONS (IN THOUSANDS) The Company's consolidated contractual cash obligations and other commercial commitments as of June 30, 2003 are as follows: PAYMENTS DUE BY PERIOD ----------------------------------------------- LESS THAN 1-3 3-5 AFTER TOTAL 1 YEAR YEARS YEARS 5 YEARS ------- --------- ------ ------ ------- CONTRACTUAL OBLIGATIONS -------------------------- Long-term debt.................................. $ -- $ -- $ -- $ -- $ -- Capital lease obligations....................... -- -- -- -- -- Operating leases................................ 18,031 4,857 6,901 3,581 2,692 Purchase obligations............................ 2,767 1,237 1,530 -- -- Other long-term obligations..................... -- -- -- -- -- ------- ------ ------ ------ ------ Total contractual cash obligations.............. $20,798 $6,094 $8,431 $3,581 $2,692 ======= ====== ====== ====== ====== AMOUNT OF COMMITMENT EXPIRATION PER PERIOD ---------------------------------------------- LESS THAN 1-3 3-5 AFTER TOTAL 1 YEAR YEARS YEARS 5 YEARS ------ --------- ------ ------ ------- Lines of credit (1).............................. $5,000 $ -- $ -- $ -- $ -- Standby letters of credit........................ -- -- -- -- -- ------ ------ ------ ------ ------ Total commercial commitments..................... $5,000 -- -- -- $ -- ====== ====== ====== ====== ====== --------------- (1) The Company's line of credit is payable upon demand under the terms of its agreement. There were no borrowings outstanding under the line of credit at June 30, 2003. 27 NEW ACCOUNTING PRONOUNCEMENTS SFAS 145 In May 2002, the Financial Accounting Standards Board issued SFAS No. 145, "Rescission of FASB Statements 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections". SFAS No. 145 eliminates the requirement that gains and losses from the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. However, an entity is not prohibited from classifying such gains and losses as extraordinary items, so long as they meet the criteria outlined in Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations -- Reporting the Effects of Disposal Occurring Events and Transactions. SFAS No. 145 also eliminates the inconsistency between the accounting for sale-leaseback transactions and certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This statement is effective for financial statements issued for fiscal years beginning after May 15, 2002, with early adoption encouraged. The Company adopted SFAS No. 145 on July 1, 2002. The adoption did not have an impact on the Company's consolidated financial statements. SFAS 146 In July 2002, the Financial Accounting Standards Board issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. Previous accounting guidance was provided by Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 replaces EITF Issue No. 94-3. This standard is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company adopted SFAS No. 146 on January 1, 2003. This adoption did not have an impact on the Company's consolidated financial statements. SFAS 148 In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company is required to follow the prescribed format and provide the additional disclosures required by SFAS No. 148 in its annual financial statements for the year ending June 30, 2003 and is also required to provide the disclosures in its quarterly reports containing condensed financial statements for interim periods beginning with the quarterly period ended March 31, 2003. The Company adopted SFAS 148 on January 1, 2003 and elects to continue to account for its stock based compensation plans under the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees" as are described in Note 14 of the audited Consolidated Financial Statements included in this Form 10-K. The adoption did not have an impact on the Company's consolidated financial statements. SFAS 149 In April 2003, the Financial Accounting Standards Board issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and hedging relationships designated after June 30, 2003, except for those provisions of SFAS No. 149 which relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003. The Company 28 does not expect the adoption of SFAS 149 to have a material impact on the Company's consolidated financial statements. SFAS 150 In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or as an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and is otherwise effective for the Company beginning July 1, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material impact on the Company's consolidated financial statements. FIN 45 In November 2002, the FASB published Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 requires that a guarantor recognize a liability for the fair value of an obligation assumed under a guarantee and also discusses additional disclosures to be made in the interim and annual financial statements of the guarantor regarding obligations under certain guarantees. The initial measurement and recognition requirements of FIN 45 are effective prospectively for guarantees issued or modified after December 31, 2002. The Company adopted FIN 45 on January 1, 2003. The adoption did not have a material impact on the Company's consolidated financial statements. FIN 46 In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities." This standard clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," and addresses consolidation by business enterprises of variable interest entities (more commonly known as Special Purpose Entities or SPE's). FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. FIN No. 46 also enhances the disclosure requirements related to variable interest entities. This statement is effective for variable interest entities created or in which an enterprise obtains an interest after January 31, 2003. The Company adopted FIN 46 on July 1, 2003. The adoption did not have a material impact on the Company's consolidated financial statements. RISK FACTORS THE MARKET RESEARCH INDUSTRY IS VULNERABLE TO GENERAL ECONOMIC CONDITIONS. Many of our clients treat all or a portion of their market research expenditures as discretionary. As general economic conditions decline and our customers seek to control variable costs, projects to be performed by the Company may be delayed or cancelled, and new project bookings may slow. As a result, the growth and earnings of the Company may be adversely impacted. OUR GROWTH WILL BE ADVERSELY AFFECTED IF THE MARKETPLACE DOES NOT CONTINUE TO CONVERT TO INTERNET-BASED MARKET RESEARCH AND POLLING. The ongoing success of our business will depend on our ability to continually develop and market Internet-based products and services that achieve broad market acceptance. Our clients must continue to accept the Internet as an attractive replacement for traditional market research methodologies, such as direct mail, telephone-based surveys, mall intercepts, focus groups and in-person interviews. Since the beginning of fiscal 1998, we have spent $67.1 million and significant management resources to develop and grow our Internet-based market research and polling business. Some of our clients have expressed concern that Internet users do not yet accurately reflect their applicable population, and that any information 29 collected via the Internet will be inherently biased. If our current and potential clients do not continue to accept our Internet-based methodologies as reliable and unbiased, our revenues may not meet expectations or may decline, and our business, financial condition and results of operations would likely suffer. WE FACE INTENSE COMPETITIVE PRESSURES AND UNCERTAINTIES WITHIN THE MARKET RESEARCH AND POLLING INDUSTRY. The market research and polling industry is highly fragmented and includes competitors much larger than we are. As competitors increase their ability to offer alternative products in the market, we may come under increasing pressures in selling and pricing our products and services. No one customer accounts for more than 5% of our revenues and most of our revenues are derived on a project by project basis. We must continuously replace completed work with new projects in order to sustain and grow our revenues. The market research industry tends to be adversely affected by slow or depressed business conditions in the market as a whole. We are at risk of decreased market research budgets as our customers respond to difficult economic conditions, as well as to delays in projects both committed and uncommitted. IF WE ARE UNABLE TO MAINTAIN ADEQUATE SIZE AND DEMOGRAPHIC COMPOSITION OF OUR GLOBAL INTERNET PANEL, OR IF WE ARE REQUIRED TO SPEND SUBSTANTIAL FUNDS TO DO SO, OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS WILL SUFFER. Our success is highly dependent on our ability to obtain and retain an adequate number of worldwide panelists in our Internet panel and its specialty-panels. Our ability to maintain an adequate online panel or increase Internet revenues may be harmed if: - a significant number of our current online panelists decide that they are no longer willing to participate in our surveys, - we lose a large number of online panelists from over-use, and then must rely on a limited number of online panelists for ongoing research, - we are unable to attract an adequate number of replacement panelists and specialty panel members, or - new regulatory requirements related to Internet "spam" make it impractical for us to continue operations as currently conducted. If the number of our active survey respondents significantly decreases, or the demographic composition of our Internet panel narrows, our ability to provide our clients with accurate and statistically projectable information would likely suffer. This risk is likely to increase as our business expands. For example, our Internet panel is surveyed for our own studies as well as for studies conducted for other market research firms by our Harris Interactive Service Bureau. Our business will be unable to grow and will suffer if we have an insufficient number of panelists to respond to our surveys, or if our panel becomes unreliable due to reduced size, or because it is not representative of the general population. Our online panelists are not obligated to participate in our surveys and polls and there can be no assurance that they will continue to do so. We believe that our HIpoints(SM), HIstakes(SM) and instant results programs currently provide adequate incentives to encourage participation in our surveys and to maintain the size of our Internet panel. These programs may lose their effectiveness in the future, resulting in a reduction in size of the panel. IF WE ARE UNABLE TO ACHIEVE THE ANTICIPATED GLOBAL GROWTH OF OUR INTERNET PANEL, OR IF WE ARE UNABLE TO OVERCOME OTHER RISKS ASSOCIATED WITH GLOBAL OPERATIONS, WE WILL BE UNABLE TO CONDUCT BUSINESS ON A GLOBAL LEVEL. Key components of our strategy are extension of our Internet-based market research and polling products and services to clients globally, expansion of our Internet panel to include global online panelists and development of strategic alliances globally. The following risks are inherent in doing business on a global level: - inability to attract a critical mass of panel members in key countries and regions, particularly in Europe, - export controls relating to encryption technology, - inability to comply with or enactment of more restrictive privacy laws, 30 - changes in regulatory requirements, - currency exchange fluctuations, - problems in collecting accounts receivable and longer collection periods, - potentially adverse tax consequences, - political instability, - Internet access restrictions, and - anti-American sentiment or terrorist activity against American interests abroad. We have little or no control over these risks. We have encountered more restrictive privacy laws in connection with our business operations in Europe, which have inhibited our ability to develop our European Internet panel. We have also experienced currency exchange fluctuations, the impact of which has not been material. As we increase our global operations in the future, we may experience some or all of these risks, which may have a material adverse effect on our business, financial condition and results of operations. IF WE DO NOT CONTINUE TO KEEP PACE WITH RAPID TECHNOLOGICAL CHANGE WITHIN THE MARKET RESEARCH AND POLLING INDUSTRY, WE WILL NOT BE ABLE TO SUCCESSFULLY IMPLEMENT OUR BUSINESS PLAN. The markets for our products and services are highly competitive. Our current competitors also offer Internet-based and traditional market research and polling services. We expect to face future competition from other organizations that develop Internet-related products and services. These companies may, either alone or in alliances with other firms, penetrate the Internet-based market research and polling market. Our ongoing success will depend on our continued ability to improve the performance features and reliability of our products and services. We may experience difficulties that could delay or prevent the successful development, introduction or marketing of new products and services. We could also incur substantial costs if we need to modify our services or infrastructure to adapt to these changes. ANY FAILURE IN THE PERFORMANCE OF OUR INTERNET-BASED TECHNOLOGY INFRASTRUCTURE COULD HARM OUR BUSINESS. Any system failure, including network, software or hardware failure, that causes an interruption in our ability to communicate with our Internet panel, collect research data, or protect visual materials included in our surveys, could result in reduced revenue, and could impair our reputation. Our systems and operations are vulnerable to damage or interruption from fire, earthquake, flooding, power loss, telecommunications failure, break-ins and similar events. One supplier of our secure off-site Web hosting facilities currently maintains approximately one-third of our servers at one facility, and while we have redundancy in our systems we depend upon the supplier and others to protect our systems and operations from the events described above. We have experienced technical difficulties and downtime of individual components of our computer system in the past and believe that technical difficulties and downtime may occur from time to time in the future. Although technical difficulties and downtime have had minimal impact on our operations during the past fiscal year, their impact may be more severe in the future. We have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for any losses that may occur due to failures in our systems. In addition, our servers and software must be able to accommodate a high volume of traffic. Any increase in demands on our servers beyond that which we currently anticipate, will require us to fund the expansion and modification of our network infrastructure. If we were unable to add additional software and hardware to accommodate increased demand, unanticipated system disruptions and slower data collection would likely result. Our Internet panel members communicate with us using various Internet service providers. These providers have experienced significant outages in the past, and could experience outages, delays and other difficulties unrelated to our systems in the future. Major components of the Internet backbone itself could fail due to terrorist attack, war or natural disaster. 31 While the impact of these outages in the past has been minimal, any future system delays or failures in the Internet could adversely affect our access to our online panelists, which could have a material adverse effect on our business, financial condition and results of operations. SUSTAINING OUR GROWTH MAY STRAIN OUR MANAGERIAL AND SYSTEMS RESOURCES. We have grown rapidly and need to continue to grow in all areas of our operations. Managing and sustaining our growth will place significant demands on management as well as on our administrative, operational, technical and financial systems and controls. If we are unable to manage our growth effectively, we will not be able to successfully implement our business plan at projected levels. WE MUST CONTINUE TO ATTRACT AND RETAIN HIGHLY SKILLED EMPLOYEES. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly skilled technical, managerial, marketing, sales and client support personnel. Competition for these personnel exists, and we may be unable to attract, integrate or retain the proper numbers of sufficiently qualified personnel that our business plan assumes. We have experienced in the past, and we may experience in the future, difficulty in hiring and retaining employees with appropriate qualifications. In the past, competition for highly skilled employees has resulted in additional costs for recruitment, compensation and relocation or the provision of remote access to our facilities. To the extent that we are unable to hire and retain skilled employees in the future, our business, financial condition and results of operations would likely suffer. THE LOSS OF THE SERVICES OF ONE OR MORE OF OUR KEY PERSONNEL COULD DISRUPT OUR OPERATIONS AND RESULT IN LOSS OF REVENUES. Our future success depends to a significant extent on the continued services of our key technical and senior management personnel. The loss of the services of any of these persons could seriously harm our business. Although some of our key employees have signed non-competitive agreements, only a few of our employees are currently bound by an employment agreement. All of our other relationships with our officers and key employees are at will. We do not have "key person" life insurance policies covering any of our employees other than Gordon S. Black. OUR SUCCESSION PLANS MAY NOT BE SUCCESSFULLY EXECUTED. We have started our search to identify potential candidates for Chief Executive Officer. The hiring of a new CEO would allow Gordon S. Black, the current CEO, to move to a position as Executive Chairman and more fully concentrate on corporate strategy, major account marketing, international expansion. investor relations, and acquisition. If the succession plans for the CEO and other senior executives are not successfully executed, and appropriate replacement(s) cannot be hired, the senior management may be overtaxed and unable to properly execute all of their duties. OUR BUSINESS IS LARGELY DEPENDENT ON THE CONTINUED DEVELOPMENT AND WORLDWIDE GROWTH OF THE INTERNET. THE INTERNET MAY NOT GROW, OR MAY BE UNABLE TO SUPPORT THE DEMANDS PLACED ON IT BY THIS GROWTH. If worldwide Internet usage does not continue to grow, we may be unable to attract International online panelists to our Internet panel or clients for our Internet-based market research and polling products and services. If Internet usage does continue to grow, the Internet infrastructure may be unable to support the demands placed on it by this growth and its performance and reliability may decline. Varying factors could inhibit future growth or the ability of the Internet infrastructure to adequately support the growth in Internet usage, including: - inadequate network infrastructure, - security concerns, - inconsistent quality of service, and - unavailability of cost effective, high speed service. 32 Our Internet panel depends on Internet service providers, online service providers and other website operators for access to the Internet and our websites. Many websites have experienced interruptions in their service as a result of outages and other delays occurring throughout the Internet network infrastructure. If worldwide Internet usage declines, or grows at a significantly slower rate than projected, our ability to maintain our current Internet panel, expand our global Internet panel and gather research data and information around the world will decrease, which would likely harm our business financial condition and results of operations. A BREACH OF OUR INTERNET SECURITY MEASURES OR SECURITY CONCERNS COULD ADVERSELY AFFECT OUR BUSINESS. Internet security concerns could cause some online panelists to reduce their participation levels, provide inaccurate responses or end their membership in our Internet panel. This could harm our credibility with our current clients. If our clients become dissatisfied, they may stop using our products and services. In addition, dissatisfied and lost clients could damage our reputation. A loss of online panelists or a loss of clients would hurt our efforts to generate increased revenues. A failure in our security measures could result in the misappropriation of private data. As a result, we may be required to expend capital and other resources to protect against the threat of such security breaches or to alleviate problems caused by such breaches, which could have a material adverse effect on our business, financial condition and results of operations. FAILURE OR INABILITY TO PROTECT OUR INTELLECTUAL PROPERTY COULD ADVERSELY AFFECT OUR BUSINESS. Our success and ability to compete depends substantially on our internally developed technologies and trademarks, which we protect through a combination of patent, copyright, trade secret and trademark laws. We have registered a number of our trademarks, including Harris Interactive and The Harris Poll. If we were prevented from using The Harris Poll name, our brand recognition and business would likely suffer. We would have to make substantial financial expenditures to promote and rebuild our brand identity. Currently, we have pending trademark applications for a number of our products and services. We also have patent applications currently pending for our CONCEPTLOC encryption system and our system and method for conducting product configuration research over a computer-based network. In addition, we may apply for additional trademarks or patents in the future. Our patent or trademark applications may not be approved, or if approved, our patents or trademarks may be successfully challenged by others or invalidated. We cannot guarantee that infringement or other claims will not be asserted or prosecuted against us in the future, whether resulting from our internally developed intellectual property or licenses or content from third parties. Any future assertions or prosecutions could be time-consuming, result in costly litigation and diversion of technical and management personnel or require us to pay money damages, introduce new trademarks, develop non-infringing technology, or enter into royalty or licensing agreements. Any of those events could substantially increase our operating expenses and potentially reduce our expected revenues. We generally enter into confidentiality or license agreements with parties with whom we do business, and generally control access to, and distribution of, our technologies, documentation and other proprietary information. Despite our efforts to protect our proprietary rights from unauthorized use or disclosure, parties may attempt to disclose, obtain or use our technologies. The steps we have taken may not prevent misappropriation of our technologies, particularly in foreign countries where laws or law enforcement practices may not protect our proprietary rights as fully as in the United States. We also rely on off-the-shelf technologies that we license from third parties. "Off-the-shelf" technology refers to generally commercially available software that is not customized for a particular user. These third party licenses may not continue to be available to us on commercially reasonable terms or at all. The inability to use licensed technology important to our business could require us to obtain substitute technology of lower quality or performance standards or at a greater cost. In the future, we may seek to license additional technology to enhance our current technology infrastructure. We cannot be certain that any such licenses will be available on commercially reasonable terms or at all. The loss of any of these technology licenses could result in delays in providing our products and services until equivalent technology, if available, is identified, licensed and integrated. 33 WE MAY BE SUBJECT TO LIABILITY FOR PUBLISHING OR DISTRIBUTING CONTENT OVER THE INTERNET. We may be subject to claims relating to content that is published on or downloaded from our websites. We also could be subject to liability for content that is accessible from our website through links to other websites. We may be accused of sending bulk unsolicited email, and have our email blocked by many ISPs and therefore be unable to conduct online data collection. Although we carry general liability insurance, our insurance may not cover potential claims of this type, such as defamation or trademark infringement, or may not be adequate to cover all costs incurred in defense of potential claims or to indemnify us for all liability that may be imposed. In addition, any claims of this type, with or without merit, would result in the diversion of our financial resources and management personnel. LIABILITY ARISING FROM THE USE OF THE PERSONAL INFORMATION OF OUR INTERNET PANEL COULD BE COSTLY. We could be subject to liability claims by our online panelists for any misuse of personal information. These claims could result in costly litigation. In addition, the Federal Trade Commission and other domestic and international agencies have been investigating various Internet companies regarding their use of personal information. We could incur additional costs and expenses if new regulations regarding the use of personal information are introduced or if our privacy practices are investigated. CHANGES IN GOVERNMENT REGULATION OR INDUSTRY PRACTICES COULD LIMIT OUR INTERNET ACTIVITIES OR RESULT IN ADDITIONAL COSTS OF DOING BUSINESS ON THE INTERNET. Any new laws pertaining to the imposition of taxes on Internet access and electronic commerce could adversely affect our business. In February 1999, the Federal Communications Commission issued a declaratory ruling interpreting the Telecommunications Act of 1996 to allow local exchange carriers to receive reciprocal compensation for traffic delivered to information service providers, particularly Internet service providers, on the basis that traffic bound for Internet service providers is largely interstate. As a result of this ruling, the costs of transmitting data over the Internet may increase and our business could suffer. As of July 2003, at least 37 U.S. state legislatures had enacted laws regulating the distribution of unsolicited email. In April 2003, The Controlling the Assault of Non-Solicited Pornography and Marketing Act of 2003 (CAN-SPAM) was introduced in the U.S. senate. This bill would require unsolicited e-mail marketing messages have a valid return address. E-mail marketers would be required to remove customers from their mailing lists if requested. The bill also give more legal ammunition for ISPs to take spammers to court, allows the Federal Trade Commission (FTC) to impose fines, and gives state attorneys general the power to bring lawsuit. Any future legislation or regulations or the application of existing laws and regulations to the Internet could limit our effectiveness in conducting Internet-based market research and polling, and increase our operating expenses. In addition, the application of existing laws to the Internet could expose us to substantial liability for which we might not be indemnified by content providers or other third parties. Existing laws and regulations currently address, and new laws and regulations and industry self-regulatory initiatives are likely to address, a variety of issues, including the following: - email distribution, - user privacy and expression, - the rights and safety of children, - intellectual property, - information security, - anti-competitive practices, - the convergence of traditional channels with Internet commerce, - taxation and pricing, and 34 - the characteristics and quality of products and services. Those laws that do reference the Internet have limited interpretation by the courts and their applicability and scope are not well defined, particularly on an International basis. Any new laws or regulations relating to the Internet could adversely affect our business. Industry standards related to the Internet are still evolving. Moreover, some private entities have proposed their own standards for communications with, and use of information related to, individuals who use the Internet. Internet service providers also have the ability to disrupt our communications with our panel. Although we believe that we maintain the highest standards for the recruitment of members into our database, communications with our panelists and use of information provided by our respondents, some service providers and/or self appointed industry regulators may not agree. As a result, our communications with our panelists may be disrupted from time to time. WE HAVE INCURRED LOSSES IN RECENT YEARS AND MAY INCUR THEM AGAIN. We incurred net losses of $14.8 million in fiscal 2002, $24.0 million in fiscal 2001 and $20.9 million in fiscal 2000. We base current and future expense levels on our operating plans, which are based on our estimates of future revenues. While we have been profitable for fiscal 2003, if our revenues grow at a slower rate than we anticipate, or if our spending levels exceed our expectations or cannot be adjusted to reflect slower revenue growth, we may not be able to maintain profitability. Even if we remain profitable in the future, we may be unable to maintain current profitability growth on an ongoing basis. VARIATIONS IN OUR OPERATING RESULTS MAY CAUSE OUR STOCK PRICE TO DECLINE. Our quarterly operating results have in the past, and may in the future, fluctuate significantly. Our future results of operations may fall below the expectations of public market analysts and investors. If this happens, the price of our common stock would likely decline. Factors that are outside of our control, and that have caused our results to fluctuate in the past or that may affect us in the future, include: - declines in general economic conditions or the budgets of our clients, - a general decline in the demand for market research and polling products and services, - seasonal decreases in demand for market research and polling services, - development of equal or superior products and services by our competitors, - technical difficulties that cause general and long-term failure of the Internet, and - currency fluctuations. Factors that are partially within our control, and that have caused our results to fluctuate in the past or that may affect us in the future, include: - our relative mix of Internet-based and traditional market research and polling businesses, - technical difficulties that negatively affect our operations, - our ability to maintain the proper critical mass and scope of our Internet panel necessary to develop and sell new products and services and generate expected revenues, - our ability to recruit respondents into our sub-panels, such as our IT Decision Makers, to conduct high-value research for our clients, and - development of new, marketable products and services The factors listed above may affect both our quarter-to-quarter operating results as well as our long-term success. You should not rely on quarter-to-quarter comparisons of our results of operations or any other trend in our performance as an indication of our future results. 35 THE PRICE OF OUR COMMON STOCK IS LIKELY TO BE VOLATILE AND SUBJECT TO WIDE FLUCTUATIONS. The market prices of the securities of Internet-related companies have been especially volatile and these securities may be overvalued. The market price of our common stock is likely to be subject to wide fluctuations. If financial operating results do not improve or improve at a slower rate than we anticipate, or if operating or capital expenditures exceed our expectations and cannot be adjusted accordingly, or if some other event adversely affects us, the market price of our common stock would likely decline. In addition, if the market for Internet-related stocks or the stock market in general experiences an additional loss in investor confidence or declines again, the market price of our common stock could fall for reasons unrelated to our business, financial condition and results of operations. Investors might be unable to resell their shares of our common stock at or above the purchase price. In the past, companies that have experienced volatility in the market price of their stock have been the subjects of securities class action litigation. If we were to become the subject of securities class action litigation, it could result in substantial costs and a diversion of management's attention and resources. ANTI-TAKEOVER PROVISIONS IN OUR CHARTER COULD DELAY OR PREVENT AN ACQUISITION OF THE COMPANY. Our restated certificate of incorporation provides for the division of our board of directors into three classes and provides our board of directors with the power to issue shares of preferred stock without stockholder approval. This preferred stock could have voting rights, including voting rights that could be superior to that of our common stock, and the board of directors has the power to determine these voting rights. In addition, Section 203 of the Delaware General Corporation Law contains provisions that impose restrictions on stockholder action to acquire our company. The effect of these provisions of our certificate of incorporation and Delaware law provisions could discourage or prevent third parties from seeking to obtain control of us, including transactions in which the holders of common stock might receive a premium for their shares over prevailing market prices. POTENTIAL ACQUISITIONS OF, OR INVESTMENTS IN, OTHER COMPANIES MAY NOT BE AVAILABLE AND/OR HAVE A NEGATIVE IMPACT ON OUR BUSINESS. As part of our continued strategy to increase revenue, expand our Internet panel, acquire additional intellectual capital and add to our portfolio of existing products and services, we may acquire or make investments in complementary businesses, services, products or technologies. We may be unable to identify suitable acquisition candidates or acquire them at reasonable prices and/or on reasonable terms. Some material risks of acquisitions are: - difficulties in the integration and assimilation of the operations, technologies, products and personnel of the acquired business, - the diversion of management's attention from other business concerns, - the availability of favorable acquisition financing, and - the potential loss of key employees and/or customers of any acquired business. Acquisitions may require the use of significant amounts of cash, resulting in the inability to use those funds for other business purposes. Acquisitions using our capital stock could have a dilutive effect, and could adversely affect the market price of our common stock. Amortization of intangible assets would reduce our earnings, which in turn could negatively influence the price of our common stock. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses. 36 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has international sales and facilities in the United Kingdom and Japan and therefore, is subject to foreign currency rate exposure. Non-U.S. sales are denominated in the functional currencies of the country in which our foreign subsidiaries reside. Total consolidated assets and liabilities of the Company are translated into U.S. dollars at the exchange rates in effect as of the balance sheet date. Income and expense items are translated at the average exchange rate for each period presented. Accumulated net translation adjustments are recorded in stockholders' equity. Foreign exchange transaction gains and losses are included in the Company's results of operations, and were not material for the periods presented. As a result of operating in foreign markets, the Company's financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions. To the extent the Company incurs expenses that are based on locally denominated sales volumes paid in local currency, the exposure to foreign exchange risk is reduced. The Company has determined that the impact of a near-term 10% appreciation or depreciation of the U.S. dollar would have an insignificant effect on our financial position, results of operations and cash flows. We have historically had very low exposure to changes in foreign currency exchange rates. While the United Kingdom now contributes significantly to our revenues, we continue to believe our exposure to foreign currency fluctuation risk is low. Therefore the Company has not entered into any derivative financial instruments to mitigate the exposure to translation and transaction risk. However, this does not preclude the Company's adoption of specific hedging strategies in the future. As we continue to expand globally, the risk of foreign currency exchange rate fluctuation may increase. Therefore, in the future, we will continue to assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis to mitigate such risks. The carrying values of financial instruments including cash and cash equivalents, marketable securities, accounts receivable and accounts payable, approximate fair value because of the short maturity of these instruments. 37 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Auditors.............................. 39 Consolidated Balance Sheets at June 30, 2003 and 2002....... 40 Consolidated Statements of Operations for the years ended June 30, 2003, 2002 and 2001.............................. 41 Consolidated Statements of Cash Flows for the years ended June 30, 2003, 2002 and 2001.............................. 42 Consolidated Statements of Stockholders' Equity for the years ended June 30, 2003, 2002 and 2001.................. 43 Notes to Consolidated Financial Statements (including unaudited quarterly results of operations)................ 44 Index to Financial Statement Schedules Schedule II -- Valuation and Qualifying Accounts............ 67 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 38 REPORT OF INDEPENDENT AUDITORS TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF HARRIS INTERACTIVE INC. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, stockholders' equity and cash flows present fairly, in all material respects, the financial position of Harris Interactive Inc. (the "Company") and its subsidiaries at June 30, 2003 and June 30, 2002, and the results of their operations and their cash flows for each of the three fiscal years in the period ended June 30, 2003, in conformity with accounting principles generally accepted in the United States of America. 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 of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in the Notes to the Consolidated Financial Statements, the Company adopted Statement of Financial Accounting Standards No. 141, "Business Combinations" and No. 142, "Goodwill and Other Intangible Assets", on July 1, 2001. /S/ PricewaterhouseCoopers LLP Rochester, New York July 25, 2003 39 HARRIS INTERACTIVE INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) JUNE 30, JUNE 30, 2003 2002 -------- -------- ASSETS Current assets: Cash and cash equivalents................................. $ 20,391 $ 10,787 Marketable securities..................................... 18,693 17,070 Accounts receivable, less allowances of $325 and $474, respectively........................................... 20,821 20,791 Costs and estimated earnings in excess of billings on uncompleted contracts.................................. 3,776 4,669 Other current assets...................................... 3,690 4,808 Deferred tax assets....................................... 127 -- -------- -------- Total current assets................................... 67,498 58,125 Property, plant and equipment, net........................ 7,806 9,703 Goodwill.................................................. 63,259 63,428 Other intangibles, less accumulated amortization of $720 and $408, respectively................................. 730 1,042 Other assets.............................................. 2,045 2,350 Deferred tax assets....................................... 3,904 815 -------- -------- Total assets........................................... $145,242 $135,463 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current installment of long-term debt..................... $ -- $ 1,193 Accounts payable.......................................... 6,752 7,417 Accrued expenses.......................................... 9,050 11,081 Short-term borrowings..................................... -- 811 Billings in excess of costs and estimated earnings on uncompleted contracts.................................. 10,375 9,824 -------- -------- Total current liabilities.............................. 26,177 30,326 Long-term debt, excluding current installment............... -- 314 Other long-term liabilities................................. 576 1,523 Stockholders' equity: Common stock, $.001 par value, 100,000,000 shares authorized; 54,500,713 shares issued at June 30, 2003 and 53,020,087 shares issued at June 30, 2002.......... 55 53 Additional paid in capital................................ 179,108 177,014 Unamortized deferred compensation......................... (56) (147) Accumulated other comprehensive loss...................... (323) (248) Accumulated deficit....................................... (60,295) (71,402) Officer loan.............................................. -- (277) Less: Treasury stock at cost, no shares at June 30, 2003 and 655,600 shares at June 30, 2002.................... -- (1,693) -------- -------- Total stockholders' equity............................. 118,489 103,300 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY............. $145,242 $135,463 ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 40 HARRIS INTERACTIVE INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) FOR THE YEARS ENDED JUNE 30, ------------------------------------ 2003 2002 2001 ---------- ---------- ---------- Revenue from services.................................... $ 130,551 $ 100,048 $ 60,061 Cost of services......................................... 66,852 53,470 30,764 ---------- ---------- ---------- Gross profit........................................ 63,699 46,578 29,297 Operating expenses: Sales and marketing expenses........................... 9,542 9,720 8,475 General and administrative expenses.................... 47,507 46,708 48,537 Restructuring (credits) charges and asset write-downs......................................... (997) 6,222 -- ---------- ---------- ---------- Operating income (loss)............................. 7,647 (16,072) (27,715) Interest and other income................................ 563 1,412 3,721 Interest expense......................................... (57) (95) (26) ---------- ---------- ---------- Income (loss) before income taxes................... 8,153 (14,755) (24,020) ---------- ---------- ---------- Income tax (benefit) expense............................. (2,954) 38 -- ---------- ---------- ---------- Net income (loss)................................... 11,107 (14,793) (24,020) ========== ========== ========== Basic net income (loss) per share........................ $ 0.21 $ (0.32) $ (0.70) ========== ========== ========== Diluted net income (loss) per share...................... $ 0.20 $ (0.32) $ (0.70) ========== ========== ========== Weighted average shares outstanding -- basic............ 52,983,689 46,136,445 34,239,393 ========== ========== ========== Weighted average shares outstanding -- diluted.......... 54,638,596 46,136,445 34,239,393 ========== ========== ========== The accompanying notes are an integral part of these consolidated financial statements. 41 HARRIS INTERACTIVE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) FOR THE YEARS ENDED JUNE 30, ----------------------------- 2003 2002 2001 ------- -------- -------- Cash flows from operating activities: Net income (loss)......................................... $11,107 $(14,793) $(24,020) Adjustments to reconcile net income (loss) to net cash used in operating activities -- Depreciation and amortization........................................... 5,583 6,534 6,441 Restructuring (credits) charges and asset write-offs... (997) 6,222 Less: Cash outflows related to restructuring charges and asset write-offs................................. (1,025) (1,258) Amortization of deferred compensation.................. 91 289 421 Amortization of premium and discount on marketable securities........................................... 259 54 (493) Loss on disposal of assets............................. 152 (Increase) decrease in -- Accounts receivable.................................. 266 3,138 (2,666) Cost and estimated earnings in excess of billings on uncompleted contracts............................. 965 425 1,892 Other current assets................................. (3,822) (379) 492 Other assets......................................... 1,033 681 (1,668) (Decrease) increase in -- Accounts payable.................................. (805) (1,975) 562 Accrued expenses.................................. (254) (4,663) (95) Other liabilities................................. (982) 1,168 -- Billings in excess of costs and estimated earnings on uncompleted contracts........................ 444 (971) 3,478 ------- -------- -------- Net cash provided by (used in) operating activities...................................... 11,863 (5,528) (15,504) ------- -------- -------- Cash flows from investing activities: Cash paid in connection with acquisitions, net of cash acquired............................................... 168 (3,751) (8,207) Purchase of marketable securities......................... (32,926) (36,603) (41,838) Proceeds from maturities and sales of marketable securities............................................. 31,023 51,208 59,742 Capital expenditures...................................... (2,178) (2,841) (7,606) ------- -------- -------- Net cash (used in) provided by investing activities...................................... (3,913) 8,013 2,091 ------- -------- -------- Cash flows from financing activities : Principal payments under long-term debt................... (2,327) Decrease in short-term borrowings......................... (811) (137) Decrease in long-term borrowings.......................... (1,507) Issuance of common stock and stock options................ 4,091 1,662 898 Repurchase of common stock................................ (901) (792) ------- -------- -------- Net cash provided by (used in) financing activities...................................... 1,773 (1,703) 106 Effect of exchange rate changes on cash and cash equivalents............................................... (119) (580) (40) ------- -------- -------- Net increase (decrease) in cash and cash equivalents........ 9,604 202 (13,347) Cash and cash equivalents at beginning of period............ 10,787 10,585 23,932 ------- -------- -------- Cash and cash equivalents at end of period.................. $20,391 $ 10,787 $ 10,585 ======= ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 42 HARRIS INTERACTIVE INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) COMMON STOCK ACCUMULATED RETAINED OUTSTANDING ADDITIONAL UNAMORTIZED OTHER EARNINGS --------------- PAID-IN DEFERRED COMPREHENSIVE (ACCUMULATED TREASURY OFFICER SHARES AMOUNT CAPITAL COMPENSATION INCOME (LOSS) DEFICIT) STOCK LOAN ------ ------ ---------- ------------ ------------- ------------ -------- ------- BALANCE AT JUNE 30, 2000...... 34,111 34 129,113 (2,075) (133) (32,589) Comprehensive loss: Net loss.................... (24,020) Unrealized gains on marketable securities..... 357 Foreign currency translation............... (40) Total comprehensive loss...... Exercise of options and warrants.................... 291 318 Issuance of common stock under Employee Stock Purchase Plan........................ 145 385 Deferred compensation related to cancelled stock options..................... (1,218) 1,218 Amortization of deferred compensation................ 421 Repurchase of common stock.... (792) Issuance of common stock...... 67 195 ------ -- ------- ------ ---- ------- ------ ---- BALANCE AT JUNE 30, 2001...... 34,614 34 128,793 (436) 184 (56,609) (792) Comprehensive loss: Net loss.................... (14,793) Unrealized loss on marketable securities..... (176) Foreign currency translation............... (256) Total comprehensive loss...... Exercise of options and warrants.................... 466 1 731 Issuance of common stock under Employee Stock Purchase Plan........................ 347 281 Amortization of deferred compensation................ 289 Repurchase of common stock.... (901) Issuance of common stock under 401(k) plan................. 120 328 Issuance of common stock for acquisitions................ 17,533 18 47,104 (500) Paydown of officer loan....... (60) (223) 223 ------ -- ------- ------ ---- ------- ------ ---- BALANCE AT JUNE 30, 2002...... 53,020 53 177,014 (147) (248) (71,402) (1,693) (277) Comprehensive income (loss): Net income.................. 11,107 Unrealized loss on marketable securities..... (20) Foreign currency translation............... (55) Total comprehensive loss...... Exercise of options........... 2,101 2 3,209 Issuance of common stock under Employee Stock Purchase Plan........................ 100 268 Amortization of deferred compensation................ 91 Retirement of common stock.... (791) (1,698) 1,693 Issuance of common stock under 401(k) plan................. 157 615 Paydown of officer loan....... (86) (300) 277 ------ -- ------- ------ ---- ------- ------ ---- BALANCE AT JUNE 30, 2003...... 54,501 55 179,108 (56) (323) (60,295) -- -- ====== == ======= ====== ==== ======= ====== ==== TOTAL STOCKHOLDERS' EQUITY (DEFICIT) ------------- BALANCE AT JUNE 30, 2000...... 94,350 Comprehensive loss: Net loss.................... (24,020) Unrealized gains on marketable securities..... 357 Foreign currency translation............... (40) ------- Total comprehensive loss...... (23,703) ------- Exercise of options and warrants.................... 318 Issuance of common stock under Employee Stock Purchase Plan........................ 385 Deferred compensation related to cancelled stock options..................... -- Amortization of deferred compensation................ 421 Repurchase of common stock.... (792) Issuance of common stock...... 195 ------- BALANCE AT JUNE 30, 2001...... 71,174 Comprehensive loss: Net loss.................... (14,793) Unrealized loss on marketable securities..... (176) Foreign currency translation............... (256) ------- Total comprehensive loss...... (15,225) ------- Exercise of options and warrants.................... 732 Issuance of common stock under Employee Stock Purchase Plan........................ 281 Amortization of deferred compensation................ 289 Repurchase of common stock.... (901) Issuance of common stock under 401(k) plan................. 328 Issuance of common stock for acquisitions................ 46,622 Paydown of officer loan....... ------- BALANCE AT JUNE 30, 2002...... 103,300 Comprehensive income (loss): Net income.................. 11,107 Unrealized loss on marketable securities..... (20) Foreign currency translation............... (55) ------- Total comprehensive loss...... 11,032 ------- Exercise of options........... 3,211 Issuance of common stock under Employee Stock Purchase Plan........................ 268 Amortization of deferred compensation................ 91 Retirement of common stock.... (5) Issuance of common stock under 401(k) plan................. 615 Paydown of officer loan....... (23) ------- BALANCE AT JUNE 30, 2003...... 118,489 ======= The accompanying notes are an integral part of these consolidated financial statements. 43 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED JUNE 30, 2003, 2002 AND 2001 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) 1. BUSINESS Harris Interactive Inc. (the "Company") is a leading global market research, polling and consulting firm, using Internet-based and traditional methodologies to provide clients with information about the views, behaviors and attitudes of people worldwide. Known for The Harris Poll (TM), the Company has over 45 years experience in providing clients with market research and polling services including custom, multi-client and service bureau research, in addition to customer relationship management services. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the assets, liabilities and results of operations of its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all highly liquid investments with a remaining maturity of three months or less at date of purchase. MARKETABLE SECURITIES Harris Interactive Inc. accounts for its investments in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." All investments have been classified as available-for-sale securities as of June 30, 2003 and 2002. Available-for-sale securities are stated at fair value, with the unrealized gains and losses reported in other comprehensive income (loss). Realized gains and losses on available-for-sale securities are included in interest and other income. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest income. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment, including improvements that significantly add to productive capacity or extend useful life, are recorded at cost, while maintenance and repairs are expensed as incurred. Depreciation is calculated on the straight-line or accelerated methods over the estimated useful lives of the assets, which are generally 3 to 7 years. Leasehold improvements are amortized on the straight-line method over the estimated useful life of the assets. In accordance with SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Lived Assets" the Company assesses property, plant and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. GOODWILL AND OTHER INTANGIBLES In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141 ("SFAS 141"), "Business Combinations," and Statement of Financial Accounting Standard No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets." SFAS No. 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, thereby eliminating the pooling-of-interests method. Effective upon adoption, SFAS No. 142 eliminates the requirement to amortize goodwill and instead requires periodic testing of goodwill for impairment. If goodwill is impaired, it will be written down to its estimated fair value. The impact of adoption of SFAS No. 142 did not result in an adjustment to recorded goodwill. Goodwill amortization expense was $330 in fiscal 2001. See also footnotes 16, 17 and 18. 44 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) COMPUTER SOFTWARE DEVELOPED OR OBTAINED FOR INTERNAL USE The Company follows the provisions of Statement of Position 98-1 "Accounting for Costs of Computer Software Developed or Obtained for Internal Use" which accounts for the costs of computer software developed or obtained for internal use and identifies the characteristics of internal use software. Such amounts are included in other assets in the balance sheet and amounted to $1,485 and $1,628 at June 30, 2003 and 2002, respectively. Amortization expense related to these costs amounted to $1,072, $913 and $678 for fiscal years 2003, 2002 and 2001, respectively. REVENUE RECOGNITION The Company recognizes revenue from services principally on a proportional performance basis based on the ratio of costs incurred to total estimated costs. Subscription revenues are recognized upon delivery of the research project. Revenues include amounts billed to customers to cover subcontractor costs and other direct expenses. Provision for estimated contract losses, if any, is made in the period such losses are determined. CONCENTRATION OF CREDIT RISK Financial instruments which potentially expose the Company to concentrations of credit risk consist principally of accounts receivable as well as costs and estimated earnings in excess of billings on uncompleted contracts. Credit losses are provided for in the financial statements and have been within management's expectations. In fiscal 2003 and fiscal 2002, no single customer accounted for more than 10% of the Company's consolidated revenue. For the year ended June 30, 2001, the Company's largest customer comprised 12% of total revenue and no other single customer comprised 10% of total revenue. INCOME TAXES The Company and its U.S. subsidiaries file a consolidated federal income tax return. The Company files separate state income tax returns in certain states and combined income tax returns in other states. The Company follows the asset and liability approach to account for income taxes, which requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of operating loss carryforwards and temporary differences between the carrying amounts and the tax bases of assets and liabilities. The Company has not provided any domestic income taxes applicable to the unremitted earnings of its foreign subsidiaries as these amounts are considered to be indefinitely reinvested outside the U.S. FOREIGN CURRENCY For the Company's subsidiaries outside of the United States, the local currency is the functional currency. In accordance with SFAS No. 52, "Foreign Currency Translation," the financial statements of the subsidiaries are translated into U.S. dollars as follows: assets and liabilities at year-end exchange rates; income, expenses and cash flows at average exchange rates; and stockholders' equity at historical exchange rates. The resulting translation adjustment is recorded as a component of accumulated other comprehensive (loss) income in the accompanying consolidated balance sheet. ADVERTISING EXPENSES Advertising expenses are expensed as incurred and are included in selling, general and administrative expenses in the accompanying consolidated statement of operations. Such expenses amounted to $1,021, $1,275 and $1,653, for the years ended June 30, 2003, 2002 and 2001, respectively. 45 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) RECLASSIFICATIONS It is the Company's policy to reclassify amounts in prior years' financial statements to conform to the current year's presentation. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities, if any, at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. FAIR VALUE OF FINANCIAL INSTRUMENTS Cash and accounts receivable are valued at their carrying or redemption amounts, which are reasonable estimates of their fair value. The fair value of all other instruments approximates cost. INCOME (LOSS) PER SHARE Basic income (loss) per share amounts are computed based on the weighted average number of shares of common stock outstanding during the year. Diluted net income (loss) per share reflects the assumed exercise and conversion of employee stock options that have an exercise price that is below the average market price of the common shares for the respective periods. RECENT ACCOUNTING PRONOUNCEMENTS SFAS 145 In May 2002, the Financial Accounting Standards Board issued SFAS No. 145, "Rescission of FASB Statements 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections". SFAS No. 145 eliminates the requirement that gains and losses from the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. However, an entity is not prohibited from classifying such gains and losses as extraordinary items, so long as they meet the criteria outlined in Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations -- Reporting the Effects of Disposal Occurring Events and Transactions. SFAS No. 145 also eliminates the inconsistency between the accounting for sale-leaseback transactions and certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This statement is effective for financial statements issued for fiscal years beginning after May 15, 2002, with early adoption encouraged. The Company adopted SFAS No. 145 on July 1, 2002. The adoption did not have an impact on the Company's consolidated financial statements. SFAS 146 In July 2002, the Financial Accounting Standards Board issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. Previous accounting guidance was provided by Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS No. 146 replaces EITF Issue No. 94-3. This 46 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) standard is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The Company adopted SFAS No. 146 on January 1, 2003. The adoption did not have an impact on the Company's consolidated financial statements. SFAS 148 In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company is required to follow the prescribed format and provide the additional disclosures required by SFAS No. 148 in its annual financial statements for the year ending June 30, 2003 and is also required to provide the disclosures in its quarterly reports containing condensed financial statements for interim periods. The Company adopted SFAS 148 on January 1, 2003 and elects to continue to account for its stock based compensation plans under the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees" as are described in Note 14 of these Audited Consolidated Financial Statements. The adoption did not have an impact on the Company's consolidated financial statements. SFAS 149 In April 2003, the Financial Accounting Standards Board issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and hedging relationships designated after June 30, 2003, except for those provisions of SFAS No. 149 which relate to SFAS No. 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003. The Company does not expect the adoption of SFAS 149 to have a material impact on the Company's consolidated financial statements. SFAS 150 In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or as an asset in some circumstances). SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and is otherwise effective for the Company beginning July 1, 2003. The Company does not expect the adoption of SFAS No. 150 to have a material impact on the Company's consolidated financial statements. FIN 45 In November 2002, the FASB published Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN 45 requires that a guarantor recognize a liability for the fair value of an obligation assumed under a guarantee and also discusses additional disclosures to be made in the interim and annual financial statements of the guarantor regarding 47 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) obligations under certain guarantees. The initial measurement and recognition requirements of FIN 45 are effective prospectively for guarantees issued or modified after December 31, 2002. The Company adopted FIN 45 on January 1, 2003. The adoption did not have an impact on the Company's consolidated financial statements. FIN 46 In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities." This standard clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," and addresses consolidation by business enterprises of variable interest entities (more commonly known as Special Purpose Entities or SPE's). FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. FIN 46 also enhances the disclosure requirements related to variable interest entities. This statement is effective for variable interest entities created or in which an enterprise obtains an interest after January 31, 2003. The Company adopted FIN 46 on July 1, 2003. The adoption did not have an impact on the Company's consolidated financial statements. 3. BUSINESS COMBINATIONS On November 1, 2001 the Company acquired all of the issued and outstanding shares of common stock, par value $.001 per share, of Total Research Corporation ("Total Research"), a Delaware corporation, located in Princeton, New Jersey, pursuant to the Agreement and Plan of Merger, dated as of August 5, 2001, among the Company, Total Merger Sub Inc., a Delaware corporation and direct, wholly owned subsidiary of the Company, and Total Research. Pursuant to the merger agreement, Total Merger Sub was merged with and into Total Research (the "Merger"), with Total Research continuing as the surviving corporation and as a direct, wholly owned subsidiary of the Company. Harris Interactive and Total Research are engaged in complementary businesses in the market research and polling industry. The acquisition has created revenue growth, cost savings and other synergies including the ability to convert Total Research traditional-based clients to the Internet, sell to one another's customers, offer customers more comprehensive and diverse services, and use a combined worldwide network. Upon consummation of the Merger, each outstanding share of Total Research common stock was converted into the right to receive 1.222 shares of Harris Interactive common stock, par value $.001 per share. An aggregate of approximately 16,610,000 shares of common stock, with an estimated fair value of $41,259, was issued to the stockholders of Total Research Corporation. The value was determined using the average fair market value of the stock for the range of trading days beginning August 2, 2001 and ending August 8, 2001. Additionally, pursuant to the merger agreement, all outstanding options to purchase shares of Total Research common stock were, upon consummation of the Merger, fully vested and converted into an option to purchase 1.222 shares of Harris Interactive common stock. As a result, the former option holders of Total Research received from Harris Interactive options to purchase approximately 2,899,000 shares of Harris Interactive common stock, with an estimated fair value of $3,609. The acquisition was accounted for as a purchase in accordance with FAS 141 and is included in the Company's financial statements commencing on November 1, 2001. The Company has recorded approximately $50,521 in goodwill and intangibles related to the acquisition in accordance with the provisions of SFAS 142 (See Notes 16 and 17). The pro forma information set forth below assumes the acquisition with Total Research Corporation had occurred at the beginning of fiscal 2002, after giving effect to adjustments for amortization of intangibles. The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that would have been achieved had the acquisition been consummated at that time. 48 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 3. BUSINESS COMBINATIONS -- (CONTINUED) TWELVE MONTHS ENDED JUNE 30, ------------------------------------ (PRO-FORMA) (PRO-FORMA) (UNAUDITED) (UNAUDITED) 2003 2002 2001 -------- ----------- ----------- Revenue............................................. $130,551 $114,139 $113,845 Net income (loss)................................... 11,107 (22,755) (21,992) Income(loss) per share -- basic..................... $ 0.21 $ (0.43) (0.43) Income(loss) per share -- diluted................... $ 0.20 $ (0.43) (0.43) In September 2001, the Company acquired all of the issued and outstanding stock of M&A Create Limited, a privately owned company headquartered in Tokyo, Japan, in consideration of cash and shares of Harris Interactive common stock. Additionally, in August 2001, the Company acquired all of the issued and outstanding stock of Market Research Solutions Limited, a privately owned U.K. company, headquartered in Oxford, England, in consideration of a combination of cash and shares of Harris Interactive common stock. Supplemental cash flow information and non-cash investing and financing activities are as follows: AS OF JUNE 30, 2003 ------------------- Acquisitions -- Market Research Solutions Limited And M&A Create Limited: Fair value of assets acquired............................. $ 4,500 Liabilities assumed....................................... 6,568 Stock issued.............................................. 2,256 Acquisition -- Total Research Corporation: Fair value of assets acquired............................. $13,861 Liabilities assumed....................................... 17,174 Stock issued.............................................. 41,259 Fair value of stock options issued........................ 3,609 4. RESTRUCTURING (CREDITS) CHARGES AND ASSET WRITE-DOWNS During the second quarter of fiscal 2002, the Company recorded a restructuring and asset write-down charge of $6,222 directly related to the operational integration of Harris Interactive and Total Research. Management developed a formal plan that included a 5% reduction in Harris Interactive staff of the full-time workforce in Rochester, NY; New York, NY; Norwalk, CT and a few other outlying locations. The affected employees were mainly support staff with overlapping functions in the combined Company. Other integration actions included the closing of our telephone center located in Youngstown, OH and offices in New York, NY and Chicago, IL, which resulted in asset write-downs and a reserve for lease commitments at these locations. The plan was formally communicated to the affected employees during the second fiscal quarter of 2002. 49 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 4. RESTRUCTURING (CREDITS) CHARGES AND ASSET WRITE-DOWNS -- (CONTINUED) The following table summarizes activity with respect to the restructuring charges for the period ended June 30, 2003: ASSET WRITE- LEASE SEVERANCE DOWNS COMMITMENTS TOTAL --------- ------------ ----------- ------ Net charge fiscal 2002.................... $1,169 $2,792 $2,261 $6,222 Asset write-offs during fiscal 2002..... 0 (2,792) 0 (2,792) Cash payments during fiscal 2002........ (1,098) 0 (160) (1,258) ------ ------ ------ ------ Remaining reserve at June 30, 2002........ 71 0 2,101 2,172 Cash payments during fiscal 2003........ (71) 0 (954) (1,025) Fiscal 2003 adjustments................. (997) (997) ------ ------ ------ ------ Remaining reserve at June 30, 2003........ $ 0 $ 0 $ 150 $ 150 ====== ====== ====== ====== As of June 30, 2002, all actions were completed, however cash payments for lease commitments will be made on a longer-term basis according to the contractually scheduled payments of such commitments and will continue through 2005. The total number of employees included in the charge and ultimately terminated was 82. During fiscal 2003, the Company adjusted the reserve for restructuring charges by $997 for lease commitments that were no longer required. The adjustments were due to the Company obtaining a release from its obligations under previous lease obligations. 5. MARKETABLE SECURITIES At June 30, 2003 and 2002, marketable securities consisted of the following: 2003 2002 -------------------- -------------------- COST FAIR VALUE COST FAIR VALUE ------- ---------- ------- ---------- Type of issue: Available-for-sale securities Commercial paper................................... $ 2,400 $ 2,400 $ 4,127 $ 4,127 Corporate bonds............................ 12,186 12,214 7,878 7,924 Government securities...................... 4,067 4,079 5,012 5,019 ------- ------- ------- ------- Total available-for-sale securities.......... $18,653 $18,693 $17,017 $17,070 ======= ======= ======= ======= Gross unrealized gains and losses on available-for-sale securities at June 30, 2003 were $41 and $1, respectively. Gross unrealized gains and losses on available-for-sale securities at June 30, 2002 were $53 and $3, respectively. The cost and fair value of available-for-sale securities at June 30, 2003 and 2002, by contractual maturity, are shown below: 2003 2002 -------------------- -------------------- COST FAIR VALUE COST FAIR VALUE ------- ---------- ------- ---------- Maturity date: Due in one year or less.................... $10,389 $10,413 $15,507 $15,560 Due after one year through three years..... 8,264 8,280 1,510 1,510 ------- ------- ------- ------- Total available-for-sale securities.......... $18,653 $18,693 $17,017 $17,070 ======= ======= ======= ======= 50 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 5. MARKETABLE SECURITIES -- (CONTINUED) There were no material gains or losses from sales of available-for-sale securities during the years ended June 30, 2003 and 2002 6. CONTRACTS IN PROGRESS Accumulated costs and estimated earnings and billings on contracts in progress at June 30 was as follows: 2003 2002 ------- ------- Accumulated costs and estimated earnings.................... $28,299 $16,687 Billings.................................................... (34,898) (21,842) ------- ------- $(6,599) $(5,155) ======= ======= Contracts in progress are included in the accompanying balance sheets under the following captions: 2003 2002 -------- ------- Costs and estimated earnings in excess of billings on uncompleted contracts..................................... $ 3,776 $ 4,669 Billings in excess of costs and estimated earnings on uncompleted contracts..................................... (10,375) (9,824) -------- ------- $ (6,599) $(5,155) ======== ======= 7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following: JUNE 30, ------------------- 2003 2002 -------- -------- Furniture and fixtures...................................... $ 4,341 $ 4,691 Equipment................................................... 19,696 17,679 Leasehold improvements...................................... 3,320 3,173 -------- -------- 27,357 25,543 Accumulated depreciation.................................. (19,551) (15,840) -------- -------- $ 7,806 $ 9,703 ======== ======== Depreciation expense on property, plant and equipment amounted to $4,198, $4,421 and $4,755 in fiscal years 2003, 2002 and 2001, respectively. The Company has several non-cancelable operating leases for office space, vehicles and equipment. Future minimum lease payments under non-cancelable operating leases as of June 30, 2003 are as follows: YEARS ENDING JUNE 30: --------------------- 2004........................................................ $4,857 2005........................................................ 4,042 2006........................................................ 2,859 2007........................................................ 1,848 2008........................................................ 1,733 2009 and beyond............................................. 2,692 51 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 7. PROPERTY, PLANT AND EQUIPMENT -- (CONTINUED) Total rental expense for operating leases in 2003, 2002 and 2001 was $5,183, $5,922 and $5,121, respectively. 8. BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION The Company identifies its segments based on the Company's geographic locations and industries in which the Company operates. The Company currently has one reportable segment. However, the Company is comprised of operations in the United States, the United Kingdom and Japan. Non-U.S. market research is comprised of operations in the United Kingdom and Japan. There were no significant inter-segment transactions that materially affected the financial statements and all inter-segment sales have been eliminated upon consolidation. Geographic information for the years ended June 30, 2003, 2002 and 2001 are as follows: U.S. U.K. JAPAN MARKET MARKET MARKET RESEARCH RESEARCH RESEARCH TOTAL -------- -------- -------- -------- Year ended June 30, 2003: Revenue...................................... $101,050 $23,044 $6,457 $130,551 Long-lived assets............................ 61,498 9,087 3,255 73,840 Year ended June 30, 2002: Revenue...................................... $ 78,488 $16,418 $5,142 $100,048 Long-lived assets............................ 64,277 9,056 3,188 76,521 Year ended June 30, 2001: Revenue...................................... $ 60,061 $ 0 $ 0 $ 60,061 Long-lived assets............................ 25,804 0 0 25,804 9. ACCRUED EXPENSES Accrued expenses consisted of the following at June 30: 2003 2002 ------ ------- Payroll and withholding expenses............................ $1,078 $ 1,022 Accrued benefits............................................ 792 1,055 Bonuses..................................................... 2,217 2,003 Accrued restructuring....................................... 150 1,053 Accrued HIpoints............................................ 1,562 930 Vacation accrual............................................ 339 688 Other....................................................... 2,912 4,330 ------ ------- $9,050 $11,081 ====== ======= Other consists of accrued expenses individually less than 5% of total current liabilities. 10. LINE OF CREDIT The Company maintains a line of credit with a commercial bank providing borrowing availability up to $5 million in fiscal 2003 and 2002, at the prime rate. The prime rate in effect at June 30, 2003 was 4.0% and 52 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 10. LINE OF CREDIT -- (CONTINUED) borrowings under this arrangement are due upon demand. There were no borrowings outstanding under this agreement at June 30, 2003 or 2002. The line of credit is collateralized by the assets of the Company. At June 30, 2003 the Company had no short-term or long-term borrowings. At June 30, 2002, the Company had short-term and long-term borrowings of $0.8 million and $1.5 million, respectively, limited to operations in the United Kingdom and Japan. Interest rates related to the borrowings ranged from 1.8% to 3.0% with maturity dates extending to 2006. There were no restrictive covenants associated with these borrowings. 11. INCOME TAXES The provision for income taxes consists of: 2003 2002 2001 ------- -------- -------- Current: Federal.............................................. $ 262 $-- $-- State................................................ 38 -- -- Foreign.............................................. 45 38 -- ------- --- --- $ 345 $38 $-- Deferred: Federal.............................................. $(2,654) $-- $-- State................................................ (382) -- -- Foreign.............................................. (263) -- -- ------- --- --- $(3,299) $-- $-- ------- --- --- $(2,954) $-- $-- ======= === === The U.S. and foreign components of loss before income taxes are as follows: 2003 2002 2001 ------ -------- -------- U.S..................................................... $7,663 $(12,528) $(23,839) Foreign................................................. 490 (2,227) (181) ------ -------- -------- $8,153 $(14,755) $(24,020) ====== ======== ======== 53 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 11. INCOME TAXES -- (CONTINUED) Deferred tax assets (liabilities) at June 30 consist of the following: 2003 2002 ------- ------- Net operating loss carryforwards............................ $31,050 $30,121 Internet database development expenses...................... 1,048 1,837 Stock option compensation................................... 180 521 HIPoints Reserve............................................ 608 361 Other....................................................... 891 1,202 ------- ------- Gross deferred tax assets................................... 33,777 34,042 Valuation allowance......................................... (29,227) (32,966) ------- ------- 4,550 1,076 Goodwill.................................................... (519) (261) ------- ------- Net deferred tax assets..................................... $ 4,031 $ 815 ======= ======= As of June 30, 2003, the Company has Federal and New York State net operating loss carryforwards of approximately $82,822 and $80,747, respectively, that will begin to expire in 2019. A change in ownership could create a limitation on the amount of income that can be offset by net operating loss carryforwards and credits. Deferred tax assets have been recognized to the extent management believes it is more likely than not that the asset will be realized. Changes in facts, circumstances and projections may have an effect on the amount of the asset recognized in future periods. The reversal of the valuation allowance established against deferred tax assets for temporary differences resulting from APB 16 purchase accounting is credited directly to goodwill, rather then income tax expense, resulting in zero net effect to the income statement. If the deferred assets underlying the valuation allowance are recognized, $3,192 of the valuation allowance would be credited to goodwill. Of the June 30, 2003 valuation allowance, $5,217 was established against deferred tax assets associated with stock option deductions. The future reversal of this portion of the valuation allowance would be credited directly to additional paid in capital, which would result in no tax benefit recorded in the income statement. The (benefit) provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to income before income taxes as follows: 2003 2002 2001 ------ ------- ------- Expense (Benefit) at Federal statutory rate............... $2,772 $(5,017) $(8,167) State income tax benefit, net of Federal income tax....... 249 (938) (1,162) Foreign rate differential................................. (10) (778) 62 Merger related expenses................................... -- (1,426) -- (Decrease) Increase in valuation allowance................ (6,023) 8,172 9,377 Other non-deductible items................................ 58 25 (110) ------ ------- ------- (2,954) $ 38 $ -- ====== ======= ======= 54 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 12. STOCKHOLDERS' EQUITY COMMON STOCK In fiscal 2000, the Company amended the Certificate of Incorporation to increase the number of authorized common stock to 100,000,000 shares. At June 30, 2003 and 2002 the Company had no outstanding Warrants. EMPLOYEE STOCK PURCHASE PLAN The Company registered 500,000 shares of common stock in March 2000 for issuance under the 1999 Employee Stock Purchase Plan ("ESPP"). The ESPP provides employees with an opportunity to purchase the Company's common stock through payroll deductions. Under the ESPP, the Company's employees may purchase, subject to certain restrictions, shares of common stock at the lesser of 85 percent of the fair value at either the beginning or the end of each offering period. During fiscal years 2003, 2002 and 2001, employees purchased 99,383, 104,507 and 145,143 shares of common stock through the ESPP, respectively. TREASURY STOCK In December 2000, the Board of Directors approved a share repurchase program authorizing the Company to purchase up to $5,000 of its common stock at market prices. The amount and timing of any purchase will depend upon a number of factors, including the price and availability of the Company's shares and general market conditions. The Company's purchases of common stock are recorded as "Treasury Stock" and result in a reduction of "Stockholders' Equity" unless such shares are formally retired. As of June 30, 2003, the Company had repurchased and retired 655,600 shares of common stock, at a cost of $1,693 under such program. INVESTOR STOCK OPTIONS At June 30, 2003 and 2002, the Company had outstanding options to acquire 12,220 and 244,400, respectively, shares of its common stock (not including options under the Company's employee stock option plan, as discussed in Note 14 below), which represent options to acquire common stock of Total Research which were assumed by the Company in connection with the Merger. 13. NET INCOME (LOSS) PER SHARE The following table presents the shares used in computing basic and diluted earnings per share ("EPS") for the years ended June 30, 2003, 2002 and 2001. Unexercised stock options to purchase 564,343 shares of the Company's common stock for the year ended June 30, 2003 at a weighted average price per share of $8.05 were not included in the computations of diluted earnings per share because the options exercise prices were greater than the average market price of the Company's common stock for fiscal 2003. As a result of losses from continuing operations, unexercised stock options to purchase 6,543,458 and 3,858,484 shares of the Company's common stock for the years ended June 30, 2002 and 2001, respectively, at weighted average prices per share of $2.67 and $3.38, were excluded from the calculation of diluted net loss per share as the effect would have been anti-dilutive. FOR THE YEAR ENDED JUNE 30, --------------------------------------- 2003 2002 2001 ----------- ----------- ----------- Weighted average outstanding common shares for basic EPS................................... 52,983,689 46,136,445 34,239,393 Diluted effect of outstanding stock options... 1,654,907 -- -- Shares for diluted EPS........................ 54,638,596 46,136,445 34,239,393 55 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 13. NET INCOME (LOSS) PER SHARE -- (CONTINUED) The following table sets forth the computation of basic and diluted net loss per share: 2003 2002 2001 ----------- ----------- ----------- Numerator: Net income(loss) attributable to holders of common stock............................. $ 11,107 $ (14,793) $ (24,020) =========== =========== =========== Denominator for basic income(loss) per share -- weighted average shares............ 52,983,689 46,136,445 34,239,393 =========== =========== =========== Basic income (loss) per share................. $ 0.21 $ (0.32) $ (0.70) =========== =========== =========== Denominator for diluted income(loss) per share -- weighted average shares............ 54,638,596 46,136,445 34,239,393 =========== =========== =========== Diluted income (loss) per share............... $ 0.20 $ (0.32) $ (0.70) =========== =========== =========== 14. EMPLOYEE STOCK OPTION PLAN The Company has a nonqualified and incentive stock option plan that enables key employees and directors of the Company to purchase shares of common stock of the Company. The Company grants options to purchase its common stock, generally at fair value as of the date of grant. Options generally vest over a period up to 4 years and expire after 10 years from the date of grant. The Company has registered 3,250,000 shares of common stock for issuance under the 1999 long-term incentive plan. There were 1,162,766 shares available for future grant at June 30, 2003. Additionally, pursuant to the terms of the Merger, outstanding options to purchase common stock of Total Research Corporation became fully vested and exercisable to purchase an aggregate of 2,654,306 shares of the Company's common stock on November 1, 2001. All other terms of these options continue to be governed by the applicable Total Research option agreements. 56 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 14. EMPLOYEE STOCK OPTION PLAN -- (CONTINUED) A summary of the status of the Company's employee stock option plan (including Total Research options after November 1, 2001) for the years ended June 30, 2003, 2002 and 2001 is as follows: NUMBER OF WEIGHTED AVERAGE SHARES PRICE PER SHARE ---------- ---------------- Outstanding at June 30, 2000............................. 4,059,400 3.52 Granted............................................. 653,250 4.25 Canceled............................................ (600,130) 6.21 Exercised........................................... (254,036) 1.25 ---------- Outstanding at June 30, 2001............................. 3,858,484 3.38 Assumed in acquisition................................. 2,654,306 2.05 Granted............................................. 877,000 2.10 Canceled............................................ (367,194) 6.51 Exercised........................................... (723,538) 1.15 ---------- Outstanding at June 30, 2002............................. 6,299,058 $2.70 Granted............................................. 785,000 2.48 Canceled............................................ (524,572) 4.51 Exercised........................................... (1,870,341) 1.49 ---------- Outstanding at June 30, 2003............................. 4,689,145 2.95 ========== Employee stock options exercisable as of June 30, 2003, 2002 and 2001 amounted to 3,436,548, 4,965,355 and 2,456,572, respectively. The weighted average exercise price of the exercisable options at June 30, 2003, 2002 and 2001 was $3.00, $2.43 and $2.50, respectively. The following represents additional information about employee stock options outstanding at June 30, 2003: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ---------------------------------------------------------------------- ------------------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED RANGE OF REMAINING AVERAGE AVERAGE EXERCISE PRICES NUMBER CONTRACTUAL LIFE EXERCISE PRICE NUMBER EXERCISABLE PRICE PER SHARE OUTSTANDING (YEARS) (PER SHARE) EXERCISABLE (PER SHARE) --------------- ----------- ---------------- -------------- ----------- ----------------- $ .35 - $ .47...... 389,000 4.3 $ 0.45 389,000 $ 0.45 1.26 - 3.70...... 3,584,866 7.1 $ 2.38 2,508,019 $ 2.41 3.75 - 7.06...... 447,279 7.1 $ 4.64 314,446 $ 4.79 11.00 - 14.00...... 268,000 6.7 $11.31 225,083 $11.33 During fiscal 2000, 617,000 stock options were granted to employees at an amount that was less than the fair value of the common stock as of the grant date. Accordingly, the Company recorded $2,431 in unamortized deferred compensation in fiscal 2000 for these options that vest over 3 to 4 years. Compensation expense is being amortized over the vesting period and unamortized deferred compensation has been recorded as a reduction in stockholders' equity. No such options were granted in fiscal 2003, 2002 and 2001. During fiscal 2003, 2002 and 2001, compensation expense recognized in the consolidated statements of operations amounted to $91, $289 and $421, respectively. The weighted average fair market value of options granted during fiscal 2003, 2002 and 2001 was $1.37, $1.17 and $2.92, respectively. For purposes of this disclosure, the fair value of each option grant was estimated 57 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 14. EMPLOYEE STOCK OPTION PLAN -- (CONTINUED) on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants outstanding in 2003, 2002 and 2001. 2003 2002 2001 ---- ---- ---- Risk-free interest rate..................................... 2.35% 3.01% 4.31% Weighted average expected life (years)...................... 4 3 3 Volatility factor........................................... 72% 81% 110% Dividend yield.............................................. -- -- -- The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees. The pro forma information below illustrates the effect on net income (loss) and net income (loss) per share based on provisions of Statement of Financial Accounting Standard ("FAS") No. 123, Accounting for Stock-Based Compensation, as amended by FAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure, issued in December 2002. BASIC NET INCOME DILUTED NET INCOME (LOSS) PER SHARE (LOSS) PER SHARE AVAILABLE TO AVAILABLE TO NET INCOME (LOSS) HOLDERS OF HOLDERS OF AVAILABLE TO HOLDERS OF COMMON STOCK COMMON STOCK COMMON STOCK ------------------------------------- ---------------- ------------------ FAIR VALUE AS COMPENSATION PRO AS PRO AS PRO REPORTED EXPENSE FORMA REPORTED FORMA REPORTED FORMA --------- ------------- --------- -------- ----- --------- ------ 2003................. $ 11,107 $1,099 $ 10,008 $ .21 $.19 $ .20 $ .18 2002................. (14,793) 1,215 (16,008) $(.32) (.35) (.32) (.35) 2001................. (24,020) 1,262 (25,282) (.70) (.74) (.70) (.74) 15. 401(K) PLAN The Company established a 401(k) Plan (the "Plan") effective January 1, 1995. Eligibility to participate in the Plan, including employer matching contributions, if any, is limited to those employees who are at least 21 years of age and have completed one year of employment with at least 1,000 hours of service. However, employees are eligible to contribute to the Plan upon completion of one quarter of service. Participants may contribute 1% to 100% of compensation up to federally established limitations. Employer matching contributions are discretionary, and include matching contributions and profit sharing contributions. Matching contribution expense incurred by the Company during 2003, 2002 and 2001 was $616, $634 and $344, respectively. 58 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 16. ACQUIRED INTANGIBLE ASSETS SUBJECT TO AMORTIZATION AS OF JUNE 30, ------------------------------------------------------------- 2003 2002 ----------------------------- ----------------------------- GROSS CARRYING ACCUMULATED GROSS CARRYING ACCUMULATED AMOUNT AMORTIZATION AMOUNT AMORTIZATION -------------- ------------ -------------- ------------ Amortized intangible assets Contract-based intangibles...... $1,450 $720 $1,450 $408 ------ ---- ------ ---- Total........................ $1,450 $720 $1,450 $408 ====== ==== ====== ==== FOR THE YEAR ENDED JUNE 30, ---------------------------------------------- 2003 2002 2001 -------------- ------------ -------------- Aggregate amortization expense: For the year ended.............. $ 312 $241 $ -- ------ ---- ------ Estimated amortization expense: For the year ending June 30, 2004......................... $ 312 ------ For the year ending June 30, 2005......................... $ 312 ------ For the year ending June 30, 2006......................... $ 106 ------ 17. GOODWILL Balance as of July 1, 2001.................................. $ 8,913 Acquisitions of Market Research Solutions Limited and M&A Create Limited during the quarter ended September 30, 2001...................................................... 5,276 Acquisition of Total Research during the quarter ended December 31, 2001......................................... 49,239 ------- Balance as of July 1, 2002.................................. $63,428 Additional purchase accounting adjustments in connection with the acquisition of Total Research.................... 249 Goodwill written off related to the reversal of deferred tax asset valuation allowance................................. (418) ------- Balance as of June 30, 2003................................. $63,259 ======= 18. GOODWILL AND OTHER INTANGIBLE ASSET -- ADOPTION OF FAS 142 On July 1, 2001 the Company adopted the provisions of SFAS No. 142 "Goodwill and Other Intangible Assets." The pronouncement required an annual impairment test in lieu of monthly amortization for goodwill. The Company completed its transitional impairment test in accordance with FAS 142 as of December 31, 2001, with no impairment identified. The Company completed its annual impairment test in accordance with FAS 142 as of June 30, 2003 and 2002, with no impairment identified. 59 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 18. GOODWILL AND OTHER INTANGIBLE ASSET -- ADOPTION OF FAS 142 -- (CONTINUED) The following table presents prior years earnings and earnings per share as if the provisions of FAS 142 had been applied to prior years: TWELVE MONTHS ENDED JUNE 30, ----------------------------- 2003 2002 2001 ------- -------- -------- Reported net income (loss)............................. $11,107 $(14,793) $(24,020) Add back goodwill amortization......................... 331 Adjusted net income (loss)............................. $11,107 $(14,793) $(23,689) Basic net income (loss) per share: Reported net income (loss)............................. $ 0.21 $ (0.32) $ (0.70) Add back goodwill amortization......................... -- -- 0.01 Adjusted basic and diluted net income (loss)........... $ 0.21 $ (0.32) $ (0.69) Diluted net income (loss) per share: Reported net income (loss)............................. $ 0.20 $ (0.32) $ (0.70) Add back goodwill amortization......................... -- -- 0.01 Adjusted basic and diluted net income (loss)........... $ 0.20 $ (0.32) $ (0.69) 19. SUPPLEMENTAL CASH FLOW INFORMATION SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid (received) during the year for: 2003 2002 2001 ----- ------- ------- Interest................................................... $(411) $(1,686) $(3,941) ----- ------- ------- Taxes...................................................... $(823) $ 41 $ -- ----- ------- ------- 20. UNAUDITED QUARTERLY RESULTS OF OPERATIONS The following table presents unaudited consolidated quarterly statement of operations data for the years ended June 30, 2003 and 2002. In management's opinion, this information has been prepared on the same basis as the audited consolidated financial statements and includes all adjustments, consisting only of normal recurring adjustments necessary for the fair presentation of the unaudited information in the periods presented. This information should be read in conjunction with the consolidated financial statements and related notes included under Item 8 of this report and in conjunction with other financial information included elsewhere in this 60 HARRIS INTERACTIVE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED JUNE 30, 2003, 2002 AND 2001 20. UNAUDITED QUARTERLY RESULTS OF OPERATIONS -- (CONTINUED) Form 10-K. The results of operations for any quarter are not necessarily indicative of results that may be expected for any future periods. THREE MONTHS ENDED --------------------------------------------------------------------------------------------------------- SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30, 2001 2001 2002 2002 2002 2002 2003 2003 ------------- ------------ --------- -------- ------------- ------------ --------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenue from services........... $17,134 $ 24,804 $28,323 $29,787 $30,329 $32,468 $32,080 $35,674 Cost of services..... 9,188 14,405 14,536 15,341 16,552 16,944 16,141 17,215 ------- -------- ------- ------- ------- ------- ------- ------- Gross Profit......... 7,946 10,399 13,787 14,446 13,777 15,524 15,939 18,459 Operating expenses: Sales and marketing expenses......... 1,599 2,742 3,023 2,344 1,909 2,226 2,352 3,055 General and administrative expenses......... 10,087 12,332 12,205 12,096 11,003 11,763 11,411 13,330 Restructuring and asset impairment....... -- 6,222 -- -- -- (389) (273) (335) ------- -------- ------- ------- ------- ------- ------- ------- Operating (loss) income............. (3,740) (10,897) (1,441) 6 865 1,924 2,449 2,409 Interest and other income............. 529 406 247 230 168 149 114 132 Interest expense..... (19) (25) (22) (29) (19) (19) (6) (13) ------- -------- ------- ------- ------- ------- ------- ------- (Loss) income before income taxes....... (3,230) (10,516) (1,216) 207 1,014 2,054 2,557 2,528 Income tax (benefit) expense............ -- -- -- 38 -- -- -- (2,954) ------- -------- ------- ------- ------- ------- ------- ------- Net (loss) income.... $(3,230) $(10,516) $(1,216) $ 169 $ 1,014 $ 2,054 $ 2,557 $ 5,482 ======= ======== ======= ======= ======= ======= ======= ======= Basic net (loss) Income per share... $ (0.09) $ (0.23) $ (0.02) $ 0.00 $ 0.02 $ 0.04 $ 0.05 $ 0.10 ======= ======== ======= ======= ======= ======= ======= ======= Diluted net (loss) Income per share... $ (0.09) $ (0.23) $ (0.02) $ 0.00 $ 0.02 $ 0.04 $ 0.05 $ 0.10 ======= ======== ======= ======= ======= ======= ======= ======= 61 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES The Company's management, with the participation of the Company's Principal Executive Officer and Principal Financial Officer, evaluated the effectiveness of the design and operation of Harris Interactive's disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based on that evaluation, the Company's Principal Executive Officer and Principal Financial Officer concluded that Harris Interactive's disclosure controls and procedures as of June 30, 2003 (the end of the period covered by this Report on Form 10-K) have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by Harris Interactive in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 of Form 10-K with respect to our directors is incorporated by reference from the information contained in the section captioned "Election of Directors" in the Company's definitive Proxy Statement for the Annual Meeting of Stockholders to be held on November 11, 2003 (the "Proxy Statement"), a copy of which will be filed with the Securities and Exchange Commission before the meeting date. For information with respect to our executive officers and significant employees, see the section captioned "Executive Officers of Harris Interactive" in Part I of this Form 10-K. The information required by Item 10 of Form 10-K with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference from the information contained in the section captioned "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 of Form 10-K is incorporated by reference from the information contained in the sections captioned "Compensation of Executive Officers and Directors and Other Matters", "Compensation Committee Report on Executive Compensation", and "Comparison of 43 Month Cumulative Total Return" in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by Item 12 of Form 10-K is incorporated by reference from the information contained in the sections captioned "Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plan Information" in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Form 10-K is incorporated by reference from the information contained in the section captioned "Certain Relationships and Related Transactions" in the Proxy Statement. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by Item 14 of Form 10-K is incorporated by reference from the information contained in the section captioned "Audit Fees" in the Proxy Statement. 62 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS The following financial statements are filed as a part of this Report under "Item 8 -- Financial Statements and Supplementary Data": Report of Independent Auditors.............................. 39 Consolidated Balance Sheets at June 30, 2003 and 2002....... 40 Consolidated Statements of Operations for the years ended June 30, 2003, 2002 and 2001.............................. 41 Consolidated Statements of Cash Flows for the years ended June 30, 2002, 2001 and 2000.............................. 42 Consolidated Statements of Stockholders' Equity for the years ended June 30, 2003, 2002 and 2001.................. 43 Notes to Consolidated Financial Statements (including unaudited quarterly results of operations)................ 44 FINANCIAL STATEMENT SCHEDULES The following financial statement schedule is filed as a part of this Report under Schedule II immediately preceding the signature page: Schedule II -- Valuation and Qualifying Accounts for the three fiscal years ended June 30, 2003. All other schedules called for by Form 10-K are omitted because they are inapplicable or the required information is shown in the financial statements, or notes thereto, included herein. REPORTS ON FORM 8-K On April 23, 2003, a report on Form 8-K was furnished to the SEC pursuant to Items 7 and 9 (Item 12) announcing the Company's earnings for the calendar quarter ended March 31, 2003. On May 1, 2003, a report on Form 8-K was filed with the SEC pursuant to Item 5 announcing the participation of certain current executives of the Company in 10b5-1 Sales plans. On May 8, 2003, a report on Form 8-K was filed with the SEC pursuant to Item 5 announcing the Company's receipt of a notice of demand registration rights with respect to registration of an aggregate of 11,810,278 shares of the common stock, par value $.001 per share, of the Company held by BVCF III, L.P., Brinson MAP Venture Capital Fund III Trust and Virginia Retirement System (collectively, the "Investors"), pursuant to a Registration Agreement dated as of July 7, 1998, as amended, between the Company and the Investors. 63 EXHIBITS EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- 2.1 Agreement and Plan of Merger, dated August 5, 2001, among Harris Interactive Inc., Total Merger Sub Inc., and Total Research Corporation (Incorporated by reference to Harris Interactive's Current Report on Form 8-K filed August 14, 2001, listed as Exhibit 99.1). 3.1 Amended and Restated Certificate of Incorporation of the Company (filed as Exhibit 3.1 to Form 10-K filed September 27, 2000 and incorporated herein by reference). 3.2 By-laws of the Company (filed as Exhibit 3.2 to Form 10-K filed August 31, 2001 and incorporated herein by reference). 10.1* 1999 Long Term Incentive Plan and form of agreements thereto of the Company (filed as Exhibit 10.1 to the Company's Registration Statement on Form S-1 filed September 17, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.2* 1999 Employee Stock Purchase Plan and form of agreements thereto of the Company (filed as Exhibit 10.2 to the Company's Registration Statement on Form S-1 filed September 17, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.5.1* Confidentiality and Non-Competition Agreement dated September 1, 1999 between the Company and Gordon S. Black (filed as Exhibit 10.5.1 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.5.2* Confidentiality and Non-Competition Agreement dated September 1, 1999 between the Company and David H. Clemm (filed as Exhibit 10.5.2 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.5.3* Confidentiality and Non-Competition Agreement dated September 1, 1999 between the Company and Leonard R. Bayer (filed as Exhibit 10.5.3 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.6.1 Leases for 135, 155 & 60 Corporate Woods, Rochester, New York dated April 12, 1991 between Gordon S. Black Corporation and Corporate Woods Associates, together with all amendments thereto (filed as Exhibit 10.6.1 to the Company's Registration Statement on Form S-1 filed September 17, 1999 and incorporated herein by reference); amendments dated February 11, 2000, March 14, 2000 and October 1, 2000 (filed as Exhibit 10.6.1 to Form 10-K filed August 31, 2001 and incorporated herein by reference). 10.6.2 Lease for 70 Carlson Road, Rochester, New York dated July 1, 1998 between Gordon S. Black Corporation and Carlson Park Associates, together with all amendments thereto (filed as Exhibit 10.6.2 to the Company's Registration Statement on Form S-1 filed September 17, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.6.3 Lease for 111 Fifth Avenue, New York, New York dated June 9, 1994 between Louis Harris and Associates, Inc. and B.J.W. Associates (filed as Exhibit 10.7 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.6.4 Sublease for 5th Floor, 500 Fifth Avenue, New York, New York dated March 31, 2000 between the Company and New York Life Insurance Company (filed as Exhibit 10.6.4 to Form 10-K filed September 27, 2000 and incorporated herein by reference). 10.7 Registration Agreement dated July 7, 1998 among the Company, Brinson Venture Capital Fund III, L.P., Brinson MAP Venture Capital Fund III Trust and the Virginia Retirement System (filed as Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed September 17, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.8 Revolving Credit Facility between Gordon S. Black Corporation and Manufacturers and Traders Trust Company dated August 18, 1999 (filed as Exhibit 10.9 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.9 Investment Agreement between Market Facts, Inc. and the Company dated April, 1999 (filed as Exhibit 10.11 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 64 EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- 10.10 Amended and Restated Investment Agreement between Riedman Corporation and the Company dated October 15, 1991 (filed as Exhibit 10.12 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.11 Investment Agreement among SEQUEL Limited Partnership II and Sequel Entrepreneur's Fund II, L.P. and the Company dated as of October 15, 1995 (filed as Exhibit 10.13 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.12 Investment Agreement between Young & Rubicam Inc. and the Company dated as of October 15, 1999 (filed as Exhibit 10.14 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.14 Amendment No. 1 to the Registration Agreement between the Company and Brinson Map Venture Capital Fund III, Brinson MAP Venture Capital Fund III Trust, BVCF III, L.P., and Virginia Retirement System dated as of October 15, 1999 (filed as Exhibit 10.16 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.15 Registration Agreement between the Company and Riedman Corporation dated as of October 15, 1999 (filed as Exhibit 10.17 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.16 Registration Agreement among the Company and Sequel Limited Partnership II and Sequel Entrepreneur's Fund II, L.P. dated as of October 15, 1999 (filed as Exhibit 10.18 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.17 Registration Agreement between the Registrant and Young & Rubicam Inc. dated as of October 15, 1999 (filed as Exhibit 10.19 to the Company's Registration Statement on Form 5-1/A filed October 26, 1999 (Registration No. 333-87311 and incorporated herein by reference). 10.18 Registration Agreement between the Registrant and Excite, Inc. dated as of October 15, 1999 (filed as Exhibit 10.20 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.19 Stockholder's Agreement by and among the Company, Brinson MAP Venture Capital Fund III, BVCF III, L.P., Virginia Retirement System, Gordon S. Black, Leonard R. Bayer, David M. Clemm, Excite, Inc., Young & Rubicam Inc., Riedman Corporation, Sequel Limited Partnership II and Sequel Entrepreneur's Fund II, L.P. dated as of October 15, 1999 (filed as Exhibit 10.21 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.20 Research Agreement between the Company and Young & Rubicam Inc. dated October 22, 1999 (filed as Exhibit 10.22 to the Company's Registration Statement on Form S-1/A filed October 26, 1999 (Registration No. 333-87311) and incorporated herein by reference). 10.21* Consulting Agreement between the Company and James R. Riedman dated April 25, 2001 (filed as Exhibit 10.21 to Form 10-K filed August 31, 2002 and incorporated herein by reference). 10.22* Separation Agreement by and between the Company and David H. Clemm, dated as of March 15, 2002 (filed as Exhibit 10.1 to Form 10-Q filed May 15, 2002 and incorporated herein by reference). 10.23* Employment Agreement by and between the Company and Albert A. Angrisani, dated as of August 5, 2001 (filed as Exhibit 10.23 to Form S-4 filed September 6, 2001 and incorporated herein by reference). 10.24* Letter Agreement of Albert A. Angrisani, dated August 5, 2001 (filed as Exhibit 10.24 to Form S-4 filed September 6, 2001 and incorporated herein by reference). 10.25* Change of Control Agreement by and between the Company and Bruce A. Newman, dated as of June 28, 2002 (filed as Exhibit 10.25 to Form 10-K filed September 30, 2002 and incorporated herein by reference). 65 EXHIBIT NUMBER EXHIBIT TITLE ------- ------------- 10.26* Amendment No. 1 to the Employment Agreement by and between the Company and Albert A. Angrisani, dated as of June 28, 2002 (filed as Exhibit 10.26 to Form 10-K filed September 30, 2002 and incorporated herein by reference). 10.27* Amendment No. 1 to the Letter Agreement of Albert A. Angrisani, dated as of June 28, 2002 (filed as Exhibit 10.27 to Form 10-K filed September 30, 2002 and incorporated herein by reference). 10.28* Employment Agreement between the Company and Gordon S. Black, dated as of December 16, 2002 (filed as Exhibit 10.1 to Form 10-Q filed on February 10, 2003 (erroneously referenced therein as Confidentiality and Non-Competition Agreement and incorporated herein by reference)). 10.29* Form of Change in Control Agreement entered into by Company with each of the following individuals (filed as Exhibit 10.1 to Form 10-Q filed on May 14, 2003 and incorporated herein by reference): Dennis K. Bhame Arthur E. Coles Gareth Davies James E. Fredrickson Ronald B. Knight Peter J. Milla Gregory T. Novak George B. Terhanian David B. Vaden 10.30* Amendment to Employment Agreement by and between the Company and Gordon S. Black, dated July 1, 2003 (filed herewith). 10.31* Employment Agreement by and between the Company and Leonard R. Bayer, dated July 1, 2003 (filed herewith). 10.32* Employment Agreement by and between the Company and George Terhanian, dated September 26, 2002 (filed herewith). 10.33* Letter Agreement of Albert A. Angrisani, effective as of July 1, 2003 (filed herewith). 10.34* Employment Agreement by and between the Company and Theresa Flanagan, dated January 1, 1999 (filed herewith). 21. List of Subsidiaries (filed as Exhibit 21 to Form 10-K filed September 30, 2002 and incorporated herein by reference). 23.1 Consent of Independent Auditors (filed herewith). 23.2 Report of Independent Auditors on Financial Statement Schedule (filed herewith). 24. Power of Attorney (included on page 69 of this Report). 31.1 Certificate of the Chief Executive Officer pursuant to 18 U.S.C. sec.1350 (Section 302 of the Sarbanes-Oxley Act of 2002) (filed herewith). 31.2 Certificate of the Chief Financial Officer pursuant to 18 U.S.C. sec.1350 (Section 302 of the Sarbanes-Oxley Act of 2002) (filed herewith). 32.1 Certificate of the Chief Executive Officer pursuant to 18 U.S.C. sec.1350 (Section 906 of the Sarbanes-Oxley Act of 2002) (filed herewith). 32.2 Certificate of the Chief Financial Officer pursuant to 18 U.S.C. sec.1350 (Section 906 of the Sarbanes-Oxley Act of 2002) (filed herewith). --------------- * Denotes management contract or compensatory plan or arrangement. 66 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) BALANCE AT ADDITIONS DEDUCTIONS BALANCE BEGINNING CHARGED TO AMOUNTS AT END OF PERIOD EARNINGS WRITTEN OFF OF PERIOD ---------- ---------- ----------- --------- Year ended June 30, 2001 Deducted in the consolidated balance sheet: Trade accounts receivable, allowance for doubtful accounts............................ $ 74 $ 309 $ 0 $ 383 ======= ====== ====== ======= Deferred tax valuation allowance............... 15,004 9,588 0 24,592 ======= ====== ====== ======= Year ended June 30, 2002 Deducted in the consolidated balance sheet: Trade accounts receivable, allowance for doubtful accounts............................ 383 364 273 474 ======= ====== ====== ======= Deferred tax valuation allowance............... 24,592 8,374 0 32,966 ======= ====== ====== ======= Year ended June 30, 2003 Deducted in the consolidated balance sheet: Trade accounts receivable, allowance for doubtful accounts............................ 474 78 227 325 ======= ====== ====== ======= Deferred tax valuation allowance............... 32,966 0 3,739 29,227 ======= ====== ====== ======= 67 SIGNATURE Pursuant to the requirements Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, HARRIS INTERACTIVE INC. September 26, 2003 By /s/ Bruce A. Newman ------------------------------------ Bruce A. Newman Chief Financial Officer, Secretary and Treasurer (On Behalf of the Registrant and as Principal Financial and Accounting Officer) 68 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints, jointly and severally, Bruce A. Newman and Gordon S. Black, and each of them, as his true and lawful attorneys-in-fact and agents, each with full power of substitution, for him, and in his name, place and stead, in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with Exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. NAME CAPACITY DATE ---- -------- ---- /s/ GORDON S. BLACK Chairman of the Board and Chief September 26, 2003 -------------------------------------- Executive Officer (Principal Gordon S. Black Executive Officer) /s/ BRUCE A. NEWMAN Chief Financial Officer, September 26, 2003 -------------------------------------- Secretary, and Treasurer Bruce A. Newman (Principal Financial and Accounting Officer) /s/ ALBERT A. ANGRISANI President, Chief Operating September 26, 2003 -------------------------------------- Officer, and Director Albert A. Angrisani /s/ LEONARD R. BAYER Director September 26, 2003 -------------------------------------- Leonard R. Bayer /s/ THOMAS D. BERMAN Director September 26, 2003 -------------------------------------- Thomas D. Berman /s/ JAMES R. RIEDMAN Director September 26, 2003 -------------------------------------- James R. Riedman /s/ BENJAMIN D. ADDOMS Director September 26, 2003 -------------------------------------- Benjamin D. Addoms /s/ DAVID BRODSKY Director September 26, 2003 -------------------------------------- David Brodsky /s/ HOWARD L. SHECTER Director September 26, 2003 -------------------------------------- Howard L. Shecter 69

GLOBAL MACRO TRUST

10-K

https://www.sec.gov/Archives/edgar/data/1145765/0001104659-03-005564.txt

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended: December 31, 2002 or o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission File Number: 000-50102 GLOBAL MACRO TRUST (Exact name of registrant as specified in its charter) Delaware 36-7362830 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) c/o MILLBURN RIDGEFIELD CORPORATION 411 West Putnam Avenue Greenwich, Connecticut 06830 (Address of principal executive offices) Registrant s telephone number, including area code: (203) 625-7554 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Units of Beneficial Interest (Title of Class) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulations 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. o Indicate by check mark whether the registrant is an accelerated filer (defined in Rule 12b-2 of the Act). Yes o No ý Aggregate market value of the voting and non-voting common equity held by non-affiliates as of March 1, 2003: $46,568,919 Documents Incorporated by Reference Registrant s Financial Statements for Period from July 1, 2002 (commencement of operations) to December 31, 2002 with Report of Independent Auditors, the annual report to security holders for the fiscal year ended December 31, 2002, is incorporated by reference into Part II Item 8 and Part IV hereof and filed as an exhibit herewith. PART I Item 1. Business (a) General development of business Global Macro Trust (the Trust ) is a Delaware statutory trust organized July 23, 2001 pursuant to a Declaration of Trust and Trust Agreement (the Trust Agreement ), under the Delaware Statutory Trust Act. Between April 1, 2002 and June 30, 2002 (the Initial Offering ), units of beneficial interest in the Trust (the Units ) were publicly offered at an initial price of $1,000 per Unit. The proceeds of the Initial Offering and interest thereon were held in an account in the name of the Trust at FBR National Bank & Trust, Bethesda, Maryland, until July 1, 2002 at which time an aggregate of $1,290,457 was turned over to the Trust and the Trust commenced operations. As of December 31, 2002, Units were being offered on a monthly basis at Net Asset Value per unit. The offering is registered under the Securities Act of 1933, as amended. The Units are offered through a number of selling agents, including UBS PaineWebber Inc., on a best efforts basis. A total of $22,561,036 of Units have been sold to the public as of December 31, 2002. The Trust engages in speculative trading in the futures, options and forward markets. Millburn Ridgefield Corporation (the Managing Owner ), a Delaware corporation, is the managing owner and the commodity trading advisor for the Trust. The Managing Owner invested $400 in the Trust as an initial capital contribution to the Trust and $2,000,000 in the Trust at the outset of trading and subsequently contributed an additional $1,600 as of December 31, 2002. After reflecting a net gain of $150,395 and profit share of $70,924, this investment totaled (after deductions for redemptions) $2,221,645, as of December 31, 2002. (b) Financial information about industry segments The Trust s business constitutes only one segment, i.e., a speculative commodity pool. The Trust does not engage in sales of goods and services. (c) Narrative description of business The Trust engages in the speculative trading of futures, options on futures and forward contracts. The Trust s sole trading advisor is the Managing Owner. The Managing Owner trades the Trust s assets in the agricultural, metals, energy, interest rate and stock indices futures and futures options markets and in the currency markets, trading primarily forward contracts in the interbank market. Pursuant to the Trust Agreement, the Managing Owner receives a flat-rate monthly brokerage fee equal to 0.58 of 1% of the month-end Net Assets (a 7.0% annual rate). The Managing Owner charges less than the annual brokerage rate of 7% to those subscribers who either invest in amounts of $100,000 or more in the Units or subscribe without incurring the selling commission paid by the Managing Owner. The Managing Owner also receives a profit share equal to 20% of any new trading profit as defined, determined as of the end of each calendar year. The annual profit share is calculated net of brokerage fees and administrative expenses and excluding interest income. UBS PaineWebber Inc. acts as the primary futures broker for the Trust, although the Trust executes futures trades on non-U.S. futures exchanges through Deutsche Bank Securities Inc. The Trust executes currency forward trades with Morgan Stanley & Co. Incorporated and Morgan Stanley Capital Group Inc. The Trust pays bid asked spreads on its forward trades, as such spreads are incorporated into the pricing of forward contracts. The Managing Owner monitors the Trust s trades to ensure that the prices it receives are competitive. The Trust s organizational and initial offering costs were paid by the Managing Owner without reimbursement from the Trust or its Unitholders. The Trust pays its administrative expenses, including costs incurred in connection with the continuing offering of the Trust s Units, and any extraordinary expenses which it may incur. 1 The Trust is open-ended and may offer Units at net asset value as of the first day of each month. Unitholders may redeem any or all of their Units upon business 10 days written notice to the Managing Owner at their net asset value as of the last day of any month. Units redeemed on or prior to the end of the first and second successive six-month periods after their sale will pay a redemption charge of 4% and 3%, respectively, of the net asset value at which they are redeemed (redemption charges are reduced, in the case of subscriptions in amounts of $100,000 or more). These redemption charges are paid to the Managing Owner. Requests for redemption will be honored and payment will be made, except in the event of highly unusual market disruptions, within 15 business days of the effective date of redemption. The Trust s assets deposited with the Trust s futures brokers as margin are maintained in customer segregated funds accounts or foreign futures and foreign options secured amount accounts and are held in cash, or U.S. Treasury instruments. Trust assets not deposited as margin are maintained in bank or brokerage accounts and are held primarily in bank money market funds or U.S. Treasury instruments. Regulation Under the Commodity Exchange Act, as amended (the CEA ), commodity exchanges and futures trading are subject to regulation by the Commodity Futures Trading Commission (the CFTC ). National Futures Association ( NFA ), a registered futures association under the CEA, is the only non-exchange self-regulatory organization for futures industry professionals. The CFTC has delegated to NFA responsibility for the registration of commodity trading advisors, commodity pool operators, futures commission merchants, introducing brokers and their respective associated persons and floor brokers and floor traders. The CEA requires commodity pool operators and commodity trading advisors, such as the Managing Owner, and commodity brokers or futures commission merchants, such as the UBS PaineWebber Inc. and Deutsche Bank A.G., to be registered and to comply with various reporting and record keeping requirements. The CFTC may suspend a commodity pool operator s or trading advisor s registration if it finds that its trading practices tend to disrupt orderly market conditions or in certain other situations. In the event that the registration of the Managing Owner as a commodity pool operator or a commodity trading advisor were terminated or suspended, the Managing Owner would be unable to continue to manage the business of the Trust. Should the Managing Owner s registration be suspended, termination of the Trust might result. As members of NFA, the Managing Owner and the Trust s futures brokers are subject to NFA standards relating to fair trade practices, financial condition and customer protection. As the self-regulatory body of the futures industry, NFA promulgates rules governing the conduct of futures industry professionals and disciplines those professionals which do not comply with such standards. In addition to such registration requirements, the CFTC and certain commodity exchanges have established limits on the maximum net long or net short position which any person may hold or control in particular commodities. Most exchanges also limit the changes in futures contract prices that may occur during a single trading day. Currency forward contracts are not subject to regulation by any United States Government agency. (i) through (xii) - not applicable. (xiii) the Trust has no employees. (d) Financial information about geographic areas The Trust does not engage in material operations in foreign countries (although it does trade from the United States in foreign currency forward contracts and on foreign futures exchanges), nor is a material portion of its revenues derived from foreign customers. (e) Available information Not Applicable. The Trust is not an accelerated filer. 2 Item 2. Properties The Trust does not own or use any physical properties in the conduct of its business. The Managing Owner or an affiliate perform administrative services for the Trust from their offices. Item 3. Legal Proceedings The Managing Owner is not aware of any pending legal proceedings to which either the Trust is a party or to which any of its assets are subject. In addition there are no pending material legal proceedings involving the Managing Owner. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Market for the Registrant s Common Equity and Related Stockholder Matters (a) Market Information. There is no trading market for the Units, and none is likely to develop. Units may be redeemed upon business 10 days written notice to the Managing Owner at their net asset value as of the last day of any month, subject to certain early redemption charges. (b) Holders. As of December 31, 2002, there were 1033 holders of Units. (c) Dividends. No distributions or dividends have been made on the Units, and the Managing Owner has no present intention to make any. (d) Securities Authorized for Issuance Under Equity Compensation Plans. None. (e) Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities. On July 23, 2001, the Trust sold $1,600 of units of beneficial interest to an initial unitholder and the Managing Owner contributed $400 to permit the formation of the Trust in preparation for the filing of the Trust initial Registration Statement on Form S-1. The sale of the units was made to Nestor Partners, an investment fund for which the Managing Owner serves as general partner, and was exempt from registration under the Securities Act of 1933 pursuant to Section 4(2) thereof. Nestor Partners is an accredited investor. No discounts or commissions were paid in connection with the sale and no other offeree or purchaser was solicited. There have been no other sales of unregistered securities of the Trust. Reg. S-K Item 701(f) (1) The use of proceeds information is being disclosed for Registration Statement No. 333-67072 declared effective on March 26, 2002. 3 (4)(iv) For the account of the issuer, the amount of Units sold as of December 31, 2002 is $22,561,036, and the aggregate offering price of the amount sold as of December 31, 2002 is $22,561,036. (vi) The net offering proceeds to the issuer totaled $22,561,036. (vii) From the effective date of the Registration Statements to December 31, 2002, the amount of net offering proceeds to the issuer for commodity futures and forward trading totaled $22,561,036. Item 6. Selected Financial Data The following is a summary of operations for the fiscal year 2002 and total assets of the Trust at December 31, 2002. The Trust commenced trading operations on July 1, 2002. For the Year Ended December 31, 2002 Revenue: Total net realized and unrealized gains (losses)* $ 953,721 Interest income 110,054 Expenses: Profit share 70,924 Administrative expenses 38,443 Brokerage Commissions 431,467 Net Income (loss) $ 522,941 Total assets $ 27,460,920 Total Unitholders capital $ 22,814,478 Net asset value per Unit $ 1,030.24 Increase in net asset value per Unit $ 30.24 * From trading of futures and forward contracts, foreign exchange transactions and U.S. Treasury obligations Item 7. Management s Discussion and Analysis of Financial Condition and Results of Operations Reference is made to Item 6. Selected Financial Data and Item 8. Financial Statements and Supplementary Data. The information contained therein is essential to, and should be read in conjunction with, the following analysis. Capital Resources Units may be offered for sale as of the beginning, and may be redeemed as of the end, of each month. The amount of capital raised for the Trust should not have a significant impact on its operations, as the Trust has no significant capital expenditure or working capital requirements other than for monies to pay trading losses, brokerage commissions and charges. Within broad ranges of capitalization, the Managing Owner s trading positions should increase or decrease in approximate proportion to the size of the Trust. 4 The Trust raises additional capital only through the sale of Units and trading profits (if any) and does not engage in borrowing. The Trust trades futures, options and forward contracts on interest rates, commodities, currencies, metals, energy and stock indices. Risk arises from changes in the value of these contracts (market risk) and the potential inability of counterparties or brokers to perform under the terms of their contracts (credit risk). Market risk is generally to be measured by the face amount of the futures positions acquired and the volatility of the markets traded. The credit risk from counterparty non-performance associated with these instruments is the net unrealized gain, if any, on these positions. The risks associated with exchange-traded contracts are generally perceived to be less than those associated with over-the-counter transactions, because exchanges typically (but not universally) provide clearinghouse arrangements in which the collective credit (in some cases limited in amount, in some cases not) of the members of the exchange is pledged to support the financial integrity of the exchange. In over-the-counter transactions, on the other hand, traders must rely solely on the credit of their respective individual counterparties. Margins which may be subject to loss in the event of a default, are generally required in exchange trading, and counterparties may require margin in the over-the-counter markets. The Managing Owner has procedures in place to control market risk, although there can be no assurance that they will, in fact, succeed in doing so. These procedures primarily focus on (1) real time monitoring of open positions; (2) diversifying positions among various markets; (3) limiting the assets committed as margin, generally within a range of 15% to 35% of an account s Net Assets at exchange minimum margins, (including imputed margins on forward positions) although the amount committed to margin at any time may be substantially higher; (4) prohibiting pyramiding (that is, using unrealized profits in a particular market as margin for additional positions in the same market); and (5) changing the equity utilized for trading by an account solely on a controlled periodic basis rather than as an automatic consequence of an increase in equity resulting from trading profits. The Trust controls credit risk by dealing exclusively with large, well capitalized financial institutions as brokers and counterparties. Due to the nature of the Trust s business, substantially all its assets are represented by cash and United States government obligations, while the Trust maintains its market exposure through open futures and forward contract positions. The Trust s futures contracts are settled by offset and are cleared by the exchange clearinghouse function. Open futures positions are marked to market each trading day and the Trust s trading accounts are debited or credited accordingly. Options on futures contracts are settled either by offset or by exercise. If an option on a future is exercised, the Trust is assigned a position in the underlying future which is then settled by offset. The Trust s spot and forward currency transactions conducted in the interbank market are settled by netting offsetting positions held with the same counterparty; net positions are then settled by entering into offsetting positions and by cash payments. Liquidity The Trust s assets are generally held as cash or cash equivalents which are used to margin the Trust s futures positions and withdrawn, as necessary, to pay redemptions and expenses. Other than potential market-imposed limitations on liquidity, due, for example, to daily price fluctuation limits, which are inherent in the Trust s futures and forward trading, the Trust s assets are highly liquid and are expected to remain so. During its operations through December 31, 2002, the Trust experienced no meaningful periods of illiquidity in any of the numerous markets traded by the Managing Owner. Results of Operations Performance Summary The Trust s success depends on the Managing Owner s ability to recognize and capitalize on trends and other profit opportunities in different sectors of the world economy. The Managing Owner s trading methods are confidential, so that substantially the only information that can be furnished regarding the Trust s results of operations is its performance record. Unlike most operating businesses, general economic or seasonal conditions 5 have no direct effect on the profit potential of the Trust, while, at the same time, its past performance is not necessarily indicative of future results. Because of the speculative nature of its trading, operational or economic trends have little relevance to the Trust s results. The Managing Owner believes, however, that there are certain market conditions for example, markets with strong price trends in which the Trust has a better opportunity of being profitable than in others. The Trust commenced trading operations July 1, 2002. 2002 During 2002, the Trust achieved net gains of $953,721 from its trading operations (including foreign exchange transactions and translations). Brokerage fees of $431,467 were paid or accrued. The Trust paid a profit share to the Managing Owner of $70,924. Interest income of $110,054 partially offset the Trust s expenses resulting in a net gain (inclusive of administrative expenses) of $522,941 and a 3.02% increase in the Net Asset Value per Unit. Interest rate trading and, to a lesser extent, stock index trading were profitable during the Trust s first six months of operation. On the other hand, the Trust s currency trading generated losses, and trading in the energy, metals and agricultural sectors had only marginal impacts on performance. Sluggish worldwide economic activity, the continuing plunge of stock prices and the flight to safety and quality prompted by geopolitical uncertainties triggered large, persistent capital flows into government bills, notes and bonds worldwide. Accordingly, the Trust s long positions in U.S., European, and Japanese interest rate futures generated sizable gains while the Trust s trading in Japanese, German and Hong Kong stock futures was modestly profitable. As tensions in the Middle East heightened at year-end, energy prices moved higher and the Trust s long energy positions were very profitable, largely offsetting losses suffered earlier in the year when energy prices were moving erratically without a trend. Similarly, a long gold position was profitable in December as geopolitical tensions heated up, and this gain offset most of the losses from the Trust s non-precious metals trading where trends were absent. The Trust sustained losses on both long and short dollar positions as the Japanese yen fluctuated erratically in the Y116-Y126 range during the later half of the year. These losses, and those experienced from trading the Korean won, overwhelmed trading gains made on long positions in the euro and South African rand. The Trust s non-dollar cross rate trading was also fractionally negative for the year. In the agricultural sector, profits from a long corn trade more than offset a loss from trading cotton, producing a fractional profit for the sector overall by year-end. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Introduction Past Results Are Not Necessarily Indicative of Future Performance The Trust is a speculative commodity pool. Unlike an operating company, the risk of market sensitive instruments is integral, not incidental, to the Trust s main line of business. Market movements result in frequent changes in the fair market value of the Trust s open positions and, consequently, in its earnings and cash flow. The Trust s market risk is influenced by a wide variety of factors, including the level and volatility of interest rates, exchange rates, equity price levels, the market value of financial instruments and contracts, the diversification effects among the Trust s open positions and the liquidity of the markets in which it trades. The Trust can rapidly acquire and/or liquidate both long and short positions in a wide range of different markets. Consequently, it is not possible to predict how a particular future market scenario will affect performance, and the Trust s past performance is not necessarily indicative of its future results. Value at Risk is a measure of the maximum amount which the Trust could reasonably be expected to lose in a given market sector. However, the inherent uncertainty of the Trust s speculative trading and the recurrence in the markets traded by the Trust of market movements far exceeding expectations could result in actual trading or 6 non-trading losses far beyond the indicated Value at Risk or the Trust s experience to date (i.e., risk of ruin ). In light of the foregoing as well as the risks and uncertainties intrinsic to all future projections, the inclusion of the quantification included in this section should not be considered to constitute any assurance or representation that the Trust s losses in any market sector will be limited to Value at Risk or by the Trust s attempts to manage its market risk. Materiality, as used in this section Quantitative and Qualitative Disclosures About Market Risk, is based on an assessment of reasonably possible market movements and the potential losses caused by such movements, taking into account the leverage, optionality and multiplier features of the Trust s market sensitive instruments. Quantifying the Trust s Trading Value at Risk Quantitative Forward-Looking Statements The following quantitative disclosures regarding the Trust s market risk exposures contain forward-looking statements within the meaning of the safe harbor from civil liability provided for such statements by the Private Securities Litigation Reform Act of 1995 (set forth in Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934). All quantitative disclosures in this section are deemed to be forward-looking statements for purposes of the safe harbor, except for statements of historical fact. The Trust s risk exposure in the various market sectors traded by the Managing Owner is quantified below in terms of Value at Risk. Due to the Trust s mark-to-market accounting, any loss in the fair value of the Trust s open positions is directly reflected in the Trust s earnings (realized or unrealized) and cash flow (at least in the case of exchange-traded contracts in which profits and losses on open positions are settled daily through variation margin). Exchange maintenance margin requirements have been used by the Trust as the measure of its Value at Risk. Maintenance margin requirements are set by exchanges to equal or exceed 95-99% of the maximum one-day losses in the fair value of any given contract incurred during the time period over which historical price fluctuations are researched for purposes of establishing margin levels. The maintenance margin levels are established by dealers and exchanges using historical price studies as well as an assessment of current market volatility (including the implied volatility of the options on a given futures contract) and economic fundamentals to provide a probabilistic estimate of the maximum expected near-term one-day price fluctuation. In the case of market sensitive instruments which are not exchange traded (almost exclusively currencies in the case of the Trust), dealers margins have been used as Value at Risk. The fair value of the Trust s futures and forward positions does not have any optionality component. However, the Managing Owner may also trade commodity options on behalf of the Trust. The Value at Risk associated with options would be reflected in the margin requirement attributable to the instrument underlying each option. In quantifying the Trust s Value at Risk, 100% positive correlation in the different positions held in each market risk category has been assumed. Consequently, the margin requirements applicable to the open contracts have simply been aggregated to determine each trading category s aggregate Value at Risk. The diversification effects resulting from the fact that the Trust s positions are rarely, if ever, 100% positively correlated have not been reflected. The Trust s Trading Value at Risk in Different Market Sectors The following table indicates the average, highest and lowest amounts of trading Value at Risk associated with the Trust s open positions by market category for fiscal year 2002. During fiscal year 2002, the Trust s average total capitalization was approximately $15,101,275. The Trust commenced operations July 1, 2002. 7 Fiscal Year 2002 Market Sector Average Value at Risk % of Average Capitalization Highest Value At Risk Lowest Value At Risk Interest Rates $ 1.1 7.0 % $ 1.4 $ 0.7 Currencies $ 3.3 21.0 % $ 4.8 $ 1.8 Stock Indices $ 0.6 4.0 % $ 0.6 $ 0.5 Metals $ 0.2 1.3 % $ 0.2 $ 0.1 Commodities $ 0.1 0.3 % $ 0.1 $ 0 Energy $ 0.6 4.3 % $ 0.6 $ 0.5 Total $ 5.9 37.9 % Average, highest and lowest Value at Risk amounts relate to the quarter-end amounts for the third and fourth calendar quarter-ends during the fiscal year. Average Capitalization is the average of the Trust s capitalization at the end of the third and fourth calendar quarters of fiscal year 2002. Dollar amounts represent millions of dollars. Material Limitations on Value at Risk as an Assessment of Market Risk The face value of the market sector instruments held by the Trust is typically many times the applicable maintenance margin requirement (maintenance margin requirements generally ranging between approximately 1% and 10% of contract face value) as well as many times the capitalization of the Trust. The magnitude of the Trust s open positions creates a risk of ruin not typically found in most other investment vehicles. Because of the size of its positions, certain market conditions unusual, but historically recurring from time to time could cause the Trust to incur severe losses over a short period of time. The foregoing Value at Risk table as well as the past performance of the Trust give no indication of this risk of ruin. Non-Trading Risk The Trust has non-trading market risk on its foreign cash balances not needed for margin. However, these balances (as well as any market risk they represent) are immaterial. The Trust also has non-trading cash flow risk as a result of holding a substantial portion (approximately 73%) of its assets in U.S. Treasury notes and other short-term debt instruments (as well as any market risk they represent) for margin and cash management purposes. Although the Managing Owner does not anticipate that, even in the case of major interest rate movements, the Trust would sustain a material mark-to-market loss on its securities positions, if short-term interest rates decline so will the Trust s cash management income. The Trust also maintains a portion (approximately 9%) of its assets in cash in interest-bearing bank accounts. These cash balances are also subject (as well as any market risk they represent) to cash flow risk, which is not material. Qualitative Disclosures Regarding Primary Trading Risk Exposures The following qualitative disclosures regarding the Trust s market risk exposures except for (i) those disclosures that are statements of historical fact and (ii) the descriptions of how the Managing Owner manages the Trust s primary market risk exposures constitute forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. The Trust s primary market risk exposures as well as the strategies used and to be used by the Managing Owner for managing such exposures are subject to numerous uncertainties, contingencies and risks, any one of which could cause the actual results of the Trust s risk 8 controls to differ materially from the objectives of such strategies. Government interventions, defaults and expropriations, illiquid markets, the emergence of dominant fundamental factors, political upheavals, changes in historical price relationships, an influx of new market participants, increased regulation and many other factors could result in material losses as well as in material changes to the risk exposures and the risk management strategies of the Trust. There can be no assurance that the Trust s current market exposure and/or risk management strategies will not change materially or that any such strategies will be effective in either the short- or long-term. Investors must be prepared to lose all or substantially all of their investment in the Trust. The following were the primary trading risk exposures of the Trust as of December 31, 2002, by market sector. Financial Instruments. Interest rate movements directly affect the price of the sovereign bond futures positions held by the Trust and indirectly the value of its stock index and currency positions. Interest rate movements in one country as well as relative interest rate movements between countries may materially impact the Trust s profitability. The Trust s primary interest rate exposure is to interest rate fluctuations in the United States and other major industrialized, or G-7, countries. However, the Trust also may take positions in futures contracts on the government debt of smaller nations. The Managing Owner anticipates that G-7 interest rates, both long-term and short-term, will remain the primary market exposure of the Trust for the foreseeable future. Currencies. Exchange rate risk is the principal market exposure of the Trust. The Trust s currency exposure is to exchange rate fluctuations, primarily fluctuations which disrupt the historical pricing relationships between different currencies and currency pairs. These fluctuations are influenced by interest rate changes as well as political and general economic conditions. The Trust trades in a large number of currencies, including cross-rates i.e., positions between two currencies other than the U.S. dollar. However, the Trust s major exposures have typically been in the dollar/yen, dollar/euro and dollar/Swiss positions. The Managing Owner does not anticipate that the risk profile of the Trust s currency sector will change significantly in the future. Stock Indices. The Trust s primary equity exposure, through stock index futures, is to equity price risk in the G-7 countries. As of December 31, 2002, the Trust s primary exposures were in the E Mini Nasdaq 100 (United States), Simex (Singapore), TOPIX (Japan), DAX (German) and Hang Seng (Hong Kong) stock indices. The Trust is primarily exposed to the risk of adverse price trends or static markets in the major U.S., European and Asian indices. (Static markets would not cause major market changes but would make it difficult for the Trust to avoid numerous small losses.) Metals. The Diversified Portfolio used for the Trust trades precious and base metals. The Trust s primary metals market exposure is to fluctuations in the price of gold, aluminum, copper and zinc. Agricultural. The Trust s primary commodities exposure is to agricultural price movements, which are often directly affected by severe or unexpected weather conditions. Grains, coffee, sugar and cotton accounted for the substantial bulk of the Trust s commodities exposure as of December 31, 2002. The Trust may, in the future, have material market exposure to live cattle, cocoa, orange juice and the soybean complex. However, the Trust will generally maintain an emphasis on grains, coffee, sugar and cotton. Energy. The Trust s primary energy market exposure is to gas and oil price movements, often resulting from political developments in the Middle East and economic conditions worldwide. Energy prices are volatile and substantial profits and losses have been and are expected to continue to be experienced in this market. Qualitative Disclosures Regarding Non-Trading Risk Exposure The following were the only non-trading risk exposures of the Trust as of December 31, 2002. Foreign Currency Balances. The Trust s primary foreign currency balances are in Japanese yen, euro, British pounds and Hong Kong dollars. The Trust controls the non-trading risk of these balances by regularly converting these balances back into dollars (no less frequently than twice a month). 9 Securities Positions. The Trust s only market exposure in instruments held other than for trading is in its securities portfolio. The Trust holds only cash or interest-bearing, credit risk-free, short-term paper typically U.S. Treasury instruments with durations no longer than 1 year. Violent fluctuations in prevailing interest rates could cause immaterial mark-to-market losses on the Trust s securities, although substantially all of these short-term instruments are held to maturity. Qualitative Disclosures Regarding Means of Managing Risk Exposure The Managing Owner attempts to control risk through the systematic application of its trading method, which includes a multi-system approach to price trend recognition, an analysis of market volatility, the application of certain money management principles, which may be revised from time to time, and adjusting leverage or portfolio size. In addition, the Managing Owner limits its trading to markets which it believes are sufficiently liquid in respect of the amount of trading it contemplates conducting. The Managing Owner develops trading systems using various quantitative models and data and tests those systems in numerous markets against historical data to simulate trading results. The Managing Owner then analyzes the profitability of the systems looking at such features as the percentage of profitable trades, the worst losses experienced, the average giveback of maximum profits on profitable trades and risk adjusted returns. The performance of all systems in the market are then ranked, and a number of systems (typically, five to eight) are selected which make decisions in different ways at different times. This multi-system approach ensures that the total risk intended to be taken in a market is spread over several different strategies. The Managing Owner also attempts to assess market volatility as a means of monitoring and evaluating risk. In doing so, the Managing Owner uses a volatility overlay system which is designed to measure the risk in a portfolio s position in a market and to signal a decrease in position size when risk increases and an increase in position size when risk decreases. The Managing Owner s volatility overlay maintains overall portfolio risk and distribution of risk across markets within designated ranges. The Managing Owner s risk management also focuses on money management principles applicable to a portfolio as a whole rather than to individual markets. The first principle is reducing overall portfolio volatility through diversification among markets. The Managing Owner seeks a portfolio in which returns from trading in different markets are not highly correlated, that is, in which returns are not all positive or negative at the same time. Additional money management principles include limiting the assets committed as margin or collateral, generally within a range of 15% to 35% of an account s net assets; avoiding the use of unrealized profits in a particular market as margin for additional positions in the same market; and changing the equity used for trading an account solely on a controlled periodic basis, not automatically due to an increase in equity from trading profits. Another important risk management function is the careful control of leverage or portfolio size. Leverage levels are determined by simulating the entire portfolio over the past five or ten years to determine the worst case experienced by the portfolio in the simulation period. The worst case or peak-to-trough drawdown, is measured from a daily high in portfolio assets to the subsequent daily low whether that occurs days, weeks or months after the daily high. If the Managing Owner considers the drawdown too severe, it reduces the leverage or portfolio size. The Managing Owner determines asset allocation among markets on the basis of a systematic portfolio allocation algorithm. From time to time the Managing Owner may adjust the size of a position, long or short, in any given market. This exercise of discretion generally occurs only in response to unusual market conditions that may not have been factored into the design of the trading systems and is generally intended to reduce risk exposure. Decisions to make such adjustments require the exercise of judgment and may include consideration of the volatility of the particular market; the pattern of price movements, both inter-day and intra-day; open interest; volume of trading; changes in spread relationships between various forward contracts; and overall portfolio balance and risk exposure. 10 Item 8. Financial Statements and Supplementary Data Financial statements required by this item, including the report of Ernst & Young LLP, are included as Exhibit 13.01 to this report. The following summarized quarterly financial information presents the results of operations for the three month periods ended September 30 and December 31, 2002. The Trust commenced operations July 1, 2002. This information has not been audited. 4th Quarter 2002 3rd Quarter 2002 Income: $ 73,119 $ 36,935 Net Realized and Unrealized Gains (Losses): (384,118 ) 1,337,839 Expenses: 327,432 142,478 Net Income (Loss): (520,253 ) 1,043,194 Net Income (Loss) per Unit (58.06 ) 88.30 There were no extraordinary, unusual or infrequently occurring items recognized in any quarter within the two most recent fiscal years, and the Trust has not disposed of any segments of its business. There have been no year-end adjustments that are material to the results of any fiscal quarter reported above. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On November 27, 2002, the Board of Directors of the Managing Owner dismissed PricewaterhouseCoopers LLP as its independent auditor for the Trust and approved the engagement of Ernst & Young LLP as independent auditors for the Trust. Disclosure regarding the change of the Trust s auditors was previously reported on the Trust s current report on Form 8-K filed December 3, 2002. There were no disagreements with PricewaterhouseCoopers LLP regarding accounting principles or practices, financial statement disclosure or audit scope or procedure. PART III Item 10. Directors and Executive Officers of the Registrant (a,b) Identification of Directors and Executive Officers The Trust has no directors or executive officers. The Trust is controlled and managed by the Managing Owner under a delegation of authority by the Trust s Trustee, Wilmington Trust Company. Millburn Ridgefield Corporation, the Managing Owner, is a Delaware corporation organized in May 1982 to manage discretionary accounts in futures and forward markets. It is the corporate successor to a futures trading and advisory organization which has been continuously managing assets in the currency and futures markets using quantitative, systematic techniques since 1971. The principals and senior officers of Millburn Ridgefield Corporation as of December 31, 2002 are as follows: Harvey Beker, age 49. Mr. Beker is Co-Chief Executive Officer and Co-Chairman of the Managing Owner and The Millburn Corporation, and a partner of ShareInVest Research L.P. He received a Bachelor of Arts degree 11 in economics from New York University in 1974 and a Master of Business Administration degree in finance from NYU in 1975. From June 1975 to July 1977, Mr. Beker was employed by Loeb Rhoades, Inc. where he developed and traded silver arbitrage strategies. From July 1977 to June 1978, Mr. Beker was a futures trader at Clayton Brokerage Co. of St. Louis. Mr. Beker has been employed by The Millburn Corporation since June 1978. During his tenure at the Managing Owner, he has been instrumental in the development of the research, trading and operations areas. Mr. Beker became a principal of the firm in 1982. George E. Crapple, age 58. Mr. Crapple is Co-Chief Executive Officer and Co-Chairman of the Managing Owner and The Millburn Corporation and a partner of ShareInVest Research L.P. In 1966 he graduated with honors from the University of Wisconsin where his field of concentration was economics and he was elected to Phi Beta Kappa. In 1969 he graduated from Harvard Law School, magna cum laude, where he was a member of the Harvard Law Review. He was a lawyer with Sidley & Austin, Chicago, Illinois, from 1969 until April 1, 1983, as a partner since 1975, specializing in commodities, securities, corporate and tax law. He was first associated with the Managing Owner in 1976 and joined the Managing Owner on April 1, 1983 on a full-time basis. Mr. Crapple is a Director, Member of the Executive Committee, Chairman of the Appeals Committee and a former Chairman of the Eastern Regional Business Conduct Committee of the NFA, past Chairman of the Managed Funds Association and a member of the Technology Advisory Committee of the CFTC. Gregg R. Buckbinder, age 44. Mr. Buckbinder is Senior Vice-President and Chief Operating Officer of the Managing Owner and The Millburn Corporation and a partner of ShareInVest Research L.P. He graduated cum laude from Pace University in 1980 with a B.B.A. in accounting and received an M.S. in taxation from Pace in 1988. He joined the Managing Owner in January 1998 from Odyssey Partners, L.P. where he was responsible for the operation, administration and accounting of the firm s merchant banking and managed account businesses from mid-1990 through December 1997. Mr. Buckbinder was employed by Tucker Anthony, a securities broker and dealer, from 1985 to 1990 where he was First Vice President and Controller, and from 1983 to 1984 where he designed and implemented various operations and accounting systems. He was with the public accounting firm of Ernst & Whinney from 1984 to 1985 as a manager in the tax department and from 1980 to 1983 as a senior auditor, with an emphasis on clients in the financial services business. He is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants. Mark B. Fitzsimmons, age 55. Mr. Fitzsimmons is a Senior Vice-President of the Managing Owner and The Millburn Corporation and a partner of ShareInVest Research L.P. His responsibilities include both marketing and investment strategy. He graduated summa cum laude from the University of Bridgeport, Connecticut in 1970 with a B.S. in economics. His graduate work was done at the University of Virginia, where he received a certificate of candidacy for a Ph.D. in economics in 1973. He joined the Managing Owner in January 1990 from Morgan Stanley & Co. Incorporated where he was a Principal and Manager of institutional foreign exchange sales and was involved in strategic trading for the firm. From 1977 to 1987 he was with Chemical Bank New York Corporation, first as a Senior Economist in Chemical s Foreign Exchange Advisory Service and later as a Vice-President and Manager of Chemical s Corporate Trading Group. While at Chemical he also traded both foreign exchange and fixed income products. From 1973 to 1977 Mr. Fitzsimmons was employed by the Federal Reserve Bank of New York, dividing his time between the International Research Department and the Foreign Exchange Department. Barry Goodman, age 45. Mr. Goodman is Executive Vice-President, Director of Trading and Co-Director of Research of the Managing Owner and The Millburn Corporation and a partner of ShareInVest Research L.P. His responsibilities include overseeing the firm s trading operation and managing its trading relationships, as well as the design and implementation of trading systems. He graduated magna cum laude from Harpur College of the State University of New York in 1979 with a B.A. in economics. From 1980 through late 1982 he was a commodity trader for E. F. Hutton & Co., Inc. At Hutton he also designed and maintained various technical indicators and coordinated research projects pertaining to the futures markets. He joined the Managing Owner in 1982 as Assistant Director of Trading. Dennis B. Newton, age 51. Mr. Newton is a Senior Vice-President of the Managing Owner and the Millburn Corporation. His primary responsibilities are in administration and marketing. Prior to joining the Managing Owner in September 1991, Mr. Newton was President of Phoenix Asset Management, Inc., a registered commodity pool operator from April 1990 to August 1991. Prior to his employment with Phoenix, Mr. Newton was a Director of Managed Futures with Prudential-Bache Securities Inc. from September 1987 to March 1990. 12 Mr. Newton joined Prudential-Bache from Heinold Asset Management, Inc. where he was a member of the senior management team. Heinold was a pioneer and one of the largest sponsors of funds utilizing futures and currency forward trading. Grant N. Smith, age 51. Mr. Smith is Executive Vice-President and Co-Director of Research of the Managing Owner and The Millburn Corporation and a partner of ShareInVest Research L.P. He is responsible for the design, testing and implementation of quantitative trading strategies, as well as for planning and overseeing the computerized decision-support systems of the firm. He received a B.S. degree from the Massachusetts Institute of Technology in 1974 and an M.S. degree from M.I.T. in 1975. While at M.I.T. he held several teaching and research positions in the computer science field and participated in various projects relating to database management. He joined the Managing Owner in 1975. (c) Identification of Certain Significant Employees None. (d) Family Relationships None. (e) Business Experience See Item 10 (a,b) above. (f) Involvement in Certain Legal Proceedings None. (g) Promoters and Control Persons The Managing Owner is the sole promoter and control person of the Trust. (h) Section 16(a) Beneficial Ownership Reporting Compliance The Managing Owner filed its initial report on Form 3 after 10 days after the Trust became registered pursuant to Section 12 of the Securities Exchange Act of 1934. The Managing Owner has not owned and does not own any securities issued by the Trust, and, accordingly, the number of transactions not reported on a timely basis is zero. George E. Crapple, Harvey Beker and Gregg R. Buckbinder, the principal executive officers and principal financial officer, respectively, of the Managing Owner are the officers and employees of the Managing Owner who perform policy making functions for the Trust. Each of Messrs. Crapple, Beker and Buckbinder filed his initial report on Form 3 after 10 days after the Trust became registered under Section 12 of the Securities Exchange Act of 1934. None of Messrs. Crapple, Beker and Buckbinder owns or has owned any securities issued by the Trust, and, accordingly, the number or transactions not reported on a timely basis by Messrs. Crapple, Beker and Buckbinder is zero. Item 11. Executive Compensation The Trust has no directors or officers. None of the directors or officers of the Managing Owner receive compensation from the Trust. The Managing Owner makes all trading decisions on behalf of the Trust. The Managing Owner receives monthly brokerage commissions of 0.58 of 1% of the Trust s Net Assets (which is reduced to 0.54 of 1%, 0.5 of 1% or 0.458 of 1% of Net Assets for Unitholders who invest amounts of $100,000, $500,000 or $1,000,000 or more, respectively, in the Trust and to 0.33 of 1% in for Unitholders who invest through selling agent fee-based accounts) and an annual profit share of 20% of any new trading profit as defined. 13 Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners The Trust knows of no person who owns beneficially more than 5% of the Units. All of the Trust s managing owner interest is held by the Managing Owner. (b) Security Ownership of Management Under the terms of the Trust Agreement, the Trust s affairs are managed by the Managing Owner, which has discretionary authority over the Trust s trading. The Managing Owner s managing owner interest was valued at $2,221,645 as of December 31, 2002, 8.87% of the Trusts total equity. (c) Changes in Control None. (d) Securities Authorized for Issuance Under Equity Compensation Plans None. Item 13. Certain Relationships and Related Transactions See Item 11. Executive Compensation and Item 12. Security Ownership of Certain Beneficial Owners and Management. The Trust allocated to the Managing Owner $431,467 in brokerage fees and $70,924 in profit share for the year ended December 31, 2002. The Managing Owners managing owner interest showed an allocation of income of $150,360 for the year ended December 31, 2002. The Trust is prohibited from making any loans. Item 14. Controls and Procedures The Managing Owner, with the participation of the Managing Owner s principal executive officers and principal financial officer, has evaluated the effectiveness of the design and operation of its disclosure controls and procedures with respect to the Trust within 90 days of the filing date of this annual report, and, based on their evaluation, have concluded that these disclosure controls and procedures are effective. There were no significant changes in the Managing Owner s internal controls with respect to the Trust or in other factors applicable to the Trust that could significantly affect these controls subsequent to the date of their evaluation. 14 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements The following are included with the 2002 Report of Independent Auditors, a copy of which is filed herewith as Exhibit 13.01. Affirmation of Millburn Ridgefield Corporation Report of Independent Auditors Statement of Financial Condition Condensed Schedule of Investments Statement of Operations Statement of Changes in Trust Capital Statement of Financial Highlights Notes to Financial Statements (a)(2) Financial Statement Schedules All Schedules are omitted for the reason that they are not required or are not applicable because equivalent information has been included in the financial statements or the notes thereto. (a)(3) Exhibits as required by Item 601 of Regulation S-K The following exhibits are included herewith. Designation Description 10.01 Form of Customer Agreement with Deutsche Bank Securities Inc. 10.02 Form of Foreign Exchange and Options Master Agreements with Morgan Stanley & Co. Incorporated and Morgan Stanley Capital Group Inc. (with schedules) 13.01 2002 Report of Independent Auditors 99.1 Certification of Principal Executive Officer 99.2 Certification of Principal Executive Officer 99.3 Certification of Principal Financial Officer The following exhibit is incorporated by reference from the exhibit of the same number and description filed with the Trust s Registration Statement (File No. 333-67072) filed on August, 2001 on Form S-1 under the Securities Act of 1933. 15 3.01 Certificate of Trust of Registrant. The following exhibits are incorporated by reference from the exhibits of the same number and description filed with Amendment No. 1 to the Trust s Registration Statement (File No. 333-67072) filed on January 11, 2002 on Form S-1 under the Securities Act of 1933. 1.01 Amended Form of Selling Agreement among the Trust, the Managing Owner and the Selling Agent (including the form of Additional Selling Agent Agreement). 10.02 Form of Customer Agreement among the Trust, the Managing Owner and UBS PaineWebber Inc. Selling Agent in its capacity as a futures commission merchant. The following exhibits are incorporated by reference from the exhibits of the same number and description filed with Post-Effective Amendment No. 1 to the Trust s Registration Statement (File No. 333-67072) filed December 16, 2002 on Form S-1 under the Securities Act of 1933. 3.03 Amended Form of Amended and Restated Declaration and Agreement of Trust of Registrant. 10.01 Form of Subscription Agreement and Power of Attorney 10.03 Form of Wholesaling Agreement (b) Reports on Form 8-K On December 3, 2002, the Trust filed a Current Report on Form 8-K to disclose, pursuant to Item 4 of Form 8-K, that on November 27, 2002 the Board of Directors of the Managing Owner had dismissed PricewaterhouseCoopers LLP as its independent auditor for the Trust and had approved the engagement of Ernst & Young LLP as independent auditors for the Trust. 16 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 28th day of March, 2003. GLOBAL MACRO TRUST By: Millburn Ridgefield Corporation, Managing Owner By: /s/ Harvey Beker Harvey Beker Co-Chief Executive 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 Managing Owner of the Registrant in the capacities and on the date indicated. Signature Title with General Partner Date /s/ Harvey Beker Co-Chief March 28, 2003 Harvey Beker Executive Officer and Director (Principal Executive Officer) /s/ George E. Crapple Co-Chief Executive March 28, 2003 George E. Crapple Officer and Director (Principal Executive Officer) /s/ Gregg R. Buckbinder Senior Vice President March 28, 2003 Gregg R. Buckbinder (Principal Financial Officer) /s/ Tod A. Tanis Vice President March 28, 2003 Tod A. Tanis (Principal Accounting Officer) (Being the principal executive officers, the principal financial officer and principal accounting officer, and a majority of the directors of Millburn Ridgefield Corporation) Millburn Ridgefield Corporation Managing Owner of Registrant March 28, 2003 By /s/ Harvey Beker Harvey Beker Co-Chief Executive Officer 17 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER I, George E. Crapple, Co-Chief Executive Officer of Millburn Ridgefield Corporation, the Managing Owner of Global Macro Trust (the Trust ), do hereby certify that: 1. I have reviewed this annual report on Form 10-K of Global Macro Trust; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Trust as of, and for, the periods presented in this annual report; 4. The Trust s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Trust and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Trust, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Trust s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the Evaluation Date ); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Trust s other certifying officers and I have disclosed, based on our most recent evaluation, to the Trust s auditors and the audit committee of the Trust s board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Trust s ability to record, process, summarize and report financial data and have identified for the Trust s auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Trust s internal controls; and 6. The Trust s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. By: /s/ George E. Crapple George E. Crapple Co-Chief Executive Officer March 28, 2003 18 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER I, Harvey Beker, Co-Chief Executive Officer of Millburn Ridgefield Corporation, the Managing Owner of Global Macro Trust (the Trust ), do hereby certify that: 1. I have reviewed this annual report on Form 10-K of Global Macro Trust; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Trust as of, and for, the periods presented in this annual report; 4. The Trust s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Trust and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Trust, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Trust s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the Evaluation Date ); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Trust s other certifying officers and I have disclosed, based on our most recent evaluation, to the Trust s auditors and the audit committee of the Trust s board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Trust s ability to record, process, summarize and report financial data and have identified for the Trust s auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Trust s internal controls; and 6. The Trust s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. By: /s/ Harvey Beker Harvey Beker Co-Chief Executive Officer March 28, 2003 19 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER I, Gregg R. Buckbinder, Chief Operating Officer and principal financial officer of Millburn Ridgefield Corporation, the Managing Owner of Global Macro Trust (the Trust ), do hereby certify that: 1. I have reviewed this annual report on Form 10-K of Global Macro Trust; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Trust as of, and for, the periods presented in this annual report; 4. The Trust s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Trust and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Trust, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Trust s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the Evaluation Date ); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Trust s other certifying officers and I have disclosed, based on our most recent evaluation, to the Trust s auditors and the audit committee of the Trust s board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Trust s ability to record, process, summarize and report financial data and have identified for the Trust s auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Trust s internal controls; and 6. The Trust s other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. By: /s/ Gregg R. Buckbinder Gregg R. Buckbinder Chief Financial Officer March 28, 2003 20 EXHIBIT INDEX The following exhibits are included herewith. Designation Description 10.01 Form of Customer Agreement with Deutsche Bank Securities Inc. 10.02 Form of Foreign Exchange and Options Master Agreements with Morgan Stanley & Co. Incorporated and Morgan Stanley Capital Group Inc. (with schedules) 13.01 2002 Report of Independent Auditors 99.1 Certification of Principal Executive Officer 99.2 Certification of Principal Executive Officer 99.3 Certification of Principal Financial Officer The following exhibit is incorporated by reference from the exhibit of the same number and description filed with the Trust s Registration Statement (File No. 333-67072) filed on August, 2001 on Form S-1 under the Securities Act of 1933. 3.01 Certificate of Trust of Registrant. The following exhibits are incorporated by reference from the exhibits of the same number and description filed with Amendment No. 1 to the Trust s Registration Statement (File No. 333-67072) filed on January 11, 2002 on Form S-1 under the Securities Act of 1933. 1.01 Amended Form of Selling Agreement among the Trust, the Managing Owner and the Selling Agent (including the form of Additional Selling Agent Agreement). 10.02 Form of Customer Agreement among the Trust, the Managing Owner and UBS PaineWebber Inc. Selling Agent in its capacity as a futures commission merchant. The following exhibits are incorporated by reference from the exhibits of the same number and description filed with Post-Effective Amendment No. 1 to the Trust s Registration Statement (File No. 333-67072) filed December 16, 2002 on Form S-1 under the Securities Act of 1933. 3.03 Amended Form of Amended and Restated Declaration and Agreement of Trust of Registrant. 10.01 Form of Subscription Agreement and Power of Attorney 10.03 Form of Wholesaling Agreement 21

De Beira Goldfields Inc.

10-K

https://www.sec.gov/Archives/edgar/data/1345756/0001108078-10-000003.txt

ANNUAL REPORT PURSUANT TO SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended August 31, 2009 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 0R 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from Commission file number 000-51707 DE BEIRA GOLDFIELDS INC. (Exact name of registrant as specified in its charter) Nevada 00-0000000 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 30 Ledgar Road, Balcatta, Western Australia 6021 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code 011-61-89-240-2836 Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered None N/A Securities registered pursuant to Section 12(g) of the Act: common stock - $0.001 par value (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [ ] Yes [ X ] No 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 [ X ] No Note - Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act from their obligations under those sections. Page - 1 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [ X ] Yes [ ] No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 229.405 of this chapter) during the preceeding 12 months (or for such shorter period that the registrant was required to submit and post such files). [ ] Yes [ ] No 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. [ ] 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 definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Larger accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] (Do not check if a smaller reporting company) Smaller reporting company [ X ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ X ] Yes [ ] No The aggregate market value of the common stock of the registrant held by non-affiliates as of February 28, 2009 the last business day of the registrant’s most recently completed second fiscal quarter based on the closing sale price of the registrant’s common stock on that date as reported on the Over the Counter Bulletin Board was $1,682,213 (37,382,500 X $0.045). There were 66,046,785 shares of common stock outstanding on December 15, 2009. Documents incorporated by reference: Exhibit 3.1 (Articles of Incorporation) filed on December 12, 2005 as an Exhibit to De Beira’s Form SB-2 (Registration Statement); Exhibit 3.2 (By-laws) filed on December 12, 2005 as an Exhibit to De Beira’s Form SB-2 (Registration Statement); Exhibit 10.1 (Management Agreement) filed on May 10, 2006 as an Exhibit to De Beira’s Form 8-K (Current Report); Exhibit 10.2 (Letter of Understanding) filed on May 25, 2006 as an Exhibit to De Beira’s Form 8-K (Current Report); Exhibit 10.3 (Letter Agreement) filed on June 29, 2006 as an Exhibit to De Beira’s Form 8-K (Current Report); Exhibit 10.4 (Share Sale Agreement) filed on July 17, 2006 as an Exhibit to De Beira’s Form 8-K (Current Report); and Exhibit 14.1 (Financial Code of Ethics) filed on December 12, 2005 as an Exhibit to De Beira’s Form SB-2 (Registration Statement.) Page - 2 TABLE OF CONTENTS PART I Item 1. Business 4 Item 1A. Risk Factors 7 Item 1B. Unresolved Staff Comments 7 Item 2. Properties 8 Item 3. Legal Proceedings 8 Item 4. Submission of Matters to a Vote of Security Holders 8 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 8 Item 6. Selected Financial Data 13 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 13 Item 7A. Quantitative & Qualitative Disclosure About Market Risk 15 Item 8. Financial Statements and Supplementary Data 16 Balance Sheets F - 2 Statements of Operations F - 3 Statements of Cash Flows F - 4 Statements of Stockholders’ Equity (Deficit) F - 5 Notes to the Financial Statements Item 9A. Controls and Procedures 18 Item 9B. Other Information 18 PART III Item 10. Directors, Executive Officer and Corporate Governance 18 Item 11. Executive Compensation 20 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stock Matters 21 Item 13. Certain Relationships and Related Transactions and Director Independence 22 Item 14. Principal and Accountant Fees and Services 22 PART IV Item 15. Exhibits and Financial Statement Schedules 24 SIGNATURES EXHIBIT INDEX Page - 3 Forward Looking Statements The information in this annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including statements regarding De Beira’s capital needs, business strategy and expectations. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “intend”, “anticipate”, “believe”, “estimate”, “predict”, “potential” or “continue”, the negative of such terms or other comparable terminology. Actual events or results may differ materially. In evaluating these statements, you should consider various factors, including the risks outlined from time to time, in other reports De Beira files with the Securities and Exchange Commission. The information constitutes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements in this Form 10-K for the fiscal year ended August 31, 2009, are subject to risks and uncertainties that could cause actual results to differ materially from the results expressed in or implied by the statements contained in this report. As a result, the identification and interpretation of data and other information and their use in developing and selecting assumptions from and among reasonable alternatives requires the exercise of judgment. To the extent that the assumed events do not occur, the outcome may vary substantially from anticipated or projected results, and accordingly, no opinion is expressed on the achievability of those forward-looking statements. No assurance can be given that any of the assumptions relating to the forward-looking statements specified in the following information are accurate. All forward-looking statements are made as of the date of filing of this Form 10-K and De Beira disclaims any obligation to publicly update these statements, or disclose any difference between its actual results and those reflected in these statements. De Beira may, from time to time, make oral forward-looking statements. De Beira strongly advises that the above paragraphs and the risk factors described in this Annual Report and in De Beira’s other documents filed with the United States Securities and Exchange Commission should be read for a description of certain factors that could cause the actual results of De Beira to materially differ from those in the oral forward-looking statements. De Beira disclaims any intention or obligation to update or revise any oral or written forward-looking statements whether as a result of new information, future events or otherwise. PART I Item 1. Description of Business. General De Beira Goldfields Inc. (“De Beira”) is a Nevada corporation that was incorporated on May 28, 2004. Since June 2006, De Beira has had its office at 30 Ledgar Road, Balcatta, Western Australia, 6021. The telephone number at this office is 011-61-89-240-2836. De Beira uses this office space under an arrangement whereby an entity related to the president and director of the Company provides office administration, accounting and corporate secretarial services to the Company for a fee based on time and hourly charge rates. De Beira maintains its statutory registered agent’s office at 1859 Whitney Mesa Drive, Henderson, Nevada, 89014. De Beira is an exploration stage company engaged in the acquisition and exploration of mineral properties. De Beira’s plan of operations is to conduct mineral exploration activities on mineral properties in order to assess whether these claims possess commercially exploitable mineral deposits. De Beira’s exploration program will be designed to explore for commercially viable deposits of base and precious minerals, such as gold, silver, lead, barium, mercury, copper, and zinc minerals. See “Business of De Beira” and “Management’s Discussion and Analysis or Plan of Operations” below for more information. On June 15, 2006, De Beira entered into an agreement with Emco Corporation (“Emco”) to acquire an 80% interest in Minanca Minera Nanguipa, Compañía Anónima (“Minanca”), subject to certain conditions. Minanca owns certain mineral exploration property, including plant and equipment, in Ecuador, South America (the “Ecuador Property”). See Exhibit 10.4 – Share Sale Agreement for more details. However, on December 9, 2007 De Beira entered into an agreement with Emco to cancel the previously executed acquisition agreement, as the Company concluded that it is not presently in its best interests to settle the acquisition. Page - 4 De Beira has an authorized capital of 75,000,000 shares of common stock with a par value of $0.001 per share with 66,046,785 shares of common stock currently issued and outstanding. De Beira has not been involved in any bankruptcy, receivership or similar proceedings. There have been no material reclassifications, mergers, consolidations or purchases or sales of a significant amount of assets not in the ordinary course of De Beira’s business. Business of De Beira De Beira is an Exploration Stage Company, as defined by Statement of Financial Accounting Standard (“SFAS”) No.7 “Accounting and Reporting for Development Stage Enterprises”. De Beira’s principal business is the acquisition and exploration of mineral resources. De Beira has not presently determined whether the properties it intends to acquire contain mineral reserves that are economically recoverable. De Beira is a start-up, development stage company, which has not generated any revenues from its mineral exploration activities. A small number of interesting projects are presently being reviewed, but it is too early to say whether they may be considered appropriate for acquisition. Management’s objective is to recapitalize De Beira, raise new capital and seek new investment opportunities in the mineral sector. Management believes that its worldwide industry contacts will make it possible to identify and assess new projects for acquisition purposes. Additionally, De Beira’s is seeking a viable business opportunity through acquisition, merger or other suitable business combination method. De Beira will attempt to locate and negotiate with a target business for the merger of a target business into De Beira. In certain instances, a target business may want to become a subsidiary of De Beira or may want to contribute assets to De Beira rather than merge. It is anticipated that management will contact broker-dealers and other persons with whom they are acquainted who are involved with corporate finance matters to advise them of De Beira’s existence and to determine if any companies or businesses that they represent have a general interest in considering a merger or acquisition with De Beira. No assurance can be given that De Beira will be successful in finding or acquiring a viable target business. Furthermore, no assurance can be given that any business opportunity, which does occur, will be on terms that are favorable to De Beira or its current stockholders. A target business, if any, which may be interested in a business combination with De Beira may include (1) a company for which a primary purpose of becoming public is the use of its securities for the acquisition of assets or businesses; (2) a company that is unable to find an underwriter of its securities or is unable to find an underwriter of securities on terms acceptable to it; (3) a company that wants to become public with less dilution of its common stock than would occur normally upon an underwriting; (4) a company that believes that it will be able to obtain investment capital on more favorable terms after it has become public; (5) a foreign company that wants to gain an initial entry into the United States securities market; (6) a special situation company, such as a company seeking a public market to satisfy redemption requirements under a qualified Employee Stock Option Plan; or (7) a company seeking one or more of the other perceived benefits of becoming a public company. Management believes that there are perceived benefits to being a reporting company with a class of publicly-registered securities. These are commonly thought to include (1) the ability to use registered securities to make acquisition of assets or businesses; (2) increased visibility in the financial community; (3) the facilitation of borrowing from financial institutions; (4) improved trading efficiency; (5) stockholder liquidity; (6) greater ease in subsequently raising capital; (7) compensation of key employees through stock options; (8) enhanced corporate image; and (9) a presence in the United States capital market. De Beira anticipates that the target businesses or business opportunities presented to it will (1) either be in the process of formation, or be recently organized with limited operating history or a history of losses attributable to under-capitalization or other factors; (2) experiencing financial or operating difficulties; (3) be in need of funds to develop new products or services or to expand into a new market, or have plans for rapid expansion through acquisition of competing businesses; (4) or other similar characteristics. De Beira intends to concentrate its acquisition efforts on properties or businesses that management believes to be undervalued or that management believes may realize a substantial benefit from being publicly owned. Given the above factors, investors should expect that any target business or business opportunity may have little or no operating history, or a history of losses or low profitability. Page - 5 De Beira does not propose to restrict its search for business opportunities to any particular geographical area or industry, and may, therefore, engage in essentially any business, to the extent of its limited resources. This includes industries such as service, finance, natural resources, manufacturing, high technology, product development, medical, communications and others. De Beira’s discretion in the selection of business opportunities is unrestricted, subject to the availability of such opportunities, economic conditions, and other factors. However, management believes that any potential business opportunity must provide audited financial statements for review, for the protection of all parties to the business combination. One or more attractive business opportunities may choose to forego the possibility of a business combination with De Beira, rather than incur the expenses associated with preparing audited financial statements. Management, which in all likelihood will not be experienced in matters relating to the business of a target business, will rely upon its own efforts in accomplishing De Beira’s business purposes. Outside consultants or advisors may be utilized by De Beira to assist in the search for qualified target companies. If De Beira does retain such an outside consultant or advisor, any cash fee earned by such person will need to be assumed by the target business, as De Beira has no cash assets with which to pay such obligation. Management does not have the capacity to conduct as extensive an investigation of a target business as might be undertaken by a venture capital fund or similar institution. The analysis of new business opportunities will be undertaken by, or under the supervision of De Beira’s officers and directors, who are not professional business analysts. In analyzing prospective business opportunities, management may consider such matters as: • the available technical, financial and managerial resources; • working capital and other financial requirements; history of operations, if any; • prospects for the future; • nature of present and expected competition; • the quality and experience of management services which may be available and the depth of that management; • the potential for further research, development, or exploration; • specific risk factors not now foreseeable but which then may be anticipated to impact our proposed activities; • the potential for growth or expansion; • the potential for profit; and • the perceived public recognition or acceptance of products, services, or trades name identification. A target business may have an agreement with a consultant or advisor, providing that services of the consultant or advisor be continued after any business combination. Additionally, a target business may be presented to De Beira only on the condition that the services of a consultant or advisor be continued after a merger or acquisition. Such pre-existing agreements of target businesses for the continuation of the services of attorneys, accountants, advisors or consultants could be a factor in the selection of a target business. In implementing a structure for a particular target business acquisition, De Beira may become a party to a merger, consolidation, reorganization, joint venture, or licensing agreement with another corporation or entity. De Beira may also acquire stock or assets of an existing business. Depending upon the nature of the transaction, the current officers and directors of De Beira may resign their management and board positions with De Beira in connection with a change of control or acquisition of a business opportunity and be replaced by one or more new officers and directors. It is anticipated that any securities issued in any reorganization would be issued in reliance upon exemption from registration under applicable federal and state securities laws. In some circumstances however, as a negotiated element of its transaction, De Beira may agree to register all or a part of such securities immediately after the transaction is consummated or at specified times thereafter. If such registration occurs, of which there can be no assurance, it will be undertaken by the surviving entity after De Beira has entered into an agreement for a business combination or has consummated a business combination. The issuance of additional securities and their potential sale into De Beira’s trading market may depress the market value of De Beira’s securities in the future. With respect to any merger or acquisition negotiations with a target business, management expects to focus on the percentage of De Beira that the target business stockholder would acquire in exchange for their shareholdings in the target business. Depending upon, among other things, the target business’s assets and liabilities, De Beira’s shareholders will in all likelihood hold a substantially lesser percentage ownership interest in De Beira following any merger or acquisition. Any merger or acquisition effected by De Beira can be expected to have a significant dilutive effect on the percentage of shares held by De Beira’s shareholders at that time. Page - 6 At the present time, management has not identified any target business or business opportunity that it plans to pursue, nor has De Beira reached any agreement or definitive understanding with any person concerning an acquisition or a business combination. When any such agreement is reached or other material fact occurs, De Beira will file notice of such agreement or fact with the Securities and Exchange Commission on Form 8-K. Persons reading this Form 10-K are advised to determine if De Beira has subsequently filed a Form 8-K. Management anticipates that the selection of a business opportunity in which to participate will be complex and without certainty of success. Management believes (but has not conducted any research to confirm) that there are numerous firms seeking the perceived benefits of a publicly registered corporation. Such perceived benefits may include facilitating or improving the terms on which additional equity financing may be sought, providing liquidity for incentive stock options or similar benefits to key employees, increasing the opportunity to use securities for acquisitions, and providing liquidity for stockholder’s investments. Business opportunities may be available in many different industries and at various stages of development, all of which will make the task of comparative investigation and analysis of such business opportunities extremely difficult and complex. Property Interests De Beira does not have any mineral property assets or mineral property interests. Competition De Beira competes with other mining and exploration companies possessing greater financial resources and technical facilities than De Beira in connection with the acquisition of mineral exploration claims and in connection with the recruitment and retention of qualified personnel. Many of De Beira’s competitors have a very diverse portfolio and have not confined their market to one mineral or property, but explore a wide array of minerals and mineral exploration properties. Some of these competitors have been in business for longer than De Beira and may have established more strategic partnerships and relationships than De Beira. Management believes that it will have a competitive advantage over its competitors due to its network of contacts, which will enable it to identify and acquire prospective mineral properties more quickly and efficiently than many of its competitors. Government Controls and Regulations De Beira is not subject to any government controls or regulations as the Company has no interests in any mineral projects. Patents/Trade Marks/Licences/Franchises/Concessions/Royalty Agreements or Labour Contracts De Beira currently does not own any patents or trade marks. Also, De Beira is not party to any license or franchise agreements, concessions, royalty agreements or labor contracts arising from any patents or trademarks. Number of Total Employees and Number of Full Time Employees There are no employees at the present time. Item 1A . Risk Factors De Beira is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information required under this item. Item 1B. Unresolved Staff Comments De Beira is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information required under this item. Page - 7 Item 2. Description of Property As at the date of this report De Beira does not own any mineral properties or mineral property interests. Since June 2006, De Beira has had its office at 30 Ledgar Road, Balcatta, Western Australia, 6021. The telephone number at this office is 011-61-89-240-2836. De Beira uses this office space under an arrangement whereby an entity related to the president and director of the Company provides office administration, accounting and corporate secretarial services to De Beira for a fee based on time and hourly charge rates. Item 3. Legal Proceedings De Beira is not a party to any pending legal proceedings and, to the best of management’s knowledge, none of De Beira’s property or assets are the subject of any pending legal proceedings. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. (a) Market Information De Beira’s shares of common stock have been quoted on the NASD OTC Bulletin Board since March 8, 2006 under the symbol “DBGF.PK”. The table on the next page gives the high and low bid information for each fiscal quarter De Beira’s common stock has been quoted for the last three fiscal years and for the interim period ended November 23, 2009. The bid information was obtained from Pink OTC Markets, Inc. (fka Pink Sheets LLC) and reflects inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions. High & Low Bids Period ended High Low Source 18 December 2009 $0.0504 $0.0502 Pink OTC Markets, Inc. 30 November 2009 $0.10 $0.04 Pink OTC Markets, Inc 31 August 2009 $0.0405 $0.031 Pink OTC Markets, Inc. 31 May 2009 $0.041 $0.031 Pink OTC Markets, Inc. 28 February 2009 $0.045 $0.045 Pink OTC Markets, Inc. 30 November 2008 $0.125 $0.041 Pink OTC Markets, Inc. 31 August 2008 $0.135 $0.11 Pink OTC Markets, Inc. 31 May 2008 $0.22 $0.10 Pink OTC Markets, Inc. 29 February 2008 $0.40 $0.21 Pink OTC Markets, Inc. 30 November 2007 $0.72 $0.37 Pink Sheets, LLC 31 August 2007 $1.03 $0.52 Pink Sheets, LLC 31 May 2007 $1.20 $0.76 Pink Sheets, LLC 28 February 2007 $2.04 $1.06 Pink Sheets, LLC 30 November 2006 $2.94 $0.91 Pink Sheets, LLC 31 August 2006 (after a 3 for 2 split on 16 June 2006) $10.12 $1.15 Pink Sheets, LLC (b) Holders of Record De Beira has approximately 57 holders of record of De Beira’s common stock as of December 15, 2009 according to a shareholders’ list provided by De Beira’s transfer agent as of that date. The number of registered shareholders does not include any estimate by De Beira of the number of beneficial owners of common stock held in street name. The transfer agent for De Beira’s common stock is Empire Stock Transfer Inc., 1859 Whitney Mesa Drive, Henderson, Nevada, 89014 and their telephone number is 702-818-5898. Page - 8 (c) Dividends De Beira has declared no cash dividends on its shares of common stock and is not subject to any restrictions that limit its ability to pay cash dividends on its shares of common stock. Cash dividends are declared at the sole discretion of De Beira’s Board of Directors. On March 10, 2006, the Board of Directors declared a stock split effected in the form of a stock dividend on the basis of seven additional shares of common stock being issued for every one share of common stock outstanding. The stock dividend was paid out on March 23, 2006. On June 5, 2006, the Board of Directors declared a second stock split effected in the form of a stock dividend on the basis of one additional share of common stock being issued for every two shares of common stock outstanding, which was the same effect as a 3:2 forward split. The stock dividend was paid out on June 15, 2006 and was effective June 16, 2006. (d) Recent Sales of Unregistered Securities There have been no sales of unregistered securities within the last three years that would be required to be disclosed pursuant to Item 701 of Regulation S-K, except for the following: November 2006 - $0.80 Private Placement Offering On November 13, 2006, the board of directors authorized the issuance of 1,875,000 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $1,500,000 in cash in this closing, and issued an aggregate 1,875,000 restricted shares of common stock to 2 non-US subscribers outside the United States. Also, under this same offering, on November 30, 2006, the board of directors authorized the issuance of an additional 1,220,000 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $976,000 in cash in this closing, and issued an aggregate 1,220,000 restricted shares of common stock to 14 non-US subscribers outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the 16 non-US subscribers outside the United States in these two closings, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The offering was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each subscriber a completed and signed subscription agreement containing certain representations and warranties, including, among others, that (a) the subscriber was not a U.S. person, (b) the subscriber subscribed for the shares for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the sale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. January 2007 - $0.80 Private Placement Offering On January 2, 2007, the board of directors authorized the issuance of 1,687,500 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $1,350,000 in cash in this closing, and issued an aggregate 1,687,500 restricted shares of common stock to 10 non-US subscribers outside the United States. Also, under this same offering, on January 25, 2007, the board of directors authorized the issuance of an additional 1,500,000 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $1,200,000 in cash in this closing, and issued an aggregate 1,500,000 restricted shares of common stock to 2 non-US subscribers outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the 12 non-US subscribers outside the United States in these two closings, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The offering was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each subscriber a completed and signed subscription agreement containing certain representations and warranties, including, among others, that (a) the subscriber was not a U.S. person, (b) the subscriber subscribed for the shares for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the sale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. February 2007 - $0.80 Private Placement Offering On February 9, 2007, the board of directors authorized the issuance of 1,250,000 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $1,000,000 in cash in this closing, and issued an aggregate 1,250,000 restricted shares of common stock to one non-US subscribers outside the United States. Also, under this same offering, on February 28, 2007, the board of directors authorized the issuance of an additional 100,000 restricted shares of common stock at a subscription price of $0.80 per restricted share. De Beira raised $80,000 in cash in this closing, and issued an aggregate 100,000 restricted shares of common stock to one non-US subscribers outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. Page - 9 For the two non-US subscribers outside the United States in these two closings, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The offering was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each subscriber a completed and signed subscription agreement containing certain representations and warranties, including, among others, that (a) the subscriber was not a U.S. person, (b) the subscriber subscribed for the shares for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the sale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. February 2009 - $0.01 Private Placement Offering On February 28, 2009, the board of directors authorized the issuance of 1,600,000 restricted shares of common stock at a subscription price of $0.01 per restricted share. De Beira raised $16,000 in cash in this closing, and on June 19, 2009 issued an aggregate 1,600,000 restricted shares of common stock to three non-US subscribers outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the three non-US subscribers outside the United States in this one closing, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The offering was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each subscriber a completed and signed subscription agreement containing certain representations and warranties, including, among others, that (a) the subscriber was not a U.S. person, (b) the subscriber subscribed for the shares for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the resale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. February 2009 - $0.01 Shares For Debt Offering Also, on February 28, 2009, the board of directors approved the settlement of debt for shares at a settlement price of $0.01 per restricted share. De Beira settled $125,000 in debt in this closing, and on June 19, 2009 issued an aggregate 12,500,000 restricted shares of common stock to four non-US creditors outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the four non-US creditors outside the United States in this one closing, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The settlement of debt was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each creditor a completed and signed shares for debt agreement containing certain representations and warranties, including, among others, that (a) the creditor was not a U.S. person, (b) the creditor accepted the shares for debt for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the resale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. Page - 10 May 2009 - $0.01 Shares For Debt Offering On May 29, 2009, the board of directors approved the settlement of debt for shares at a settlement price of $0.01 per restricted share. De Beira settled $15,000 in debt in this closing, and on June 19, 2009 issued an aggregate 1,500,000 restricted shares of common stock to two non-US creditors outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the two non-US creditors outside the United States in this one closing, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The settlement of debt was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each creditor a completed and signed shares for debt agreement containing certain representations and warranties, including, among others, that (a) the creditor was not a U.S. person, (b) the creditor accepted the shares for debt for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the resale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. October 2009 - $0.01 Private Placement Offering On October 19, 2009, the board of directors authorized the issuance of 4,000,000 restricted shares of common stock at a subscription price of $0.01 per restricted share. De Beira raised $40,000 in cash in this closing, and on October 19, 2009 issued an aggregate 4,000,000 restricted shares of common stock to two non-US subscribers outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the two non-US subscribers outside the United States in this one closing, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The offering was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each subscriber a completed and signed subscription agreement containing certain representations and warranties, including, among others, that (a) the subscriber was not a U.S. person, (b) the subscriber subscribed for the shares for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the resale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. October 2009 - $0.01 Shares For Debt Offering On October 19, 2009, the board of directors approved the settlement of debt for shares at a settlement price of $0.01 per restricted share. De Beira settled $23,500 in debt in this closing, and on October 19, 2009 issued an aggregate 2,350,000 restricted shares of common stock to two non-US creditors outside the United States. De Beira set the value of the restricted shares arbitrarily without reference to its assets, book value, revenues or other established criteria of value. All the restricted shares issued in this offering were issued for investment purposes in a “private transaction”. For the two non-US creditors outside the United States in this one closing, De Beira relied upon Section 4(2) of the Securities Act of 1933 and Rule 903 of Regulation S promulgated pursuant to that Act by the Securities and Exchange Commission. Management is satisfied that De Beira complied with the requirements of the exemption from the registration and prospectus delivery of the Securities Act of 1933. The settlement of debt was not a public offering and was not accompanied by any general advertisement or any general solicitation. De Beira received from each creditor a completed and signed shares for debt agreement containing certain representations and warranties, including, among others, that (a) the creditor was not a U.S. person, (b) the creditor accepted the shares for debt for their own investment account and not on behalf of a U.S. person, and (c) there was no prearrangement for the resale of the shares with any buyer. No offer was made or accepted in the United States and the share certificates representing the shares were issued bearing a legend with the applicable trading restrictions. Page - 11 Except as disclosed above, there are no other outstanding options or warrants to purchase, or securities convertible into, shares of De Beira’s common stock at this time. (e) Penny Stock Rules The SEC has also adopted rules that regulate broker-dealer practices in connection with transactions in penny stocks. Penny stocks are generally equity securities with a price of less than $5.00 (other than securities registered on certain national securities exchanges or quoted on the NASDAQ system provided that current price and volume information with respect to transactions in such securities is provided by the exchange or system). The shares of De Beira will remain penny stock for the foreseeable future. The classification of penny stock makes it more difficult for a broker-dealer to sell the stock into a secondary market, which makes it more difficult for a purchaser to liquidate his or her investment. Any broker-dealer engaged by the purchaser for the purpose of selling his or her shares in De Beira will be subject to rules 15g-1 through 15g-10 of the Exchange Act. Rather than creating a need to comply with those rules, some broker-dealers will refuse to attempt to sell penny stock. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock not otherwise exempt from those rules, deliver a standardized risk disclosure document prepared by the SEC, which: · contains a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; · contains a description of the broker’s or dealer’s duties to the customer and of the rights and remedies available to the customer with respect to a violation to such duties or other requirements; · contains a brief, clear, narrative description of a dealer market, including “bid” and “ask” prices for penny stocks and the significance of the spread between the bid and ask price; · contains a toll-free telephone number for inquiries on disciplinary actions; · defines significant terms in the disclosure document or in the conduct of trading penny stocks; and · contains such other information and is in such form (including language, type, size, and format) as the Commission shall require by rule or regulation. The broker-dealer also must provide, prior to effecting any transaction in a penny stock, the customer: · with bid and offer quotations for the penny stock; · the compensation of the broker-dealer and its salesperson in the transaction; · the number of shares to which such bid and ask prices apply, or other comparable information relating to the depth and liquidity of the market for such stock; and · monthly account statements showing the market value of each penny stock held in the customer’s account. Page - 12 In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from those rules; the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser’s written acknowledgment of the receipt of a risk disclosure statement, a written agreement to transactions involving penny stocks, and a signed and dated copy of a written suitability statement. These disclosure requirements will have the effect of reducing the trading activity in the secondary market for De Beira’s stock because it will be subject to these penny stock rules. Therefore, stockholders may have difficulty selling those securities. Item 6. Selected Financial Data De Beira is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information required under this item. Item 7. Management’s Discussion and Analysis. The following discussion and analysis should be read in conjunction with the Financial Statements and Notes to the Financial Statements filed with this Report. Business Overview De Beira was incorporated in the State of Nevada on May 28, 2004. De Beira’s primary business is the acquisition and exploration of mineral resources. De Beira is an Exploration Stage Company, as defined by Statement of Financial Accounting Standard No. 7 “Accounting and Reporting for Development Stage Enterprises”. The financial statements for the year ended August 31, 2009 have been prepared assuming De Beira will continue as a going concern. De Beira has incurred net losses of approximately $154,600 and $66,700 for the years ended August 31, 2009 and 2008. The report of the independent registered public accounting firm on De Beira’s financial statements as of and for the year ended August 31, 2009 includes a ‘going concern’ explanatory paragraph which means that the accounting firm has expressed substantial doubt about De Beira’s ability to continue as a going concern. Management’s plans with respect to these matters are described in this section and in its financial statements, and does not include any adjustments that might result from the outcome of this uncertainty. There is no guarantee that De Beira will be able to raise the funds or raise further capital for the operations planned in the future. Plan of Operation Management’s objective is to recapitalize the Company, raise new capital and seek new investment opportunities in the mineral sector. De Beira will continue to identify and assess undervalued mineral properties when capital raisings are completed. A small number of interesting projects are presently being reviewed, but it is too early to say whether they may be considered appropriate for acquisition. Results of Operations De Beira has generated no operating revenues since its inception on May 28, 2004 through the year ended August 31, 2009. For the year ended August 31, 2009, De Beira had interest income of $252 compared to $1,286 for the year ended August 31, 2008. Total expenses for the year ended August 31, 2009 were $88,584 compared to $1,244,109 for the year ended August 31, 2008. Expenses were lower in fiscal year 2009 than 2008 primarily due to no mineral property and exploration costs being incurred during 2009 and $843,914 during the previous fiscal year. Management fees, professional fees and travel costs ($90,988 versus $351,562) were lower in fiscal year 2009 than 2008 primarily due to lower expenditures for corporate promotions, public relations, legal fees, accounting and audit fees as a result of decreased company activity. Liquidity and Capital Resources As of August 31, 2009, De Beira had cash of $72,424 and a working capital deficit of $1,175,055. During the year ended August 31, 2009, De Beira used $20,211 in operating activities compared to $318,356 in the prior year. As previously noted, De Beira is not generating revenues and accordingly has not generated any cash flows from operations. De Beira is uncertain as to when it will produce cash flows from operations to meet operating and capital requirements and will require significant funding from external sources. Page - 13 During the year ended August 31, 2009, De Beira received $56,000 through private placements of common stock compared to zero in the prior year. During the prior year, De Beira repaid loans to related parties using cash of $177,581. During the year ended August 31, 2009, no cash was used to repay any debt, however, $140,000 of debt and accrued expenses were converted to common stock. Critical Accounting Policies De Beira has identified the following policies below as critical to its business and results of operations. De Beira’s reported results are impacted by the application of the following accounting policies, certain of which require management to make subjective or complex judgments. These judgments involve making estimates about the effect of matters that are inherently uncertain and may significantly impact quarterly or annual results of operations. For all of these policies, management cautions that future events rarely develop exactly as expected, and the best estimates routinely require adjustment. Specific risks associated with these critical accounting policies are described in the paragraphs below. Mineral property and exploration costs De Beira has been in the exploration stage since its formation on May 28, 2004 and has not yet realized any revenues from its planned operations. It is primarily engaged in the acquisition and exploration of mining properties. Mineral property and exploration costs are expensed as incurred. When it has been determined that a mineral property can be economically developed as a result of establishing proven and probable reserves, the costs incurred to develop such property are capitalized. Such costs will be amortized using the units-of-production method over the estimated life of the probable reserve. If mineral properties are subsequently abandoned or impaired, any capitalized costs will be charged to operations. Valuation of loan advances De Beira evaluates loan advances for possible collectibility concerns on a quarterly basis. De Beira considers both the intent or ability of the borrower to repay the loan advances as part of its collectibility analysis. Allowances are recorded against the loan advances in an amount management believes would be adequate to cover estimated losses, based on its evaluation of the collectibility of the loan advances. Outlook As of August 31, 2009, De Beira had cash and cash equivalents of $72,424 and a working capital deficit of $1,175,055. De Beira will need to raise additional capital to execute its business plan of project identification and assessment. Although the agreement for the acquisition of an 80% interest in Minanca has been cancelled, management continues to seek recovery of all or part of the $6.1 million owed to De Beira on the loan. As mentioned previously, management intends to recapitalize the Company, raise new capital and seek new investment opportunities within the mineral sector. Management believes that its worldwide industry contacts will make it possible to raise capital and identify and assess new projects. If De Beira does not receive sufficient funding on a timely basis, it could have a material adverse effect on its liquidity, financial condition and business prospects. Additionally, if De Beira receives funding, it may be on terms that are not favorable to De Beira and its shareholders. Off-Balance Sheet Arrangements De Beira does not have any off-balance sheet arrangements (as that term is defined in Item 303 of Regulation S-K) that are reasonably likely to have a current or future material effect on our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources. Page - 14 Recent Accounting Pronouncements In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No.115 (SFAS 159). SFAS 159 allows companies the choice to measure many financial instruments and certain other items at fair value. This gives 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 159 was effective for the Company on September 1, 2008. The adoption of SFAS 159 did not have an impact on the Company’s financial statements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 was effective for the Company on September 1, 2008. The adoption of SFAS 157 did not have an impact on the Company’s financial statements. In December 2007, the FASB issued SFAS No. 160 (SFAS 160), Noncontrolling Interests in Consolidated Financial Statements—an Amendment of ARB 51. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest (minority interest) in a subsidiary and for the deconsolidation of a subsidiary. Upon adoption of SFAS 160, effective for the Company as of September 1, 2009, any noncontrolling interests will be classified as equity in the Company's financial statements and any income and comprehensive income attributed to the noncontrolling interest will be included in the Company's income and comprehensive income. The presentation and disclosure provisions of this standard must be applied retrospectively upon adoption. The adoption of SFAS 160 is not expected to have an impact on the Company’s financial statements. In December 2007, the FASB issued FASB Statement No. 141R (SFAS 141R), Business Combinations, which changes how business acquisitions are accounted for. SFAS 141R requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction and establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed in a business combination. Certain provisions of this standard will, among other things, impact the determination of acquisition-date fair value of consideration paid in a business combination (including contingent consideration); exclude transaction costs from acquisition accounting; and change accounting practices for acquired contingencies, acquisition-related restructuring costs, in-process research and development, indemnification assets, and tax benefits. SFAS 141R is effective for the Company on September 1, 2009. The adoption of SFAS 141R is not expected to have a material impact on the Company’s financial statements, unless the Company enters into any future business acquisitions. In May 2009, the FASB issued SFAS No. 165, Subsequent Events (“SFAS No. 165”). SFAS No. 165 is effective for interim or annual periods ending after June 15, 2009 and establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. An entity must disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued, or the date they were available to be issued. In June 2009, the FASB issued SFAS No. 168 (SFAS 168) Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162. SFAS 168 establishes the FASB Accounting Standards Codification as the single official source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with US GAAP. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. On the effective date, all non-SEC accounting and reporting standards will be superseded. The Company will adopt SFAS 168 for the quarterly period ending November 30, 2009, as required, and adoption is not expected to have a material impact on the Company’s financial statements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk De Beira is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information required under this item. Page - 15 Item 8. Financial Statements De Beira’s financial statements are stated in United States Dollars (US$) and are prepared in accordance with accounting principles generally accepted in the United States of America. See Exhibit A – Financial Statements attached below. The Report of De Beira’s Independent Registered Public Accounting Firm, GHP Horwath, P.C., on its audited financial statements as of August 31, 2009 and 2008 and for each of the years then ended, and for the period from May 28, 2004 (inception) through August 31, 2009 is included immediately preceding the audited financial statements at the end of this Report. Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable Item 9A. Controls and Procedures Disclosure Controls and Procedures In connection with the preparation of this annual report on Form 10-K, an evaluation was carried out by De Beira’s management, with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of De Beira’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)) as of August 31, 2009. Disclosure controls and procedures are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures. Based on that evaluation, De Beira’s management concluded, as of the end of the period covered by this report, that De Beira’s disclosure controls and procedures were not effective in recording, processing, summarizing, and reporting information required to be disclosed, within the time periods specified in the SEC rules and forms and that such information was not accumulated or communicated to management to allow timely decisions regarding required disclosure, for the reasons listed below in management’s report on internal control over financial reporting. Management’s Report on Internal Controls over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting, as required by Sarbanes-Oxley (SOX) Section 404 A. De Beira’s internal control over financial reporting is a process designed under the supervision of De Beira’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of De Beira’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: · pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of De Beira’s assets; · provide reasonable assurance that transactions are recorded as necessary to permit preparation of the financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the Board of Directors; and · provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of De Beira’s assets that could have a material effect on the financial statements. Because of its inherent limitations, 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 or procedures may deteriorate. Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of August 31, 2009, based on criteria established in Internal Control –Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). As a result of this assessment, management identified material weaknesses in internal control over financial reporting. Page - 16 A material weakness is a control deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of De Beira’s annual or interim financial statements will not be prevented or detected on a timely basis. The matters involving internal controls and procedures that management considered to be material weaknesses under the standards of the Public Company Accounting Oversight Board were: (1) lack of a functioning audit committee and lack of a majority of outside directors on De Beira’s board of directors, resulting in ineffective oversight in the establishment and monitoring of required internal controls and procedures; (2) inadequate segregation of duties consistent with control objectives; (3) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of US GAAP and SEC disclosure requirements; and (4) ineffective controls over period end financial disclosure and reporting processes. The aforementioned material weaknesses were identified by De Beira’s Chief Financial Officer in connection with the audit of its financial statements as of August 31, 2009 and these matters were communicated to the board of directors. As a result of the material weaknesses in internal control over financial reporting described above, management has concluded that, as of August 31, 2009, De Beira’s internal control over financial reporting was not effective based on the criteria in Internal Control – Integrated Framework issued by COSO. Management believes that the material weaknesses set forth above did not have an affect on De Beira’s financial results. Management also believes that the lack of a functioning audit committee and lack of a majority of outside directors on De Beira’s board of directors caused and continues to cause an ineffective oversight in the establishment and monitoring of the required internal controls over financial reporting. De Beira is committed to improving its financial organization. As part of this commitment and when funds are available, De Beira will create a position within De Beira’s accounting and finance team to segregate duties consistent with its control objectives and will increase its personnel resources and technical accounting expertise within the accounting function by: i) appointing one or more outside directors to its board of directors who will also be appointed to the audit committee of De Beira resulting in a fully functioning audit committee who will undertake the oversight in the establishment and monitoring of required internal controls over financial reporting; and ii) preparing and implementing sufficient written policies and checklists that will set forth procedures for accounting and financial reporting with respect to the requirements and application of US GAAP and SEC disclosure requirements. Management believes that the appointment of one or more outside directors, who will also be appointed to a fully functioning audit committee, will remedy the lack of a functioning audit committee and a lack of a majority of outside directors on De Beira’s Board. In addition, management believes that preparing and implementing sufficient written policies and checklists will remedy the following material weaknesses: (i) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of US GAAP and SEC disclosure requirements; and (ii) ineffective controls over period end financial close and reporting processes. Further, management believes that the hiring of additional personnel who have the technical expertise and knowledge will result proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide the cross training needed to support De Beira if personnel turn-over issues within the department occur. This coupled with the appointment of additional outside directors will greatly decrease any control and procedure issues De Beira may encounter in the future. Management will continue to monitor and evaluate the effectiveness of De Beira’s internal controls over financial reporting on an ongoing basis and is committed to taking further action and implementing additional enhancements or improvements, as necessary and as funds allow. De Beira’s independent auditors have not issued an attestation report regarding De Beira’s internal control over financial reporting. As a result, this annual report does not include such a report. De Beira was not required to have, nor has De Beira, engaged its independent registered public accounting firm to perform an audit of internal control over financial reporting pursuant to the rules of the Securities and Exchange Commission that permit De Beira to provide only management’s report in this annual report. Page - 17 Changes in Internal Controls There were changes in De Beira’s internal controls over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) during the quarter ended August 31, 2009, that materially affected, or are reasonably likely to materially affect, De Beira’s internal control over financial reporting. During the quarter ended August 31, 2009, management completed its assessment of De Beira’s internal controls over financial reporting and found the internal controls to be ineffective. As a result of such assessment, in June 2009 management decided that certain changes to De Beira’s internal controls over financial reporting were required, as discussed above, and those changes materially affected De Beira’s internal control over financial reporting when implemented. Also, in June 2009 management made certain changes to De Beira’s disclosure controls and procedures and implemented certain remediation procedures, as discussed above. Item 9B. Other Information During the fourth quarter of the year covered by this Form 10-K, De Beira had no information to be disclosed as required on a Form 8-K that was not previously disclosed. PART III Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act (a) Identify Directors and Executive Officers The directors named below will serve until the next annual meeting of the stockholders. Thereafter, directors will be elected for one-year terms at the annual stockholders' meeting. Officers will hold their positions at the discretion of the board of directors, absent any employment agreement, of which none currently exists or is contemplated. There is no arrangement or understanding between the directors and officers and any other person pursuant to which any director or officer was to be selected as a director or officer. The names, addresses, ages and positions of De Beira’s officers and directors that held their positions during or since the fiscal year ended August 31, 2009 are set forth below: Name and Address Age Positions Klaus Eckhof 30 Ledgar Road Balcatta, Western Australia, 6021 51 Chairman, Chief Executive Officer and director Susmit Shah 30 Ledgar Road Balcatta, Western Australia, 6021 53 Chief Financial Officer, and Treasurer, Corporate Secretary Klaus Eckhof Dipl. Geol. TU, AusIMM ● Mr. Eckhof has been the Chairman of De Beira since May 2006 and was appointed sole director and Chief Executive Officer on June 1, 2008. Mr. Eckhof is a senior exploration geologist and a member of the Australian Institute of Mining and Metallurgy. Mr Eckhof has many global contacts and has been instrumental in sourcing and developing successful projects in Australia, Africa, Russia, South America and the Philippines. Since 1994, Mr. Eckhof has managed his own geological consultancy company and has considerable experience in assessing and acquiring mineral prospects around the world. He was formerly President and Chief Executive Officer of Moto Goldmines Limited, a company which is listed on the Toronto Stock Exchange and within 4 years from Mr Eckhof’s appointment discovered just under 20,000,000 ounces of gold and completed a Bankable Feasibility Study (BFS) in the Democratic Republic of Congo (DRC). He is currently Chief Executive officer of KILO Goldmines Ltd. Page - 18 During the past three years, Mr. Eckhof has also served as a director of the following listed companies: Moto Goldmines Limited (February 2003 - January 2008), Elemental Minerals Ltd (February 2006 - November 2007), Aurora Gold Inc (July 2004 to May 2007), Condor Resources Limited (since September 1996), African Metals Corporation (since November 2005), Carnavale Resources Ltd (since January 2008) and Windy Knob Resources Ltd (since April 2008). Susmit Mohanlal Shah CA, Corporate ● Mr. Shah has been the Chief Financial Officer, Treasurer, and Corporate Secretary of De Beira since June 2006. Mr. Shah is a chartered accountant with over 20 years’ experience. Over the last 15 years, Mr. Shah has been involved with a diverse range of Australian public listed companies in company secretarial and financial roles. (b) Identify Significant Employees De Beira currently does not have any significant employees. (c) Family Relationships There are no family relationships among the directors, executive officers or persons nominated or chosen by De Beira to become directors or executive officers. (d) Involvement in Certain Legal Proceedings (1) No bankruptcy petition has been filed by or against any business of which any director was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time. (2) No director has been convicted in a criminal proceeding and is not subject to a pending criminal proceeding (excluding traffic violations and other minor offences). (3) No director has been subject to any order, judgement, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities. (4) No director has been found by a court of competent jurisdiction (in a civil action), the Securities Exchange Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, that has not been reversed, suspended, or vacated. (e) Compliance with Section 16(a) of the Exchange Act All reports were filed with the SEC on a timely basis and De Beira is not aware of any failures to file a required report during the period covered by this annual report. (f) Nomination Procedure for Directors De Beira does not have a standing nominating committee; recommendations for candidates to stand for election as directors are made by the board of directors. De Beira has not adopted a policy that permits shareholders to recommend candidates for election as directors or a process for shareholders to send communications to the board of directors. (g) Audit Committee Financial Expert De Beira does not have a separately-designated standing audit committee. Susmit Shah, De Beira’s chief financial officer has skills and experience commensurate with an “audit committee financial expert”. Page - 19 (h) Identification of Audit Committee De Beira does not have a separately-designated standing audit committee. Rather, De Beira’s board of directors performs the required functions of an audit committee. De Beira’s board of directors is responsible for: (1) selection and oversight of De Beira’s independent accountant; (2) establishing procedures for the receipt, retention and treatment of complaints regarding accounting, internal controls and auditing matters; (3) establishing procedures for the confidential, anonymous submission by De Beira’s employees of concerns regarding accounting and auditing matters; (4) engaging outside advisors; and, (5) funding for the outside auditory and any outside advisors engagement by the audit committee. (i) Code of Ethics De Beira has adopted a code of ethics that applies to all its executive officers and employees, including its CEO and CFO. See Exhibit 14.1 – Code of Ethics for more information. Also, De Beira’s code of ethics has been posted on its website at www.debeira.com. De Beira undertakes to provide any person with a copy of its code of ethics free of charge. Please contact Susmit Shah at 011-61-8-9240-6717 to request a copy of De Beira’s code of ethics. Management believes De Beira’s code of ethics is reasonably designed to deter wrongdoing and promote honest and ethical conduct; provide full, fair, accurate, timely and understandable disclosure in public reports; comply with applicable laws; ensure prompt internal reporting of code violations; and provide accountability for adherence to the code. Item 11. Executive Compensation De Beira has paid $43,799 in compensation to its named executive officers during its fiscal year ended August 31, 2009. SUMMARY COMPENSATION TABLE Name and principal position (a) Year (b) Salary ($) (c) Bonus ($) (d) Stock Awards ($) (e) Option Awards ($) (f) Non-Equity Incentive Plan ($) (g) Non-qualified Deferred Compen- sation Earnings ($) (h) All other compen-sation ($) (i) Total ($) (j) Klaus Eckhof Chairman May 2006 – present CEO and President June 2008 - present 2007 2008 2009 48,145 54,940 43,799 nil nil nil Nil nil nil nil nil nil nil nil nil nil nil nil nil nil nil 48,145 54,940 43,799 Susmit Shah (1) CFO June 2006 – present 2007 2008 2009 87,559 30,981 21,492 nil nil nil Nil nil nil nil nil nil nil nil nil nil nil nil nil nil nil 87,559 30,981 21,492 Reg Gillard CEO and President April 2006 – June 2008 2007 2008 2009 49,622 39,538 n/a nil nil n/a Nil nil n/a nil nil n/a nil nil n/a nil nil n/a nil nil n/a 49,622 39,538 n/a (1) Administration, accounting and secretarial fees of $21,492 (2008 - $30,981) were paid or payable to Corporate Consultants Pty Ltd, a company in which Mr. Shah is a director and has a beneficial interest. Since De Beira’s inception, no stock options, stock appreciation rights, or long-term incentive plans have been granted, exercised or repriced. Currently, there are no arrangements between De Beira and any of its directors whereby such directors are compensated for any services provided as directors. There are no other employment agreements between De Beira and any named executive officer, and there are no employment agreements or other compensating plans or arrangements with regard to any named executive officer which provide for specific compensation in the event of resignation, retirement, other termination of employment or from a change of control of De Beira or from a change in a named executive officer’s responsibilities following a change in control, with the exception of the following: Page - 20 Management Agreement Pursuant to the terms and conditions of a management agreement, De Beira Goldfields Inc. had retained the services of Reg Gillard for a term of 12 months beginning April 19, 2006 which expired on April 18, 2007. However, the agreement continued and was reviewed on a monthly basis until Mr Gillard’s resignation on June 1, 2008. See Exhibit 10.2 - Management Agreement for more details. Item 12. Security Ownership of Certain Beneficial Holders and Management The following tables set forth, as of the date of this annual report, the total number of common shares owned beneficially by De Beira’s director and officers, individually and as a group, and the present owners of 5% or more of De Beira’s total outstanding common shares. The stockholders listed below have direct ownership of their shares and possess sole voting and dispositive power with respect to the shares. Security Ownership of Certain Beneficial Owners (more than 5%) (1) Title of Class (2) Name and Address of Beneficial Owner (3) Amount and Nature of Beneficial Owner [1] (4) Percent of Class [2] shares of common stock Reg Gillard 30 Ledgar Road Balcatta, Western Australia, 6021 6,000,000 9.08% [1] The listed beneficial owner has no right to acquire any shares within 60 days of the date of this Form 10-K from options, warrants, rights, conversion privileges or similar obligations excepted as otherwise noted. [2] Based on 66,046,785 shares of common stock issued and outstanding as of December 15, 2009. Security Ownership of Management (1) Title of Class (2) Name and Address of Beneficial Owner (3) Amount and Nature of Beneficial Owner (4) Percent of Class [1] shares of common stock Klaus Eckhof 30 Ledgar Road Balcatta, Western Australia, 6021 714,285 1.08% shares of common stock Susmit Shah 30 Ledgar Road Balcatta, Western Australia, 6021 Nil 0% shares of common stock Directors and Executive Officers (as a group) 714,285 1.08% [1] Based on 66,046,785 shares of common stock issued and outstanding as of December 15, 2009. Changes in Control De Beira is not aware of any arrangement that may result in a change in control of De Beira. Page - 21 Item 13. Certain Relationships and Related Transactions. (a) Relationships with Insiders Since the beginning of De Beira’s last fiscal year, no director, executive officer, security holder, or any immediate family of such director, executive officer, or security holder has had any direct or indirect material interest in any transaction or currently proposed transaction, which De Beira was or is to be a participant, that exceeded the lesser of (1) $120,000 or (2) one percent of the average of De Beira’s total assets at year-end for the last three completed fiscal years, except for the following: Consultant Agreements Mr. Eckhof and Mr. Shah are directors and shareholders of Corporate Consultants Pty Ltd. (“CCPL”). CCPL provides administration, accounting and company secretarial services to De Beira Goldfields Inc. Fees paid or payable to CCPL for the year ended August 31, 2009 were $21,492 (2008 - $30,981). (b) Transactions with Promoters De Beira’s officers are currently the only promoters of De Beira. None of the officers have received anything of value from De Beira nor are any of the officers entitled to receive anything of value from De Beira for services provided as a promoter of De Beira. (c) Director independence De Beira’s board of directors currently solely consists of Klaus Eckhof. Pursuant to Item 407(a)(1)(ii) of Regulation S-B of the Securities Act, De Beira’s board of directors has adopted the definition of “independent director” as set forth in Rule 4200(a)(15) of the NASDAQ Manual. In summary, an “independent director” means a person other than an executive officer or employee of De Beira or any other individual having a relationship which, in the opinion of De Beira’s board of directors, would interfere with the exercise of independent judgement in carrying out the responsibilities of a director, and includes any director who accepted any compensation from De Beira in excess of $200,000 during any period of 12 consecutive months within the three past fiscal years. Also, the ownership of De Beira’s stock will not preclude a director from being independent. In applying this definition, De Beira’s board of directors has determined that Mr. Eckhof does not qualify as an “independent director” pursuant to the same Rule. As of the date of the report, De Beira did not maintain a separately designated compensation, nominating or audit committee. De Beira has also adopted this definition for the independence of the members of its audit committee. De Beira’s board of directors has determined that only Mr. Eckhof is not “independent” for purposes of Rule 4200(a)(15) of the NASDAQ Manual, applicable to audit, compensation and nominating committee members, and is “independent” for purposes of Section 10A(m)(3) of the Securities Exchange Act. Item 14. Principal Accounting Fees and Services (1) Audit Fees and Related Fees The aggregate fees billed (2008) and expected to be billed (2009) for each of the last two fiscal years for professional services rendered by the principal accountant for De Beira’s audit of its annual financial statements or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for those fiscal years was: 2009 - $12,500 - GHP Horwath, P.C. 2008 - $15,500 - GHP Horwath, P.C. (2) Audit-Related Fees The aggregate fees billed in each of the last two fiscal years for audit related services by the principal accountants that are reasonably related to the performance of the audit or review of De Beira’s financial statements and are not reported in the preceding paragraph: 2009 - $Nil - GHP Horwath, P.C. 2008 - $Nil - GHP Horwath, P.C. Page - 22 (3) Tax Fees The aggregate fees billed in each of the last two fiscal years for professional services rendered by the principal accountant for tax compliance, tax advice, and tax planning was: 2009 - $Nil - GHP Horwath, P.C. 2008 - $Nil - GHP Horwath, P.C. (4) All Other Fees The aggregate fees billed in each of the last two fiscal years for the products and services provided by the principal accountant, other than the services reported in paragraphs (1) and (2) was: 2009 - $Nil - GHP Horwath, P.C. 2008 - $Nil - GHP Horwath, P.C. (5) De Beira does not have an audit committee. Therefore De Beira’s Board of Director’s pre-approval policies and procedures described in paragraph (c)(7)(i) of Rule 2-01 of Regulation S-X were that the Board of Director’s pre-approve all accounting related activities prior to the performance of any services by any accountant or auditor. Page - 23 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Index to and Description of Exhibits. All Exhibits required to be filed with the Form 10-K are included in this annual report or incorporated by reference to De Beira’s previous filings with the SEC, which can be found in their entirety at the SEC website at www.sec.gov under SEC File Number 333-130264 and SEC File Number 000-51707. Exhibit Description Status Exhibit A Audited Financial Statements as of August 31, 2009 and 2008 and for the years ended August 31, 2009 and 2008, and for the period May 28, 2004 (inception) to August 31, 2009. Included 3.1 Articles of Incorporation of De Beira Goldfields Inc. filed as an Exhibit to De Beira’s Form SB-2 (Registration Statement) filed on December 12, 2005 and incorporated herein by reference. Filed 3.2 By-Laws of De Beira Goldfields Inc. filed as an Exhibit to De Beira’s Form SB-2 (Registration Statement) filed on December 12, 2005 and incorporated herein by reference. Filed 10.1 Management Agreement dated April 19, 2006 between De Beira Goldfields Inc. and Reg Gillard, filed as Exhibit 10.2 to De Beira’s Form 8-K (Current Report) filed on May 10, 2006 and incorporated herein by reference. Filed 10.2 Letter of Understanding dated May 6, 2006 among De Beira Goldfields Inc., Goldplata Corporation Limited, Goldplata Resources Inc, and Goldplata Resources, Sucursal-Columbia, filed as an Exhibit to De Beira’s Form 8-K (Current Report) filed on May 25, 2006 and incorporated herein by reference. Filed 10.3 Letter Agreement dated June 15, 2006 between De Beira Goldfields Inc. and Emco Corporation, filed as an Exhibit to De Beira’s Form 8-K (Current Report) filed on June 29, 2006 and incorporated herein by reference. Filed 10.4 Share Sale Agreement dated July 10, 2006, between De Beira Goldfields Inc. and Emco Corporation Inc. S.A., filed as an Exhibit to De Beira’s Form 8-K (Current Report) filed on July 17, 2006, and incorporated herein by reference. Filed 10.5 Heads of Agreement dated July 26, 2007 among De Beira Goldfields Inc., Goldplata Resources Peru S.A.C., Goldplata Resources Inc., Golplata Resources Sucursal-Colombia, Goldplata Corporation Limited, and Goldplata Mining International Corporation, filed as an Exhibit to De Beira’s Form 10-K (Annual Report) filed on July 28, 2009 and incorporated herein by reference. Filed 10.6 Letter Agreement dated December 6, 2007 among De Beira Goldfields Inc., Emco Corporation Inc. S.A. and Minanca Minera Nanguipa, Compania Anonima, filed as an Exhibit to De Beira’s Form 10-K (Annual Report) filed on July 28, 2009 and incorporated herein by reference. Filed 10.7 Deed dated January 11, 2008 among De Beira Goldfields Inc., Windy Knob Resources Limited, Goldplata Mining International Corporation, Goldplata Resources Inc., and Golplata Resources Sucursal-Colombia, filed as an Exhibit to De Beira’s Form 10-K (Annual Report) filed on July 28, 2009 and incorporated herein by reference. Filed 14.1 Financial Code of Ethics filed as an Exhibit to De Beira’s Form SB-2 (Registration Statement) filed on December 12, 2005 and incorporated herein by reference. Filed 31 Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Included 32 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Included 99.1 Disclosure Committee Charter, filed as an Exhibit to De Beira’s Form 10-K (Annual Report) filed on July 28, 2009 and incorporated herein by reference. Filed Page - 24 SIGNATURES In accordance with Section 13 or 15(d) of the Securities and Exchange Act of 1934, De Beira Goldfields Inc. has caused this report to be signed on its behalf by the undersigned duly authorized person. DE BEIRA GOLDFIELDS INC. By: /s/ Klaus Eckhof Name: Klaus Eckhof Title: Director and CEO Dated: January 5, 2010 Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of De Beira Goldfields Inc. and in the capacities and on the dates indicated have signed this report below. Signature Title Date /s/ Klaus Eckhof President, Chief Executive Officer, and member of the Board of Directors January 5, 2010 /s/ Susmit Shah Chief Financial Officer, Principal Financial Officer, Treasurer and Corporate Secretary January 5, 2010 Page - 25 Exhibit A Page - 26 De Beira Goldfields Inc. Financial Statements De Beira Goldfields Inc. (An Exploration Stage Company) Years ended August 31, 2009 and 2008, and for the period from May 28, 2004 (Date of Inception) to August 31, 2009 Contents Page Report of Independent Registered Public Accounting Firm F-1 Balance sheets F-2 Statements of operations F-3 Statements of cash flows F-4 Statements of stockholders’ equity (deficit) F-5 Notes to financial statements F-6 Page - 27 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders De Beira Goldfields Inc. We have audited the accompanying balance sheets of De Beira Goldfields Inc. (an Exploration Stage Company) as of August 31, 2009 and 2008, and the related statements of operations, cash flows and stockholders’ equity (deficit) for each of the years then ended, and for the period from May 28, 2004 (inception) through August 31, 2009. 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 audits 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 the 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 financial statements referred to above present fairly, in all material respects, the financial position of De Beira Goldfields Inc. as of August 31, 2009 and 2008, and the results of its operations and cash flows for each of the years then ended, and for the period from May 28, 2004 (inception) through August 31, 2009, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company incurred a net loss of $154,585 for the year ended August 31, 2009, and a deficit accumulated during the exploration stage of $12,030,055 for the period from May 28, 2004 (inception) through August 31, 2009. The Company also has a limited history and no revenue producing operations. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans with regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. GHP HORWATH, P.C. Denver, Colorado December 15, 2009 F - 1 De Beira Goldfields Inc. (An Exploration Stage Company) Balance Sheets (Expressed in US dollars) August 31, 2009 $ August 31, 2008 $ ASSETS Current Assets Cash 72,424 38,609 Receivables and other assets - 38 Total Assets (all current) 72,424 38,647 LIABILITIES & STOCKHOLDERS’ (DEFICIT) EQUITY Current Liabilities Accounts payable 156,114 148,631 Accrued liabilities, related party (Note 4) 182,010 206,638 Accrued liabilities, other 114,107 96,953 Loans and borrowings, related party (Note 4) 45,248 52,895 Loans and borrowings (Notes 7) 740,000 740,000 Deposits for common stock subscriptions (Note 6) 10,000 - Total Liabilities (all current) 1,247,479 1,245,117 Contingencies and Commitments (Notes 3, 4, 5 and 7) Stockholders’ (Deficit) Equity (Note 6) Common stock, $0.001 par value; 75,000,000 shares authorized; 59,696,785 (2008: 44,096,785) shares issued and outstanding 59,696 44,096 Additional paid-in capital 10,779,554 10,609,154 Donated capital 15,750 15,750 Deficit accumulated during the exploration stage (12,030,055 ) (11,875,470 ) Total Stockholders’ Deficit (1,175,055 ) (1,206,470 ) Total Liabilities and Stockholders’ Deficit 72,424 38,647 The accompanying notes are an integral part of these financial statements F - 2 De Beira Goldfields Inc. (An Exploration Stage Company) Statements of Operations (Expressed in US dollars) For the Year Ended August 31, 2009 For the Year Ended August 31, 2008 Accumulated from May 28, 2004 (Date of Inception) to August 31, 2009 $ $ $ Revenue - - - Operating expenses Donated rent - - 5,250 Donated services - - 10,500 General and administrative 2,475 11,027 73,528 Foreign currency transaction (gain) loss (4,879 ) 37,606 44,272 Mineral property and exploration costs - 843,914 4,739,777 Management fees (Note 4) 41,999 248,521 598,947 Professional fees (Note 4) 45,873 67,641 840,494 Travel costs 3,116 35,400 335,415 Write-off deferred acquisition cost (Note 3) - - 400,000 Provision against Minanca loan (Note 3) - - 6,100,000 Total operating expenses 88,584 1,244,109 13,148,183 Other income (expense) Interest income 252 1,286 31,260 Interest expense (66,253 ) (73,874 ) (163,178 ) Loss on sale of investment (Note 5) - (126,182 ) (126,182 ) Gain on sale of mineral property rights (Note 5) - 1,376,228 1,376,228 Total other income (expense) (66,001 ) 1,177,458 1,118,128 Net Loss (154,585 ) (66,651 ) (12,030,055 ) Net Loss Per Share – Basic and Diluted * * Weighted Average Shares Outstanding 52,478,429 44,096,785 * Amount is less than (0.01) per share The accompanying notes are an integral part of these financial statements F - 3 De Beira Goldfields Inc. (An Exploration Stage Company) Statements of Cash Flows (Expressed in US dollars) For the Year Ended August 31, 2009 $ For the Year Ended August 31, 2008 $ Accumulated From May 28, 2004 (Date of Inception) to August 31, 2009 $ Cash Flows From Operating Activities Net loss (154,585 ) (66,651 ) (12,030,055 ) Adjustments to reconcile net loss to net cash used in operating activities: Gain on sale of mineral property rights - (586,228 ) (586,228 ) Loss on sale of investment - 126,181 126,181 Donated services and rent - - 15,750 Expenses paid by issue of common stock - - 500 Write-off deferred acquisition cost - - 400,000 Provision against Minanca loan - - 6,100,000 Change in operating assets and liabilities Decrease in receivables and other assets 38 20,090 - Increase in accounts payable and accrued liabilities 64,284 62,114 319,867 Increase in amounts due to related parties 70,052 126,138 266,689 Net cash used in operating activities (20,211 ) (318,356 ) (5,387,296 ) Cash Flows From Investing Activities Cash received from sale of investment - 250,047 250,047 Cash received from sale of mineral property rights - 210,000 210,000 Deferred acquisition costs - - (400,000 ) Loan advances - - (7,100,000 ) Repayment of loan advance - - 1,000,000 Net cash provided by (used in) investing activities - 460,047 (6,039,953 ) Cash Flows From Financing Activities Loans from related parties - - 594,313 Loan repaid to related parties - (177,581 ) (576,483 ) Loan from unrelated third party - - 740,000 Deposits received for common shares to be issued 40,000 - 40,000 Common shares issued for cash 16,000 - 10,668,750 Net cash provided by (used in) financing activities 56,000 (177,581 ) 11,466,580 Effect of exchange rate changes on cash (1,974 ) 35,067 33,093 Increase (Decrease) in Cash 33,815 (823 ) 72,424 Cash - Beginning of Period 38,609 39,432 - Cash - End of Period 72,424 38,609 72,424 Supplemental Disclosures Interest paid - - - Income taxes paid - - - The accompanying notes are an integral part of these financial statements F - 4 De Beira Goldfields Inc. (An Exploration Stage Company) Statements of Stockholders’ Equity (Deficit) (Expressed in US dollars) Common Shares Additional Deficit Total Number of Shares Amount $ Paid-in Capital $ Donated Capital $ Accumulated During the Exploration Stage $ Stockholders’ Equity(Deficit) $ Balances, May 28, 2004 (Date of inception) - - - - - - Common stock issued for services to president (Note 6) 6,000,000 6,000 (5,500 ) - - 500 Return and cancellation of shares (Note 6) (6,000,000 ) (6,000 ) 6,000 - - - Net loss - - - - (500 ) (500 ) Balances, August 31, 2004 - - 500 - (500 ) - Common stock issued for cash 64,500,000 64,500 (17,750 ) - - 46,750 Return and cancellation of shares (Note 6) (30,000,000 ) (30,000 ) 30,000 - - - Donated rent - - - 3,000 - 3,000 Donated services - - - 6,000 - 6,000 Net loss - - - - (15,769 ) (15,769 ) Balances, August 31, 2005 34,500,000 34,500 12,750 9,000 (16,269 ) 39,981 Common stock issued for cash (Note6) 1,964,285 1,964 4,498,036 - - 4,500,000 Donated rent - - - 2,250 - 2,250 Donated services - - - 4,500 - 4,500 Net loss - - - - (848,560 ) (848,560 ) Balances, August 31, 2006 36,464,285 36,464 4,510,786 15,750 (864,829 ) 3,698,171 Common stock issued for cash (Note 6) 7,632,500 7,632 6,098,368 - - 6,106,000 Net loss - - - - (10,943,990 ) (10,943,990 ) Balances, August 31, 2007 44,096,785 44,096 10,609,154 15,750 (11,808,819 ) (1,139,819 ) Net loss - - - - (66,651 ) (66,651 ) Balances, August 31, 2008 44,096,785 44,096 10,609,154 15,750 (11,875,470 ) (1,206,470 ) Common stock issued for cash (Note 6) 1,600,000 1,600 14,400 - - 16,000 Common stock issued for settlement of debt (Note 6) 14,000,000 14,000 126,000 - - 140,000 Shares to be issued - - 30,000 - - 30,000 Net loss - - - - (154,585 ) (154,585 ) Balances, August 31, 2009 59,696,785 59,696 10,779,554 15,750 (12,030,055 ) (1,175,055 ) The accompany notes are an integral part of these financial statements F - 5 De Beira Goldfields Inc. (An Exploration Stage Company) Notes to the Financial Statements (Expressed in US dollars) 1. Organization, Nature of Business, Going Concern and Management’s Plans: Organization and nature of business: The Company was incorporated in the State of Nevada on May 28, 2004. The Company is an Exploration Stage Company, as defined by Statement of Financial Accounting Standard (“SFAS”) No.7 “Accounting and Reporting for Development Stage Enterprises”. The Company’s principal business is the acquisition and exploration of mineral resources. Going concern and management’s plans: The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. Since its inception in May 2004, the Company has not generated revenue and has incurred net losses. The Company incurred a net loss of $154,585 for the year ended August 31, 2009, and a deficit accumulated during the exploration stage of $12,030,055 for the period from May 28, 2004 (inception) through August 31, 2009. Accordingly, it has not generated cash flow from operations and has primarily relied upon advances from shareholders and proceeds from equity financings to fund its operations. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. As a consequence of the Company’s withdrawal from the Minanca acquisition in Ecuador, the Colombian Projects (Titiribi and Acandi) and the Peruvian Projects (Condoroma and Suyckutambo) the Company has no mineral property interests as of the date of this report. Certain mineral property interests are presently being considered, but it is too early to say whether they may be considered appropriate for acquisition. As of August 31, 2009, the Company had cash and cash equivalents of $72,424. Management’s objective is to recapitalize the Company, raise new capital and seek new investment opportunities in the mineral sector. Management believes that its worldwide industry contacts will make it possible to find and assess new projects. There is no assurance that the Company will be able to consummate the contemplated capital raisings. In the event that the Company is unsuccessful in raising additional capital in a timely manner, it will have a material adverse affect on the Company’s liquidity, financial condition and business prospects. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts or classification of liabilities that may result from the possible inability of the Company to continue as a going concern. 2. Significant Accounting Policies a) Basis of Presentation These financial statements and related notes are presented in accordance with accounting principles generally accepted in the United States of America. The Company’s fiscal year-end is August 31. b) Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 revenues and expenses during the reporting period. Actual results could differ from those estimates. F - 6 2. Significant Accounting Policies (continued) c) Basic and Diluted Net Loss Per Share The Company computes net loss per share in accordance with SFAS No. 128, "Earnings per Share". SFAS No. 128 requires presentation of both basic and diluted earnings per share (EPS) on the face of the income statement. Basic EPS is computed by dividing net income (loss) available to common shareholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted EPS gives effect to all potential dilutive common shares outstanding during the period using the treasury stock method and convertible preferred stock using the if-converted method. In computing EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Diluted EPS excludes all dilutive potential shares if their effect is anti-dilutive. There were no potential dilutive securities outstanding at August 31, 2008 and 2009. d) Cash and Cash Equivalents The Company considers all highly liquid instruments with maturity of three months or less at the time of issuance to be cash equivalents. e) Mineral Property and Exploration Costs The Company has been in the exploration stage since its formation on May 28, 2004 and has not yet realized any revenues from its planned operations. It is primarily engaged in the acquisition and exploration of mining properties. Mineral property and exploration costs are expensed as incurred. When it has been determined that a mineral property can be economically developed as a result of establishing proven and probable reserves, the costs incurred to develop such property are capitalized. Such costs will be amortized using the units-of-production method over the estimated life of the probable reserve. If mineral properties are subsequently abandoned or impaired, any capitalized costs will be charged to operations. f) Deferred Acquisition Costs The Company capitalizes deposits paid during the acquisition of equity interests as deferred acquisition costs. Deferred acquisition costs are recorded at cost and are included in the purchase price of the equity interest once the acquisition has been consummated. g) Fair Value of Financial Instruments Financial instruments, which include cash, receivables, accounts payable, and loans and borrowings, were estimated to approximate their carrying values due to the immediate or short-term maturity of these financial instruments. The fair value of amounts due to related parties is not practicable to estimate, due to the related party nature of the underlying transactions. The Company’s operations are located in Australia, which results in exposure to market risks from changes in foreign currency rates. The financial risk is the risk to the Company’s operations that arise from fluctuations in foreign exchange rates and the degree of volatility of these rates. Currently, the Company does not use derivative instruments to reduce its exposure to foreign currency risk. h) Income Taxes The Company recognizes deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax bases, as well as net operating losses. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets or liabilities of a change in tax rates is recognized in the period in which the tax change occurs. A valuation allowance is provided to reduce the deferred tax assets to a level, that more likely than not, will be realized. The Company files income tax returns in the U.S. federal jurisdiction and in the state of Nevada. Management does not believe there will be any material changes in the Company’s unrecognized tax positions over the next 12 months. The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, there was no accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the year. F - 7 2. Significant Accounting Policies (continued) i) Foreign Currency Translation The Company’s functional and reporting currency is the United States dollar. Monetary assets and liabilities denominated in foreign currencies are translated in accordance with SFAS No. 52 “Foreign Currency Translation”, using the exchange rate prevailing at the balance sheet date. Foreign currency transactions are primarily undertaken in Australian and Canadian dollars. Gains and losses arising on settlement of foreign currency denominated transactions or balances are included in the determination of income. Realized foreign currency transaction gains and losses were not significant during the periods presented. j) Concentration of Credit Risk The Company’s financial instruments that are exposed to concentration of credit risk consist of cash and cash equivalents. The Company’s cash and cash equivalents are in demand deposit accounts placed with federally insured financial institutions in Australia. The Company has not experienced any losses on such accounts. k) Comprehensive Income (Loss) SFAS No. 130, “Reporting Comprehensive Income” establishes standards for reporting and display of comprehensive income (loss), its components, and accumulated balances. For the periods presented there were no differences between net loss and comprehensive loss. l) Recent Accounting Pronouncements In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No.115 (SFAS 159). SFAS 159 allows companies the choice to measure many financial instruments and certain other items at fair value. This gives 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 159 was effective for the Company on September 1, 2008. The adoption of SFAS 159 did not have an impact on the Company’s financial statements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 was effective for the Company on September 1, 2008. The adoption of SFAS 157 did not have an impact on the Company’s financial statements. In December 2007, the FASB issued SFAS No. 160 (SFAS 160), Noncontrolling Interests in Consolidated Financial Statements—an Amendment of ARB 51. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest (minority interest) in a subsidiary and for the deconsolidation of a subsidiary. Upon adoption of SFAS 160, effective for the Company as of September 1, 2009, any noncontrolling interests will be classified as equity in the Company's financial statements and any income and comprehensive income attributed to the noncontrolling interest will be included in the Company's income and comprehensive income. The presentation and disclosure provisions of this standard must be applied retrospectively upon adoption. The adoption of SFAS 160 is not expected to have an impact on the Company’s financial statements. In December 2007, the FASB issued FASB Statement No. 141R (SFAS 141R), Business Combinations, which changes how business acquisitions are accounted for. SFAS 141R requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction and establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed in a business combination. Certain provisions of this standard will, among other things, impact the determination of acquisition-date fair value of consideration paid in a business combination (including contingent consideration); exclude transaction costs from acquisition accounting; and change accounting practices for acquired contingencies, acquisition-related restructuring costs, in-process research and development, indemnification assets, and tax benefits. SFAS 141R is effective for the Company on September 1, 2009. The adoption of SFAS 141R is not expected to have a material impact on the Company’s financial statements, unless the Company enters into any future business acquisitions. F - 8 2. Significant Accounting Policies (continued) l) Recent Accounting Pronouncements (continued) In May 2009, the FASB issued SFAS No. 165, Subsequent Events (“SFAS No. 165”). SFAS No. 165 is effective for interim or annual periods ending after June 15, 2009 and establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. An entity must disclose the date through which subsequent events have been evaluated, as well as whether that date is the date the financial statements were issued, or the date they were available to be issued. In June 2009, the FASB issued SFAS No. 168 (SFAS 168) Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162. SFAS 168 establishes the FASB Accounting Standards Codification as the single official source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with US GAAP. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. On the effective date, all non-SEC accounting and reporting standards will be superseded. The Company will adopt SFAS 168 for the quarterly period ending November 30, 2009, as required, and adoption is not expected to have a material impact on the Company’s financial statements. 3. Deferred Acquisition Costs and Loan Advances On June 15, 2006, the Company entered into an agreement with Emco Corporation (“Emco”) whereby the Company was granted an option to acquire 80% of the issued and outstanding shares of Minanca, which owns mineral exploration property in Ecuador (the “Property”), for an aggregate purchase price of $30,400,000 comprised of 10 million restricted common shares of the Company at an issue price of $3 per common share and a cash payment of $400,000. Under the terms of the acquisition agreement and pursuant to settlement of the acquisition, the Company was obligated to pay loan advances of $7,000,000 to Minanca as follows: i. $1,500,000 within 15 days of settlement of the acquisition transaction for upgrade expenditures on the Property (paid in full); ii. $400,000 by July 31, 2006 for upgrades to the Property (paid in full); iii. $1,375,000 by October 2, 2006 to be paid for existing debt owed by Minanca (paid in full); and iv. The balance of $3,725,000 for exploration expenditures on the Property to be paid equally over a period of 5 months beginning September 1, 2006 with the final payment due on January 1, 2007 (the total amount has been paid in full). As of August 31, 2009 the loan advances equalled $6,100,000 ($1,000,000 was repaid during a previous financial year). Minanca is to undertake to grant a mortgage of all its assets to the Company as security against the loan advances noted above. Repayment of the loan advances rank in priority ahead of any dividend or distribution payments to shareholders of Minanca. On December 9, 2007, the Company entered into an agreement with Emco to cancel the acquisition by De Beira of an 80% interest in Minanca. As a consequence, neither party has any further rights or obligations to each other, except that Minanca remains indebted to De Beira for an amount of $6,100,000 which it had agreed to repay as follows: (i) payment of US$250,000 to De Beira by close of business on December 14, 2007; (ii) payment of US$1,750,000 to De Beira within 21 days of the execution of the agreement; and (iii) payment of the remainder of the loan balance in accordance with the provisions of the June 2006 agreement (which provided for loan repayment from cash surpluses from the sale of mineral products) or as otherwise agreed between the parties. As at the date of this report, no repayments have been made. The loan was fully reserved for in the financial statements during the year ended August 31, 2007, however management continues to seek recovery of all or part of the loan. On June 16, 2006, the Company paid $400,000 as per the terms of the agreement and provided a loan advance of $100,000 to Minanca. Prior to August 31, 2007, the Company had recorded the $400,000 as deferred acquisition costs pending the final settlement of the agreement, however this amount was expensed to the income statement during the year ended August 31, 2007. F - 9 4. Related Party Transactions a) The Company incurred management fees of $nil ($39,538 for the year ended August 31, 2008) and $43,799 ($54,940 for the year ended August 31, 2008) for services provided by the former president and director of the Company, and the chairman of the Company, respectively, for the year ended August 31, 2009. As of August 31, 2009 and 2008 the Company has an accrued liability of $84,679 and $134,245, respectively owing for management fees to these related parties. b) Included in professional fees are consulting fees of $21,492 during the year ended August 31, 2009 ($30,981 for the year ended August 31, 2008) for administration, office rent, accounting and company secretarial services provided by a company in which the president and former director are directors and shareholders. As of August 31, 2009 and 2008, the Company has an accrued liability of $85,858 and $64,271, respectively, owing for services provided under this agreement. c) In June 2007 the Company received loan proceeds of $93,650 from an entity associated with the Company’s president and chief executive officer. Interest was charged at 8% simple interest, the loan was unsecured and had no stated maturity date. The principal and a small portion of interest totalling $110,338 (AUD115,000) was repaid on May 29, 2008. This loan had an outstanding balance of $7,140 and accrued interest outstanding of $149 as of August 31, 2008. The balance of the loan totalling $5,673 was settled by the issue of shares to a third party on February 29, 2009. In August 2007 the Company received loan proceeds totalling $105,068, from companies in which the president and chief executive officer is a director and shareholder. Interest is charged at 8% simple interest, is unsecured and has no stated maturity date. In May 2008 $67,193 was repaid. As of August 31, 2009 and 2008, the outstanding loan balances are $45,248 and $45,755, respectively. As of August 31, 2008, the loans have accrued interest outstanding of $11,472 and $7,973, respectively. 5. Mineral Properties a) Titiribi Gold/Copper Project The Company entered into an agreement with Goldplata Corporation Limited, Goldplata Resources Inc. and Goldplata Resources Sucursal Colombia (the “Goldplata Group”) dated May 6, 2006, whereby the Company was granted an option to acquire up to 70% interest in the Titiribi Gold/Copper project in Colombia, South America. The agreement allowed the Company to acquire an initial interest of 65% by sole funding $8 million in exploration expenditures within a 3 year period (the “Option Period”). The Option Period commenced on June 9, 2006. After acquiring 65% interest, the Company had 60 days to elect to sole fund further expenditures in order to acquire another 5%, giving it a total interest of 70%. The additional interest was to be acquired upon the earlier of completing a bankable feasibility study or spending a further $12 million, both within a period of no more than 3 years from the time of the election. The Company could not withdraw from the agreement after the start of the Option Period until it either incurred $1 million in exploration expenditures or paid $1 million to the Goldplata Group. Through August 31, 2008, $2,830,000 of exploration expenditures have been paid by the Company and recorded as mineral property and exploration costs on the statement of operations. No further payments were made during the year ended August 31, 2009 or up to the date of this report. On January 11, 2008 the Company entered into an agreement with Australian publicly traded company, Windy Knob Resources Limited (“Windy Knob”) to assign its interests in the Titiribi Gold/Copper Project for cash proceeds of $1 million being reimbursement of exploration expenditures and 3,250,000 shares of common stock in Windy Knob. The terms of the agreement were as follows: (i) payment of $250,000 to the Goldplata Group on behalf of De Beira to satisfy outstanding cash call requirements (this was paid in January 2008); (ii) payment of $540,000 to the Goldplata Group on behalf of De Beira to satisfy outstanding cash calls at the completion of due diligence by Windy Knob (this was paid in January 2008); and (iii) payment of $210,000 direct to De Beira at the completion of due diligence by Windy Knob (this was received on February 4, 2008). In connection with this transaction, the Company recognized a gain of $1,376,288, during the year ended August 31, 2008 which is reported in other income. As noted above, $790,000 of this gain is offset within mineral property and exploration costs, as it was paid to the Goldplata Group by Windy Knob on behalf of the Company to secure the Company’s rights under the original agreement prior to the sale. The 3,250,000 shares in Windy Knob were issued to the Company on April 16, 2008 and sold on May 23, 2008 for cash proceeds of $250,047. In connection with this sale, the Company recognized a realized loss of $126,182 during the year ended August 31, 2008. This prior year loss represented the difference between the fair value at the date the shares were issued to the Company and the date the shares were sold to a third party. F - 10 b) Peruvian Gold / Silver Projects On July 5, 2006, the Company entered into agreements with the Goldplata Group to acquire an interest of up to 70% in the Condoroma and Suyckutambo Projects in Peru. The Company was granted an option to acquire up to 70% interest in each of these two projects on identical terms. The agreements allowed the Company to acquire an initial interest of 65% by sole funding $4 million in exploration expenditures within a 3 year period (the “Option Period”). The Option Period commenced on August 4, 2006. After acquiring 65%, the Company had 60 days to elect to sole fund further expenditures in order to acquire another 5%, giving it a total interest of 70%. The additional interest was to be acquired upon the earlier of completing a bankable feasibility study or spending a further $6 million, both within a period of no more than 3 years from the time of the election. The Company could not withdraw from the agreement after the start of the Option Period until it either incurred $500,000 in exploration expenditures or paid $500,000 to the Goldplata Group. Through August 31, 2008, $1,110,000 of exploration expenditures have been paid by the Company on the Condoroma & Suyckutambo projects and recorded as mineral property and exploration costs on the statement of operations. No further payments were made during the year ended August 31, 2009 or up to the date of this report. In September 2007, De Beira decided to withdraw from the Condoroma and Suyckutambo Projects as it became apparent that De Beira and the permit holders, the Goldplata Group, had different philosophies about how the projects should be further explored and developed. De Beira favored a measured approach, with a focus on further exploration to maximize the resource potential whereas the Goldplata Group favored a short term development and production strategy. c) Acandi Project On October 19, 2006, the Company entered into a preliminary agreement in association with the Goldplata Group to earn an 80% interest in the Acandi copper / gold project in North East Colombia, near the Panama border, by sole funding exploration expenditures and making cash payments to the present beneficial holder of the project interest. Through August 31, 2008, $525,000 of exploration expenditures have been paid by the Company. No further payments were made during the year ended August 31, 2009 or up to the date of this report. In September 2007, the Company withdrew from the Acandi project and there are no residual rights or financial obligations. 6. Stockholders’ Equity Common stock Stock cancellations and recapitalization: On May 25, 2006 and June 9, 2006, the Company completed the return and cancellation of 30,000,000 and 6,000,000 common shares to the treasury, respectively. The shares were returned by the former president of the Company. The net loss per share amounts and stockholders’ equity (deficiency) have been retroactively restated (accounted for as a recapitalization) to reflect the return and cancellation of 36,000,000 common shares by the former president of the Company. Common stock issuances: On May 28, 2004, the Company issued 6,000,000 shares of common stock to the then President of the Company for reimbursement of legal expenses of $500 incurred on behalf of the Company. On June 30, 2005, the Company issued 6,000,000 shares of common stock for cash proceeds of $25,000. On April 15, 2005, the Company issued 22,500,000 shares of common stock for cash proceeds of $18,750. On March 22, 2005 the Company issued 36,000,000 shares of common stock for cash proceeds of $3,000. On June 8, 2006, the Company completed a private placement with a director of the Company for 714,285 common shares at a price of $2.80 per share for proceeds of $2,000,000. F - 11 6. Stockholders’ Equity (continued) Common stock (continued) On August 30, 2006, the Company completed a private placement of 1,250,000 units at a price of $2.00 per unit for proceeds of $2,500,000. Each unit consists of one common share and one common share purchase warrant. Each share purchase warrant entitles the holder to acquire one additional common share at an exercise price of $2.50 per share for a period of two years. All warrants expired unexercised on August 31, 2008. During November 2006, the Company completed private placements for 3,095,000 shares of restricted common stock at $0.80 per share, raising proceeds of $2,476,000. In January 2007 the Company completed two private placements for 3,187,500 shares of restricted common stock at $0.80 per share raising proceeds of $2,550,000. In February 2007 the Company completed two private placements for 1,350,000 shares of restricted common stock at $0.80 per share raising proceeds of $1,080,000. On February 28, 2009, the board of directors authorized the issuance of 14,100,000 restricted shares of common stock at a subscription price of $0.01 per restricted share, for cash proceeds of $16,000 and the settlement of $125,000 accrued liabilities and debt. The shares were issued on June 19, 2009. On May 29, 2009, the Company completed a private placement for 1,500,000 shares of restricted common stock at price of $0.01 per restricted share in exchange for the settlement of $15,000 debt. Subscription agreements for 3,000,000 shares were received in June 2009 in exchange for $30,000 in cash (received in December 2008) and the shares were issued on October 19, 2009. Subscriptions agreements for 1,000,000 shares were not received prior to August 31, 2009 and as a result $10,000 is included as a liability at August 31, 2009 as issuance of the shares of common stock is not solely within the control of the Company. 7. Other Loans and Borrowings In March and July 2007 the Company received loan proceeds of $240,000 and $500,000 respectively, from an unrelated third party. These loans are unsecured and bear a simple interest of 8% per annum with no fixed repayment date, but the understanding with the lender that the loans will be repaid from proceeds of future equity financings and/or the repayment of amounts lent to Minanca. 8. Non-Cash Investing and Financing Activities August 31, 2009 $ August 31, 2008 $ Accumulated from May 28, 2004 (Date of Inception) to August 31, 2009 $ Issuance of common stock for settlement of debt (including accrued interest: Related party (refer note 6) 5,673 - 5,673 Non-related party 39,647 - 39,647 Issuance of common stock for settlement of accounts payable: Related party (refer note 6) 94,680 - 94,680 Cash paid to Goldplata on behalf of the Company (Note 5) - 790,000 790,000 F - 12 9. Income Taxes The components of the Company’s net deferred tax asset for the years ended August 31, 2009 and 2008 and the statutory tax rate, the effective tax rate and the valuation allowance are as follows: August 31, 2009 August 31, 2008 Net operating losses 5,930,055 5,775,470 Loan loss reserves 6,100,000 6,100,000 Statutory tax rate 35% 35% Deferred tax asset 4,210,519 4,156,415 Valuation allowance (4,210,519) (4,156,415) Net deferred tax asset - - The Company has net operating loss carry-forwards for tax purposes of approximately $5,930,000 which commence expiring in 2029. The utilization of the net operating loss carry-forwards cannot be assured. Deferred income tax reflects the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company provided a valuation allowance of 100% of its net deferred tax asset due to the uncertainty of generating future profits that would allow for the realization of such deferred tax assets. 10. Subsequent Events The Company has evaluated subsequent events through December 18, 2009, the date the financial statements were available to be issued. Subsequent to year end and up to the date of this report, borrowings of $23,500 have been converted into 2,350,000 shares of the Company’s common stock, and 4,000,000 shares previously awaiting issue pending completion of stock subscription agreements were issued in October 2009. In total, 6,350,000 shares were issued on October 19, 2009. F - 13 Exhibit 31 Page - 41 DE BEIRA GOLDFIELDS INC. CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION I, Klaus Eckhof, certify that: 1. I have reviewed this annual report on Form 10-K for the fiscal year ending August 31, 2009 of De Beira Goldfields Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: January 5, 2010 /s/ Klaus Eckhof Klaus Eckhof Chief Executive Officer Page - 42 DE BEIRA GOLDFIELDS INC. CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION I, Susmit Shah, certify that: 1. I have reviewed this annual report on Form 10-K for the fiscal year ending August 31, 2009 of De Beira Goldfields Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; (c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: January 5, 2010 /s/ Susmit Shah Susmit Shah Chief Financial Officer Page - 43 Exhibit 32 Page - 44 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of De Beira Goldfields Inc. (“De Beira”) on Form 10-K for the period ending August 31, 2009 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Klaus Eckhof, President and Chief Executive Officer of De Beira and a member of the Board of Directors, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Klaus Eckhof Klaus Eckhof Chief Executive Officer January 5, 2010 Page - 45 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of De Beira Goldfields Inc. (“De Beira”) on Form 10-K for the period ending August 31, 2009 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Susmit Shah, Chief Financial Officer of De Beira, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Susmit Shah Susmit Shah Chief Financial Officer January 5, 2010 Page - 46

ABATIX CORP

10-K

https://www.sec.gov/Archives/edgar/data/845779/0001275287-07-001594.txt

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2006 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission File Number - 1-10184 ABATIX CORP. (Exact name of registrant as specified in its charter) Delaware 75-1908110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 2400 Skyline Drive Suite 400, Mesquite, Texas 75149 (Address of principal executive offices) (Zip Code) Registrant s telephone number, including area code: (214) 381-0322 Securities registered pursuant to Section 12 (b) of the Act: Title of each class Name of each exchange on which registered Common Stock NASDAQ Capital Market Securities registered pursuant to Section 12 (g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by 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 preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes 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. o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Act. (Check one): Large accelerated filer o Accelerated filer o Non-accelerated filer x Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x The aggregate market value of the registrant s common stock held by non-affiliates on June 30, 2006 (based on the closing stock price on the NASDAQ Capital Market on such date) was approximately $7,040,000. 1,711,148 shares of common stock, $.001 par value, were issued and outstanding on March 23, 2007. Documents Incorporated By Reference Certain information contained in the definitive Proxy Statement for the Company s Annual Meeting of Stockholders to be held on May 22, 2007 is incorporated by reference into Part III hereof. PART I Item 1. Business. (a) Development of Business Abatix Corp. ( Abatix ) markets and distributes personal protection and safety equipment and durable and nondurable supplies predominantly to the environmental industry, the industrial safety industry and, combined with tools and tool supplies, to the construction industry. Abatix, through its wholly owned subsidiary, International Enviroguard Systems, Inc. ( IESI ), a Delaware corporation, imports disposable clothing sold through Abatix and other distribution companies not in direct competition with Abatix. Abatix and IESI are collectively referred to herein as the Company. The Company began operations in May 1983 as an industrial safety supply company located in Dallas, Texas, and was originally incorporated in Texas as T&T Supply Company, Inc. in March 1984. To prepare for its initial public offering of its securities in March 1989, Abatix incorporated in Delaware on December 5, 1988 to effect and complete an Agreement and Plan of Merger with T&T Supply on December 9, 1988. As opportunities to enter new markets arose over the years, the Company expanded geographically. The basic growth philosophy has been to find the right people, and then determine if the geographic market can support a full service sales office/distribution center. During our history, the following branches, beyond our initial Dallas location, were opened: San Francisco – December 1988 Houston – February 1990 Los Angeles – August 1991 Phoenix – January 1993 Seattle – January 1994 Las Vegas – December 1995 Tampa – August 2004 – The Company opened a temporary facility in response to the hurricanes that damaged property in that state. This facility was closed in February 2005. Ponchatoula, Louisiana – August 2005 – The Company opened a temporary facility in response to hurricanes Katrina and Rita and the ensuing floods that devastated parts of Louisiana, Mississippi and Alabama. This facility was closed in August 2006. Jacksonville – August 2006 (b) Financial Information About Operating Segments Information about the Company s operating segments is included in Note 8 in the Notes to the Consolidated Financial Statements at Part IV, Item 15. (c) Narrative Description of Business Based on 2006 sales, approximately 45% of the Company s products are sold to environmental contractors, 20% to construction related firms, 26% to the industrial safety market and 9% to other firms. The Company believes a majority of its sales for the foreseeable future will continue to be made to environmental contractors and considers its relationship with its customers to be excellent. 2 Environmental Industry Asbestos Abatement Industry Between 1900 and the early 1970 s, asbestos was extensively used for insulation and fireproofing in industrial, commercial and governmental facilities as well as private residences in the United States and in other industrialized countries. In the mid-1980 s it was estimated that in the United States, approximately 20% of all buildings, excluding residences and schools, contained friable asbestos-containing materials that were brittle and were susceptible to the release of asbestos dust. Various diseases, such as asbestosis, lung cancer and mesothelioma, have been linked to the exposure to airborne asbestos. Through medical studies and the legal system, the public is aware of the diseases associated with asbestos. Maintenance, repair, renovation or other activities can disturb asbestos-containing material and, if disturbed or damaged, asbestos fibers become airborne and pose a hazard to building occupants and the environment. In 1986, Congress passed the Asbestos Hazard Emergency Response Act, which mandates inspections for asbestos, the adoption of asbestos abatement plans and the removal of asbestos from schools and facilities scheduled for renovation or demolition. In addition, state and local governments have also adopted asbestos-related regulations. Even with these federal, state and local regulations, public and private budgetary constraints continue to limit the number and scope of asbestos abatement projects. Lead Abatement Industry The hazards of lead-based paint have been known for many years; however, the federal and state regulations requiring identification, disclosure and cleanup have been minimal. In 1996, the Environmental Protection Agency ( EPA ) and the Department of Housing and Urban Development unveiled rules regarding lead-based paint in the residential markets. These rules give homebuyers the right to test for lead-based paint before signing a contract. In addition, although a landlord or home seller is not required to test for lead-based paint, the rules do require disclosure of such, if known. Many asbestos abatement contractors added lead abatement to their range of services in the mid- to late-1990 s in an attempt to diversify their revenue stream. The asbestos abatement contractors bring equipment, a trained labor force and experience working in a hazardous environment to the lead abatement industry; however, public and private budgetary constraints have also limited the number of these projects. 3 Restoration Industry This industry is comprised of contractors that handle primarily fire, smoke and water damage. In recent years, the damage caused by wildfires in the west and southwest, heavy rains in the west and the hurricanes in Florida and Louisiana have increased the visibility of this industry to the residential consumer as well as the commercial consumer. A component of the restoration industry, mold remediation, has been around for years although litigation in the late 1990 s and early 2000 s surrounding the health hazards of human exposure to mold created public awareness and forced property owners and the construction industry to deal with the problem. To grow, mold requires moisture, a carbon source (wood, plasterboard, natural fibers, or any organic matter), lack of air movement and little to no light. The energy crisis in the 1970 s inspired many energy efficiency programs, including the building of structures that promoted less air movement which increased the likelihood of a mold problem. Although there are approximately 100,000 species of fungi, about 100 are considered to be pathogenic to humans. Currently, there are still very few regulations concerning tolerable mold levels or approved processes to remove mold. However, in 2003, the Institute of Inspection, Cleaning and Restoration Certification adopted S520, Mold Remediation Standard and Reference Guide. The S520 Standard describes the procedures to be followed and the precautions to be taken when performing mold remediation. This standard is now widely accepted in the industry. Many asbestos and lead abatement contractors added restoration, including mold remediation, to their range of services, as did traditional restoration contractors. Prior to 2000, the Company had very few sales to restoration contractors. In late 2000, the Company began to see high levels of activity from this industry, primarily in Texas. The growth in this portion of the restoration industry continued into the early part of the fourth quarter of 2002, but slowed significantly in the first half of 2003 primarily because insurance laws in Texas changed to eliminate or limit the insurance companies exposure to mold liabilities, resulting in fewer projects for contractors. While there has been some increased legal activity in states other than Texas, the limited liability on insurance policies has inhibited the growth of this portion of the restoration industry. Recently, the effects of the hurricanes that hit Florida in 2004 and the hurricanes that hit Louisiana and other parts of the Gulf Coast in 2005 have created a significant opportunity for the Company. Although this revenue is not considered recurring, it provided an opportunity to improve our revenues and profitability and in limited circumstances it provides us the ability to gain new customers. Construction Tools Supply Industry Besides the normal hand and power tools, and associated consumable parts, supplied to the construction industry, the EPA and Occupational Safety and Health Administration ( OSHA ) have also established certain rules and regulations governing the protection of the environment and the protection of workers in this industry. 4 Currently, the Company supplies the construction tools industry primarily from its Las Vegas, Los Angeles, and Phoenix facilities and on a limited basis from its other facilities. This industry is directly tied to the local economies and more specifically, the commercial real estate conditions within those markets. The commercial real estate industry initially declined after the events of September 11, 2001, but has improved since 2004. The Company anticipates this industry will remain stable in 2007 as the economy remains stable. Industrial Safety Industry The EPA and OSHA have established numerous rules and regulations governing environmental protection and worker safety and health. The demand for supplies and equipment by U.S. businesses and governments to meet these rules and regulations has resulted in the creation of a multi-billion dollar industry. As research identifies the degree of environmental or health risk associated with various substances and working conditions, new rules and regulations would be expected, although there have been no significant regulations in the past few years that have resulted in significant opportunities for the Company. In addition, potentially offsetting these gains from new regulations are manufacturing automation and productivity improvements, which potentially result in fewer people to protect, and movement of labor intensive operations offshore where there is less regulation and lower labor costs. Geographic Distribution of Business The Company distributes over 22,000 industrial, construction tool, personal protection, safety and hazardous waste remediation products to approximately 4,000 active customers primarily located in the Southeast, Southwest, Midwest, Pacific Coast, Alaska and Hawaii. Equipment and Supplies An estimated 40% of the Company s current year sales were environmental products and 31% were safety products, while construction tools and supplies accounted for 14%. The remaining 15% of sales were miscellaneous products used by environmental contractors, construction contractors and industrial manufacturing facilities. The Company buys products from manufacturers based on orders received from its customers as well as anticipated needs based on prior buying patterns and customer inquiries. The Company maintains an inventory of disposable products and commodities as well as low cost equipment items. Approximately 80% of the Company s sales are of disposable items and commodity products, which are sold to customers at unit prices ranging from under $1.00 to $100.00. The balance of sales is attributable to items consisting of lower priced equipment beginning at $20.00 to construction related tools or environmental equipment that can retail in excess of $10,000. The Company currently does not manufacture any products, nor does it rent or lease any products to customers. On a very limited scale, the Company provides warranty repair on certain equipment. The Company does distribute certain disposable items under its own private label. 5 Except with regard to certain specialty equipment associated with environmental remediation activities such as filtration, vacuum and pressure differential systems, many of the Company s products can be used interchangeably within many of the industries it supplies. Equipment distributed by the Company includes manufacturers product descriptions, instructions pertaining to use and, when appropriate, Material Safety Data Sheets ( MSDS ). Marketing The Company s marketing program is conducted by its sales representatives, as well as by senior management and the leaders at each of its operating facilities. The sales representatives are compensated by a combination of salary and/or commission, which is based upon negotiated sales standards. The Company maintains 24-hours-a-day/7-days-a-week telephone service for its customers and typically ships supplies and equipment within two days of the receipt of an order. The Company is prepared to provide products on an expedited basis in response to requests from customers who require immediate deliveries because their work is performed during non-business hours, involves substantial costs because of the specialized labor crews involved or may arise on short notice as a result of exigent conditions. The Company also has a web site, www.abatix.com, with over 8,000 products. This website allows customers to not only place orders on-line, but allows them to check pricing and availability, review their purchasing history and check the status of their account, including the ability to print copies of invoices. Additionally, the web site has current industry and Company information, including historical press releases and the Company s filings with the United States Securities and Exchange Commission ( SEC ). Backlog Substantially all the Company s products are shipped to customers within 48 hours following receipt of the order; therefore backlog is not material to the Company s operations. During severe weather conditions, such as the hurricanes in the United States in 2004 and 2005, the Company can experience severe backlog situations because products in the quantities needed are unavailable from the manufacturers. Since the customer s need for products is immediate in these situations, the customers will purchase from whichever supplier has the product available. Inflation The inflation rate for the United States economy has been relatively low over the past several years, with the 2006 inflation rate at 2.5%. With the 2007 inflation rate expected to be in this same range, the Company believes inflation will not have a material impact on the Company s operations or profitability in the near term; however, there are inflationary factors affecting our business. The Company experienced cost increases in several of its major product lines during 2005 and 2006. The majority of the price increases were passed along to customers in the form of higher selling prices, thereby having little effect on product margins. We do not expect further price increases in certain product lines in 2007, but we believe any price increases will be able to be passed on to customers. If we are unable to pass on these price increases, our gross margins and profitability would be negatively impacted. 6 The cost of fuel for the delivery vehicles (both inbound and outbound deliveries) increased during 2006 and impacted our profitability. Also affecting profitability is the increased cost for utilities. Environmental Impact The Company distributes a variety of products in the environmental industry which requires the Company to maintain MSDS on file. These MSDS, which are provided to the Company by the manufacturers, inform purchasers and users of any potential hazards which could occur if the products spill or leak and other hazards. Although the Company provides no assurance, it reviews all products that could have a potential for environmental hazards and tries to ensure the products are safe for on site storage and distribution. The Company currently distributes no products it believes would create an environmental hazard if leaked or spilled and has safety procedures in place to minimize any impact if such an event occurred. Seasonality In the past, sales to the environmental supply business has been seasonal as a result of (1) the substantial amount of work performed in educational facilities during the summer months when the weather is generally more conducive to construction or during other vacation periods and (2) the severe weather (e.g. hurricanes, wildfires, flooding) that generally impacts the United States from August through November. Absent the severe weather, which can be considered non-recurring revenue, the Company believes seasonality is not a major characteristic in the non-educational or private sector, which includes the industrial, commercial and residential markets. In addition to the private sector environmental business, the Company s expansion in the construction and industrial safety supply markets helps mitigate the seasonal impacts of government environmental projects on the Company s sales. The Company s profitability historically increases in the second and third quarters, relative to the first and fourth quarters. This increase in profitability is attributable to the historically small increase in revenues during the second and third quarters without the corresponding increase in costs, as fixed costs represent a majority of total general and administrative costs. Government Regulation As a supplier of products manufactured by others, the Company s internal operations are not substantially affected by federal laws and regulations including those promulgated by the EPA and OSHA. Most of the contractors and other purchasers of the Company s equipment and supplies are subject to various government regulations. However, legislation and regulations affecting manufacturers and purchasers of the Company s products could have a substantial effect on the Company. 7 Competition The Company competes on the basis of delivery, credit arrangements and price, as well as product availability, variety and quality. The environmental supply, industrial safety and construction tools supply businesses are highly competitive. These markets are served by a limited number of large national firms as well as many regional and local firms, none of which can be characterized as controlling the market. Many of these existing firms have greater financial, marketing and technical resources than the Company. Substantial regulatory or economic barriers to entry do not characterize the Company s business. Therefore, additional companies could enter any of these industries and may have greater financial, marketing and technical resources than the Company. Employees As of February 28, 2007, the Company employed a total of 105 full time, non-union employees including 3 executive officers, 17 managers, 60 administrative and marketing personnel and 25 clerical and warehouse personnel. Not included in the aforementioned numbers are 15 contract employees working at the Company. These contract employees are primarily performing warehouse activities. The Company believes relations with its employees are excellent. Item 1A. Risk Factors Certain matters discussed in this Form 10-K, or documents, a portion of which are incorporated by reference, concerning, among other things, the business outlook, including growth, cost savings, anticipated financial and operating results, strategies and contingencies, constitute forward-looking statements and are based upon management s expectations and beliefs concerning future events impacting the Company. There can be no assurance that these events will occur or that the Company s results will be as estimated. The assumptions used as a basis for the forward-looking statements include many estimates that, among other things, depend on the achievement of future cost savings and projected volume increases. In addition, many factors outside the control of the Company, including the prices and availability of the Company s products, potential competitive pressures on selling prices and fuel prices, as well as general economic conditions in the markets in which the Company operates, also could impact the realization of such estimates. The following factors, as well as factors described elsewhere in the Form 10-K, or in other SEC filings, among others, could cause the Company s future results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. These factors are described in accordance with the provisions of the Private Securities Litigation Reform Act of 1995. 8 Economy. The Company s business follows the U.S. economy and, in particular, the health of the commercial real estate sector. Although the U.S. economy has grown over the past two years, there is no assurance this growth or this level of output will continue. In addition, further interest rate hikes could stifle the economy and the real estate sector such that there would be no growth or even a decline which would negatively impact our business. Competition. The Company experiences intense competition for sales of its principal products. The Company has several major competitors in each of its markets, some of which are larger and have more resources than the Company. The principal methods and elements of the competition include product quality, product breadth, product availability, price, credit terms and delivery services. Inherent risks in the Company s competitive strategy include uncertainties concerning the effects of consolidation of suppliers and distribution channels, the lack of barriers to entry and competitive reaction. Increased competition with respect to pricing would reduce revenue and profitability and could have an adverse impact on the Company s financial position. Personnel. A key component of our strategy is to provide value to our customers by building relationships and establishing a trusting working environment between our customers, our vendors and our staff. The Company provides competitive compensation, benefits and other factors that have attracted our current staff. In addition, hiring and training of additional staff is a key component to our growth plan. However, there can be no assurance that our staff will remain employed by the Company, or that the Company will be able to hire and train replacement or additional staff. Loss of staff could have an adverse impact on the Company s financial results. Non-recurring Revenue and Collection of Accounts Receivable. Over the past two years the Company has benefited from several disasters. For example, the Company benefited from the hurricanes that damaged Florida in 2004 and the hurricanes that damaged Louisiana, Mississippi and Alabama in 2005. There are numerous factors in determining if a disaster will result in business for the Company. Some of these factors are (1) the strength and size of the disaster, (2) the density of structures/population of the affected area and (3) our customers must be part of the team of contractors that are responding to the disaster. There are no assurances that there will be another disaster that benefits the Company. Much of the work performed during these disasters is ultimately paid by the Federal government or by insurance companies. There is risk in the timeliness of collection of the monies owed to our customers from these entities, which can result in a slow down of payments made the Company. This slowdown could stress the financial resources of the Company significantly. In addition, events like these attract people and companies that may not be competent or equipped to handle the magnitude of the projects which increases the risk for collection. While we follow our normal credit application process to determine the credit worthiness of these potential customers, there is no assurance amounts will ultimately be collected. However, the Company believes its reserves are adequate to cover any collection issues. Cost Controls. The Company has made strategic investments in its information systems and has other plans to improve our cost structure. There is no assurance that such cost savings will be achieved. 9 Products. A number of the Company s products, such as plastic sheeting and bags, contain certain materials which are principally derived from petroleum. These products are subject to price fluctuations based on changes in petroleum prices, availability and other factors. Significant increases in prices for these products, as we experienced in 2005 and 2006, could adversely affect earnings if the Company does not or is unable to increase its selling price to customers or if adjustment to our selling price to customers significantly trails the increases in the cost of the products to us. Global economic and political conditions, especially in China, supplier capacity constraints, severe weather conditions and other factors could materially affect the availability of or prices for certain products. Many customers in the industries we serve are brand conscious. If the relationships with certain vendors were to be discontinued, there would be a negative impact on the financial results of the Company. Fuel Costs. We depend heavily on third party delivery services as well as our own fleet of delivery vehicles. Fuel costs are a component of the total cost of shipments inbound from our vendors and shipments outbound to our customers. Significant increases in fuel prices could adversely affect earnings if the Company does not or is unable to pass along increases to customers. Internal Controls over Financial Reporting. We expect to expend significant resources in developing the necessary documentation and testing procedures and performing the testing required by Section 404 of the Sarbanes-Oxley Act of 2002 ( SOX 404 ). The total expenditure is currently estimated to be $800,000; however, the level of effort and resources needed to comply could change significantly. In addition, if management identifies any significant deficiency or material weakness, we may be unable to attest to our internal controls and investors and others may lose confidence in the reliability of our financial statements and our ability to obtain equity or debt financing may be negatively impacted. Low Float and Volatility of Stock Price. The low number of outstanding shares and resulting low amount of shares available for trade in the open market place can result in extreme volatility in the Company s stock price. Not only can the volatility of the stock price be concerning to long-term investors, but it could increase the difficulty in utilizing the stock to obtain capital for growth. Interruptions in the Proper Functioning of Information Systems. The continued proper functioning of our information systems is critical to operations of our business. Although our information systems are protected through physical and software safeguards, these systems remain vulnerable to both intentional and unintentional issues. For example, these systems are vulnerable to power interruptions, unauthorized physical access, unauthorized access to the system (hacking), communication interruptions, hardware failure, software corruption and natural disasters. If the critical information systems fail or are unusable, our ability to conduct normal business could be severely affected. 10 Item 1B. Unresolved Staff Comments. None Item 2. Properties. The Company maintains sales, distribution and warehouse centers in Los Angeles and San Francisco, California; Dallas and Houston, Texas; Phoenix, Arizona; Las Vegas, Nevada; Seattle, Washington; and Jacksonville, Florida. In August 2006, the Company closed a temporary office in Ponchatoula, Louisiana that was set up to help contractors respond to the devastation in Louisiana, Mississippi and Alabama from the hurricanes. As of December 31, 2006, the Company leases and occupies approximately 232,000 square feet of industrial space. Included is approximately 8,000 square feet of office space for the Company s headquarters. Abatix branch facilities range in size from 13,200 square feet to 33,900 and have leases expiring between April 2007 and August 2016. IESI leases approximately 21,000 square feet of warehouse space. Item 3. Legal Proceedings. None Item 4. Submission of Matters to a Vote of Security Holders. None 11 PART II Item 5. Market for the Registrant s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities. (a) The Company s common stock trades on The Nasdaq Capital Market under the symbol ABIX . The following table sets forth the high and low bid prices for the common stock for the periods indicated. These quotations reflect prices between dealers, do not include retail mark-ups, mark-downs or commissions and may not necessarily represent actual transactions. Common Stock Bid Price High Low 2005 First Quarter $ 10.46 $ 5.67 Second Quarter 8.30 4.75 Third Quarter 16.50 6.54 Fourth Quarter 18.50 9.75 2006 First Quarter $ 14.78 $ 10.02 Second Quarter 11.69 7.87 Third Quarter 9.18 7.11 Fourth Quarter 7.71 5.60 On March 23, 2007, the closing price for the common stock was $7.05. (b) As of March 23, 2007, the approximate number of stockholders of record of the Company s common stock is estimated to be less than 100, although we estimate that there are approximately 1,000 beneficial stockholders. (c) The Company has never paid cash dividends on its common stock. Future dividend policy will depend on the Company s earnings, capital requirements, expansion plans, financial conditions, tax laws and other relevant factors. The Company currently does not anticipate paying cash dividends for the foreseeable future. (d) At the previous Annual Meeting of Stockholders in May 2006, the stockholders approved the 2006 Stock Plan. As of March 23, 2007, no grants have been made from this plan. (e) The Company does not currently have an active share repurchase program and has not repurchased any of its common stock since 1999. 12 Item 6. Selected Financial Data. The tables below set forth, in summary form, selected financial data of the Company. This data, which is not covered by the report of the independent registered public accounting firm, should be read in conjunction with the consolidated financial statements and notes thereto which are included elsewhere herein (amounts in thousands except per share amounts). Year Ended December 31, 2006 2005 a 2004 a 2003 b 2002 c Selected Operating Results: Net sales $ 66,448 $ 70,626 $ 52,892 $ 48,893 $ 59,801 Gross profit $ 18,848 $ 19,961 $ 14,370 $ 14,050 $ 17,437 Earnings before cumulative effect of change in accounting principle $ 998 $ 2,084 $ 214 $ 61 $ 1,345 Cumulative effect of change in accounting principle d (492 ) Net earnings $ 998 $ 2,084 $ 214 $ 61 $ 853 Basic and diluted net earnings per common share: Earnings before cumulative effect of change in accounting principle $ .58 $ 1.22 $ .13 $ .04 $ .79 Cumulative effect of change in accounting principle d (.29 ) Net earnings $ .58 $ 1.22 $ .13 $ .04 $ .50 Basic and diluted weighted average shares outstanding 1,711 1,711 1,711 1,711 1,711 As of December 31, 2006 2005 2004 2003 2002 Selected Balance Sheet Data: Current assets $ 20,451 $ 24,966 $ 17,837 $ 14,617 $ 15,602 Current liabilities 10,364 15,347 10,306 7,590 8,461 Total assets 22,342 26,431 19,272 16,342 17,152 Total liabilities 10,377 15,381 10,306 7,590 8,461 Retained earnings 11,646 10,730 8,646 8,432 8,371 Stockholders equity 11,965 11,050 8,966 8,752 8,691 a The 2005 and 2004 results include the increase in sales and profitability related to the cleanup efforts from the hurricanes in Louisiana and Florida, respectfully. b Sales to mold related jobs declined significantly in 2003 due to the reduction in insurance coverage for homeowners. c The 2002 results include the increase in sales related to the affects of Tropical Storm Allison in Texas. In addition, the Company, primarily in the Texas markets, experienced a significant growth in sales related to the increased awareness of toxic molds in homes and buildings. d The cumulative effect of change in accounting principle resulted from the adoption of Financial Accounting Standards Board Statement of Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets. 13 Item 7. Management s Discussion and Analysis of Financial Condition and Results of Operation. Introduction The Company is a supplier of mainly safety related products and tools to workers involved in the construction and manufacturing markets. From eight fully-stocked distribution facilities/sales offices in the western and southeastern part of the United States, the Company primarily distributes equipment and commodity products to the local geographic areas surrounding its facilities. IESI, the Company s wholly-owned subsidiary, primarily imports disposable clothing from China. IESI sells their product throughout the United States and the Caribbean through the Abatix distribution channels, as well as through other distributors. The Company s management believes that hiring additional sales staff, controlling costs, geographic expansion, diversification of customer base and responding effectively to competitive challenges are important to the long-term success of the Company. Sales Staff – We sell our products based on relationships, among other things. Our ability to hire, train and retain staff, especially in the sales and customer service area is critical to our long-term success. Competitive compensation and benefits as well as a good work-life balance are critical to this area. Controlling Costs – To maintain our competitive position by providing competitively priced products while also maintaining our profitability, we must control our costs and effectively utilize our assets. We continuously review our general and administrative costs making adjustments where appropriate. Our ability to control costs can be affected by outside factors, such as the price of oil or other raw materials or increases in interest rates. In addition, the cost to initially comply with SOX 404 is expected to total approximately $800,000 by December 31, 2007. This cost would most likely negate any of our cost reduction efforts. Geographic Expansion – The Company needs to leverage our infrastructure and knowledge over a larger revenue base. While the Company intends to focus on growing revenues in its existing locations, the Company will also explore geographic expansion. This expansion could come in the form of opening a new location in a new geographic market or acquiring an existing company in a market where we currently do not operate. These possibilities require significant planning time and financial resources which could limit our ability to implement. 14 Customer Base – While no customer represents 10% or more of the Company s revenues, there are several large customers, especially at IESI. The loss of one or more of those customers would have an impact on our revenue and profitability. The Company intends to pursue additional customers in an attempt to lessen the impact of any one customer and improve on existing customer relationships. While we intend to market our customer service in an attempt to obtain higher margins, obtaining market share generally has a negative effect on product margins. Competitive Environment – Past results and future prospects are significantly affected by the competitive environment in which we operate. We experience intense competition for sales of our products in all of our markets. Our competition ranges from small owner-operator distributors to large national retail chains selling to the construction industry and large national companies selling to the construction and industrial industries. Typically, the smaller companies are built around very strong relationships which make it hard to penetrate, while the larger companies have a distinct geographic and price advantage. In addition to the above mentioned critical success factors, significant short-term boosts of revenue, like the hurricanes of 2004 and 2005, although positively impacting the sales and net income of the Company, also place strains on the Company s resources as partially identified below: Non-recurring revenues o Comparisons of financial results between periods are not always evident without reading the financial statements as a whole. o There is no reliable method to determine the amount of impact these events will have on the Company, nor is there a reliable method to determine how long the impact may last. Accounts receivable o The sharp rise in non-recurring revenues from these events can cause significant balances owed to the Company by a few customers. Balancing this concentration risk with sales is a difficult process that involves significant judgment. o Much of the work performed by the Company s customers is related to insurance claims. Occasionally, there is difficulty in getting the insurance company to pay the amount owed and can possibly delay when Abatix is paid. Inventory o Certain products can be in short supply because the Company s vendors are unable to ramp up production to meet the demand in the required time frame. o Damage caused by catastrophic events can affect the manufacturing and transportation of inventory, including raw materials used by others to manufacture products sold by the Company. o Products in demand in the affected areas can decimate inventory levels in other facilities and not allow us to serve all of our customers in a normal manner. o Potential shortages in product lead to advance purchasing and maintaining higher levels of safety stock. If there is little or no damage caused by a catastrophic event or if advance purchasing is too aggressive in estimated needs, the Company could be left with excess inventory. 15 Cash o Significant increases in revenues in a short period of time utilize the cash resources available to the Company as the inventory is purchased and paid for generally between 10 – 40 days, while the average collection period is generally more than 60 days. o Advance purchases in anticipation of increased sales and possible shortages in supply elongates the cash cycle. o As interest rates continue to rise, the higher borrowing levels normally associated with these events translate to higher interest expense. Human Resources o There is significant planning time involved in responding to these events that would normally be spent on other areas of the business. o Immediate response to these disasters is handled by currently employed personnel which can detract from the service levels provided to our customer base in our other facilities. o We have generally found a lack of human resource talent outside of the Company to meet the short-term needs demanded by our temporary facilities. o Significant amounts of time are spent managing and projecting the cash flows to ensure cash resources are available. o Fluctuations in financial results can result in extra requirements placed on the corporate staff as a result of comments, inquiries from the investment community and compliance with requests from regulatory agencies. Other than historical and factual statements, the matters and items discussed herein are forward-looking statements that involve risks and uncertainties. Actual results of the Company may differ materially from the results discussed herein. Certain, but not all, factors that could contribute to such differences are discussed throughout this report. We do not undertake any obligation to publicly update forward-looking statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events, except as required by law or regulation. Overview of 2006 Results Net sales decreased 6% when compared to 2005. Gross profit decreased 6% when compared to 2005. Selling, general and administrative costs increased 2% when compared to 2005. Net income of $998,000 decreased $1,086,000 when compared to 2005. This discussion and analysis of our results of operations and financial condition is intended to provide investors with an understanding of the Company s recent performance, its financial condition and its prospects. We will discuss and provide our analysis of the following: Results of Operation and Related Information Liquidity and Capital Resources Critical Accounting Policies New Accounting Standards Business Outlook Information Concerning Forward-Looking Statements 16 Results of Operation and Related Information 2006 Compared With 2005 Net Sales Consolidated net sales decreased 6% to $66,448,000 from 2005. The Abatix operating segment net sales decreased 5% to $63,429,000, while the IESI operating segment net sales to external customers decreased 15% to $3,019,000. The decrease in sales at the Abatix operating segment resulted from: o decreased sales to the environmental market, primarily the restoration submarket, due to the lack of events in 2006 comparable to the hurricanes in 2005, partially offset by o increased sales to the industrial market as spending from manufacturing facilities have improved due to the current state of the U.S. economy, and o increased sales to the construction market due to the current state of the commercial real estate sector of the U.S. economy. The decrease in sales to external customers at the IESI operating segment resulted from lower sales to its two largest customers due to lower sales to end users. Gross Profit Consolidated gross profit of $18,848,000 decreased 6% from 2005. Expressed as a percentage of sales, gross profit was 28.4% and 28.3% in 2006 and 2005, respectively. The decrease in gross profit dollars is primarily a result of: lower sales volume in the environmental market at the Abatix Segment and, lower sales volume within the IESI segment, partially offset by higher pricing at the IESI segment. Selling, General and Administrative Expenses Selling, general and administrative expenses of $16,591,000 increased 2% from 2005. Expressed as a percentage of sales, selling, general and administrative expenses were 25.0% and 23.0% for 2006 and 2005, respectively. The significant changes are: Higher labor costs as a result of normal annual increases in wages and an increase in staff, Higher rent due to the temporary facility in Louisiana and higher rent for our Dallas operations as we had a short-term lease for six months while awaiting completion of a new facility, Higher travel and entertainment expenses, Higher depreciation expense resulting primarily from improved materials handling equipment in our Las Vegas, Houston and Dallas facilities, Higher freight expenses as a result of higher fuel costs, partially offset by a lower sales volume, and Higher expenses relating to our preparation towards complying with SOX 404, partially offset by Lower commissions due to the lower sales volume, Lower bad debt expense as the receivable quality and collection risk has improved, Lower legal expenses relating to the collection of accounts. 17 Additional Statement of Operations Commentary Operating profit of 3.4% of sales for 2006 decreased from 5.3% of sales in 2005. The Abatix segment operating profit of 2.5% of sales for 2006 decreased from 4.3% of sales in 2005. The IESI segment operating profit of 15.8% of sales in 2006 decreased from 19.8% in 2005. o The decrease at the Abatix segment is a result of lower gross profit and higher selling, general and administrative expenses. o The decline at the IESI segment is a result of lower sales volume. Interest expense of $518,000 increased approximately $147,000 from 2005 primarily due to higher interest rates. Our effective tax rate was 42.6% in 2006 which compared with 38.0% in 2005. The effective tax rate is greater than the Federal statutory rate because it includes items that are not deductible for Federal income taxes, as well as state income taxes. A significant portion of the increase in our effective rate for 2006 is attributable to the reduction of deferred tax assets (increasing income tax expense) in the third quarter as a result of the change in law in the State of Texas. Net earnings of $998,000 or $.58 per share decreased $1,086,000 from net earnings of $2,084,000 or $1.22 per share in 2005 as a result of lower operating income, higher interest expense and higher taxes due to the change in law. 2005 Compared With 2004 Net Sales Consolidated net sales increased 34% to $70,626,000 from 2004. The Abatix operating segment net sales increased 34% to $67,058,000, while the IESI operating segment net sales to external customers increased 28% to $3,568,000. The increase in sales at the Abatix operating segment resulted from: o increased sales, estimated to be approximately $9,000,000 in 2005, to the restoration market as a result of the potentially non-recurring weather related events in the Gulf Coast region; whereas sales related to the 2004 weather related events in Florida were estimated to be approximately $4,000,000, o increased sales to the restoration market as a result of the potentially non-recurring weather related events in California, o increased sales to the industrial manufacturing market as spending from manufacturing facilities have increased due to current state of the U.S. economy, o increased sales to the construction market due to the current state of the commercial real estate sector of the U.S. economy, and o increased selling prices on many products resulting from increases in product costs from suppliers primarily due to the increase in raw material and transportation costs. The increase in sales at the IESI operating segment resulted from market penetration at primarily two key customers and those customers ability to capture market share from competitors products. 18 Gross Profit Consolidated gross profit of $19,961,000 increased 39% from 2004. Expressed as a percentage of sales, gross profit was 28.3% and 27.2% in 2005 and 2004, respectively. The increase in gross profit dollars is primarily a result of higher sales volume primarily to the restoration market. The increase in the gross profit rate is primarily a result of product mix. Selling, General and Administrative Expenses Selling, general and administrative expenses of $16,236,000 increased 18% from 2004. Expressed as a percentage of sales, selling, general and administrative expenses were 23.0% and 25.9% for 2005 and 2004, respectively. The significant changes are: higher labor costs (21%) primarily as a result of higher commissions, bonuses, overtime and staffing levels to accommodate the higher sales volume, higher freight costs as a result of the higher sales volume and higher fuel costs, and costs of approximately $125,000 have been incurred to begin compliance with SOX 404, partially offset by lower legal expenses. Additional Statement of Operations Commentary Operating profit of 5.3% of sales for 2005 improved from 1.2% of sales in 2004. The Abatix segment operating profit of 4.3% of sales for 2005 improved from 0.3% of sales in 2004. The IESI segment operating profit of 19.8% of sales in 2005 improved from 15.2% in 2004. o The improvement at the Abatix segment is a result of higher sales volumes and pricing without a corresponding increase in general and administrative costs. o The improvement at the IESI segment is primarily a result of higher sales volumes without the corresponding increase in general and administrative costs, partially offset by lower pricing. Interest expense of $371,000 increased approximately $128,000 from 2004 primarily due to higher interest rates and higher line of credit balances. Our effective tax rate was 38.0% in 2005, which compared with 47.7% in 2004. The effective rate in 2005 is lower than 2004 as a result of the following. o Certain federal deductions are added back to arrive at taxable income for Texas franchise tax purposes. At lower pre-tax income levels, as in 2004, these add-backs have a larger impact on the effective rate. o 2004 includes a $20,000 additional tax expense as a result of an adjustment to the 2001 tax year. Net earnings of $2,084,000 or $1.22 per share increased $1,870,000 from net earnings of $214,000 or $.13 per share in 2004. The increase in net earnings is primarily due to the higher sales volume. 19 Liquidity and Capital Resources Cash provided by operations during 2006 of $4,634,000 compared to cash used in operations during 2005 of $3,482,000. Accounts receivable o Gross accounts receivable decreased 21% since December 31, 2005 as the Company collected a majority of the money it was owed, primarily in the first quarter 2006, from customers that did significant hurricane related work in the Gulf Coast region in the second half of 2005. o Approximately 31% of the receivables balance is held by ten companies, with the largest company comprising approximately 6% of the receivables balance. While these companies are long-term customers of Abatix and payment in full is expected, non-payment or delays in payment of these balances owed would have a significant negative impact on the cash flows of the Company. Gross inventory decreased 8% since December 31, 2005. This decrease is a result of a decrease in inventory related to hurricane related work in the Gulf Coast Region. Cash requirements for investing activities during 2006 of $951,000 increased by $474,000 when compared to 2005. These requirements were primarily the purchase of: delivery vehicles, computer hardware and software, new furniture, and warehouse equipment related to the move of two branches into new facilities. Purchases in 2007 are estimated to be approximately $300,000 and will primarily include replacement of vehicles and computers. The Company has a $12,000,000 working capital line of credit with its financial institution and a $500,000 capital equipment credit facility. Based on the borrowing formula calculated as of February 28, 2007, the Company had the capacity to borrow up to a maximum of $9,881,000 on its working capital line. As of March 27, 2007, there are advances of $4,160,000 outstanding on the working capital credit facility. As of March 27, 2007, there are advances of $292,000 outstanding on the capital equipment credit facility. Both credit facilities expire in October 2007 and bear a variable rate of interest tied to the prime rate. Although, the Company, at its option, can convert the loan to a Libor rate loan. The equipment facility is payable on demand. The majority of the Company s credit facilities are at one financial institution. There is risk associated with having the majority of the Company s relationship with one financial institution. 20 Off-Balance Sheet Arrangements The Company does not have any material exposure to off-balance sheet arrangements, nor does the Company have any variable interest entities or activities that include nonexchange-traded contracts accounted for at fair value. Contractual Obligations The following table presents the Company s total contractual obligations as of December 31, 2006 for which cash flows are fixed or determinable (in thousands). Payments due by period Contractual obligations Total Less than 1 year 1-3 years 3-5 years More than 5 years Working Capital Line of Credit $ 5,270 $ 5,270 $ $ $ Long-Term Debt Obligations 359 151 208 Capital Lease Obligations Operating Lease Obligations 5,717 1,022 2,540 906 1,249 Inventory Purchase Obligations 1,552 1,552 Other Purchase Obligations 409 246 163 Employment Contracts 1,230 615 615 Other Long-Term Liabilities Reflected on the Registrant s Balance Sheet Under GAAP Total $ 14,537 $ 8,856 $ 3,526 $ 906 $ 1,249 Commentary: Even though the Company s working capital line of credit agreement is a two-year term with a maturity date of October 2007, there is no defined payment schedule. Therefore, this line of credit is classified as a current liability on the Consolidated Balance Sheets. In addition, the above amount does not include a contractual obligation related to the interest since the interest rate is variable and the working capital line of credit balance fluctuates, therefore making the interest component not fixed and determinable. If the December 31, 2006 balance were outstanding for an entire year, the interest payable would be approximately $409,000 at the Company s current interest rate. The Company s long-term debt obligations are comprised of equipment notes with terms of 24 to 60 months in length. Certain of these term notes also have a call feature, and are therefore classified as current liabilities on the Consolidated Balance Sheets. The other term notes with no call feature are properly classified between the current liabilities and non-current liabilities sections on the Consolidated Balance Sheets. The inventory purchase obligations represent purchase order amounts the Company anticipates will become payable within the next year for saleable product. The other purchase obligations include amounts due on contracts for telecommunication and credit services. The employment agreements with the Chief Executive, Operating and Financial Officers were effective on January 1, 2007 and expire on December 31, 2008. 21 Critical Accounting Policies and Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net sales and expenses during the reporting period. Actual results could differ from these estimates, and changes in these estimates are recorded when known. The critical accounting policies used by management in the preparation of the Company s consolidated financial statements are those that are important both to the presentation of the Company s financial condition and results of operations and require significant judgments by management with regard to estimates used. The critical judgments by management relate to allowance for doubtful accounts; excess and obsolete inventory; depreciation, amortization and impairment testing for property and equipment; deferred tax assets and potential income tax assessments; and retained insurance risks. The Company s critical accounting policies have been reviewed with the Audit Committee of the Board of Directors. Allowance for Doubtful Accounts The Company has estimated the net realizable value of accounts receivable by evaluating the current pool of accounts receivable in light of past experience and current knowledge of its customer base. The Company believes the reserves recorded in the financial statements are adequate for potential credit losses. It is possible the accuracy of the estimation process could be materially impacted as the composition of this pool of accounts receivable changes over time or if the health of the economy, its customers or the markets served by the Company deteriorates. Excess and Obsolete Inventory The Company evaluates whether inventory is stated at the lower of cost or market based on historical experience with the carrying value and life of inventory. The assumptions used in this evaluation are based on current market conditions and the Company believes inventory is stated at the lower of cost or market in the financial statements. Depreciation, Amortization and Impairment Testing for Property and Equipment Estimating the useful lives of property, plant and equipment requires the exercise of management judgment, and actual lives may differ from these estimates. Changes to these initial useful life estimates would be made if and when appropriate. Property, plant and equipment are tested for impairment in accordance with Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, whenever events or changes in circumstances indicate that the carrying amounts of such long-lived assets may not be recoverable from future net pretax cash flows. Impairment testing requires significant management judgment including estimating the future success of product lines and facilities, future sales volumes, growth rates for selling prices and costs, alternative uses for the assets and estimated proceeds from disposal of the assets. The Company makes estimates regarding future undiscounted cash flows from the use of long-lived assets in assessing potential impairment whenever events or changes in circumstances indicate the carrying value of a long-lived asset may not be recoverable. Since there were no events or changes in circumstances to indicate the carrying value of long-lived assets were impaired, the Company recorded no adjustment to the carrying value of these assets. The Company does not expect events or circumstances to significantly change, thereby affecting the carrying value of long-lived assets. 22 Deferred Tax Assets and Potential Income Tax Assessments As of December 31, 2006, the Company has recorded a net deferred tax asset. In determining the valuation allowances to establish against these deferred tax assets, if any, the Company considers many factors, including the specific taxing jurisdiction, income tax strategies and forecasted earnings. A valuation allowance is recognized if, based on the weight of available evidence, the Company concludes that it is more likely than not that some portion or all of the deferred tax asset will not be realized. The Company records liabilities in current income taxes for potential assessments resulting from tax audits. Any accruals relate to uncertain tax positions in, potentially, a variety of taxing jurisdictions and are based on what management believes will be the ultimate resolution of these positions. These liabilities may be affected by changing interpretations of laws, rulings by tax authorities, or the expiration of the statute of limitations. The Company s U.S. federal income tax returns have been audited through 2001 and all federal assessments of additional taxes, interest and penalties have been paid through 2001. Retained Insurable Risks The Company has elected to self insure for health care related costs, but does have catastrophic coverage. The accrued liabilities for incurred but not reported events are based upon historical loss patterns, specific events that the Company may become aware of and management s judgment. New Accounting Standards In November 2004, Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( Statement ) No. 151, Inventory Costs – an amendment of Accounting Research Bulletin No. 43, Chapter 4. Statement No. 151 requires that abnormal amounts of costs, including idle facility expense, freight, handling costs and spoilage, should be recognized as current period charges. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Statement No. 151 was adopted on January 1, 2006. There was no material impact resulting from the adoption of Statement No. 151 on the Company s financial statements. In December 2004, FASB issued Statement No. 123R, Share-Based Payment. Statement No. 123R revises Statement No. 123, supersedes Accounting Principles Board ( APB ) Opinion No. 25 and amends Statement No. 95. Statement No. 123R requires the cost of employee services received in exchange for an award of equity instruments be recognized over the period during which an employee is required to provide service in exchange for the award. The provisions of this Statement are effective for public entities that do not file as small business issuers as of the beginning of the first interim period or annual reporting period that begins after June 15, 2005. Statement No. 123R was adopted on January 1, 2006. There was no impact resulting from the adoption of Statement No. 123R on the Company s financial statements. 23 In March 2005, the FASB issued Interpretation ( FIN ) 47, Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies the term conditional asset retirement obligation as used in Statement No. 143, Accounting for Asset Retirement Obligations, by stating that the obligation to perform the asset retirement activity is not conditional even though the timing or method of retirement may be conditional. Consequently, FIN 47 requires that a liability be recognized for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is effective for years ending after December 15, 2005. FIN 47 was adopted on January 1, 2006. There was no impact resulting from the adoption of FIN 47 on the Company s financial statements. In June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections a replacement for APB Opinion No. 20 and FASB Statement No. 3. Statement 154 applies to all voluntary changes in accounting principle and changes the requirement for accounting for and reporting of a change in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB Opinion No. 20 required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. Statement No. 154 establishes that unless impracticable, retrospective application is the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. While the correction of an error is not an accounting change, Statement 154 requires the restatement of previously issued financial statements. This Statement is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Statement No. 154 was adopted on January 1, 2006. There was no material impact resulting from the adoption of Statement No. 154 on the Company s financial statements. In September 2005, the Emerging Issues Task Force ( EITF ) reached a final consensus on Issue No. 04-13, Accounting for Purchases and Sales of Inventory With the Same Counterparty. The first issue surrounds the recognition of a nonmonetary transaction at fair value rather than at recorded amounts. The second issue surrounds the classification of two or more nonmonetary transactions being viewed as a single nonmonetary transaction. With respect to the first issue, the Company does, on occasion, purchase and sell finished goods inventory to other companies within the same line of business. These transactions have been recognized at the recorded amount in accordance with the EITF tentative conclusion. With respect to the second issue, the EITF created a list of indicators that would trigger two or more nonmonetary transaction be accounted for as a single transaction. The Task Force agreed that this Issue should be applied to new arrangements entered into, and modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. There was no material impact resulting from the application of this Issue No. 04-13 on the Company s financial statements. 24 In February 2006, the FASB posted the final FSP Statement No. 123R-4, Classification of Options and Similar Instruments Issued as Employee Compensation that Allow for Cash Settlement upon the Occurrence of a Contingent Event. This FSP amends paragraphs 32 and A229 of FASB Statement of No. 123R. This FSP is to be applied on the initial adoption of FASB Statement No. 123R. This FSP was adopted on January 1, 2006. There was no material impact resulting from the adoption of this FSP on the Company s financial statements. In February 2006, the FASB issued Statement No. 155, Accounting for Certain Hybrid Financial Instruments. This Statement, which amends Statement No. 133 and No. 140, (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (5) amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of the entity s first fiscal year that begins after September 15, 2006. Statement No. 155 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 155 on the Company s financial statements. In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets – an Amendment of FASB Statement No. 140. This Statement, which amends Statement No. 140: (1) Requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; (2) Requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value; (3) Permits an entity to choose either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities; (4) At its initial adoption, permits a one-time reclassification of available-for-sale securities under Statement 115 under certain conditions; and (5) Requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the balance sheet and additional disclosures for all separately recognized servicing assets and servicing liabilities. This Statement is effective as of the beginning of the first fiscal year that begins after September 15, 2006. Statement No. 156 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 156 on the Company s financial statements. In July 2006, the FASB issued FIN 48, Accounting for Uncertainties in Income Tax. The purpose of FIN 48 is to clarify and set forth consistent rules for accounting for uncertain tax positions in accordance with Statement No. 109, Accounting for Income Taxes. FIN 48 defines the threshold for recognizing the benefits of tax-return positions in the financial statements as more-likely-than-not to be sustained by the taxing authority and applies to all tax positions. The cumulative effect of applying the provisions of this interpretation is required to be reported separately as an adjustment to the opening balance of retained earnings in the year of adoption. Additionally, FIN 48 requires other annual disclosures. FIN 48 is effective as of the beginning of the first fiscal year beginning after December 15, 2006 with earlier application permitted if no interim financial statements have been issued. FIN 48 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Fin 48 on the Company s financial statements. 25 In September 2006, The FASB posted FSP No. AUG-AIR-1, Accounting for Planned Major Maintenance Activities. This FSP addresses the accounting for planned major maintenance activities and amends certain provisions in APB Opinion No. 28, Interim Financial Reporting. This FSP is applicable to all industries and prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods. The effective date of FSP No. AUG-AIR-1 is for the first fiscal year beginning after December 15, 2006. FSP No. AUG-AIR-1 was adopted on January 1, 2007. There was no material impact resulting from the adoption of FSP No. AUG-AIR-1 on the Company s financial statements. In September 2006, the SEC released Staff Accounting Bulletin ( SAB ) No. 108, Quantifying Financial Statement Misstatements. The SEC staff believes registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that when all relevant quantitative and qualitative factors are considered, is material. Effective January 1, 2006, the Company adopted SAB No. 108. The transition provisions of SAB No. 108 allow the cumulative effect of immaterial misstatements relating to prior periods to be adjusted to retained earnings as of the beginning of the year of adoption. In accordance with these transition provisions, we reduced retained earnings to reflect the proper carrying cost of inventory for rebates received from vendors in prior years. These misstatements do not affect previously reported cash flows from operations and the impact on prior years financial position and results of operations was immaterial. See Notes 1 and 11 to the Consolidated Financial Statements for more information. The total cumulative impact is as follows: Retained earnings $ 83,208 Deferred income taxes 49,924 Inventory (133,132 ) In September 2006, the FASB issued Statement No. 157, Fair Value Measurement. Statement No. 157 will change current practice by defining fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date. Statement No. 157 will require the market-based measurement, not an entity-specific measurement, based on the assumptions market participants would make in pricing the asset or liability. The effective date of Statement No. 157 is for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company does not expect the adoption of Statement No. 157 to have a material impact on its financial statements. In September 2006, the FASB issued Statement No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans. Statement No. 158 amends Statements 87, 88, 106 and 132(R). Statement No. 158 would require employers to recognize the funded status of a benefit plan in its statement of financial position and recognize the gains or losses and prior service costs as a component of other comprehensive income. Employers must also measure defined benefit plan assets and obligations as of the date of the fiscal year financial statements and to disclose in the notes to the financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arises from gains, losses or prior costs of service as well as transition of asset or obligation. The effective date of Statement No. 158 is for fiscal years ending after December 15, 2006 for the funded status of a benefit plan and the disclosure requirements and fiscal years ending after December 15, 2008 for the measurement of plan assets benefit obligations. Statement No. 158 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 158 on the Company s financial statements. 26 Business Outlook Our goal for 2007 is to produce revenue growth, exclusive of any non-recurring revenues that may occur, as it is vital to our long-term success. We are anticipating the industrial manufacturing and construction markets to remain steady as the general economy and, in particular, the commercial real estate market, have stabilized. However, recent increases in interest rates and the cost of materials for real estate projects could negatively impact those segments and the economy in general. We anticipate growth in the environmental market, and in particular, the restoration subset of that market. Hiring of additional sales and support staff will be critical for long-term growth of the Company. Diversification of our customer base, especially at the IESI segment, will also help provide more consistent results. Although no customer is more than 5% of our revenues, we have several large customers, the loss of which would impact our sales and profitability. We are focused on helping all of our customers grow, as well as adding to our customer base. New locations and acquisitions will most likely be critical for the long-term growth of the Company. Although we are not certain if and when we will open new locations, we are currently evaluating certain markets as possibilities. We are not currently evaluating any acquisitions. Overall margins for 2007 are anticipated to be in the 27 – 28% range. We are utilizing certain tools and reporting from our computer system in an effort to enhance margins. In addition, these tools and reporting should allow us to identify issues that can be addressed more quickly, thereby minimizing possible margin erosion. We continue to evaluate the consolidation of certain vendors to gain value. Alternative methods for sourcing products are also being evaluated to enhance our purchasing process. However, further competitive pressures or changes in the customer or product mix could negatively impact any and all efforts by the Company to maintain or improve product margins. 27 The Company will need to further reduce costs to stay competitive and improve on its profitability. We intend to continue evaluating costs, including labor related costs, rent and freight which make up approximately 75% of our selling, general and administrative costs, to ensure our cost structure is in line with our revenue stream and supports our business model. In 2005, the Company began its work to comply with SOX 404. The Company currently estimates that it will incur in excess of $800,000 in costs, most of which are external costs, related to this work. Unless revenues improve significantly and are sustainable, selling, general and administrative expenses are estimated to be in the 24 – 25% range for 2007. The Company s credit facilities are variable rate notes tied to the lending institution s prime or Libor rates. Increases in these rates have already and could continue to negatively affect the Company s earnings. Depending on many factors, including the timing of sales, cash flow from operations for the entire year of 2007 is expected to be positive as improvements are made to inventory and purchasing and there is further refinement in our cost structure. Unless the Company employs a more aggressive growth strategy, management believes the Company s current credit facilities, together with cash provided by operations, will be sufficient for its capital and liquidity requirements for the next twelve months. The Company does not expect a significant change in its accounts receivable collection days and also believes its allowance for bad debts is sufficient to cover any anticipated losses. The Company s inventory turns have decreased over the past twelve months. This decrease is primarily a result of the inventory levels in anticipation of continued sales in the areas impacted by the hurricanes in 2005 or for future water restoration business. Continued work in reducing inventory levels is still needed; however, the Company believes its allowance for inventory obsolescence is sufficient to cover any valuation issues. A new location would require approximately $100,000 in fixed asset purchases, comprised of computers, office furniture, warehouse racking and potentially a delivery vehicle. In addition, cash will also be required to stock this location with product and to finance the customers purchases. Cash flow from operations and borrowings on our lines of credit would most likely be used to finance any new location. Unless the Company s stock could be used as currency, any acquisitions would most likely require the raising of capital as the borrowing capacity on the lines of credit and the cash flow from operations would most likely not be sufficient to support an acquisition of reasonable size. The Company currently estimates that it will incur approximately $480,000 in additional costs through 2007 related to the implementation of SOX 404. Information Concerning Forward-Looking Statements Certain statements contained herein, among other things, are of a forward-looking nature relating to future events or the future business performance of Abatix. Such statements involve a number of risks and uncertainties including, without limitation, the occurrence, timing and property devastation of disasters; global, national and local economic and political conditions; changes in laws and regulations relating to the Company s products and the import of such products; market acceptance of new products; existence or development of competitive products the Company represents that outperform current product lines or are priced more competitively; inability to hire and train quality people or retain current employees; changes in interest rates; the financial status of and relationships with key customers and vendors; efforts to control and/or reduce costs; fluctuations in oil prices; or the Company s success in the process of management s assessment and auditor attestation of internal controls, as required by the SOX 404. We do not undertake any obligation to publicly update forward-looking statements to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events, except as required by law or regulation. 28 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. Since the Company s working capital and equipment lines of credit are variable rate notes, the Company is exposed to interest rate risk. Based on the Company s debt at December 31, 2006 and 2005, an increase of 100 basis points in the United States prime rate would have negatively impacted the Company s net earnings for the years then ended by $31,000 and $61,000, respectively. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and supplementary data are included under Part IV, Item 15(a)(l) and (2) of this Report. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. None Item 9A. Controls and Procedures. Evaluation of Disclosure Controls and Procedures As of December 31, 2006, the Company evaluated, under the supervision and with the participation of the Company s management, including the Company s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company s disclosure controls and procedures pursuant to Rule 13a-15 and 15d-15 of the Securities Exchange Act of 1934 (the Exchange Act ). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer conclude that the Company s disclosure controls and procedures were effective in timely alerting them to material Company (including its consolidated subsidiary) events and information required to be included in the Company s Exchange Act filings. Internal Control over Financial Reporting The Company is currently undergoing a comprehensive effort to ensure compliance with the regulations under SOX 404 that take effect for the Company s fiscal year ending December 31, 2007. This effort includes internal control documentation and design evaluation under the direction of senior management. In the course of its ongoing evaluation, management has identified certain areas requiring improvement, which the Company is addressing. Management routinely reviews potential internal control issues with the Company s Audit Committee. 29 Changes in Internal Control There have been no changes in the Company s internal controls over financial reporting or in other factors that occurred during the fourth quarter of the fiscal year ended December 31, 2006, that has materially affected, or is reasonably likely to materially affect, the Company s internal controls over financial reporting. Limitations on the Effectiveness of Controls Our management, including the Chief Executive Officer and the Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies and procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Item 9B. Other Information. None. 30 PART III Item 10. Directors, Executive Officers and Corporate Governance. This Item 10 is incorporated herein by reference from the Company s definitive Proxy Statement to be filed with the SEC not later than one hundred twenty (120) days after December 31, 2006. Item 11. Executive Compensation. This Item 11 is incorporated herein by reference from the Company s definitive Proxy Statement to be filed with the SEC not later than one hundred twenty (120) days after December 31, 2006. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. This Item 12 is incorporated herein by reference from the Company s definitive Proxy Statement to be filed with the SEC not later than one hundred twenty (120) days after December 31, 2006. Item 13. Certain Relationships and Related Transactions, and Director Independence. This Item 13 is incorporated herein by reference from the Company s definitive Proxy Statement to be filed with the SEC not later than one hundred twenty (120) days after December 31, 2006. Item 14. Principal Accounting Fees and Services. This Item 14 is incorporated herein by reference from the Company s definitive Proxy Statement to be filed with the SEC not later than one hundred twenty (120) days after December 31, 2006. 31 PART IV Item 15. Exhibits and Financial Statement Schedules. (a) Documents filed as part of this report. 1 and 2. Consolidated Financial Statements and Financial Statement Schedule The consolidated financial statements and financial statement schedule listed on the index to consolidated financial statements on page F-l are filed as part of this Form l0-K. 3. Exhibits (2)(a) Agreement of Merger filed as Exhibit (2) to the Registration Statement on Form S-18, filed January 11, 1989, and herein incorporated by reference. (2)(b) Asset Purchase Agreement filed as Exhibit (2)(b) to the Report on Form 8-K, filed October 19, 1992, and herein incorporated by reference. (2)(c) Asset Purchase Agreement for Keliher Hardware Company filed as exhibit (2)(c) to the Report on Form 10-K for the year ended December 31, 1998, and herein incorporated by reference. (2)(d) Asset Purchase Agreement for North State Supply Co. of Phoenix filed with Report on Form 8-K on June 15, 1999, and herein incorporated by reference. (3)(a)(1) Certificate of Incorporation filed as Exhibit (3)(a)(1) to the Registration Statement on Form S-18, filed January 11, 1989; filed electronically as Exhibit 3(i)(a) to the Form 10-Q for the quarter ended December 31, 1995, filed on November 9, 1995, and herein incorporated by reference. (3)(a)(2) Certificate of Amendment of Certificate of Incorporation filed as Exhibit (3)(a)(2) to the Registration Statement on Form S-18, filed January 11, 1989; filed electronically as Exhibit 3(i)(b) to the Form 10-Q for the quarter ended December 31, 1995, filed on November 9, 1995, and herein incorporated by reference. (3)(a)(3) Certificate of Amendment of Certificate of Incorporation filed as Exhibit (3)(i)(c) to the Form 10-Q for the quarter ended December 31, 1995, filed November 9, 1995; filed electronically as Exhibit 3(i)(c) to the Form 10-Q for the quarter ended December 31, 1995, filed on November 9, 1995, and herein incorporated by reference. 32 (3)(b) Bylaws filed as Exhibit (3)(b) to the Registration Statement on Form S-18, filed January 11, 1989; filed electronically as Exhibit 3(ii) to the Form 10-Q for the quarter ended December 31, 1995, filed on November 9, 1995, and herein incorporated by reference. (4)(a) Specimen Certificate of Common Stock filed as Exhibit (4)(a) to the Registration Statement on Form S-18, filed January 8, 1989, and herein incorporated by reference. (4)(b) Specimen of Redeemable Common Stock Purchase Warrant filed as Exhibit (4)(b) to the Registration Statement on Form S-18, filed February 9, 1989, and herein incorporated by reference. (10)(a)(vi) Employment Agreement with Terry W. Shaver effective January 1, 2007.* (10)(b)(vi) Employment Agreement with Gary L. Cox effective January 1, 2007.* (10)(c)(ii) Employment Agreement with Frank J. Cinatl, IV effective January 1, 2007.* (10)(e)(iv) Credit Facility, Master Revolving Note and Advance Formula Agreement with Comerica Bank-Texas dated October 14, 2005 filed as Exhibit 99 to the Report on Form 8-K on October 19, 2005, and herein incorporated by reference. (14) Code of Business Conduct and Ethics for Directors, Officers and Employees filed as Exhibit 99 to the Report on Form 8-K on May 10, 2004, and herein incorporated by reference. (22) Information Statement dated September 1, 1995 filed as Exhibit (22) to the Report on Form 10-K for the year ended December 31, 1995, and herein incorporated by reference. (31.1) Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended (the Exchange Act ).* (31.2) Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a) of the Exchange Act.* (32.1) Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.* 33 (32.2) Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the United States Code.* (99.1) Audit Committee Charter filed as Exhibit 99.1 to the Report on Form 8-K on June 7, 2005, and herein incorporated by reference. (99.2) Compensation Committee Charter filed as Exhibit 99.2 to the Report on Form 8-K on June 7, 2005, and herein incorporated by reference. (99.3) Nominating and Corporate Governance Committee Charter filed as Exhibit 99.3 to the Report on Form 8-K on June 7, 2005, and herein incorporated by reference. * Filed herewith as part of the Company s electronic filing. 34 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 26th day of March, 2007. ABATIX CORP. By: /s/ Terry W. Shaver Terry W. Shaver President, Chief Executive Officer and Director (Principal Executive 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 and on the dates indicated. Signatures Title Date /s/ Terry W. Shaver President, Chief Executive Officer March 26, 2007 and Director (Principal Executive Officer) Terry W. Shaver /s/ Gary L. Cox Executive Vice President, March 26, 2007 Chief Operating Officer and Director Gary L. Cox /s/ Frank J. Cinatl Executive Vice President and Chief March 26, 2007 Financial Officer (Principal Financial and Accounting Officer) Frank J. Cinatl, IV /s/ Donald N. Black Director March 26, 2007 Donald N. Black /s/ Eric A. Young Director March 26, 2007 Eric A. Young /s/ A. David Cook Director March 26, 2007 A. David Cook 35 ABATIX CORP. AND SUBSIDIARY Index to Consolidated Financial Statements Page Report of Independent Registered Public Accounting Firm F-2 Financial Statements: Consolidated Balance Sheets as of December 31, 2006 and 2005 F-3 Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004 F-4 Consolidated Statements of Stockholders Equity for the years ended December 31, 2006, 2005 and 2004 F-5 Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 F-6 Notes to Consolidated Financial Statements F-7 Financial Statement Schedule: II - Valuation and Qualifying Accounts for the years ended December 31, 2006, 2005 and 2004 S-1 All other schedules have been omitted as the required information is not applicable. F-1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders Abatix Corp.: We have audited the accompanying consolidated balance sheets of Abatix Corp. and subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders equity and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements we also have audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company s management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule 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 and related schedules. 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 Abatix Corp. and subsidiary as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 1 and 11 to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, and the provisions of Securities and Exchange Commission Staff Accounting Bulletin No. 108, Considering the Effect of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements. KPMG LLP Dallas, Texas March 23, 2007 F-2 ABATIX CORP. AND SUBSIDIARY Consolidated Balance Sheets December 31, 2006 and 2005 2006 2005 Assets Current assets: Cash $ 151,311 $ 790,097 Trade accounts receivable, net of allowance for doubtful accounts of $731,569 in 2006 and $663,300 in 2005 9,286,359 12,029,054 Inventories 9,773,334 10,842,852 Prepaid expenses and other assets 625,165 861,480 Deferred income taxes (note 4) 614,558 440,646 Receivables from employees 1,630 Total current assets 20,450,727 24,965,759 Property and equipment, net (note 2) 1,433,184 1,034,248 Deferred income taxes (note 4) 346,942 328,067 Other assets 111,434 103,649 $ 22,342,287 $ 26,431,723 Liabilities and Stockholders Equity Current liabilities: Notes payable and current maturities of long term debt (note 3) $ 5,615,779 $ 9,917,338 Accounts payable 3,523,849 3,419,561 Accrued compensation 190,996 413,506 Other accrued expenses 1,033,076 1,597,145 Total current liabilities 10,363,700 15,347,550 Long term debt 13,412 33,697 Total liabilities 10,377,112 15,381,247 Stockholders equity (note 5): Preferred stock - $1 par value, 500,000 shares authorized; none issued Common stock - $.001 par value, 5,000,000 shares authorized; issued 2,437,314 shares in 2006 and 2005 2,437 2,437 Additional paid-in capital 2,574,560 2,574,560 Retained earnings 11,645,520 10,730,821 Treasury stock at cost, 726,166 common shares in 2006 and 2005 (2,257,342 ) (2,257,342 ) Total stockholders equity 11,965,175 11,050,476 Commitments and contingencies (note 10) $ 22,342,287 $ 26,431,723 See accompanying notes to consolidated financial statements. F-3 ABATIX CORP. AND SUBSIDIARY Consolidated Statements of Operations Years ended December 31, 2006, 2005 and 2004 2006 2005 2004 Net sales $ 66,447,847 $ 70,626,403 $ 52,892,213 Cost of sales (47,599,603 ) (50,665,826 ) (38,521,908 ) Gross profit 18,848,244 19,960,577 14,370,305 Selling, general and administrative expenses (16,590,757 ) (16,236,361 ) (13,719,943 ) Operating profit 2,257,487 3,724,216 650,362 Other income (expense): Interest expense (517,686 ) (370,655 ) (242,643 ) Other, net (904 ) 5,507 1,763 Earnings before income taxes 1,738,897 3,359,068 409,482 Income tax expense (note 4) (740,990 ) (1,274,808 ) (195,317 ) Net earnings $ 997,907 $ 2,084,260 $ 214,165 Basic and diluted net earnings per common share $ .58 $ 1.22 $ .13 Basic and diluted weighted average shares outstanding 1,711,148 1,711,148 1,711,148 See accompanying notes to consolidated financial statements. F-4 ABATIX CORP. AND SUBSIDIARY Consolidated Statements of Stockholders Equity Years ended December 31, 2006 2005 and 2004 Common Stock Additional Paid-in Capital Retained Earnings Treasury Stock Total Equity Shares Issued Amount Shares Amount Balance at December 31, 2003 2,437,314 $ 2,437 $ 2,574,560 $ 8,432,396 726,166 $ (2,257,342 ) $ 8,752,051 Net earnings 214,165 214,165 Balance at December 31, 2004 2,437,314 2,437 2,574,560 8,646,561 726,166 (2,257,342 ) 8,966,216 Net earnings 2,084,260 2,084,260 Balance at December 31, 2005 2,437,314 2,437 2,574,560 10,730,821 726,166 (2,257,342 ) 11,050,476 Cumulative effect of adjustments from the adoption of SAB No. 108, net of taxes (see Note 11) (83,208 ) (83,208 ) Adjusted balance at January 1, 2006 2,437,314 2,437 2,574,560 10,647,613 726,166 (2,257,342 ) 10,967,268 Net earnings 997,907 997,907 Balance at December 31, 2006 2,437,314 $ 2,437 $ 2,574,560 $ 11,645,520 726,166 $ (2,257,342 ) $ 11,965,175 See accompanying notes to consolidated financial statements. F-5 ABATIX CORP. AND SUBSIDIARY Consolidated Statements of Cash Flows Years ended December 31, 2006, 2005 and 2004 2006 2005 2004 Cash flows from operating activities: Net earnings $ 997,907 $ 2,084,260 $ 214,165 Adjustments to reconcile net earnings to net cash provided by (used in) operating activities: Depreciation and amortization 545,051 423,472 462,437 Deferred income taxes (142,863 ) (94,529 ) (71,914 ) Provision for losses on receivables 171,509 672,463 416,026 Provision for obsolescence of inventory 165,982 252,824 151,720 Loss on disposal of assets 8,773 11,078 1,261 Changes in operating assets and liabilities: Receivables 2,571,186 (3,398,377 ) (2,531,603 ) Inventories 770,404 (3,895,835 ) (1,397,147 ) Prepaid expenses and other assets 236,315 (180,735 ) 161,753 Refundable income taxes 204,894 Other assets, primarily deposits (7,785 ) (21,199 ) (2,000 ) Accounts payable 104,288 (199,003 ) 1,108,245 Accrued expenses (786,579 ) 863,243 591,293 Net cash provided by (used in) operating activities 4,634,188 (3,482,338 ) (690,870 ) Cash flows from investing activities: Purchase of property and equipment (974,935 ) (481,804 ) (157,784 ) Proceeds from the disposal of fixed assets 22,175 700 Advances to employees (11,385 ) (1,063 ) (8,997 ) Collection of advances to employees 13,015 4,860 3,570 Net cash used in investing activities (951,130 ) (477,307 ) (163,211 ) Cash flows from financing activities: Borrowings on notes payable 18,281,590 25,184,279 16,248,866 Repayments on notes payable (22,603,434 ) (20,772,980 ) (15,232,420 ) Net cash (used in) provided by financing activities (4,321,844 ) 4,411,299 1,016,446 Net (decrease) increase in cash (638,786 ) 451,654 162,365 Cash at beginning of year 790,097 338,443 176,078 Cash at end of year $ 151,311 $ 790,097 $ 338,443 See accompanying notes to consolidated financial statements. F-6 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (a) General Abatix Corp. ( Abatix ) and subsidiary (collectively, the Company ) market and distribute personal protection and safety equipment, and durable and nondurable supplies to the environmental industry, the industrial safety industry and, combined with tools and tool supplies, the construction industry. At December 31, 2006, the Company operated eight sales and distribution centers in six states. Abatix s wholly-owned subsidiary, International Enviroguard Systems, Inc. ( IESI ) imports disposable protective clothing products sold through Abatix s distribution channels and through other distributors. The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The accompanying consolidated financial statements include the accounts of Abatix and IESI. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain prior year amounts have been reclassified for consistency in presentation. (b) Accounts Receivable Accounts receivable consist of sales, on terms, to customers that have been deemed to be credit worthy. The Company establishes reserves for customer accounts that are potentially uncollectible. Management s methodology used to estimate the allowance is based on many factors including economic conditions that may affect a specific industry, geographic region or specific customer, historical trends, the age of the receivables, which is based on days past invoice date, and payment history of specific customers. A write-off occurs when Management deems the Company will not collect on the receivable. Actual write-offs could be materially different than the reserves. (c) Inventories Inventories consist of materials and equipment for resale and are stated at the lower of cost or market. Cost is determined by the first-in, first-out method. F-7 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (d) Vendor Consideration The Company provides numerous programs to promote its vendors products, including catalogs, the Internet and other marketing programs. Most of these programs support multiple vendors. To the extent funds received from vendors can specifically be identified with a marketing program, those funds are included in selling, general and administrative (advertising) expenses as a reduction to the cost of the marketing program. Rebates earned from vendors that are based on purchases reduce cost of sales. However, the Company calculates the amount of rebates that should be applied to ending inventory in each reporting period and capitalizes that estimate into inventory. (e) Property and Equipment Property and equipment are stated at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the assets. (f) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying value of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. (g) Revenue Recognition As the Company s standard shipping terms are FOB shipping point, revenue is recognized when the goods are shipped. Shipping fees billed to customers are included in net sales. The costs related to these shipping fees, which are included in selling, general and administrative expense, were $1,782,000, $1,641,000 and $1,262,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Taxes assessed by governmental agencies and ultimately remitted to such governmental agencies are not recorded as revenue on the Company s Statement of Operations. F-8 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (h) Lease Costs The Company has operating leases for all of its facilities. The Company factors the known terms that will occur during the term of the lease and applies the straight-line method to determine rent expense. Known factors include such items as rent increases, if determinable, rent holidays or rent concessions. (i) Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $324,000, $289,000 and $134,000 in 2006, 2005 and 2004, respectively. (j) Retained Insurance Reserves The Company has elected to self insure for health care related costs, but does have catastrophic coverage. The accrued liabilities for incurred but not reported events are based upon historical loss patterns, specific events that the Company may become aware of and management s judgment. (k) Earnings per Share At the Annual Stockholders Meeting on May 23, 2006, the stockholders approved the 2006 Stock Plan, which became effective June 1, 2006. The Plan provides the Compensation Committee of the Board of Directors with the ability to grant stock awards, including restricted stock awards, restricted stock units, performance units, performance shares or other stock-based awards, including stock options, to employees, directors and/or third-party service providers. The maximum number of shares of Common Stock authorized for issuance and issuable under the Plan is three hundred thousand (300,000) shares, although no shares have been issued. Basic earnings per share is calculated using the weighted average number of common shares outstanding during each year, while diluted earnings per share includes the effects of all dilutive potential common shares. As of December 31, 2006, 2005 and 2004, there were no dilutive securities outstanding. Basic earnings per share and diluted earnings per share amounts were equal for the years ended December 31, 2006, 2005, and 2004. F-9 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (l) Statements of Cash Flows For purposes of the Statements of Cash Flows, the Company considers all short-term investments with original maturities of three months or less to be cash equivalents. The Company held no cash equivalents at December 31, 2006 or 2005. The Company paid interest of $496,512, $381,116 and $233,259 in 2006, 2005, and 2004, respectively, and income taxes of $1,508,717, $989,749 and $32,139 in 2006, 2005, and 2004, respectively. (m) Income Taxes The Company accounts for income taxes using the asset and liability method. Under this method the Company records deferred income taxes for the temporary differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. The resulting deferred tax liabilities and assets are adjusted to reflect changes in tax laws or rates in the period that includes the enactment date. (n) New Accounting Standards In November 2004, Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( Statement ) No. 151, Inventory Costs – an amendment of Accounting Research Bulletin No. 43, Chapter 4. Statement No. 151 requires that abnormal amounts of costs, including idle facility expense, freight, handling costs and spoilage, should be recognized as current period charges. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Statement No. 151 was adopted on January 1, 2006. There was no material impact resulting from the adoption of Statement No. 151 on the Company s financial statements. In December 2004, FASB issued Statement No. 123R, Share-Based Payment. Statement No. 123R revises Statement No. 123, supersedes Accounting Principles Board ( APB ) Opinion No. 25 and amends Statement No. 95. Statement No. 123R requires the cost of employee services received in exchange for an award of equity instruments be recognized over the period during which an employee is required to provide service in exchange for the award. The provisions of this Statement are effective for public entities that do not file as small business issuers as of the beginning of the first interim period or annual reporting period that begins after June 15, 2005. Statement No. 123R was adopted on January 1, 2006. There was no impact resulting from the adoption of Statement No. 123R on the Company s financial statements. F-10 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements In March 2005, the FASB issued Interpretation ( FIN ) 47, Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies the term conditional asset retirement obligation as used in Statement No. 143, Accounting for Asset Retirement Obligations, by stating that the obligation to perform the asset retirement activity is not conditional even though the timing or method of retirement may be conditional. Consequently, FIN 47 requires that a liability be recognized for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. FIN 47 is effective for years ending after December 15, 2005. FIN 47 was adopted on January 1, 2006. There was no impact resulting from the adoption of FIN 47 on the Company s financial statements. In June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections a replacement for APB Opinion No. 20 and FASB Statement No. 3. Statement 154 applies to all voluntary changes in accounting principle and changes the requirement for accounting for and reporting of a change in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. APB Opinion No. 20 required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. Statement No. 154 establishes that unless impracticable, retrospective application is the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. While the correction of an error is not an accounting change, Statement 154 requires the restatement of previously issued financial statements. This Statement is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Statement No. 154 was adopted on January 1, 2006. There was no material impact resulting from the adoption of Statement No. 154 on the Company s financial statements. In September 2005, the Emerging Issues Task Force ( EITF ) reached a final consensus on Issue No. 04-13, Accounting for Purchases and Sales of Inventory With the Same Counterparty. The first issue surrounds the recognition of a nonmonetary transaction at fair value rather than at recorded amounts. The second issue surrounds the classification of two or more nonmonetary transactions being viewed as a single nonmonetary transaction. With respect to the first issue, the Company does, on occasion, purchase and sell finished goods inventory to other companies within the same line of business. These transactions have been recognized at the recorded amount in accordance with the EITF tentative conclusion. With respect to the second issue, the EITF created a list of indicators that would trigger two or more nonmonetary transaction be accounted for as a single transaction. F-11 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements The Task Force agreed that this Issue should be applied to new arrangements entered into, and modifications or renewals of existing arrangements, beginning in the first interim or annual reporting period beginning after March 15, 2006. There was no material impact resulting from the application of this Issue No. 04-13 on the Company s financial statements. In February 2006, the FASB posted the final FSP Statement No. 123R-4, Classification of Options and Similar Instruments Issued as Employee Compensation that Allow for Cash Settlement upon the Occurrence of a Contingent Event. This FSP amends paragraphs 32 and A229 of FASB Statement of No. 123R. This FSP is to be applied on the initial adoption of FASB Statement No. 123R. This FSP was adopted on January 1, 2006. There was no material impact resulting from the adoption of this FSP on the Company s financial statements. In February 2006, the FASB issued Statement No. 155, Accounting for Certain Hybrid Financial Instruments. This Statement, which amends Statement No. 133 and No. 140, (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133, (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (5) amends Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of the entity s first fiscal year that begins after September 15, 2006. Statement No. 155 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 155 on the Company s financial statements. In March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets – an Amendment of FASB Statement No. 140. This Statement, which amends Statement No. 140: (1) Requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; (2) Requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value; (3) Permits an entity to choose either the amortization method or the fair value measurement method for each class of separately recognized servicing assets and servicing liabilities; (4) At its initial adoption, permits a one-time reclassification of available-for-sale securities under Statement 115 under certain conditions; and (5) Requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the balance sheet and additional disclosures for all separately recognized servicing assets and servicing liabilities. This Statement is effective as of the beginning of the first fiscal year that begins after September 15, 2006. Statement No. 156 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 156 on the Company s financial statements. F-12 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements In July 2006, the FASB issued FIN 48, Accounting for Uncertainties in Income Tax. The purpose of FIN 48 is to clarify and set forth consistent rules for accounting for uncertain tax positions in accordance with Statement No. 109, Accounting for Income Taxes. FIN 48 defines the threshold for recognizing the benefits of tax-return positions in the financial statements as more-likely-than-not to be sustained by the taxing authority and applies to all tax positions. The cumulative effect of applying the provisions of this interpretation is required to be reported separately as an adjustment to the opening balance of retained earnings in the year of adoption. Additionally, FIN 48 requires other annual disclosures. FIN 48 is effective as of the beginning of the first fiscal year beginning after December 15, 2006 with earlier application permitted if no interim financial statements have been issued. FIN 48 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Fin 48 on the Company s financial statements. In September 2006, The FASB posted FSP No. AUG-AIR-1, Accounting for Planned Major Maintenance Activities. This FSP addresses the accounting for planned major maintenance activities and amends certain provisions in APB Opinion No. 28, Interim Financial Reporting. This FSP is applicable to all industries and prohibits the use of the accrue-in-advance method of accounting for planned major maintenance activities in annual and interim financial reporting periods. The effective date of FSP No. AUG-AIR-1 is for the first fiscal year beginning after December 15, 2006. FSP No. AUG-AIR-1 was adopted on January 1, 2007. There was no material impact resulting from the adoption of FSP No. AUG-AIR-1 on the Company s financial statements. In September 2006, the U.S. Securities and Exchange Commission ( SEC ) released Staff Accounting Bulletin ( SAB ) No. 108, Quantifying Financial Statement Misstatements. The SEC staff believes registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that when all relevant quantitative and qualitative factors are considered, is material. Effective January 1, 2006, the Company adopted SAB No. 108. See Note 11 for further discussion. F-13 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements In September 2006, the FASB issued Statement No. 157, Fair Value Measurement. Statement No. 157 will change current practice by defining fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date. Statement No. 157 will require the market-based measurement, not an entity-specific measurement, based on the assumptions market participants would make in pricing the asset or liability. The effective date of Statement No. 157 is for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company does not expect the adoption of Statement No. 157 to have a material impact on its financial statements. In September 2006, the FASB issued Statement No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans. Statement No. 158 amends Statements 87, 88, 106 and 132(R). Statement No. 158 would require employers to recognize the funded status of a benefit plan in its statement of financial position and recognize the gains or losses and prior service costs as a component of other comprehensive income. Employers must also measure defined benefit plan assets and obligations as of the date of the fiscal year financial statements and to disclose in the notes to the financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arises from gains, losses or prior costs of service as well as transition of asset or obligation. The effective date of Statement No. 158 is for fiscal years ending after December 15, 2006 for the funded status of a benefit plan and the disclosure requirements and fiscal years ending after December 15, 2008 for the measurement of plan assets benefit obligations. Statement No. 158 was adopted on January 1, 2007. There was no material impact resulting from the adoption of Statement No. 158 on the Company s financial statements. (2) Property and Equipment Property and equipment consists of the following at December 31, 2006 and 2005: Estimated Useful Life 2006 2005 Furniture and equipment 3 - 5 years $ 3,499,105 $ 3,013,540 Transportation equipment 3 - 5 years 486,678 473,770 Leasehold improvements 3 - 10 years 490,078 507,977 4,475,861 3,995,287 Less accumulated depreciation and amortization (3,042,677 ) (2,961,039 ) Net property and equipment $ 1,433,184 $ 1,034,248 F-14 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (3) Notes Payable At December 31, 2006, the Company has a $12,000,000 working capital line of credit and a $500,000 capital equipment facility with its financial institution. The working capital facility allows the Company to borrow up to 80% of the book value of eligible trade receivables plus the lesser of 40% of eligible inventory or $3,000,000, up to a maximum of $12,000,000. The capital equipment facility provides for individual borrowings at 80% of the purchased equipment s cost. These credit facilities require the Company to maintain a minimum level of trailing twelve months earnings before interest, taxes, depreciation and amortization and a debt to equity level that the Company is not to exceed. These credit facilities are secured by accounts receivable, inventories and equipment. Based on the borrowing formula calculated as of December 31, 2006, the Company had the capacity to borrow up to the maximum of $9,584,805 on its working capital line. As of December 31, 2006, there are advances of $5,270,000 outstanding on the working capital credit facility. As of December 31, 2006 there are advances of $325,000 outstanding on the capital equipment credit facility. As of December 31, 2006 and 2005, the Company s rate of interest on these agreements was 7.75% and 6.75%, respectively. Both credit facilities expire in October 2007. The Company believes it will be able to extend our credit facilities or obtain financing from another source as substantially similar amounts, terms and conditions. Since there is no defined payment schedule for the working capital line of credit, it is classified as a current liability on the Consolidated Balance Sheets. Although the terms of the equipment facility range from twenty-four to forty-eight monthly installments of principal and interest, this facility is payable on demand. Both credit facilities bear a variable rate of interest tied to the prime rate. The working capital line of credit also gives the Company the ability, at its option, to convert a portion of its prime based loan to a Libor based loan. The Company s credit facilities are currently at one financial institution. Although the Company has relationships with two financial institutions, none of its credit facilities are at the second institution. The Company has two notes payable to Ford Motor Credit Corporation secured by two of the Company s vehicles. The first note is for 36 months, maturing in February 2008, and carries a 0% interest rate. At December 31, 2006, the balance owed was approximately $18,000. The second note is for 60 months, maturing in February 2010, and carries a 0% interest rate. At December 31, 2006, the balance owed was approximately $16,000. F-15 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (4) Income Taxes Income tax expense (benefit) for the years ended December 31, 2006, 2005 and 2004 consists of: 2006 2005 2004 Current: Federal $ 750,489 $ 1,159,855 $ 215,012 State 133,363 209,482 52,219 Total current expense 883,852 1,369,337 267,231 Deferred: Federal (129,528 ) (80,350 ) (61,127 ) State (13,334 ) (14,179 ) (10,787 ) Total deferred expense (142,862 ) (94,529 ) (71,914 ) Total income tax expense $ 740,990 $ 1,274,808 $ 195,317 A reconciliation of expected federal income tax expense (based on the U.S. corporate income tax rate of 34%) to actual income tax expense for the years ended December 31, 2006, 2005 and 2004 follows: 2006 2005 2004 Expected income tax expense $ 591,225 $ 1,142,083 $ 139,224 State income taxes, net of related federal tax benefit 79,219 128,900 27,345 Nondeductible meals, entertainment expense 25,826 18,742 7,160 Other 44,720 (14,917 ) 21,588 Actual income tax expense $ 740,990 $ 1,274,808 $ 195,317 The effective tax rate is greater than the Federal statutory rate because it includes items that are not deductible for Federal income taxes, as well as state income taxes. A significant portion of the increase in our effective rate for the 2006 is attributable to the reduction of deferred tax assets (increasing income tax expense) as a result of the change in law in the State of Texas on May 18, 2006 when the Texas Governor signed into law a Texas margin tax (H.B. No. 3). This law restructures the state business tax by replacing the taxable capital and earned surplus components of the current franchise tax with a new taxable margin component. Because the tax base on the Texas margin tax is derived from an income-based measure, we believe the margin tax is an income tax and, therefore, the provisions of Statement No. 109 regarding the recognition of deferred taxes apply to the new margin tax. In accordance with Statement No. 109, the effect on deferred tax assets of a change in tax law should be included in tax expense attributable to continuing operations in the period that includes the enactment date. Therefore, the Company recalculated its deferred tax assets and liabilities for Texas based on the new margin tax and the cumulative effect of changes was reported for income taxes in 2006. The impact of this change in deferred tax assets increased our tax expense by approximately $50,000 in 2006. F-16 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements The state income taxes in 2004 are higher than expected because Texas is not a unitary state and excludes certain deductions in calculating the Texas franchise tax. The income tax effects of temporary differences that gave rise to the deferred tax assets and liabilities at December 31, 2006 and 2005 are as follows: 2006 2005 Deferred tax assets: Allowance for doubtful accounts $ 274,340 $ 265,321 Inventory 424,026 291,930 Goodwill 225,315 273,907 Property and equipment, principally due to differences in depreciation 45,322 54,160 Deferred rent 76,304 Total gross deferred tax assets 1,045,307 885,318 Deferred tax liabilities: Retained insurance reserves (43,109 ) Prepaid expenses (40,698 ) (116,605 ) Total gross deferred tax liabilities (83,807 ) (116,605 ) Net deferred tax assets $ 961,500 $ 768,713 The net deferred tax assets are classified as follows: Current assets $ 614,559 $ 440,646 Noncurrent assets 346,941 328,067 Net deferred tax assets $ 961,500 $ 768,713 Management has determined, based on the Company s history of prior operating earnings and its expectations for the future, that operating earnings will more likely than not be sufficient to realize the benefit of the deferred tax assets. Accordingly, the Company has not provided a valuation allowance for deferred tax assets in any period presented. The Company records liabilities in current income taxes for potential assessments resulting from tax audits. Any accruals relate to uncertain tax positions in, potentially, a variety of taxing jurisdictions and are based on what management believes will be the ultimate resolution of these positions. These liabilities may be affected by changing interpretations of laws, rulings by tax authorities, or the expiration of the statute of limitations. The Company s U.S. federal income tax returns have been audited through 2001 and all federal assessments of additional taxes, interest and penalties have been paid through 2001. The Company has no liabilities recorded as of December 31, 2006 or 2005. F-17 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (5) Stockholders Equity The Company has 726,166 shares that are held as treasury shares. The last purchase of treasury shares was in 1999. Currently, there is no authorized plan to repurchase shares. (6) Benefit Plans The Company has a 401(k) profit sharing plan, under which eligible employees may request the Company deduct and contribute a portion of their compensation to the plan. The Company, at its discretion, matches a portion of employee contributions to the plan. Contributions by the Company to the 401(k) plan aggregated $97,120, $92,432 and $77,823 during 2006, 2005 and 2004, respectively. (7) Fair Value of Financial Instruments The reported amounts of financial instruments such as cash, accounts receivable, accounts payable and accrued expenses approximate fair value because of their short maturity. The carrying value of notes payable to bank approximates fair value because these instruments bear interest at current market rates. Although the notes payable to Ford Motor Credit Corporation bear zero interest, the current balance of the notes approximates fair value because of their short term, small balance and the fact that current market interest rates are low. (8) Segment Information Identification of operating segments is based principally upon differences in the types and distribution channel of products. The Company s reportable segments consist of Abatix and IESI. The Abatix operating segment includes the Company s corporate operations, seven aggregated branches and temporary facilities, if any, which are principally engaged in distributing environmental, safety and construction equipment and supplies to contractors and industrial manufacturing facilities in the western half of the United States. The IESI operating segment, which consists of the Company s wholly-owned subsidiary, International Enviroguard Systems, Inc., is engaged in the wholesale distribution of disposable protective clothing to companies similar to, and including, Abatix. The IESI operating segment distributes products throughout the United States and Caribbean. The accounting policies are consistent in each operating segment as described in Note 1 of the Notes to Consolidated Financial Statements. The Company evaluates the performance of its operating segments based on operating profit after a charge for the carrying value of inventory and accounts receivable. Intersegment sales are at agreed upon pricing and intersegment profits are eliminated in consolidation. F-18 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements Summarized financial information concerning the Company s reportable segments is shown in the following table. There are no other significant noncash items. Abatix IESI Totals 2006 Sales from external customers $ 63,428,622 $ 3,019,225 $ 66,447,847 Intersegment sales 1,183,184 1,183,184 Interest expense 517,686 517,686 Depreciation and amortization 526,868 18,183 545,051 Segment profit 1,603,764 665,876 2,269,640 Segment assets 20,592,919 1,877,793 22,470,712 Capital expenditures 846,856 128,079 974,935 2005 Sales from external customers $ 67,058,222 $ 3,568,181 $ 70,626,403 Intersegment sales 849,205 849,205 Interest expense 370,655 370,655 Depreciation and amortization 416,067 7,405 423,472 Segment profit 2,857,589 874,573 3,732,162 Segment assets 25,158,984 1,355,270 26,514,254 Capital expenditures 477,787 4,017 481,804 2004 Sales from external customers $ 50,105,619 $ 2,786,594 $ 52,892,213 Intersegment sales 567,399 567,399 Interest expense 242,643 242,643 Depreciation and amortization 456,597 5,840 462,437 Segment profit 148,990 509,778 658,768 Segment assets 17,679,153 1,757,079 19,436,232 Capital expenditures 157,784 157,784 F-19 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements Below is a reconciliation of (i) total segment profit to operating profit on the Consolidated Statements of Operations, and (ii) total segment assets to total assets on the Consolidated Balance Sheets for all periods presented. The sales from external customers represent the net sales on the Consolidated Statements of Operations. 2006 2005 2004 Profit for reportable segments $ 2,269,640 $ 3,732,162 $ 658,768 Elimination of intersegment profits (12,153 ) (7,946 ) (8,406 ) Operating profit $ 2,257,487 $ 3,724,216 $ 650,362 Total assets for reportable segments $ 22,470,712 $ 26,514,254 $ 19,436,232 Elimination of intersegment assets (128,425 ) (82,531 ) (164,308 ) Total assets $ 22,342,287 $ 26,431,723 $ 19,271,924 The Company s sales, substantially all of which are on an unsecured credit basis, are to various customers from its permanent distribution centers in Texas, California, Arizona, Washington, Nevada and Florida and its temporary facilities, if any. The Company evaluates credit risks on an individual basis before extending credit to its customers and it believes the allowance for doubtful accounts adequately provides for loss on uncollectible accounts. During 2006, 2005 and 2004, no single customer accounted for more than 10% of net sales, although sales to environmental contractors, which include sales to contractors responding to the effects of hurricanes in both 2005 and 2004, were approximately 45%, 53% and 46% of consolidated net sales in 2006, 2005 and 2004, respectively. A reduction in spending on environmental projects could significantly impact sales. The top ten companies owing money to the Company make up approximately 31% of the total receivable balance, with the largest customer accounting for approximately 6%. These accounts have been customers of the Company for more than four years, with several being customers of the Company for more than ten years. While payment is expected in full, non-payment or delays in payment by any one of these accounts would have a significant negative impact on the cash flows of the Company. Although no vendor s products accounted for more than 10% of the Company s sales, three product classes (groupings of similar products) accounted for greater than 10% of sales in 2006. The first product class, plastic sheeting and bags, accounted for approximately 19%, 17% and 16% of net sales in 2006, 2005 and 2004, respectively. A major component of these products is petroleum. Increases in oil prices or shortages in supply could significantly impact sales and the Company s ability to supply its customers with certain products at a reasonable price. F-20 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements The second product class, disposable clothing, accounted for approximately 13%, 13% and 12% of net sales in 2006, 2005 and 2004, respectively. A majority of these products are produced internationally, predominantly in China. Changes in political climates could impact our ability to obtain these products from our current source. The third product class, abatement and restoration equipment, accounted for approximately 8%, 13% and 8% of net sales in 2006, 2005 and 2004, respectively. This product class is made up of many vendors with many dissimilar products. (9) Change in Accounting Estimate In the second quarter of 2006, the Company obtained improved data related to its liability for health care costs incurred, but not reported. Based on this improved data, the Company reduced its liability for these costs by approximately $134,000. In the third quarter of 2006, the Company became aware of certain health care costs related to three separate instances that were considered to be beyond our normal accrual. Therefore, the Company increased its liability for these costs by $70,000 for these three instances during the third quarter. (10) Commitments and Contingencies The Company leases warehouse and office facilities and certain office equipment under long-term noncancelable operating leases expiring at various dates through August 2016. These leases generally contain standard terms and conditions. The following is a schedule of future minimum lease payments under these leases as of December 31, 2006: 2007 $ 1,022,000 2008 905,000 2009 869,000 2010 767,000 2011 587,000 Thereafter 1,567,000 $ 5,717,000 Rental expense under operating leases for the years ended December 31, 2006, 2005 and 2004 was $1,386,592, $1,258,912 and $1,261,156, respectively. The Company has non-cancellable contracts with other companies that provide a range of services, including telecommunications and credit services. The terms of these contracts range between twenty-four and thirty-six months. Future payments for these contracts as of December 31, 2006 will be approximately $246,000 and $163,000 in 2007 and 2008, respectively. The Company has employment agreements with three officers that are effective from January 1, 2007 through December 31, 2008. The agreements provide for minimum annual compensation of $614,900. F-21 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (11) Adoption of SAB No. 108 As discussed under New Accounting Standards in Note 1, the SEC released SAB No. 108 in September 2006. Under SAB 108 registrants are required to consider both a rollover method which focuses primarily on the income statement impact of misstatements and the iron curtain method which focuses primarily on the balance sheet impact of misstatements. The transition provisions of SAB No. 108 permit the Company to adjust retained earnings for the cumulative effect of immaterial errors relating to prior years. SAB No. 108 also requires the adjustment of any prior quarterly financial statements within the fiscal year of adoption for the effects of such errors on the quarters when the information is next presented. Such adjustments do not require previously filed reports with the SEC to be amended. During the fourth quarter, the Company reviewed the accounting for rebates received from vendors in accordance with the provisions of EITF Issue No. 02-16. The result of this review showed that a portion of the consideration received from vendors should be applied as a reduction of the carrying cost of inventory rather than as an immediate reduction of cost of sales. Historically, the Company evaluated uncorrected errors utilizing the rollover approach and the impact of this rebate timing error was immaterial to prior years financial position and statement of operations. However, in accordance with the provisions of SAB No. 108, the Company reduced retained earnings as of January 1, 2006 to reflect the capitalization to inventory for rebates received from vendors in prior years. The total cumulative impact is as follows: Retained earnings $ 83,208 Deferred income taxes 49,924 Inventory (133,132 ) The following table shows the impact on amounts previously reported in 2006 under the provisions of SAB No. 108 (unaudited). Increase (decrease) For the three months ended March 31, 2006 For the three months ended June 30, 2006 For the six months ended June 30, 2006 For the three months ended September 30, 2006 For the nine months ended September 30, 2006 Cost of sales $ 656 $ 26,746 $ 27,402 $ (16,499 ) $ 10,903 Gross profit (656 ) (26,746 ) (27,402 ) 16,499 (10,903 ) Operating profit (656 ) (26,746 ) (27,402 ) 16,499 (10,903 ) Earnings before income taxes (656 ) (26,746 ) (27,402 ) 16,499 (10,903 ) Income tax expense (256 ) (10,579 ) (10,835 ) 6,012 (4,823 ) Net earnings (400 ) (16,167 ) (16,567 ) 10,487 (6,080 ) F-22 ABATIX CORP AND SUBSIDIARY Notes to Consolidated Financial Statements (12) Selected Quarterly Data (unaudited) Quarter First a Second a Third a, b Fourth b Total 2006 Net sales $ 16,606,330 $ 16,955,806 $ 16,743,297 $ 16,142,414 $ 66,447,847 Gross profit 4,638,707 4,872,666 4,771,353 4,565,518 18,848,244 Operating profit 485,822 747,554 540,710 483,401 2,257,487 Net earnings 219,597 367,795 172,097 238,418 997,907 Basic and diluted earnings per common share .13 .21 .10 .14 .58 2005 Net sales $ 14,726,765 $ 16,027,711 $ 20,148,247 $ 19,723,680 $ 70,626,403 Gross profit 4,141,745 4,389,450 5,969,217 5,460,165 19,960,577 Operating profit 389,032 649,914 1,626,295 1,058,975 3,724,216 Net earnings 198,315 349,713 981,348 554,884 2,084,260 Basic and diluted earnings per common share .12 .20 .57 .32 1.22 a Certain amounts for the first, second and third quarters of 2006 have been changed to reflect the changes related to SAB No. 108. See Note 11. b The growth in revenues and profitability in the third and fourth quarters of 2005 is primarily a result of the clean up following the hurricanes that hit the Gulf Coast. F-23 Schedule II ABATIX CORP. AND SUBSIDIARY Valuation and Qualifying Accounts Years ended December 31, 2006, 2005 and 2004 Balance at beginning of year Additions charged tocosts and expenses Other Deductions Balance at end of year Year ended December 31: Allowance for Doubtful Accounts: 2006 $ 663,300 171,509 103,240 A $ 731,569 2005 $ 368,074 672,463 377,237 A $ 663,300 2004 $ 277,830 416,026 325,782 A $ 368,074 Inventory Reserve: 2006 $ 461,694 165,982 141,597 B $ 486,079 2005 $ 476,424 252,824 267,554 B $ 461,694 2004 $ 454,699 151,720 129,995 B $ 476,424 Retained Insurance Reserve: 2006 $ 153,687 535,947 622,002 C $ 67,632 2005 $ 152,131 413,071 411,515 C $ 153,687 2004 $ 66,456 541,674 455,999 C $ 152,131 A Represents the write-off of uncollectible accounts. B Represents the disposal of obsolete inventory. C Represents claims and administrative cost. S-1

Green Standard Technologies, Inc.

10-K

https://www.sec.gov/Archives/edgar/data/1365357/0001091818-16-000261.txt

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2015 | | TRANSITION REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the period from _________________ to __________________ Commission File Number 333-134991 _______________________________________________ GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) (Exact name of registrant as specified in its charter) ______________________________________________ Nevada 20-3486523 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) Unit 1010 Miramar Tower, 132 Nathan Road, Tsimshatsui, Kowloon, Hong Kong N/A (Address of principal executive offices) (zip code) Registrant s telephone number, including area code: (852) 5984 7571 _____________________________________________ Securities registered under Section 12(b) of the Exchange Act: None. Securities registered under Section 12(g) of the Exchange Act: Common Stock, $.0001 par value per share (Title of Class) Indicate by check mark if registrant is a well known seasoned issuer, as defined in Rule 405 of the Securities Act. | | Yes | X | No. Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. | | Yes | X | No. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. | X | Yes | | No. i Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) 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 Form 10-K. | | Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ X ] (Do not check if a smaller reporting company) Indicate by check mark whether the issuer is a shell company (as defined in Rule 12b-2 of the Exchange Act). | | Yes | X | No. State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant s most recently completed second quarter. Note: If determining whether a particular person or entity is an affiliate cannot be made without involving an unreasonable effort and expense, the aggregate market value of the common equity held by non-affiliates may be calculated on the basis of reasonable assumptions, if the assumptions are set forth in this form. The aggregate market value of the voting and non-voting common stock of the issuer held by non-affiliates computed by reference to the price at which the common stock was sold as of June 30, 2015 was approximately $3,004,751.02. ii APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes | | No. | | APPLICABLE ONLY TO CORPORATE REGISTRANTS Indicate the number of shares outstanding of each of the registrant s classes of common stock, as of the latest practicable date. 18,725,003 common shares issued and outstanding as of December 31, 2015 DOCUMENTS INCORPORATED BY REFERENCE: None. FORWARD-LOOKING STATEMENTS Certain statements made in this Annual Report on Form 10-K are forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) regarding the plans and objectives of management for future operations. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of Green Standard Technologies, Inc (F/K/A Baoshinn Corporation) (the Company ) to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. The Company s plans and objectives are based, in part, on assumptions involving the continued expansion of business. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes its assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove inaccurate and, therefore, there can be no assurance the forward-looking statements included in this Report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved. iii TABLE OF CONTENTS PART I Page Item 1. Business 2 Item 1A. Risk Factors 7 Item 1B. Unresolved Staff Comments 7 Item 2. Properties 8 Item 3 Legal Proceedings 8 Item 4. Mine Safety Disclosures 8 PART II Item 5. Market for Registrant s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 8 Item 6. Selected Financial Data 10 Item 7. Management s Discussion and analysis of Financial Condition and Results of Operations 10 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 14 Item 8. Financial Statements and Supplementary Data 15 Report of Independent Registered Public Accounting Firm 15 Consolidated Balance Sheet 16 Consolidated Statement of Income 17 Consolidated Statement of Cash Flows 18 Consolidated Statements of Stockholders Equity and Comprehensive Income 19 Notes to Consolidated Financial Statements 20 Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosures 37 Item 9A. Controls and Procedures 37 Item 9B. Other Information 38 PART III Item 10. Directors, Executive Officers and Corporate Governance 38 Item 11. Executive Compensation 41 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 42 Item 13. Certain Relationships and Related Transactions, and Director Independence 43 Item 14. Principal Accounting Fees and Services 43 Item 15. Exhibits, Financial Statement Schedules 44 Signatures 45 1 PART I ITEM 1. BUSINESS. Background Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) ( The Company ) was incorporated under the laws of the State of Nevada on September 9, 2005, under the name of JML Holdings, Inc. The Company merged with Baoshinn International Express, Inc. ( BSIE ) on March 31, 2006, by acquiring all of the issued and outstanding common stock of BSIE in a share exchange transaction. We issued 16,500,000 shares of our common stock in exchange for 100% of the issued and outstanding shares of BSIE common stock. The transaction was accounted for as a recapitalization of BSIE whereby BSIE is deemed to be the accounting acquirer and is deemed to have adopted our capital structure. Effective on October 19, 2011, each of ten (10) shares of the Company s Common Stock, par value $.0001 per share, issued and outstanding immediately prior to that date (the Old Common Stock ) were automatically and without any action on the part of the shareholders, reclassified and changed into one (1) share of the Company s outstanding Common Stock (the New Common Stock ) with a par value $.0001 per share. On June 17, 2015, Baoshinn Corporation has been amended to the name Green Standard Technologies, Inc. . On March 4, 2013 the Company acquired all the outstanding stock of Olive Oils Direct International Inc. ( OODI ), a corporation formed under the laws of the State of Wyoming. In accordance with the terms of the Exchange Agreement between the parties, certain Company s shareholders (the Company Selling Shareholders ) transferred 1,485,000 shares of the common stock of the Company (the Company Shares ) to the shareholders of OODI (the OODI Shareholders ). In return, the OODI Shareholders transferred all of the outstanding shares of common stock of OODI to the Company, and they paid $100,000.00 in cash to the Company Selling Shareholders. In addition, immediately prior to the closing of the acquisition, the Company spun off its operating subsidiary, Hong Kong Holdings, Inc., to its shareholders. OODI then became a wholly-owned subsidiary of the Company. The transaction was accounted for as a reverse merger , since the original stockholders of the OODI own a majority of the outstanding shares of the Company stock immediately following the completion of the transaction on March 4, 2013. OODI was the legal acquiree but deemed to be the accounting acquirer, the Company was the legal acquirer but deemed to be the accounting acquiree in the reverse merger. The historical financial statements prior to the acquisition are those of the accounting acquirer (OODI). Historical stockholders equity of the acquirer prior to the merger was acquirer s stockholders equity. Operations prior to the merger are those of the acquirer. After completion of the transaction, the Company s consolidated financial statements include the assets and liabilities of the Company and its subsidiaries, the operations and cash flow of the Company and its subsidiaries. OODI is a development-stage company that plans to develop and operate a retail internet website specializing in gourmet Italian food products. Those products shall include olive oils, pastas, vinegars and other gourmet Italian food items. In addition, in the future OODI may offer cooking items, such as utensils, cooking tools and similar products from other countries. OODI is currently developing an e-commerce website by the name of www.OliveOilsDirect.com that will sell products inventoried by OliveOilsDirect.com and other products offered by other large well-established retailers. OODI is a development stage company and is subject to compliance under ASC915-15. It is devoting its resources to establishing the new business, and its planned operations have not yet commenced; accordingly, no revenues have been earned during the period from April 15, 2011 (date of inception) to March 31, 2015. On March 31, 2015, the Company disposed the operation unit of OODI for US$1,000 to Jet Express Trading Limited, a Hong Kong registered company. On April 23, 2013 the Company incorporated a subsidiary company in Hong Kong under the name Syndicore Asia Limited. 2 On April 1, 2013, the Board of Directors resolved to pay an officer for a monthly service fee of US$4,250. The fee was raised to US$10,000 per month as of October 1, 2013. The Company has an option to pay the officer by common stock in lieu of cash at a rate of $0.005 per share. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. On May 31, 2013 the Registrant completed an offering of 15,000,000 shares of its common stock. These shares were sold to a total of eighteen (18) shareholders for a total consideration of $75,000. These shares were sold on a private placement basis and the Company paid no commission in connection with such sales. On November 15, 2013 we forfeited and canceled 3,365,000 shares common stock which was subscribed by four (4) shareholders on May 31, 2013. However, they did not fulfill their payment obligation on the shares that were valued at $16,825 according to the subscription term. The Company forfeited and canceled such 3,365,000 common shares. Syndicore Asia Limited – Professional Sports Video Syndication Syndicore Asia Limited ( SAL ) is a wholly owned subsidiary of the Company formed under the laws of Hong Kong. SAL is an online media company that syndicates professional sports video in a cloud-based, multimedia conduit serving a growing, global community of content creators, news outlets and leading brands. SAL will be a provider of syndicated sports video media to news organizations in the Asia Pacific region. In addition, SAL plans to aggregate content from the Asia Pacific region and provide it to news organizations around the world. On December 15, 2013, SAL entered into a Distribution Agreement (the Distribution Agreement ) with SendtoNews Video, Inc., a British Columbia company ( STN ). Under the terms of the Distribution Agreement, SAL was granted an exclusive license to use, modify, edit, reproduce, distribute, feed, store, communicate, display, and transmit STN s content in the Asia Pacific Territory (the Content ). STN is the content provider for various worldwide sporting events. STN would also provide on-going assistance to SAL with regard to technical, administrative, and service-orientated issues relating to the delivery, utilization, transmission, storage and maintenance of the Content. On January 20, 2014, SAL entered into a revised Distribution Agreement whereby STN has agreed to provide SAL transferrable rights for the use, reproduction, storage, display, and transmission of certain content subject to pre-approval in writing from STN. In addition, the revised Distribution Agreement includes changes to the revenue sharing terms, and adds a share of advertising revenue directly resulting from aggregated content by SAL within the territory. SAL will strive to become a leading digital content provider for the Asia Pacific region, capitalizing on an explosively growing market with local, regional and national content that was previously unavailable in the area. This is a new and exciting market, and offers exciting opportunities for expansion and growth. SAL will also be the exclusive Asian partner and distributor for SendtoNews. There is no assurance, however, that SAL will be successful in its efforts. SAL s exclusive distribution agreement with SendtoNews Video Incorporated ( STN ) for the Asia Pacific region includes major markets such as Japan, China and India. SAL now has distribution rights of online content for some of the world s leading sports organizations with some highlights, player interviews and other fan-interest content. SAL, being the exclusive provider in the Asia Pacific region for highly sought after content, offers deep market exposure with unprecedented efficiency and metrics-driven transparency. On the other side of the distribution chain, we plan to create SAL s own proprietary news partnerships to provide guaranteed content distribution in return for a corresponding share of advertising revenues to a news industry looking to supplement their rapidly declining traditional ad revenue with viable digital-age revenue. Digital ad spending is on the rise. It is forecasted to expand from $117.60 billion USD in 2013 to $173.12 billion USD in 2017. (Go-Globe.com) The increase in worldwide digital ad spending is led by the Asia-Pacific region and specifically China. In 2013, China accounted for nearly 4 in every 10 digital ad dollars spent in the Asia-Pacific region. (Infographic) China is estimated to reach 33% of the world s total ad spending by 2017. (Infographic) Online Video Overview for 2013: 3 Watching online videos is now a mainstream activity. 78% of people watch online videos at least once a week and 55% watch online videos everyday Branded video content reaches nearly half (46%) of all internet users. More than half of these people (54%) go on to click though to the brand s website (Econsultancy) 80% of internet users recall watching a video ad on a website they visited in the past 30 days; 46% took some action after viewing the ad (Online Publishers Association) Video promotion is over 6 times more effective than print and online (b2bmarketing.net) Dr. James McQuivey of Forrester Research says a minute of video is worth 1.8 million words 81% of senior marketing executives now use online video content in their marketing programs, up from 70% in 2011 (MarketingProfs) Cisco expects video to account for 57% of consumer internet traffic by 2015, nearly four times as much as regular web browsing and email 90% of information transmitted to the brain is visual, and visuals are processed 60,000X faster in the brain than text (3M Corporation & Zabisco) Management believes that SAL s customers will be willing to pay a premium CPM because: The ability to sponsor exclusive, highly sought-after short form sports video content Deep, creative advertising opportunities – other than rudimentary logo/banner overlays and pre-roll Premium positioning Unprecedented transparency and near real-time performance metrics to evaluate their investment Securing sponsorships with sports related enterprises Stronger control over distribution to help target intended audience. SAL currently have a mobile app in development and hope to move into that segment of the market. SAL has been engineering its own cutting edge, interactive mobile app for smart phones and tablet use. App functionality will also be targeted to allow user uploads of local content for sporting events that have no rights holders but are of local interest. The market potential for mobile apps is increasing. For example, currently 30% of South China Morning Post s traffic comes from smart phones and expecting that number to reach 40% in 2014. (www.inma.org). In addition, we also hope to use our website platform and mobile application to expand into other areas of online content such as news clips, amateur video, social media, games or gaming applications, and premium direct content sales. Online applications and mobile platforms may also be used in a multitude of ways including advertising, direct sales, targeted ad campaigns, items or ideas promotions. These online applications allow the SAL the opportunity to diversify into any number of broad spectrum businesses which rely on communicating with a direct audience across a wide spectrum of media platforms. Other segments of the market are also benefiting. The high and rapidly increasing popularity of social media platforms such as Facebook, YouTube, and Twitter are expected to revolutionize the marketing strategies employed in areas such as the pharmaceuticals industry. There, in addition to marketing, an increasing number of pharma players have also begun leveraging these platforms to enhance consumer relationships and improve brand management, based on the market intelligence generated by monitoring and analyzing user-generated content. The ability to incorporate consumer feedback to develop new products is also expected to initiate a strategic shift in the operational model of pharma companies. Social media involvements are expected to increase product sales, especially those of OTC drugs, in the long term. Novartis for instance has already begun using YouTube and Facebook to enhance the sales for its OTC drugs such as Comtrex, Orofar and Bufferin. Johnson &Johnson, one of the first pharma giants to enter the social media space, has used online platforms for crisis management – when the company recalled its products (Tylenol and Benadryl tablets) it used social websites to apologize to consumers for irregularities in its manufacturing plant found during FDA inspection. 4 Subsequently, on January 20, 2014, the parties entered into a revised Distribution Agreement whereby STN has agreed to provide SAL transferrable rights for the use, reproduction, storage, display, and transmission of certain content subject to pre-approval in writing from STN. In addition, the revised Distribution Agreement includes changes to the revenue sharing terms, and adds a share of advertising revenue directly resulting from aggregated content by SAL within the territory. Syndicore Asia Limited will strive to become a leading digital content provider for the Asia Pacific region, capitalizing on an explosively growing market with local, regional and national content that was previously unavailable. This is a new and exciting market, and offers unparalleled opportunities for expansion and rapid growth. Syndicore Asia Limited will also be the exclusive Asian partner and distributor for SendtoNews. SAL s exclusive distribution agreement with SendtoNews Video Incorporated ( STN ) for the Asia Pacific region includes major markets such as Japan, China and India. SAL now has distribution rights of online content for some of the world s leading sports organizations with the same highlights, player interviews and other fan-interest content. SAL, being the exclusive provider in the Asia Pacific region for highly sought after content, offers deep market exposure with unprecedented efficiency and metrics-driven transparency. On the other side of the distribution chain, we will create SAL s own proprietary news partnerships to provide guaranteed content distribution in return for a corresponding share of advertising revenues to a News industry looking to supplement their rapidly declining traditional ad revenue with viable digital-age revenue. Digital ad spending is on the rise. It is forecasted to expand from $117.60 billion USD in 2013 to $173.12 billion USD in 2017. (Go-Globe.com) · The increase in worldwide digital ad spending is led by the Asia-Pacific region and specifically China. · In 2013, China accounted for nearly 4 in every 10 digital ad dollars spent in the Asia-Pacific region. (Infographic) · China is estimated to reach 33% of the world s total ad spending by 2017. (Infographic) Online Video Overview for 2013: Watching online videos is now a mainstream activity. 78% of people watch online videos at least once a week and 55% watch online videos everyday Branded video content reaches nearly half (46%) of all internet users. More than half of these people (54%) go on to click though to the brand s website (Econsultancy) 80% of internet users recall watching a video ad on a website they visited in the past 30 days; 46% took some action after viewing the ad (Online Publishers Association) Video promotion is over 6 times more effective than print and online (b2bmarketing.net) Dr. James McQuivey of Forrester Research says a minute of video is worth 1.8 million words 81% of senior marketing executives now use online video content in their marketing programs, up from 70% in 2011 (MarketingProfs) Cisco expects video to account for 57% of consumer internet traffic by 2015, nearly four times as much as regular web browsing and email 90% of information transmitted to the brain is visual, and visuals are processed 60,000X faster in the brain than text (3M Corporation & Zabisco) SAL s customers are willing to pay a premium CPM because: The ability to sponsor exclusive, highly sought-after short form sports video content Deep, creative advertising opportunities – other than rudimentary logo/banner overlays and pre-roll Premium positioning Unprecedented transparency and near real-time performance metrics to evaluate their investment Securing sponsorships with sports related enterprises Stronger control over distribution to help target intended audience. 5 SAL currently has a mobile app in development and hopes to move into that segment of the market. SAL has been engineering its own cutting edge, interactive mobile app for smart phones and tablet use. App functionality will also be targeted to allow user uploads of local content for sporting events that have no rights holders but are of local interest. The market potential for mobile apps is increasing. For example, currently 30% of South China Morning Post s traffic comes from Smartphones and it is expected that that number will reach 40% in 2014. (www.inma.org). In addition, we also plan to use our website platform and mobile application to expand into other areas of online content such as news clips, amateur video, social media, games or gaming applications, and premium direct content sales. Online applications and mobile platforms may also be used in a multitude of ways including advertising, direct sales, and targeted ad campaigns. Items or ideas promotions allow SAL the opportunity to diversify into any number of broad spectrum businesses which rely on communicating with a direct audience across a wide spectrum of media platforms. Other segments of the market are also benefiting. The high and rapidly increasing popularity of social media platforms such as Facebook, YouTube, and Twitter are expected to revolutionize the marketing strategies employed in areas such as the pharmaceuticals industry. There, in addition to marketing, an increasing number of pharma players have also begun leveraging these platforms to enhance consumer relationships and improve brand management, based on the market intelligence generated by monitoring and analyzing user-generated content. The ability to incorporate consumer feedback to develop new products is also expected to initiate a strategic shift in the operational model of pharma companies. Social media involvements are expected to increase product sales, especially those of OTC drugs, in the long term. Novartis for instance has already begun using YouTube and Facebook to enhance the sales for its OTC drugs such as Comtrex, Orofar and Bufferin. Johnson & Johnson, one of the first pharma giants to enter the social media space, has used online platforms for crisis management – when the company recalled its products (Tylenol and Benadryl tablets) it used social websites to apologize to consumers for irregularities in its manufacturing plant found during an FDA inspection. Syndicore Asia Limited is a wholly-owned subsidiary of the Company. Syndicore Asia Limited is also in the startup phase and is in the process of entering into arrangements and agreements to implement the current business plan. Syndicore Asia Limited is an online media company that syndicates professional sports video in a cloud-based, multimedia conduit serving a growing, global community of content creators, news outlets and leading brands. Syndicore Asia Limited will be a provider of syndicated sports video media to news organizations in the Asia Pacific region. In addition, Syndicore Asia Limited plans to aggregate content from the Asia Pacific region and provide it to news organizations around the world. Syndicore Asia Limited is devoting its resources to establishing the new business, and its planned operations have not yet commenced. Accordingly, no revenues have been earned during the period from its inception on April 23, 2013 to December 31, 2015. Green Standard Technologies Enterprises, Inc. (F/K/A Green Standard Technologies, Inc.) – Service Provider to the Cannabis Industry On August 1, 2014 the Company formed Green Standard Technologies, Inc. (F/K/A Green Standard Technologies, Inc.) ( GSTE ) as a wholly owned subsidiary incorporated under the laws of the state of Nevada. The Company s second line of business is carried on by this subsidiary. On June 6, 2015, Green Standard Technologies Inc. amended their name to Green Standard Technologies Enterprises, Inc. GSTE is in the medical and recreation marijuana industry, and the establishment of a website will be used to further its business by providing customers with medical and recreational marijuana resources. Management believes that this online presence is essential in developing and expanding their existing business. On October 29, 2014, GSTE entered into a Website Development Agreement with Social Asylum Inc. ( SAI ). Under the terms of the Agreement SAI has agreed to provide a fully functioning ecommerce website with unique and proprietary functions according to a mutually agreed upon set of features and milestones for a minimum cost of $150,000; however, the cost could potentially be higher depending on the finalized functionality, scope and details. Also included are plans for launch, market and geographic expansion. 6 GSTE is developing software and support solutions for the cannabis industry. The new business model will consist of a website [www.greenNVY.com] and business management software available to cannabis retailers in those states where the sale of cannabis is legal, either for medical purposes or for recreational purposes. The website will provide a platform for cannabis retailers to interface with retail customers. It will also allow for the creation of an online community for retailers and the consumer. The website will feature a clean, uncluttered and professional interface where the consumers can explore menus while researching strains of cannabis and pricing of cannabis from multiple sources. The website will allow consumers to get discounts and coupons, which will encourage them to try new stores. It will contain a geographical target map of the closest cannabis retail locations with a full profile of each retail outlet. In addition, it will contain a social platform which will allow consumers to chat with each other and read and post reviews within the community. In addition, it will create menu searches that can help the consumer quickly locate their favorite type or brand of cannabis products and services. For a retailer the website will provide a cloud based business management system that centralizes and automates every aspect of running their business. It will provide encrypted communications through GSTE s proprietary whisper email and instant messaging platform. It will also provide advertising opportunities in order to allow the retailer to develop new customers. The software will also provide the retailer with global applications which outline menu and review information for each retail location. It will provide mobile coupons through proximity marketing, email and text messages. In addition, it will administer customer loyalty programs and customer porting features that include consumers past orders. For the retailers business, it will offer employee management and human resources applications, payroll management, and employee scheduling. It will also offer retailers payment processing, integration and inventory management. The software will also provide the retailer with a sophisticated level of reporting of all the activity in the store, sales reporting by hour, day, etc., and reports of the best selling products broken down by category, average sale total and spot trends. At the current time, 23 states have legalized the medicinal use of marijuana and another 10 states are currently considering legalization. In addition, 4 states have made recreational use of cannabis legal, and there are several other states considering legalization of recreational use. Revenues will be generated from retailers based on monthly subscriptions to the management software and placement on the website. The fees will depend upon what types of features, functionality, marketing, advertising and exposure retailers with to have. In addition, GSTE will generate revenues from banner and text messages, blast advertising, and proximity marketing of email newsletter ads. GSTE is currently in the startup stage and has no earnings to date. Once it becomes fully operational its business will be strictly to provide products and services to the cannabis industry. GSTE will not be involved in the purchase or sale of cannabis products. Management s plans to support GSTE s operations by raising funds through the sale of the Company s securities and to rely on officers and directors to perform essential functions with minimal compensation. If we do not raise all of the money we need from the sale of securities, we will have to find alternative sources, such as loans from our officers, directors or others. If we can t raise enough cash, we will either have to suspend operations until the cash is raised, or cease business entirely. ITEM 1A. RISK FACTORS. Not Applicable as a smaller reporting company. ITEM 1B. UNRESOLVED STAFF COMMENTS None. 7 ITEM 2. PROPERTIES. We do not own any real property for use in our operations or otherwise. We do not need to rent office space after the spinoff of BSIE. ITEM 3. LEGAL PROCEEDINGS. We may be subject to litigation from time to time as a result of our normal business operations. Presently, there are no material pending legal proceedings to which we are a party or as to which any of our property is subject, and no such proceedings are known to be threatened or contemplated against us. ITEM 4. MINE SAFETY DISCLOSURES. Not Applicable. PART II ITEM 5. MARKET FOR REGISTRANT S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES (a) MARKET INFORMATION. Our common shares are quoted for trading on the OTC Bulletin Board under the symbol GSTC . The closing price of our common stock, as reported by the NASDAQ.com on December 31, 2015, was $0.13. National Association of Securities Dealers OTC Bulletin Board* Quarter End High Low March 31, 2014 1.04 .72 June 30, 2014 .85 .70 September 30, 2014 .89 .55 December 31, 2014 .61 .25 March 31, 2015 .35 .34 June 30, 2015 .34 .34 September 30, 2015 .40 .34 December 31, 2015 .40 .13 *Over-the-counter market quotations reflects high and low bid quotations and inter-dealer prices without retail mark-up, mark-down or commission, and may not represent actual transactions. Our transfer agent and registrar for our common stock is Madison Stock Transfer Inc. Their address is PO Box 145, Brooklyn, New York, USA 11229-0145. Their telephone number is (718) 627-4453. Their fax number is (718) 627-6341. 8 (b) HOLDERS. As of December 31, 2015, we had approximately 28 shareholders of record who held 18,725,003 shares of the Company s common stock. This number of shareholders does not include shareholders whose shares are held in street or nominee names. We believe that as of December 31, 2015, there are approximately 50 beneficial owners of our Common Stock, when these shareholders are considered. . (c) DIVDEND POLICY. We have not declared or paid any cash dividends on our common stock and we do not intend to declare or pay any cash dividends in the foreseeable future. The payment of dividends, if any, is within the discretion of our Board of Directors and will depend on our earnings, if any, our capital requirements and financial condition and such other factors as our Board of Directors may consider. (d) SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS. Plan CategoryNumber of Securities to Be Issued Upon Exercise of Outstanding Options, Warrants and Rights Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column) Equity compensation plans approved by security holders None Nil Nil (e) RECENT SALE OF UNREGISTERED SECURITIES. 1) On January 13, 2015 the Registrant completed an offering of 140,000 shares of common stock and warrants (the Units ). The warrants are exercisable for a period of two years after the subscription date at an exercise price of $.40 per shares. These Units were sold to one shareholder for a total consideration of $42,000. These Units were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. Securities issued by the Company in these transactions are deemed restricted securities within the meaning of that term as defined in Rule 144 of the Securities Act and have been issued pursuant to the private placement exemption under Section 4(2) of the Securities Act. These transactions did not involve any public offering of securities. The Investor who purchased securities in the private placement had access to information about the Registrant which was necessary to allow it to make an informed investment decision. The Registrant has been informed that the shareholder is able to bear the economic risk of his investment and it is aware that the securities are not registered under the Securities Act. The purchaser of the securities has been notified that the securities cannot be re-offered or re-sold unless the securities are registered or are qualified for sale pursuant to an exemption from registration. Neither the Registrant nor any person acting on its behalf offered or sold the securities by means of any form of general solicitation or general advertising. All purchasers represented in writing that it acquired the securities for its own accounts and not with a view to or for resale in connection with any distribution. A legend will be placed on each of the stock certificates stating that the securities are restricted, they have not been registered under the Securities Act and they cannot be sold or otherwise transferred without an effective registration or an exemption therefrom. 9 ITEM 6. SELECTED FINANCIAL DATA. Not Applicable. ITEM 7. MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS This discussion and analysis of our financial condition and results of operations includes forward-looking statements that reflect our current views with respect to future events and financial performance. We use words such as expect, anticipate, believe, and intend and similar expressions to identify forward-looking statements. You should be aware that actual results may differ materially from our expressed expectations because of risks and uncertainties inherent in future events and you should not rely unduly on these forward-looking statements. We disclaim any obligation to publicly update these statements, or disclose any difference between its actual results and those reflected in these statements. Reference in the following discussion to our , us and we refer to the operations of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) and its subsidiaries ( We ), except where the context otherwise indicates or requires. The following discussion of our financial condition and results of operations should be read in conjunction with the audited financial statements and the notes to the audited financial statements included in this annual report. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results may differ materially from those anticipated in these forward-looking statements. Current Operating In the twelve (12) months ended December 31, 2015, we derived no revenues from our current business operations. Olive Oil Direct International, Inc. On March 4, 2013 Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) ( Company ) acquired all the outstanding stock of Olive Oils Direct International, Inc. ( OODI ), a corporation formed under the laws of the State of Wyoming. In accordance with the terms of the Exchange Agreement between the parties, certain Company shareholders (the Company Selling Shareholders ) transferred 1,485,000 shares of the common stock of Company (the Company Shares ) to the shareholders of OODI (the OODI Shareholders ). In return, the OODI Shareholders transferred all of the outstanding shares of common stock of OODI to Company, and they paid $100,000.00 in cash to the Company Selling Shareholders. Immediately prior to the closing of the acquisition, Company spun off its operating subsidiary, Hong Kong Holdings, Inc., to its shareholders. OODI became a wholly-owned subsidiary of the Company. On March 31, 2015 OODI was sold to a third party. On August 1, 2014, the Company formed Green Standard Technologies Enterprises, Inc. (F/K/A Green Standard Technologies, Inc.)( GSTEI ) as a wholly owned subsidiary incorporated under the laws of the state of Nevada. The Company s second line of business is carried out by this subsidiary. On June 6, 2015, Green Standard Technologies Inc. filed articles of amendment to change its name to Green Standard Technologies Enterprises, Inc. GSTEI is in medical and recreation marijuana industry, and the establishment of a website will be used to further its business by providing customers with medical and recreational marijuana resources. Management believes that this online presence is essential in developing and expanding their existing business. GSTEI is no revenues have been earned during the period from its inception on August 1, 2014 to December 31, 2015. Results of Operations for the Twelve Months Ended December 31, 2015 as Compared to the Twelve Months Ended December 31, 2014 The Company had no revenue or cost of sales for the year ended December 31, 2015 and 2014. 10 The following table sets forth a summary of our consolidated statements of operations for the periods indicated: Twelve months Ended December 31, 2015 Twelve months Ended December 31, 2014 $ $ Revenue $0 $0 Administrative and other operating expenses (247,239) (364,830) Income/(Loss) from operations (247,239) (364,830) Other non-operating income - 131 Interest expenses - - Income/(Loss) before income taxes (247,239) (364,699) Income taxes - - Net Income/(Loss) (247,239) (364,699) Non-controlling interest - - Net Income/(Loss) attributable to The Group (247,239) (364,699) Revenues Revenues Composition and Sources of Revenue Growth In the twelve months ended December 31, 2015 and 2014, we derived no revenues from our current business operations. We anticipate that we will generate revenue from website business, although there is no assurance that this will occur, and we have not started to receive revenues yet from that business. Cost of Sales and Gross Profit We do not have revenue, cost of sales and gross profit for the current period. 11 Operating Expenses Overview Total operating expenses for the twelve months ended December 31, 2015 were $247,239, while the operating expenses for twelve months ended December 31, 2014 were $364,830. The expenses decreased due to service fee expenses incurred on the web business venture decreased. The table below sets forth the main category of expenses both in dollar amount and as a percentage of total expenses with the periods indicated, Twelve months ended December 31, 2015 % of Expense Twelve months ended December 31, 2014 % of Expense Salaries, commission, allowance $0 0% $0 0% Legal & Professional fees 57,688 23.3% 60,081 16.5% Office Rental 0 0% 0 0% Other operating expenses 189,551 76.7% 304,749 83.5% $247,239 100% $364,830 100% Salaries, Commissions and Allowances Salaries, Commissions and Allowances were $0 for the twelve months ended December 31, 2014, and they were $0 for the twelve months ended December 31, 2015. This was due to the fact that there was no salaries paid in the current period. Legal and Professional Fees Legal and professional fees for the twelve months ended December 31, 2014 were $60,081, while the legal and professional fees for twelve months ended December 31, 2015 were $57,688. Legal and professional fees in the year ended in 2015 were decreased as compared to the year ended in 2014 due to the reduction of our legal and professional expenses incurred as a result of this on the SEC filings for the relevant period after the spinoff of BSIE. Office Rental Office rental for the twelve months ended December 31, 2014 was $0 and the office rental for the twelve months ended December 31, 2015 was $0. This is due to the fact that we did not have operations during this period. Other General and Administration Expenses Other expenses for the twelve months ended December 31, 2014 were $304,749, while the other expenses for the twelve months ended December 31, 2015 were $189,551 with no revenue earned during this period in the current operation. The decrease in expenses was due to the decrease in service fee expenses incurred on the web business venture. Other Operating Income Income Income for the twelve months ended December 31, 2015 and 2014 was zero. In 2015, we had no income because our new operations had not commenced. 12 Exchange Gain The exchange gain was $0 for the twelve months ended December 31, 2015 as compared to $0 in the twelve months ended December 31, 2014. Interest Income Interest income was zero for the twelve months ended December 31, 2015, as compared to $0 for the twelve months ended December 31, 2014. Net Income/Loss Our net loss was $247,239 for the twelve months ended December 31, 2015, as compared to a net loss of $364,699 for the twelve months ended December 31, 2014. The decrease in net loss was due to the reduction in legal and professional expenses and decrease in service fee expenses incurred on the web business venture. Liquidity and Capital Resources Operating Activities Going Concern We had a net loss of $247,239 for the twelve months ended December 31, 2015 and a net loss since inception of $1,591,451. The 2015 and 2014 loss were generated as a result of paying all necessary administrative expenses. On December 31, 2015 we had cash on hand of $173. The accumulative loss has raised substantial doubt about our ability to continue as a going concern. These doubts were outlined in Note 3 to our independent auditor s report on our Consolidated Financial Statements for the year ended December 31, 2015. Although our Consolidated Financial Statements raise substantial doubt about our ability to continue as a going concern, they did not include any adjustments relating to recoverability and classification of recorded assets, or the amounts or classifications of liabilities that might be necessary in the event we cannot continue as a going concern. Certain of our shareholders have verbally agreed to provide financial support to us for losses we may incur in the future. Liquidity The following table sets forth the summary of our cash flows for the periods indicated: For Twelve Months Ended Dec 31, 2015 For Twelve Months Ended Dec 31, 2014 (audited) (audited) $ $ Net cash flows generated from/( used in) operating activities (37,747) (232,484) Net cash flows (used in)/provided by investing activities 22,942 - Net cash flows provided by/(used in) financing activities 12,944 228,238 Net increase/(decrease) in cash and cash equivalents (1,861) (4,246) Effect of foreign currency translation - - Cash and cash equivalents – beginning of year 2,034 6,280 Cash and cash equivalents – end of period 173 2,034 13 Operating Activities Net cash used in operating activities was $232,484 for the twelve months ended December 31, 2014 as compared to net cash used by operating activities of $37,747 for the twelve months ended December 31, 2015. The decrease in cash used during the twelve months ended December 31, 2015 is mainly due to the reduction of legal and professional expenses and decrease in service fee expenses incurred on the web business venture. Investing Activities Net cash used in investing activities was $0 for the twelve months ended December 31, 2014 as compared to net cash generated in investing activities of $22,942 for the twelve months ended December 31, 2015. Cash was generated from disposal of subsidiary OODI. Financing Activities For the twelve months ended December 31, 2014 and 2015, there were no external financing activities except for the gross proceeds of $260,000 and $42,000 received from the sale of 560,000 and 140,000 shares of common stock, respectively. From time to time, related parties of the Company finance the working capital requirements for operations on a temporary basis. This financing is provided in the form of temporary loans to the Company. The net cash generated from a related party s loan was $29,056 for the twelve months ended December 31, 2015. These funds were used to help bridge the working capital gap, as compared to the repayment of loans of $31,762 from related parties during the twelve months ended December 31, 2014. The increase in borrowing from related parties is due to the need for cash to operate and build up our new business which is met by the support from related parties. The amounts due to related parties are interest-free loans. These loans are unsecured and have no fixed repayment terms. SUBSEQUENT EVENTS Subsequently, on January 5, 2016 Mr. Ka Yeung Lee submitted his resignation as a Director of Green Standard Technologies, Inc. based on personal matters, and he did not have any disagreement with the Company on any matter related to the Company s operations, policies or procedures. Off-balance Sheet Arrangements The Company does not have off-balance sheet arrangements as of December 31, 2015. Tabular Disclosure of Contractual Obligations The Company s had no known contractual obligations as of December 31, 2015. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not Applicable 14 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Green Standard Technologies, Inc (F/K/A Baoshinn Corporation) Consolidated Financial Statements For the Year Ended December 31, 2015 and 2014 (Stated in US Dollars) REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation), We have audited the accompanying consolidated balance sheet of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) (the Company ) and its subsidiaries (collectively referred to as the Group ) as of December 31, 2015 and 2014 and the related consolidated statements of income, stockholders equity and comprehensive income and cash flows for the years and period ended December 31, 2015, 2014 and from April 15, 2011 (inception) through December 31, 2015. These consolidated financial statements are the responsibility of the Group s management. Our responsibility is to express an opinion on these consolidated 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. We were not engaged to examine management s assertion about the effectiveness of the Company s internal control over financial reporting as of December 31, 2015 included in the Company s Item 9A Controls and Procedures in the Annual Report on Form 10-K and, accordingly, we do not express an opinion thereon. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Group and its subsidiaries as of December 31, 2015 and 2014 and the consolidated results of their operations and their cash flows for the years and period ended December 31, 2015, 2014 and from April 15, 2011 (inception) through December 31, 2015, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements have been prepared assuming that the Group will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Group has suffered losses from operations and has significant accumulated losses. In addition, the Group experienced negative cash flows from operations. These factors raise substantial doubt about the Group s ability to continue as a going concern. Management s plans in regard to these matters are also described in Note 3. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/AWC (CPA) Limited Certified Public Accountants Hong Kong, SAR March 31, 2016 15 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) CONSOLIDATED BALANCE SHEET (Stated in US Dollars) As At December 31, 2015 2014 $ $ ASSETS Current Assets Cash and cash equivalents 173 2,034 Accounts receivable - - Deferred cost - - Restricted cash - - Deposits, prepaid expenses and other receivables - - Amount due from related party - - Income tax prepaid - - Total Current Assets 173 2,034 Plant and equipment - - TOTAL ASSETS 173 2,034 LIABILITIES AND STOCKHOLDERS EQUITY LIABILITIES Current Liabilities Accounts payable - - Deferred revenue - - Other payables and accrued liabilities – Note 8 408,387 198,895 Income tax payable - - Due to related party (14,490) 14,566 Total current liabilities 393,897 213,461 TOTAL LIABILITIES 393,897 213,461 COMMITMENTS AND CONTINGENCIES – Note 15 STOCKHOLDERS EQUITY Common stock Par value : 2015 - US$.0001 (2014: US$.0001) Authorized: 2012 – 300,000,000 common shares, 100,000,000 preferred shares (2014: 300,000,000 common shares, 100,000,000 preferred shares) Issued and outstanding: 2015 – 18,725,003 shares (2014:18,585,003) 1,873 1,859 Additional paid-in capital 1,195,854 1,153,868 Accumulated other comprehensive income - - Accumulated deficit (1,591,451) (1,367,154) TOTAL STOCKHOLDERS EQUITY OF THE GROUP (393,724) (211,427) ATTRIBUTABLE TO NON-CONTROLLING INTERESTS - - ATTRIBUTBLE TO THE GROUP (393,724) (211,427) TOTAL LIABILITIES AND STOCKHOLDERS EQUITY 173 2,034 See notes to consolidated financial statement. 16 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) CONSOLIDATED STATEMENT OF INCOME (Stated in US Dollars) For Year Ended Dec. 31, 2015 For Year Ended Dec. 31, 2014 April 15, 2011 (inception) Through Dec. 31, 2015 $ $ $ Revenue - - - Net sales - - - Cost of sales - - - Gross profit - - - Other operating income - - - Depreciation - - - Administrative and other operating expenses (247,239) (364,830) (853,163) (Loss)/income from operations (247,239) (364,830) (853,163) Other non-operating income - Note 5 130 131 Interest expenses – Note 6 - (15) (Loss)/income before income taxes (247,239) (364,699) (853,047) Income taxes - Note 8 - - - Net (loss)/income (247,239) (364,699) (853,047) Non-controlling interest - - - Net (loss)/income attributable to the Company (247,239) (364,699) (853,047) (Loss)/earnings per share of common stock, basic and diluted – Note 4 (1.32 cents) (2.00 cents) (6.26 cents) Weighted average number of common stock, basic and diluted – Note 4 18,725,000 18,221,932 13,618,971 See notes to consolidated financial statements 17 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) CONSOLIDATED STATEMENT OF CASH FLOWS (Stated in US Dollars) For Year Ended Dec 31, 2015 For Year Ended Dec 31, 2014 April 15, 2011 (inception) Through Dec. 31, 2015 $ $ $ Cash flows from operating activities Net (loss)/income (247,239) (364,699) (853,047) Adjustments to reconcile net income to net cash flows provided by operating activities: Depreciation - - - Re-organization (reverse merger and spin-off) - - (9,195) Stock based compensation - - 85,000 Non-controlling interest - - Changes in operating assets and liabilities: Accounts receivable - - - Deferred cost - - - Deposits, prepaid expenses and other receivables - - - Accounts payable - (1,904) - Disposal of fixed asset - - - Deferred revenue - - - Other payables and accrued liabilities 209,492 134,119 408,387 Income tax payable - - - Net cash flows (used in)/generated from operating activities (37,747) (232,484) (368,855) Cash flows from investing activity Disposal of subsidiary OODI 22,942 - 22,942 Acquisition of plant and equipment - - - Net cash flows (used in) investing activity 22,942 - 22,942 Cash flows from financing activities Proceeds from issuance of common stock 42,000 260,000 360,576 Amounts due from related parties - - - Amounts due to related parties (29,056) (31,762) (14,490) Increase in restricted cash - - - Dividend paid to non-controlling interest - - - Net cash flows generated from /(used in) financing activities 12,944 228,238 346,086 Net (decrease)/increase in cash and cash equivalents (1,861) (4,246) 173 Effect of foreign currency translation on cash and cash equivalents - - - Cash and cash equivalents - beginning of year 2,034 6,280 - Cash and cash equivalents - end of year 173 2,034 173 Supplemental disclosures for cash flow information : Cash paid for : Interest - - - Income taxes - - See notes to consolidated financial statements. 18 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE INCOME (Stated in US Dollars) Accumulated Additional other Common stock paid-in comprehensive Accumulated Shares Amount capital Income deficit Total $ $ $ $ $ Balance, April 1, 2012 400,000 400 - - - 400 Comprehensive income Net Loss - - - - (336) (336) Foreign currency translation Adjustments - - - - - - Balance, December 31, 2012 400,000 400 - - (336) 64 Balance, December 31, 2013 18,025,003 1,803 893,924 - (1,002,455) (106,728) Balance, December 31, 2014 18,585,003 1,859 1,153,868 (1,367,154) (211,427) Issuance of common stock 140,000 14 41,986 - 42,000 Disposal of OODI 22,942 22,942 Net loss - - - - (247,239) (247,239) Balance, December 31, 2015 18,725,003 1,873 1,195,854 - (1,591,451) (393,724) See notes to consolidated financial statements 19 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) 1. Corporation information Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) (the Company ) was incorporated under the laws of the State of Nevada on September 9, 2005, under the name of JML Holdings, Inc. On March 31, 2006, the Company consummated a merger (the Merger ) with Bao Shinn International Express Limited ( BSIE ) by issuing 16,500,000 shares in the share exchange transaction for 100% of the issued and outstanding shares of BSIE common stock. As a result of the share exchange transaction, BSIE became our wholly-owned subsidiary. BSIE owns 55% of Bao Shinn Holidays Limited ( BSHL ). During the year ended March 31, 2009, the Company and its subsidiaries (collectively referred to as the Group ) issued 2,400,000 restricted common shares of $0.001 per share at a value of $0.3 per share with a net proceeds of approximately $624,000 and redeemed 2,500,000 restricted common shares and these shares are classified as not issued and outstanding. Effective on October 19, 2011, each of ten (10) shares of the Company s common stock, par value $.001 per share, issued and outstanding immediately prior to the Effective Time (the Old Common Stock ) shall automatically and without any action on the part of the holder thereof, be reclassified as and changed, pursuant, into one (1) share of the Company s outstanding Common Stock (the New Common Stock ). On March 4, 2013 the Company acquired all the outstanding stock of Olive Oils Direct International Inc. ( OODI ), a corporation formed under the laws of the State of Wyoming. In accordance with the terms of the Exchange Agreement between the parties, certain Company s shareholders (the Company Selling Shareholders ) transferred 1,485,000 shares of the common stock of the Company (the Company Shares ) to the shareholders of OODI (the OODI Shareholders ). In return, the OODI Shareholders transferred all of the outstanding shares of common stock of OODI to the Company, and they paid $100,000.00 in cash to the Company Selling Shareholders. In addition, immediately prior to the closing of the acquisition, the Company spun off its operating subsidiary, Hong Kong Holdings, Inc., to its shareholders. OODI is now a wholly-owned subsidiary of the Company. The transaction was accounted for as a reverse merger , since the original stockholders of the OODI own a majority of the outstanding shares of the Company stock immediately following the completion of the transaction on March 4, 2013. OODI was the legal acquiree but deemed to be the accounting acquirer, the Company was the legal acquirer but deemed to be the accounting acquiree in the reverse merger. The historical financial statements prior to the acquisition are those of the accounting acquirer (OODI). Historical stockholders equity of the acquirer prior to the merger was acquirer s stockholders equity. Operations prior to the merger are those of the acquirer. After completion of the transaction, the Company s consolidated financial statements include the assets and liabilities of the Company and its subsidiaries, the operations and cash flow of the Company and its subsidiaries. OODI is a development-stage company that plans to develop and operate a retail internet website specializing in gourmet Italian food products. These products are expected to include olive oils, pastas, vinegars and other gourmet Italian food items. In addition, in the future OODI may offer cooking items, such as utensils, cooking tools and similar products from other countries. OODI is currently developing an e-commerce website by the name of www.OliveOilsDirect.com that will sell products inventoried by OliveOilsDirect.com and other products offered by other large well-established retailers. OODI is a development stage company and is subject to compliance under ASC915-15. It is devoting its resources to establishing the new business, and its planned operations have not yet commenced; accordingly, no revenues have been earned during the period from April 15, 2011 (date of inception) to March 31, 2015. 20 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) On March 31, 2015, the Company disposed the operation unit of OODI for US$1,000 to Jet Express Trading Limited, a Hong Kong registered company. On April 23, 2013 the Company incorporated a subsidiary company in Hong Kong under the name Syndicore Asia Limited. Syndicore Asia Limited ( SAL ) is an online media company that syndicates professional sports video in a cloud-based, multimedia conduit serving a growing, global community of content creators, news outlets and leading brands. Syndicore Asia Limited will be a provider of syndicated sports video media to news organizations in the Asia Pacific region. In addition, Syndicore Asia Limited plans to aggregate content from the Asia Pacific region and provide it to news organizations around the world. On May 31, 2013 the Registrant completed an offering of 15,000,000 shares of its common stock. These shares were sold to a total of eighteen (18) shareholders for a total consideration of $75,000. These shares were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. Securities issued by the Company did not involve any public offering of securities. Investors who purchased securities in the private placement had access to information about the Registrant which was necessary to allow them to make an informed investment decision. The Registrant has been informed that each shareholder is able to bear the economic risk of his investment they ar aware that the securities are not registered under the Securities Act. The purchasers of the securities have been notified that the securities cannot be re-offered or re-sold unless the securities are registered or are qualified for sale pursuant to an exemption from registration. Neither the Registrant nor any person acting on its behalf offered or sold the securities by means of any form of general solicitation or general advertising. All purchasers represented in writing that they acquired the securities for their own accounts and not with a view to or for resale in connection with any distribution. A legend will be placed on each of the stock certificates stating that the securities are restricted, they have not been registered under the Securities Act and they cannot be sold or otherwise transferred without an effective registration or an exemption therefrom. On April 1, 2013, the Board of Director resolved to pay an officer for a monthly service fee of US$4,250. The fee was raised to US$10,000 per month as of October 1, 2013. The Company has an option to pay the officer by common stock in lieu of cash at a rate of $0.005 per share. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. On November 15, 2013 we forfeited and canceled 3,365,000 shares common stock which was subscribed by four (4) shareholders on May 31, 2013. However, they did not fulfill their payment obligation on the shares that were valued at $16,825 according to the subscription term. The Company forfeited and canceled such 3,365,000 common shares. On December 15, 2013, the Company, through its wholly-owned subsidiary Syndicore Asia Limited, a Hong Kong Company ( SAL ), entered into a Distribution Agreement (the Distribution Agreement ) with SendtoNews Video, Inc., a British Columbia company ( STN ). Under the terms of the Distribution Agreement, SAL was granted an exclusive license to use, modify, edit, reproduce, distribute, feed, store, communicate, display, and transmit STN s content in the Asia Pacific Territory (the Content ). STN is the content provider for various worldwide sporting events. STN would also provide on-going assistance to SAL with regard to technical, administrative, and service-orientated issues relating to the delivery, utilization, transmission, storage and maintenance of the Content. On January 20, 2014, the parties entered into a revised Distribution Agreement whereby STN has agreed to provide SAL transferrable rights for the use, reproduction, storage, display, and transmission of certain content subject to pre-approval in writing from STN. In addition, the revised Distribution Agreement includes changes to the revenue sharing terms, and adds a share of advertising revenue directly resulting from aggregated content by SAL within the territory. 21 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) On July 8, 2014 the Registrant completed an offering of 300,000 shares of common stock and warrants (the Units ). These Units were sold to one shareholder for a total consideration of $150,000. These Units were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. On August 1, 2014 the Company subscribed to 1,000,000 shares of the $.0001 par value common stock of Green Standard Technologies Enterprises, Inc. (F/K/A Green Standard Technologies, Inc.), a Corporation duly organized under the laws of the state of Nevada for $100.00. Green Standard Technologies Enterprises, Inc. is in the medical and recreation marijuana industry, and the establishment of a website will be used to further their business by providing visitors with medical and recreational marijuana resources. Management believes that this online presence is essential in developing and expanding their existing business. On October 29, 2014 the Company, through its wholly owned subsidiary, Green Standard Technologies Enterprises, Inc., entered into a Website Development Agreement with Social Asylum Inc. ( SAI ). Under the terms of the Agreement SAI has agreed to provide a fully functioning ecommerce website with unique and proprietary functions. According to a mutually agreed upon set of features and milestones for a minimum cost of $150,000, but the cost could potentially be higher depending on finalized functionality, scope and details. Also included are plans for launch, market and geographic expansion. On October 29, and November 3, 2014 the Registrant completed an offering of 160,000 shares of common stock and warrants (the Units ). These Units were sold to two shareholders for a total consideration of $80,000. These units were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. On December 8, 2014 the Registrant completed an offering of 100,000 shares of common stock and warrants (the Units ). These Units were sold to one shareholder for a total consideration of $30,000. These Units were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. On January 13, 2015, the Registrant completed an offering of 140,000 shares of common stock and warrants (the Units ). The warrants are exercisable for a period of two years after the subscription date at an exercise price of $.40 per shares. These Units were sold to one shareholder for a total consideration of $42,000. These Units were sold on a private placement basis and the Company paid no commission in connection with such sales. All sales were made outside of the United States. On June 6, 2015, the Nevada subsidiary, Green Standard Technologies Inc. amended their name to Green Standard technologies Enterprises, Inc. On June 17, 2015, the Nevada holding company, Baoshinn Corporation has been amended to the name Green Standard Technologies, Inc. Description of business OODI is a development-stage company that plans to develop and operate a retail internet website specializing in gourmet Italian food products. On March 31, 2015, the Company disposed the operation unit of OODI for US$1,000 to Jet Express Trading Limited, a Hong Kong registered company. Syndicore Asia Limited ( SAL ) is an online media company that syndicates professional sports video in a cloud-based, multimedia conduit serving a growing global community of content creators, news outlets and leading brands. Syndicore Asia Limited will be a provider of syndicated sports video media to news organizations in the Asia Pacific region. In addition, Syndicore Asia Limited plans to aggregate content from the Asia Pacific region and provide it to news organizations around the world. 22 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Syndicore Asia Limited will strive to become a leading digital content provider for the Asia Pacific region, capitalizing on an explosively growing market with local, regional and national content that was previously unavailable. This is a new and exciting market, and offers unparalleled opportunities for expansion and rapid growth. Syndicore Asia Limited will also be the exclusive Asian partner and distributor for SendtoNews. SAL s exclusive distribution agreement with SendtoNews Video Incorporated ( STN ) for the Asia Pacific region includes major markets such as Japan, China and India. SAL now has distribution rights of online content for some of the world s leading sports organizations with the same highlights, player interviews and other fan-interest content. SAL, being the exclusive provider in the Asia Pacific region for highly sought after content, offers deep market exposure with unprecedented efficiency and metrics-driven transparency. On the other side of the distribution chain, we will create SAL s own proprietary news partnerships to provide guaranteed content distribution in return for a corresponding share of advertising revenues to a News industry looking to supplement their rapidly declining traditional ad revenue with viable digital-age revenue. On August 1, 2014 Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) formed Green Standard Technologies Enterprises, Inc. (F/K/A Green Standard Technologies, Inc.), ( GSTEI) as a wholly owned subsidiary incorporated under the law of the state of Nevada. The Company s second line of business is carried out by this subsidiary. Green Standard Technologies Enterprises, Inc. ( GSTEI) is in the medical and recreation marijuana industry, and the establishment of a website will be used to further their business by providing visions with medical and recreational marijuana resource. On October 29, 2014 Green Standard Technologies Enterprises, Inc., entered into a Website Development Agreement with Social Asylum Inc. ( SAI ). Under the terms of the Agreement SAI has agreed to provide a fully functioning ecommerce website with unique and proprietary functions, according to a mutually agreed upon set of features and milestones for minimum cost of $150,000, but the cost could potentially be higher depending on finalized functionality, scope and details. Also included are plans for launch, market and geographic expansion in the USA and potentially Europe. On April 1, 2015, Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) and Rider Capital Corp. signed the following agreements: (1) Contractor Agreement to serve as an expert on filing services. GST shall pay $360,000 USD for one (1) year on April 1, 2015 and on the anniversary date of the contract to Rider Capital Corp., unless otherwise terminated. (2) Contractor Agreement to serve as an expert on compliance services. GST shall pay $450,000 USD for one (1) year on April 1, 2015 and on the anniversary date of the contract to Rider Capital Corp., unless otherwise terminated. (3) Contractor Agreement to serve as an expert on distribution and business development. GST shall pay $550,000 USD for one (1) year on April 1, 2015 and on the anniversary date of the contract to Rider Capital Corp., unless otherwise terminated. On April 1, 2015, the Company issued three convertible promissory notes to Rider Capital Corp. in the sum of $360,000, $450,000 and $550,000 with 8% annual interest rate, no collateral and redeemable on October 2015 in exchange for the contractor agreement signed for the filing, compliance and distribution and business development services to be provided. 23 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) On September 24, 2015, the Company and Rider Capital Corp. signed the Debt Cancellation Notes for the following Consulting Contracts and Promissory Note agreements, leaving no outstanding balance owing between the Contractor and the Company: (1) Contractor Agreement to serve as an expert on filing services signed on April 1, 2015. Promissory Note is in the amount of $360,000. (2) Contractor Agreement to serve as an expert on compliance services signed on April 1, 2015. Promissory Note is in the amount of $450,000. (3) Contractor Agreement to serve as an expert on distribution and business development signed on April 1, 2015. Promissory Note is in the amount of $550,000. 3. Going concern The financial statements have been prepared in accordance with generally accepted principles in the United States applicable to a going concern, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. Although the Company generated a net loss of $247,239 for the year ended December 31, 2015 and net loss $364,699 for the year ended December 31, 2014, it had an accumulated deficit of $1,591,451 and $1,367,154 as at December 31, 2015 and 2014. Management believes that actions presently taken to revise the Group s operating and financial requirements provide the opportunity for the Group to continue as a going concern. The Group s ability to achieve these objectives cannot be determined at this stage. If the Group is unsuccessful in its endeavors, it may be forced to cease operations. These financial statements do not include any adjustments that might result from this uncertainty. These consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or amounts and classifications of liabilities that might be necessary should the Company be unable to continue as a going concern. 4. Summary of significant accounting policies Basis of presentation and consolidation The accompanying consolidated financial statements of the Group have been prepared in accordance with generally accepted accounting principles in the United States of America. On June 29, 2010, the Financial Accounting Standards Board (FASB) established the FASB Accounting Standards Codification (Codification) as the single source of authoritative US generally accepted accounting principles (GAAP) for all non-governmental entities Rules and interpretive releases of the Securities and Exchange Commission (SEC) and also sources of authoritative US GAAP for SEC registrants. The Codification does not change US GAAP but takes previously issued FASB standards and other U.S. GAAP authoritative pronouncements, changes the way the standards are referred to, and includes them in specific topic arrears. The adoption of the Codification did not have any impact on the Group s financial statements. The consolidated financial statements include the accounts of the Group and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. The results of subsidiaries acquired or disposed of during the years are included in the consolidated income statement from the effective date of acquisition or up to the effective date of disposal. 24 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Use of estimates In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting year. These accounts and estimates include, but are not limited to, the valuation of accounts receivable, deferred income taxes and the estimation on useful lives of plant and equipment. Actual results could differ from those estimates. Concentrations of credit risk Financial instruments that potentially subject the Group to significant concentrations of credit risk consist principally of accounts receivable. In respect of accounts receivable, the Group extends credit based on an evaluation of the customer s financial condition, generally without requiring collateral or other security. In order to minimize the credit risk, the management of the Group has delegated a team responsibility for determination of credit limits, credit approvals and other monitoring procedures to ensure that follow-up action is taken to recover overdue debts. Further, the Group reviews the recoverable amount of each individual trade debt at each balance sheet date to ensure that adequate impairment losses are made for irrecoverable amounts. In this regard, the directors of the Group consider that the Group s credit risk is significantly reduced. Cash and cash equivalents Cash and cash equivalents include all cash, deposits in banks and other highly liquid investments with initial maturities of three months or less. Accounts receivable Accounts receivable are stated at original amount less allowance made for doubtful receivables, if any, based on a review of all outstanding amounts at the year end. An allowance is also made when there is objective evidence that the Group will not be able to collect all amounts due according to original terms of receivables. Bad debts are written off when identified. The Group extends unsecured credit to customers in the normal course of business and believes all accounts receivable in excess of the allowances for doubtful receivables to be fully collectible. The Group does not accrue interest on trade accounts receivable. The Group has a credit policy in place and the exposure to credit risk is monitored on an ongoing basis credit evaluations are preferred on all customers requiring credit over a certain amount. The Group had experienced the bad debts of $nil and $nil during the year ended December 31, 2015 and 2014 respectively. Plant and equipment Plant and equipment are stated at cost less accumulated depreciation. Cost represents the purchase price of the asset and other costs incurred to bring the asset into its existing use. Maintenance, repairs and betterments, including replacement of minor items, are charged to expense; major additions to physical properties are capitalized. 25 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Depreciation of plant and equipment is provided using the straight-line method over their estimated useful lives at the following annual rates: Furniture and fixtures 20% - 50% Office equipment 20% Property and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. Revenue recognition The Group recognizes revenue when it is earned and realizable based on the following criteria: persuasive evidence that an arrangement exists, services have been rendered, the price is fixed or determinable and collectability is reasonably assured. The Group also evaluates the presentation of revenue on a gross versus a net basis in accordance with ASC 605 Revenue Recognition which codified the Emerging Issues Task Force No. ( EITF ) 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. The consensus of this literature is that the presentation of revenue as the gross amount billed to a customer because it has earned revenue from the sale of goods or services or the net amount retained (that is, the amount billed to a customer less the amount paid to a supplier) because it has earned a commission or fee is a matter of judgment that depends on the relevant facts and circumstances. In making an evaluation of this issue, some of the factors that should be considered are: whether the Group is the primary obligor in the arrangement (strong indicator); whether it has general inventory risk (before customer order is placed or upon customer return) (strong indicator); and whether we have latitude in establishing price. The guidance clearly indicates that the evaluations of these factors, which at times can be contradictory, are subject to significant judgment and subjectivity. If the conclusion drawn is that the Group performs as an agent or a broker without assuming the risks and rewards of ownership of goods, revenue should be reported on a net basis. 26 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Advertising expenses Advertising expenses are charged to expense as incurred. For the year ended December 31, 2015 and 2014, the company incurred $293 and $7,754 advertising expenses respectively. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The FASB issued Accounting Standard Codification Topic 740 (ASC 740) Income Taxes . ASC 740 clarifies the accounting for uncertainty in tax positions. This requires that an entity recognized in the consolidated financial statements the impact of a tax position, if that position is more likely than not of being sustained upon examination, based on the technical merits of the position. The adoption of ASC 740 did not have any impact on the Group s results of operations or financial condition for the year ended 31 December, 2015. As of the date of the adoption of ASC 740, the Group has no material unrecognized tax benefit which would favorably affect the effective income tax rate in future periods. The Group has elected to classify interest and penalties related to unrecognized tax benefits, if and when required, as part of income tax expense in the consolidated statements of operations. Comprehensive income Other comprehensive income refers to revenues, expenses, gains and losses that under U.S. GAAP are included in comprehensive income but are excluded from net income as these amounts are recorded as a component of stockholders equity. The Group s other comprehensive income represented foreign currency translation adjustments. Foreign currency translation The functional currency of the Group is Hong Kong dollars ( HK$ ). The Group maintains its financial statements 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 dates. Transactions denominated in currencies other than the functional currency are translated into the functional currency at the exchanges rates prevailing at the dates of the transaction. In 2015, the exchange rate being use to translate amount in HK$ is fixed at 7.8 to 1 for the purpose of preparing the consolidated financial statements which is derived from October 17, 1983 monetary policy from Hong Kong Monetary Authority where the Hong Kong dollar was pegged at a rate of 7.8 HK$ = 1 US$, through the currency board system with a limited floating range from 7.85 to 7.75. Exchange gains or losses arising from foreign currency transactions are included in the determination of net income for the respective periods. 27 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) For financial reporting purposes, the financial statements of the Group which are prepared using the functional currency have been translated into United States dollars. Assets and liabilities are translated at the exchange rates at the balance sheet dates and revenue and expenses are translated at the average exchange rates and stockholders equity is translated at historical exchange rates. Any translation adjustments resulting are not included in determining net income but are included in foreign exchange adjustment to other comprehensive income, a component of stockholders equity. Year ended Year ended Dec 31, 2015 Dec 31, 2014 Year end HK$ : US$ exchange rate 7.8 7.8 Average yearly HK$ : US$ exchange rate 7.8 7.8 Fair value of financial instruments The carrying values of the Group s financial instruments, including cash and cash equivalents, trade and other receivables, deposits, trade and other payables approximate their fair values due to the short-term maturity of such instruments. The carrying amounts of borrowings approximate their fair values because the applicable interest rates approximate current market rates. Stock-based Compensation Share-based compensation including stock options and common stock awards issued to employees and directors for services and are accounted for in accordance with FASB ASC 718 "Compensation - Stock Compensation" and share-based compensation including warrants and common stock awards issued to consultants and nonemployees are accounted for in accordance with FASB ASC 505-50 "Equity-Based Payment to Non-employees. All grant of common stock awards and stock options/warrants to employees and directors are recognized in the financial statements based on their grant date fair values. Awards to consultants and nonemployees are recognized based upon their fair value as of the earlier of a commitment date or completion of services. The grant date(s) of all awards are determined under the guidance of ASC 718-10-25-5. The Company estimates fair value of common stock awards based the quoted price of the Company's common stock on the grant date. The fair value of stock options and warrants is determined using the appropriate option pricing model depends on the applicable of situation. On April 1, 2013, the Board of Director resolved to pay an officer for a monthly service fee of US$4,250. The fee was raised to US$10,000 per month as at October 1, 2013. The Company has an option to pay the officer by common stock in lieu of cash at a rate of $0.005 per share. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. Basic and diluted earnings per share The Group computes earnings per share ( EPS ) in accordance with FASB Accounting Standard Codification Topic 260 (ASC 260) Earnings Per Share , and SEC Staff Accounting Bulletin No. 98 ( SAB 98 ). ASC 260 requires companies with complex capital structures to present basic and diluted EPS. Basic EPS is measured as the income or loss available to common shareholders divided by the weighted average common shares outstanding for the period. Diluted EPS is similar to basic EPS but presents the dilutive effect on a per share basis of potential common shares (e.g., convertible securities, options, and warrants) as if they had been converted at the beginning of the periods presented, or issuance date, if later. Potential common shares that have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation of diluted EPS. The calculation of diluted weighted average common shares outstanding for the year ended December 31, 2015 is based on the estimate fair value of the Group s common stock during such periods applied to options using the treasury stock method to determine if they are dilutive. Effective on October 19, 2011, each of ten (10) shares of the Company s Common Stock, par value $.001 per share, issued and outstanding immediately prior to the Effective Time (the Old Common Stock ) shall automatically and without any action on the part of the holder thereof, be reclassified as and changed, pursuant, into one (1) share of the Company s outstanding Common Stock (the New Common Stock ). 28 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) The following tables are a reconciliation of the weighted average shares used in the computation of basic and diluted earnings per share for the periods presented: Year Ended Dec. 31, 2014 Year Ended Dec. 31, 2014 $ $ Numerator for basic and diluted earnings per share: Net (loss)/income (247,239) (364,699) Denominator: Basic weighted average shares 18,725,000 18,221,932 Effect of dilutive securities - - Diluted weighted average shares 18,725,000 18,221,932 Basic earnings per share: (1.32 cents) (2.00 cents) Diluted earnings per share: (1.32cents) (2.00 cents) Related parties transactions A related party is generally defined as (i) any person that holds 10% or more of the Group s securities and their immediate families, (ii) the Group s management, (iii) someone that directly or indirectly controls, is controlled by or is under common control with the Group, or (iv) anyone who can significantly influence the financial and operating decisions of the Group. A transaction is considered to be a related party transaction when there is a transfer of resources or obligations between related parties. Commitments and contingencies Liabilities for loss contingencies arising from claims, assessments, litigation, fines and other sources are recorded when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. 29 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Recently issued accounting pronouncements The FASB has issued Accounting Standards Update ( ASU ) No. 2015-01 about Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items. The objective is to reduce the cost and complexity of income statement presentation by eliminating the concept of extraordinary items while maintaining or improving the usefulness of the information provided to the users of financial statements. The extraordinary items must met two criteria s: unusual nature and infrequency of occurrence. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes. This amendment will be effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2015. The board decided to permit early adoption provided that the guidance is applied from the beginning of the fiscal year of adoption. The FASB has issued ASU No. 2015-03 about Simplifying the Presentation of Debt Issuance Costs. The objective is to require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this Update. For public business entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal year. For all other entities, the amendments in this Update are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016. Early adoption of the amendments in the Update is permitted for financial statements that have not been previously issued. The FASB has issued ASU No. 2015-05 about Intangibles-Goodwill and Other-Internal-Use Software. The objective is to provide a guidance about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The amendment will not change GAAP for a customer s accounting for service contracts. In addition, the guidance in this Update supersedes paragraph 350-40-25-16. Consequently, all software licenses within the scope of Subtopic 350-40 will be accounted for consistent with other licenses of intangible assets. For public business entities, the Board decided that the amendments will be effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. For all other entities, the amendment will be effective for annual periods beginning after December 15, 2015, and interim periods in annual periods beginning after December 15, 2016. Early adoption is permitted for all entities. The FASB has issued ASU No. 2015-06 about Topic 260, Earnings Per Share, which contains guidance that addresses master limited partnerships that originated from Emerging Issues Task Force (EITF) Issue No. 07-4. This amendment in this Update specify that for purposes of calculating historical earnings per unit under the two-class method, the earnings (losses) of a transferred business before the date of a dropdown transaction should be allocated entirely to the general partner. In that circumstance, the previously reported earnings per unit of the limited partners (which is typically the earnings per unit measure presented in the financial statements) would not change as a result of the dropdown transaction. Qualitative disclosures about how the rights to the earnings (losses) differ before and after the dropdown transaction occurs for purposes of computing earnings per unit under the two-class method also are required. The amendments in this Update are effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Earlier application is permitted. The FASB has issued ASU No. 2015-07 about Topic 820, Fair Value Measurement, which permits a reporting entity, as a practical expedient, to measure the fair value of certain investments using the net asset value per share of the investment. The amendments in this Update remove the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. The amendments in this Update apply to reporting entities that elect to measure the fair value of an investment within the related scope by using the net asset value per share (or its equivalent) practical expedient. The FASB has issued No. 2015-10 Technical Corrections and Improvements , which aims to address feedback received from stakeholders on the Codification and make improvements to GAAP. The amendments in this update represent changes to clarify the Codification, correct unintended application of guidance, or make minor improvements to the Codification that are not expected to have a significant effect on current accounting practice or create a significant administrative cost to most entities. Some of the amendments will make the Codification easier to understand and apply by eliminating inconsistencies, providing needed clarifications, and improving the presentation of guidance in the Codification. The amendments in this update will apply to all reporting entities within the scope of the affected accounting guidance. The amendments in this update are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The FASB has issued No. 2015-11 Topic 330, Inventory , which aims to simplify the measurement of inventory by changing the subsequent measurement guidance from the lower of cost or market to the lower of cost and net realizable value for inventory within the scope of this Update. The amendments in this update do not apply to inventory that is measured using last-in, first-out (LIFO) or the retail inventory method. The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out (FIFO) or average cost. An entity should measure inventory within the scope of this Update at the lower of cost and net realizable value. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. For all other entities, the amendments in this update are effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. The FASB has issued No. 2015-14 Topic 606, Revenue from Contracts with Customers , which aims to respond to stakeholders requests to defer the effective date of the guidance in Update 2014-09 and to consider feedback received through extensive outreach with preparers, practitioners, and users of financial statements. The amendments in this update defer the effective date of Update 2014-09 for all entities by one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in Update 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. The FASB has issued No. 2015-15 Subtopic 835-30, Interest - Imputation of Interest : Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements - Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting. This amendment adds SEC paragraphs pursuant to the SEC Staff Announcement on June 18, 2015, Emerging Issues Task Force meeting about the presentation and subsequent measurement of debt issuance costs associated with line-of-credit arrangements. 30 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Recently issued accounting pronouncements (continued) The FASB has issued No. 2015-16 Topic 805, Business Combinations : Simplifying the Accounting for Measurement-Period Adjustments, which aims to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to users of financial statements. The amendments in this Update require that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The amendments in this update require that the acquirer record, in the same period s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The amendments in this update require an entity to present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. For public business entities, the amendments in this update are effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. For all other entities, the amendments in this update are effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. The FASB has issued No. 2015-17 Topic 740, Income Taxes : Balance Sheet Classification of Deferred Taxes, which aims to identify, evaluate, and improve areas of generally accepted accounting principles (GAAP) for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to users of financial statements. The amendments in this update require that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The amendments in this update apply to all entities that present a classified statement of financial position. The current requirement that deferred tax liabilities and assets of a tax-paying component of an entity be offset and presented as a single amount is not affected by the amendments in this Update. The amendments in this update will align the presentation of deferred income tax assets and liabilities with International Financial Reporting Standards (IFRS). For public business entities, the amendments in this Update are effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods. For all other entities, the amendments in this update are effective for financial statements issued for annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Earlier application is permitted for all entities as of the beginning of an interim or annual reporting period. Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company s consolidated financial statements upon adoption. 5. Other non-operating income Year Ended Year Ended Dec 31, 2015 Dec 31, 2014 $ $ Gain on exchange - - Interest income - - Sundry income - 130 - 130 6. Interest expenses Year Ended Year Ended Dec 31, 2015 Dec 31, 2014 $ $ Bank charges 499 1,007 Interest expense - - 499 1,007 31 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) 7. Income taxes The Company and its subsidiaries file separate income tax returns. The Company is incorporated in the United States, and is subject to United States federal and state income taxes. The Company did not generate taxable income in the United States in 2015 and 2014. The subsidiaries are incorporated in Hong Kong, and are subject to Hong Kong Profits Tax at 16.5% for the year ended December 31, 2015 and 2014. Provision for Hong Kong profits tax has been made for the year presented as the subsidiaries have assessable profits during the year. The following table accounts for the differences between the actual tax provision and the amounts obtained by applying the applicable statutory income tax rate of 16.5% to income before taxes for the year ended December 31, 2015 and 2014. Year Ended Year Ended December 31, 2015 December 31, 2014 $ $ (Loss)/income before taxes (247,239) (364,699) Computed tax benefit at Hong Kong income tax rate - - Valuation allowance adjustment - - Unrecognized tax losses - - Non-taxable items - - Non-deductible expenses - - Tax rebate - - Others - - Total 0 0 Deferred taxes are determined based on the temporary differences between the financial statement and income tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. For the year ended December 31, 2015 and 2014, the Group has tax loss carrying-forwards, which does not recognize deferred tax assets as it is not probable that future taxable profits against which the losses can be utilized will be available in the relevant tax jurisdiction and entity. The Company did not have U.S, taxable income due to operating in Hong Kong, SAR. The Company did not file the U.S. federal income tax returns. The Company did not have uncertainty tax positions or events leading to uncertainty tax position within the next 12 months. No Hong Kong Corporations Profits Tax Return filings are subject to Hong Kong Inland Revenue Department examination. 32 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) 8. Other payables and accrued liabilities At December 31, 2015 2014 $ $ Sale deposits received - - Accrued expenses 408,387 198,895 Other payables - - 408,387 198,895 9. Amount due from/to related parties Amount due from/to related parties are as follows: As of 12/31/2015 As of 2/28/2014 $ $ Amount due from related parties 14,490 - Amount due to related parties - (14,566) As of December 31, 2015 and 2014, the amount due from/to related parties represent advances from shareholders of the Group and are interest free, unsecured and have no fixed repayment terms. Amounts due from/to related parties were $14,490 (2014: $nil) and $nil (2014: $(14,566)) including in accounts receivable and payable, respectively, which are trade in nature. 33 GREEN STANDARD TECHNOLOGIES, INC. (F/K.A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) 10. Stock options The Group has stock option plans that allow it to grant options to its key employees. During 2015 and 2014, the Company did not issue any stock options and there were no stock options being issued or outstanding. 11. Concentration of credit A substantial percentage of the Group's sales are made to the following customers. Details of the customers accounting for 10% or more of total net revenue are as follows: Year ended Year ended Dec 31, 2015 Dec 31, 2014 Company A 0% 0% Company B 0% 0% Details of the accounts receivable from the one customer with the largest receivable balances at December 31, 2015 and 2014 are as follows: Percentage of accounts receivable Dec 31, 2015 Dec 31, 2014 Company A 0% 0% Company B 0% 0% 12. Pension Plans In 2015, the Group participates in a defined contribution pension scheme under the Mandatory Provident Fund Schemes Ordinance ( MPF Scheme ) for all its eligible employees in Hong Kong. The MPF Scheme is available to all employees aged 18 to 64 with at least 60 days of service in the employment in Hong Kong. Contributions are made by the Group s subsidiary operating in Hong Kong at 5% of the participants relevant income with a ceiling of HK$30,000. The participants are entitled to 100% of the Group s contributions together with accrued returns irrespective of their length of service with the Group, but the benefits are required by law to be preserved until the retirement age of 65. The only obligation of the Group with respect to MPF Scheme is to make the required contributions under the plan. In 2015, the assets of the schemes are controlled by trustees and held separately from those of the Group. In 2015, no assets are allocated to pension. Total pension cost was $0 during year ended December 31, 2015 (2014: $0). 34 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) 13. Fair value measurements The Group adopted FASB ASC 820, Fair Value Measurements and Disclosures ( ASC 820 ), related to the Group s financial assets and liabilities. ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 defines fair value as the price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also describes three levels of inputs that may be used to measure fair value: Level 1 quoted prices in active markets for identical assets and liabilities. Level 2 observable inputs other than quoted prices in active markets for identical assets and liabilities. Level 3 unobservable inputs in which there is little or no market data available, which require the reporting entity to develop its own assumptions. ASC 820 also provides guidance for determining the fair value of a financial asset when the market for that asset is not active, and for determining fair value when the volume and level of activity for an asset or liability have significantly decreased and includes guidance on identifying circumstances that indicate when a transaction is not orderly. The effective date for certain aspects of ASC 820 was deferred and is currently being evaluated by the Group. Areas impacted by the deferral relate to nonfinancial assets and liabilities that are measured at fair value, but are recognized or disclosed at fair value on a nonrecurring basis. The effects of these remaining aspects of ASC 820 are to be applied by the Group to fair value measurements prospectively beginning November 1, 2010. The adoption of the remaining aspects of ASC 820 is not expected to have a material impact on its financial condition or results of operations. The following table details the fair value measurements of assets and liabilities within the three levels of the fair value hierarchy at December 31, 2015 and 2014: Fair Value Measurements at reporting date using: December 31, 2015 Quoted Price in active Markets for identical assets (level 1) Significant Other Observable Inputs (Level 2) Significant Other Unobservable Inputs (Level 3) $ $ $ $ Assets Restricted cash - - - Cash and cash equivalents 173 173 - - 35 GREEN STANDARD TECHNOLOGIES, INC. (F/K/A BAOSHINN CORPORATION) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Stated in US Dollars) Fair Value Measurements at reporting date using: December 31, 2014 Quoted Price in active Markets for identical assets (level 1) Significant Other Observable Inputs (Level 2) Significant Other Unobservable Inputs (Level 3) $ $ $ $ Assets Restricted cash - - - - Cash and cash equivalents 2,034 2,034 - - 14. Commitments and contingencies Operating lease commitments The Company did not have commitments during the year ended of December 31, 2015 and December 31, 2014. 15. Related party transactions As of December 31, 2015 and December 31, 2014, the Company had received advancement of $nil and $14,566 from the shareholders for operating expenses. These advancements bear no interest, no collateral and have no repayment term. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. 16. Subsequent events The Company has evaluated all other subsequent events from January 1, 2016 through the date these financial statements were issued. The Company determined that there were no any material subsequent events or transactions that require recognition or disclosure in the financial statements except that on January 5, 2016, Mr. Ka Yeung Lee submitted his resignation as a Director of Green Standard Technologies, Inc. 36 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. None. ITEM 9A. CONTROLS AND PROCEDURES Disclosure Controls and Procedures As required by paragraph (b) of Rules 13a-15 or 15d-15 under the Securities Exchange Act of 1934, the Company s principal executive officer and principal financial officer have evaluated the Company s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by the Annual Report on Form 10-K. Based on this evaluation, these officers have concluded that as of the end of the period covered by the Annual Report on Form 10-K, our disclosure controls and procedures were effective and were adequate to insure that the information required to be disclosed by the Company in reports it files or submits under the Exchange Act were recorded, processed, summarized and reported within the time period specified in the Commission s rules and forms. Management s Report on Internal Control over Financial Reporting Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company s principal executive and principal financial officers 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 consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. The Company s internal control over financial reporting is supported by written 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 Company s assets; (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 and that receipts and expenditures of the Company are being made only in accordance with authorizations of the Company s management and directors; 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. The Company s internal control system was designed to provide reasonable assurance to the Company s management and board of directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations which may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. 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 or procedures may deteriorate. Management conducted an evaluation of the effectiveness of the Company s internal control over financial reporting as of December 31, 2015. In making this assessment, management used the framework set forth in the report entitled Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or ( COSO ). The COSO framework summarizes each of the components of a company s internal control system, including (i) the control environment, (ii) risk assessment, (iii) control activities, (iv) information and communication, and (v) monitoring. Based on this evaluation, management concluded that the Company s internal control over financial reporting was effective as of December 31, 2015. 37 Changes in Internal Control Over Financial Reporting There were no changes in the Company s internal control over financial reporting during the quarter ended December 31, 2015 that have materially affected, or are reasonably likely to materially affect the Company s internal control over financial reporting. Regulatory Statement This annual report does not include an attestation report of the Company s registered public accounting firm regarding internal control over financial reporting. As a Smaller Reporting Company management s report was not subject to attestation by the Company s registered public accounting firm. ITEM 9B. OTHER INFORMATION. None. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE. The following table sets forth certain information regarding the Company s directors and executive officers for the fiscal year ended December 31, 2015: The following table provides information concerning our officers and directors. All directors hold office until the next annual meeting of stockholders or until their successors have been elected and qualified. Name and Address Age Position(s) Sean Webster 43 President, C.F.O., Director Ka Yeung Lee (resigned on January 5, 2016) 31 Director Akimasa Fujita (resigned on July 16, 2014) 43 Director Brent Inzer (resigned on March 26, 2015) 42 Director Mr. Sean Webster serves for a one year term or until his successors are elected or they are re-elected at the annual stockholders meeting. Mr. Benny Kan and Mr. Mike Lam have resigned all of their positions as on March 4, 2013. Officers hold their positions at the pleasure of the board of directors, absent any employment agreement, none of which currently exists or is contemplated. There is no arrangement or understanding between any of our directors or officers and any other person pursuant to which any director or officer was or is to be selected as a director or officer, and there is no arrangement, plan or understanding as to whether non-management shareholders will exercise their voting rights to continue to elect the current directors to the Company s board. Sean Webster has been the President and Chief Financial Officer of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) since March 25, 2008. Mr. Webster has been the Chief Operating Officer, Chief Financial Officer, Treasurer and Secretary of Biopack Environmental Solutions, Inc. from October 6, 2008 until April 27, 2012 and also served as its Chief Technology Officer and Principal Accounting Officer. Mr. Webster had been Senior Vice President of Finance & Business Development of Grand Power Logistics Group Inc., from April 8, 2008 until June 1, 2011. Since May, 1999 he served as an Investment Advisor (Investment Dealers Association of Canada, Registered Representative) at Blackmont Capital Inc. until October 2007. Mr. Webster graduated from the University of Calgary in 1996 with BA in Economics, and a minor in Management and Commerce. 38 Effective December 20, 2013, the Board of Directors of Syndicore Asia Limited, appointed Mr. Ritesh Jha s the Company s new Chief Technology Officer ( CTO ). In his capacity as CTO, Mr. Jha will be responsible for assisting the Company to develop its digital sports video media, distribution capabilities, content management solutions, web administration and development and general technology strategy. Mr. Jha was a software engineer at the National College of Computer Studies in Kathmandu, Nepal from 2006 to 2010. From 2011 to the present, Mr. Jha has been a Team Leader at Traffic Geyser Nepal Pvt. Ltd., Asia Pacific Region. In 2003, Mr. Jha received a Bachelor of Computer Science Degree from Tribhuvan University in Kathmandu, Nepal. In 2006, Mr. Jha received a Masters of Computer Science and Information Technology from Tribhuvan University in Kathmandu, Nepal. Mr. Ritesh Jha resigned on March 2, 2015. Effective January 17, 2014, the Board of Directors of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) elected Mr. Ka Yeung Lee (Mr. Lee ) as a new Director of the Company to fill a newly-created directorship. Since 2009, Mr. Lee served as Operations Director for Youhaha Marketing and Promotions Limited, an internet advertising and online media consulting Company located in Hong Kong. Mr. Lee received a Bachelor of Science Degree with honors from the Open University of Hong Kong in 2009. Mr. Lee resigned on January 5, 2016. Effective February 13, 2014, the Board of Directors of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) elected Mr. Akimasa Fujita ( Mr. Fujita ) as a new Director of the Company to fill a newly-created directorship. Since 2010, Mr. Fujita served as President of Japan Flood Control, an emergency flood protection system company located in Tokyo, Japan. Mr. Fujita received a Bachelor of Arts degree in Economics from Nihon University in 1993. Mr. Fujita resigned on July 16, 2014. Effective July 16, 2014, the Board of Directors of Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation) elected Mr. Brent Inzer ( Mr. Inzer ) as a new Director of the Company. Since 2008, Mr. Inzer was the Founder/CEO of Synergistic Resources, LLC where he provided consulting services to the medical marijuana industry and opened a division called Marijuana Medicine Evaluation Centers (M.M.E.C.) which expanded rapidly into 14 standalone clinics. Synergistic Resources, LLC was acquired by General Cannabis, Inc., a publicly traded company, in 2010, Mr. Inzer stayed on with General Cannabis as Director of Business development unit 2012. After his tenure with General Cannabis. Mr. Inzer completed development and marketing strategies for the nutraceutical cannabis industry, with Medco Systems of Los Angeles, California. Mr. Inzer resigned his position on March 26, 2015. Significant Employees As of the date hereof, we have no other significant employees. Family Relationships None Involvement in Certain Legal Proceedings None. Subsequent Events As noted above, under the heading of Subsequent Events of Note 16 in Item 8 Financial Statements. Section 16(a) Beneficial Ownership Reporting Compliance. Section 16(a) of the Exchange Act requires the Company s directors and officers, and persons who beneficially own more than 10% of a registered class of the Company s equity securities, to file reports of beneficial ownership and changes in beneficial ownership of the Company s securities with the SEC on Forms 3, 4 and 5. Officers, directors and greater than 10% stockholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on the Company s review of the copies of the forms received by it during the fiscal year ended December 31, 2015, the Company does not believe that any person required to make filings under Section 16(a) during such fiscal year failed to file such reports or filed such reports late. Code of Ethics Our board of directors adopted a Code of Business Conduct and Ethics that applies to, all our officers, directors, employees and agents. Certain provisions of the Code apply specifically to our president and secretary (being our principle executive officer, principle financial officer and principle accounting officer, controller), as well as persons performing similar functions. As adopted, our Code of Business Conduct and Ethics sets forth written standards that are designed to deter wrongdoing and to promote the following: 39 1. Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; 2. Full, fair, accurate, timely, and understandable disclosure in reports and documents that we file with, or submit to, the Securities and Exchange Commission and in other public communications made by us; 3. Compliance with applicable governmental laws, rules and regulations; 4. The prompt internal reporting of violations of the Code of Business Conduct and Ethics to an appropriate person identified in our Code of Business Conduct and Ethics; and 5. Accountability for adherence to the Code of Business Conduct and Ethics. Our Code of Business Conduct and Ethics requires, among other things, that all of our Company s senior officers commit to timely, accurate and consistent disclosure of information; that they maintain confidential information; and that they act with honesty and integrity. In addition, our Code of Business Conduct and Ethics emphasizes that all employees, and particularly senior officers, have a responsibility for maintaining financial integrity within our Company, consistent with generally accepted accounting principles, and federal and state securities laws. Any senior officer who becomes aware of any incidents involving financial or accounting manipulation or other irregularities, whether by witnessing the incident or being told of it, must report it to our management. We will provide a copy of our code of ethics without charge to any person that requests it. Any such request should be made in writing to the attention of Sean Webster, Chief Executive Officer, Green Standard Technologies, Inc., Unit 1010, Miramar Tower, 132 Nathan Road, Tsimshatsui, Kowloon, Hong Kong. Nominating Committee We do not have a separate nominating committee. Management believes that it is not necessary to have a separate nomination committee, because our entire board acts as our nominating committee. Audit Committee Our Board of Directors acts as our audit committee and we do not have an audit committee charter. We do not have a qualified financial expert on the Board at this time, because we have not been able to hire a qualified candidate. Further, we believe that we have inadequate financial resources at this time to hire such an expert. Compensation Committee Our board of directors acts as our compensation committee, and due to this fact we believe it is not necessary for us to have a separate compensation committee. 40 ITEM 11. EXECUTIVE COMPENSATION. The following table sets forth the cash compensation paid by the Company to its President and all other executive officers for services rendered during the fiscal year ended December 31, 2015. SUMMARY COMPENSATION TABLE (All amounts in US $ s) Long Term Compensation Total Compensation Awards Payouts (1) Name & Principal Position Period Salary Bonus Other Annual Comp. Restricted Stock Awards Securities Underlying Options/ SARs (#) LTIP Payouts All Other Compensation Sean Webster (3) 12 months ended December 31,2015 0 0 *120,000 0 0 0 0 120,000 12 months ended December 31,2014 0 0 *120,000 0 0 0 0 120,000 Mike Lam (2) 12 months ended December 31,2015 0 0 0 0 0 0 0 0 12 months ended December 31,2014 0 0 0 0 0 0 0 0 Benny Kan (2) 12 months ended December 31,2015 0 0 0 0 0 0 0 0 12 months ended December 31,2014 0 0 0 0 0 0 0 0 Note: (1) No other executive received any compensation from the Company and any of its subsidiaries for the previous three years. (2) Mike Lam and Benny Kan both resigned from their director and executive positions on March 4, 2013.Sean Webster is the President, CFO and a director of the Company. (3) * According to the April 2013 service fee agreement, the Board of Directors resolved to pay an officer, Sean Webster, in the amount of a monthly service fee of US$4,250. The fee was raised to US$10,000 per month as at October 1, 2013. The Company has an option to pay the officer by common stock in lieu of cash at a rate of $0.005 per share. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. (a) Option/SAR Grants The Company has stock option plans that allow it to grant options to its key employees. Over the course of employment, the Company may issue vested or non-vested stock options to an employee. 41 In March, 2008 the Company implemented a vested and non-vested stock option plan and all the options granted under those plans expired March 31, 2011. In the year ended March 31, 2008, a total of 300,000 of vested and 80,000 non-vested options were granted to employees of the Company at a price of $0.35 per share, exercisable for a term of three years. No stock options have been granted to any of the officers or directors of the Company. No stock options have been exercised by any employees, officers or directors since we were founded. Green Standard Technologies, Inc. (F/K/A Baoshinn Corporation), Syndicore Asia Limited and Green Standard Technologies Enterprises, Inc. currently have no option plans. (b) Long-Term Incentive Plans and Awards We do not have any long-term incentive plans that provide compensation intended to serve as incentive for performance. No individual grants or agreements regarding future payouts under non-stock, price-based plans have been made to any executive officer or any director or any employee or consultant since our inception; accordingly, no future payouts under non-stock price-based plans or agreements have been granted or entered into or exercised by any of our officers, directors, employees or consultants since we were founded. (c) Compensation of Directors The members of the Board of Directors are not compensated for acting as such. There are no arrangements pursuant to which directors are or will be compensated in the future for any services provided as a director. There were no reimbursement expenses paid to any director. (d) Employment Contracts, Termination of Employment, Change-in-Control Arrangements. The service agreement was approved by the Board of Directors as of April 1, 2013 and October 1, 2013. There are no compensation plans or arrangements, including payments to be made by us with respect to our officers, directors, employees or consultants that would result from the resignation, retirement or any other termination of such directors, officers, employees or consultants. There are no arrangements for compensation to our directors, officers, employees or consultants that would result from a change-in-control. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS. The following table sets forth certain information regarding the beneficial ownership of our common stock as of December 31, 2015, by (i) each person who is known by us to own beneficially more than 5% of our outstanding common stock; (ii) each of our officers and directors; and (iii) all our directors and officers as a group. Name and Address of Beneficial Owner Amount & Nature of Beneficial Ownership Percentage of Class(1) Sean Webster Unit 1010, Miramar Tower 132 Nathan Road, TST, Kowloon, Hong Kong 4,992,500 26.662% All Officers and Directors as a Group 4,992,500 26.662% [1] Applicable percentage ownership is based on 18,725,003 shares of our common stock outstanding as of December 31, 2015. There are no options, warrants, rights, conversion privileges or similar right to acquire the common stock of the Company outstanding as of December 31, 2015. 42 (a) Changes in Control We do not anticipate at this time any changes in control of the Company. There are no arrangements either in place or contemplated which may result in a change of control of the Company. There are no provisions within the Articles or the Bylaws of the Company that would delay or prevent a change of control. As of December 31, 2015, Sean Webster, an officer and director of the company controlled the largest percentage of shares of common stock. (b) Future Sales by Existing Shareholders As of December 31, 2015 there are a total of 28 Stockholders of record holding 18,725,003 shares of our common stock, excluding the shareholders that hold our shares in street name. 9,887,500 of our outstanding shares of common stock are restricted securities , as that term is defined in Rule 144 of the Rules and Regulations of the SEC promulgated under the Securities Act. Under Rule 144, such shares can be publicly sold, subject to certain restrictions commencing six (6) months after the acquisition of such shares. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE As of December 31, 2015 and December 31, 2014, the Company had received advances of $nil and $14,566 from its shareholders for operating expenses. These advances bear no interest, no collateral and have no repayment term. During 2013, the Company issued 1,700,000 shares on June 3, 2013; 850,000 shares on July 2, 2013; 850,000 shares on August 5, 2013 and 850,000 shares on September 6, 2013 with an aggregate of 4,250,000 shares in lieu of $21,250 compensation to the officer. The amounts recorded were about $85,000 at fair price per ASC 718. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES. AWC (CPA) Limited is the Company s independent registered public accountant. Audit Fees The aggregate fees billed by AWC (CPA) Limited for professional services rendered for the audits of our annual financial statements in connection with statutory and regulatory filings were $14,103 and $14,103 for the year ended December 31, 2015 and 2014. Audit-Related Fees The aggregate fees billed by AWC (CPA) Limited for assurance and related services that are reasonably related to the performance of the audit or review of the Company s financial statements were $0 or the year ended December 31, 2015. Tax Fees The aggregate fees billed by AWC (CPA) Limited for professional services for tax compliance, tax advice and tax planning were $0 for the year ended December 31, 2015. All Other Fees The aggregate fees billed by AWC (CPA) Limited for other products and services were $0 for the year ended December 31, 2015. Pre-approval Policy We do not currently have a separate audit committee. The services described above were approved by our Board of Directors, which serves as our audit committee. 43 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. Index to Exhibits Exhibit Description *3.1 Certificate of Incorporation *3.2 Amended and Restated Certificate of Incorporation *3.3 Bylaws *4.0 Stock Certificate 31.1 Certification of the Company s Principal Executive Officer to Section 302 of the Sarbanes-Oxley Act of 2002, with respect to the registrant s Annual Report on Form 10-K for the year ended December 31, 2015. 31.2 Certification of the Company s Principal Financial Officer to Section 302 of the Sarbanes-Oxley Act of 2002, with respect to the registrant s Annual Report on Form 10-K for the year ended December 31, 2015. 32.1 Certification of the Company s Principal Executive Officer 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 the Company s Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002. 101.INS** XBRL Instance Document 101.SCH** XBRL Taxonomy Extension Schema 101.CAL** XBRL Taxonomy Extension Calculation Linkbase 101.DEF** XBRL Taxonomy Extension Definition Linkbase 101.LAB** XBRL Taxonomy Extension Label Linkbase 101.PRE** XBRL Taxonomy Extension Presentation Linkbase. ______________________________________ *Filed as an exhibit to the Company s registration statement on Form SB-2, as filed with the Securities and Exchange Commission on June 14, 2006, and incorporated herein by this reference. ** To be filed as an amendment to this Form 10-K 44 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. GREEN STANDARD TECHNOLOGIES, INC. Dated: April 13, 2016 By: /s/ Sean Webster Name: Sean Webster Title: President In accordance with the Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Title Date /s/ Sean Webster President/CFO/Director/ Secretary/CEO April 13, 2016 Sean Webster 45

Essex Rental Corp.

10-K

https://www.sec.gov/Archives/edgar/data/1373988/0001144204-12-014837.txt

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended DECEMBER 31, 2011 ¨ Transition Report Pursuant to Section 13 or 15(d) of thE Securities Exchange Act f 1934 For the transition period from __________ to ___________ Commission File Number: 000-52459 Essex Rental Corp. (Exact Name of Registrant as specified in its Charter) Delaware 20-5415048 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1110 Lake Cook Road, Suite 220 Buffalo Grove, Illinois 60089 (Address of Principal Executive Offices) (Zip code) (847) 215-6500 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Shares, $.0001 par value per share The NASDAQ Capital Market (Title of each class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. ¨ Yes þ No 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 þ No Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes ¨ No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). þ Yes ¨ No 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. ¨ 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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act): Large Accelerated Filer ¨ Accelerated Filer þ Non-Accelerated Filer ¨ Smaller Reporting Company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes þ No The aggregate market value of the voting and non-voting common equity of the Registrant held by non-affiliates as of June 30, 2011 was $110,365,953. The number of shares of outstanding common stock of the Registrant as of March 1, 2012 was 24,537,156. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Definitive Proxy Statement with respect to the 2012 Annual Meeting of Stockholders, which is anticipated to be filed with the Securities and Exchange Commission within 120 days after the end of the registrant’s fiscal year covered by this Annual Report on Form 10-K, are incorporated by reference into Part III of this Annual Report on Form 10-K. FORM 10-K REPORT INDEX 10-K Part and Item No. Page No. PART I Item 1 Business 1 Item 1A Risk Factors 13 Item 1B Unresolved Staff Comments 20 Item 2 Properties 21 Item 3 Legal Proceedings 22 Item 4 Mine Safety Disclosures 22 PART II Item 5 Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 23 Item 6 Selected Financial Data 25 Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations 26 Item 7A Quantitative and Qualitative Disclosures About Market Risk 43 Item 8 Financial Statements and Supplementary Data 44 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 44 Item 9A Controls and Procedures 44 Item 9B Other Information 44 PART III Item 10 Directors, Executive Officers and Corporate Governance of the Registrant 45 Item 11 Executive Compensation 45 Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 45 Item 13 Certain Relationships and Related Transactions 45 Item 14 Principal Accountant Fees and Services 45 PART IV Item 15 Exhibits and Financial Statement Schedules 46 CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS Some of the statements in this Annual Report on Form 10-K are “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements include statements regarding the intent and belief or current expectations of Essex Rental Corp. (“Essex”) and its management team and may be identified by the use of words like "anticipate", "believe", "estimate", "expect", "intend", "may", "plan", "will", "should", "seek", the negative of these terms or other comparable terminology. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. Important factors that could cause actual results to differ materially from Essex’s expectations include, without limitation, the continued ability of Essex to successfully execute its business plan, the possibility of a change in demand for the products and services that Essex provides (through its operating subsidiaries, Essex Crane Rental Corp., Coast Crane Company and Coast Crane Ltd.), intense competition which may require us to lower prices or offer more favorable terms of sale, our reliance on third party suppliers, our indebtedness which could limit our operational and financial flexibility, global economic factors including interest rates, general economic conditions, geopolitical events and regulatory changes, our dependence on our management team and key personnel, as well as other relevant risks. The factors listed here are not exhaustive. Many of these uncertainties and risks are difficult to predict and beyond management’s control. Forward-looking statements are not guarantees of future performance, results or events. Certain of such risks and uncertainties are discussed below under Item 1A – Risk Factors. Essex assumes no obligation to update or supplement forward-looking information in this Annual Report whether to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results or financial conditions, or otherwise. PART I As used in this Annual Report, references to “the Company” or “Essex” or to “we,” “us” or “our” refer to Essex Rental Corp., together with its consolidated subsidiaries, Essex Holdings, LLC, Essex Crane Rental Corp., Essex Finance Corp., CC Acquisition Holding Corp., Coast Crane Company and Coast Crane Ltd., unless the context otherwise requires. Item 1. Business Background Essex Rental Corp. (formerly Hyde Park Acquisition Corp.) was incorporated in Delaware on August 21, 2006 as a blank check company whose objective was to effect a merger, capital stock exchange, asset acquisition or other similar business combination with an operating business. Our activities from our inception through October 31, 2008 were limited to completing our initial public offering and completing a business combination. On October 31, 2008, we acquired Essex Crane Rental Corp., which we refer to as Essex Crane, through the acquisition of substantially all of the ownership interests of Essex Crane’s parent company, Essex Holdings, LLC, which we refer to as Holdings. Essex Crane is a leading provider of lattice-boom crawler crane and attachment rental services and possesses one of the largest fleets of such equipment in the United States (U.S.). For more information regarding the acquisition of Holdings and Essex Crane, see “Business Combinations – Acquisition of Holdings and Its Subsidiary Essex Crane” below. From October 31, 2008 until November 24, 2010, we conducted substantially all of our operations through Essex Crane. On November 24, 2010 we acquired substantially all of the assets, and assumed certain liabilities (the “Coast Acquisition”) of Coast Crane Company (“Coast Liquidating Co.”), a leading provider of specialty lifting solutions and crane rental services on the West Coast of the United States. The assets acquired included all of the outstanding shares of capital stock of Coast Crane Ltd., a British Columbia corporation, through which Coast Liquidating Co. conducted its operations in Canada. References to “Coast Crane” in this Annual Report mean Coast Crane Company, a Delaware corporation, formerly known as CC Bidding Corp. (“CCBC”), through which we operate the business and assets acquired in the Coast Acquisition. For more information regarding the Coast Acquisition, see Note 1 to our consolidated financial statements and “Business Combinations – Acquisition of the Assets of Coast Crane Company and Subsidiary”, below. 1 We conduct substantially all of our operations through Essex Crane and Coast Crane. Business Combinations Acquisition of Holdings and Its Subsidiary Essex Crane On October 31, 2008, we acquired Essex Crane through the acquisition of substantially all of the ownership of Holdings. The purchase agreement provided for a gross purchase price of $210.0 million, less the amount of Essex Crane’s indebtedness outstanding as of the closing (which was refinanced as of the closing date with a credit facility made available to Essex Crane as of the closing date), the $5.0 million stated value of the membership interests in Holdings not acquired in the acquisition and the amount of certain other liabilities of Essex Crane as of the closing of the acquisition. The purchase price was subject to adjustment at and after the closing based on Essex Crane’s working capital as of the closing date and crane purchases and sales by Essex Crane prior to the closing date. The adjusted purchase price of the Holdings acquisition was $215.5 million, (including the amount of Essex’s indebtedness outstanding under Essex Crane’s credit facility immediately prior to the closing). The ownership interests in Holdings that were not acquired by the Company in the acquisition were retained by the management members of Holdings, including Ronald Schad, our Chief Executive Officer, and Martin Kroll, our Chief Financial Officer, and are referred to throughout this annual report on Form 10-K as the “Retained Interests”. The Retained Interests are exchangeable at the option of the holder for an aggregate of 632,911 shares of our common stock. The Retained Interests do not carry any voting rights and are entitled to distributions from Holdings only if the Company pays a dividend to its stockholders, in which case a distribution on account of the Retained Interests will be made on an “as exchanged” basis. We granted certain registration rights to the holders of the Retained Interests with respect to the shares of our common stock issuable upon exchange of the Retained Interests and, in February 2011, a registration statement covering the resale of such shares was declared effective. Acquisition of the Assets of Coast Crane Company and Subsidiary On November 24, 2010, through CCBC, we acquired substantially all of the assets and assumed certain liabilities of Coast Liquidating Co., which consisted of all of the assets used in the operation of its specialty lifting solutions and crane rental services business including all of the outstanding shares of capital stock of Coast Crane Ltd., a wholly-owned British Columbia corporation, through which Coast Liquidating Co. conducted its operations in Canada. The purchase agreement provided for a gross purchase price of $103.2 million which included net cash payments of $82.5 million and the assumption of certain liabilities of Coast Crane and its subsidiary as of the closing of the acquisition. For additional information regarding the gross purchase price paid in the Coast Acquisition, including related transaction expenses, see Note 1 to our consolidated financial statements. The Coast Acquisition was financed with $14.2 million of proceeds from the issuance of 3.3 million shares of common stock, cash of $20.3 million, primarily funded by Essex Crane’s revolving credit facility, proceeds of $49.6 million from a new revolving credit facility and the assumption of certain liabilities and indebtedness outstanding of Coast Crane and its subsidiary as of the closing date of approximately $20.7 million. Business Overview Through our operating subsidiaries, Essex Crane and Coast Crane, we are one of North America's largest providers of lifting equipment (including lattice-boom crawler cranes, truck cranes and rough terrain cranes, tower cranes, and other lifting equipment) used in a wide array of construction projects. In addition, we provide product support including installation, maintenance, repair, and parts and services for our equipment provided to customers and customer owned equipment. With a fleet of over 1,000 cranes and other construction equipment and customer service and support, we supply a wide variety of innovative lifting solutions for construction projects related to power generation, petro-chemical, refineries, water treatment and purification, bridges, highways, hospitals, shipbuilding, offshore oil fabrication and industrial plants, and commercial and residential construction. We rent our equipment “bare,” meaning without supplying an operator and, in exchange for a fee, make arrangements for the transportation and delivery of equipment. Once the crane is delivered and erected on the customer’s site, inspected and determined to be operating properly by the customer’s crane operator and management, most of the maintenance and repair costs are the responsibility of the customer while the equipment is on rent. This business model allows us to minimize our headcount and operating costs including reduced liability related to operator error and provides the customer with a more flexible situation where they control the crane and the operator’s work schedule. 2 Through a network of sixteen main service centers, other smaller service locations and several remote storage yards, complemented by a geographically dispersed highly skilled staff of sales and maintenance service professionals, we serve a variety of customers engaged in construction and maintenance projects. We have significantly diversified the end-markets that we serve in recent years, including through the Coast Acquisition, to avoid over-exposure to any one sector of the construction market. We use our significant investment in modern enterprise resource planning (“ERP”) systems and business process methods to help our management assimilate information more quickly than others in our industry, and to provide management with real time visibility of the factors that must be effectively managed to achieve our goals. Our end-markets are characterized by major construction projects that often have long lead times. Management believes that these longer lead times, coupled with most contracts having rental periods of between 4 and 18 months for lifting equipment with heavier capacities, provide them more visibility over future project pipelines and revenues. Although Essex Crane and Coast Crane experience some overlap in the customers and projects that they serve, they are distinct from one another in the equipment comprising their fleets. Essex Crane Essex Crane is a leading provider of lattice-boom crawler crane and attachment rental services and possesses one of the largest fleets of such equipment in the United States. Over 51 years of operation, since its founding in 1960, Essex Crane has steadily grown from a small, family-owned crane rental company to a professionally managed company that today is one of the leading players in its industry offering lattice boom crawler rental services to a variety of customers, industries and regions mainly throughout the United States and Canada. Essex Crane’s fleet size currently stands at more than 350 lattice-boom crawler cranes and various types of attachments which are made available to clients depending on their lifting requirements, such as weight, pick and carry aspects, reach and angle of reach. The fleet’s combination of crawler cranes and attachments is diverse by lift capacity and capability, allowing Essex Crane to meet the crawler crane requirements of its engineering and construction firm customer base. Coast Crane Coast Crane is a market leader for innovative lifting solutions throughout Western North America, Alaska, Hawaii, Guam and the South Pacific. Through Coast Crane, we provide both used and new tower cranes, boom trucks, rough terrain cranes and other lifting equipment to customers in the infrastructure, energy, crane rigger/operator, and municipal, commercial and industrial construction sectors. Coast Crane’s operations are headquartered in Seattle, Washington and its products are rented and sold through a regional network including 11 branch locations. According to the industry publication American Cranes and Transport, Coast Crane is one of the largest crane service providers within its core rental equipment categories. In addition to providing crane rental services, Coast Crane is a leading crane distributor of self-erecting tower cranes, rough terrain cranes, boom trucks and all terrain cranes in its West Coast territories. Coast Crane enjoys strong working partnerships with leading crane and lifting manufacturers in the U.S. Coast Crane has exclusive distribution relationships with such manufacturers for certain territories on the West Coast and Coast Crane provides after-sale spare parts and services to customers to whom it sells equipment as well as to customers who purchase equipment from other sources. Coast Crane implemented the ERP system platform that Essex Crane uses with certain modifications during 2011. Products and Services; Operating Segments Our principal products and services, as grouped within the Company’s three defined operating segments, are described below. 3 Equipment Rental Segment We offer for rent crawler cranes and attachments, rough terrain cranes, boom trucks, tower cranes, and other construction related rental equipment. Most attachments are rented separately and increase either the lifting capacity or the reach capabilities of the base crawler cranes and tower cranes. We also offer transportation, rigging and repair and maintenance services while equipment is on rent. We rent our fleet of over 1,000 cranes and attachments and other lifting equipment to a variety of engineering and construction customers under contracts, most of which have rental periods of between 4 and 18 months. Boom trucks and other smaller equipment may be rented as frequently as daily. The contracts typically provide for an agreed rental rate and a specified rental period. The revenue from crane and attachment rentals is primarily driven by rental rates (which are typically higher for the more expensive cranes with heavier lifting capacities than less expensive cranes with lower lifting capacities) charged to customers and the fleet utilization rate. Rental revenue is recognized as earned in accordance with the terms of the relevant rental agreement on a pro rata daily basis. Transportation services revenue is derived from the management of the logistics process by which our rental equipment is transported to and from customers’ construction sites, including the contracting of third party trucking for such transportation. Transportation revenue is earned under equipment rental agreements on a gross basis representing both the third-party provider’s fee for transportation and our fee for managing these transportation services and they are matched with the associated costs, and related costs for amounts paid to third party providers. The key drivers of transportation revenue are crane and attachment and other lifting equipment utilization rates and average contract lengths. Shorter average contract durations and high utilization rates generally result in higher requirements for transportation of equipment and resulting revenue. The distance that equipment has to move between different jobsites and the type of equipment being moved (number of truckloads) are also major drivers of transportation revenue and associated costs. Transportation revenue is recognized upon completion of the transportation of equipment. While crawler cranes or attachments, tower cranes, rough terrain cranes, boom trucks or other equipment are on rent, much of the repair and maintenance work is paid for by the customer. We perform a portion of the repair and maintenance work and recognize revenues for such services to the extent they are the customer’s responsibility. This category of revenues also includes providing certain services while erecting the equipment during initial assembly or disassembly of the equipment at the end of the rental. In the ordinary course of business, we sell used cranes and attachments and other lifting equipment to optimize the combination of crane models and lifting capacities available in our rental fleet to match perceived market demands and opportunities. On average, we have historically achieved sale prices for equipment in excess of the appraised value. This is due to the long useful life of the crane and attachment fleet, the conditions prevailing in the secondary market and the high content of engineered high-strength steel included in these fleet assets. Used rental equipment sales are recognized upon acceptance by the customer or the execution of a definitive sales agreement stipulating the date of transferring the risk of ownership. The rate at which we replace used equipment with new equipment depends on a number of factors, including changing general economic conditions, growth opportunities and the need to adjust fleet mix to meet customer requirements and demand. Equipment Distribution Segment We offer a variety of construction equipment products for sale including tower cranes, boom trucks, rough terrain cranes and other lifting equipment used in the construction industry. The revenue from retail equipment sales is primarily driven by the level of construction activity in a particular geographic region. Equipment sales revenue is recognized at the time ownership transfers, which is generally based on delivery and/or inspection and acceptance of the equipment in accordance with the terms of the corresponding agreement. Our equipment distribution operations are conducted through our Coast Crane subsidiary. Parts and Service Segment We are a parts distributor for various lifting equipment manufacturers and routinely sell parts to our customers in the construction industry. We also provide repairs and maintenance services for customers that own their own equipment and request our services at one of our service center locations. Our target customers for these ancillary services are our current rental customers, customers that own their own equipment and those who purchase new and used equipment from us. Key drivers for repair and maintenance revenue are the general construction activity in a given geographic region and our skilled mechanics. Repair and maintenance revenue is recognized as such services are performed. Parts revenue is recognized at the time of sale. Our parts and services operations are conducted through our Coast Crane subsidiary. In summary, 65.7% of total revenues were derived from our equipment rental segment for the year ended December 31, 2011, 15.9% through our equipment distribution segment and 18.4% through our parts and service segment. More specifically, 46.8% of total revenues were generated through equipment rentals, 15.9% through retail equipment sales, 7.3% through used rental equipment sales, 11.0% through retail part sales, 6.0% through rental related transportation services and 5.6% through repair and maintenance services provided with respect to cranes on rent and 7.4% through repair and maintenance services provided otherwise. 4 US Crane and Lifting Equipment Rental Industry According to the Rental Equipment Register and the American Rental Association, the US equipment rental sector has grown from a minor industry in 1982 to an industry generating over $30.0 billion in annual revenues in 2008. Driving this growth has been an increase in crane and attachment penetration rates with engineering and construction firms, the result of a fundamental shift in contractor preferences to rent versus purchasing equipment based on the following factors: ·focus on core construction services businesses rather than equipment ownership; ·access to broader pool of equipment through rental; and ·an efficient use of capital as rental equipment has minimal equipment downtime compared to owned equipment, which reduces servicing and storage costs between projects. The following table summarizes descriptions of the types of equipment that we offer for rent: Equipment Type Crawler cranes Other cranes (all terrain, rough terrain, tower and boom truck) Small equipment (e.g., aerial work platforms, forklifts, etc.) Economic life 50 plus years with proper maintenance due to higher strength steel percentage content 15-30 years due to higher relative machinery percentage content Often 10 years or less Typical Projects Large infrastructure components requiring heavy lifts: bridges, power plants, municipal infrastructure Range from residential condominium to large infrastructure Range from single house builds to large construction projects End markets Primarily large infrastructure and industrial Residential construction to large infrastructure Residential construction to large infrastructure Residual value High Medium Medium to low Within the U.S. heavy lifting crane rental (including crawler cranes, rough terrain cranes and tower cranes) sector operators either provide cranes “bare” or “manned.” Bare rental involves the provision of cranes without an operator, the crane being operated by an employee of the customer. Bare rental is suited to construction firms with access to trained staff to operate the heavy machinery. Manned rental involves the provision of an operator with the crane and is often suited to customers unable or unwilling to provide an operator of their own and is often more common with customers who perform shorter duration work. Manned rental involves the maintenance of adequate staffing levels to ensure equipment can be rented as required. We operate a bare rental model, because we believe bare rental offers an opportunity for higher returns on invested capital primarily due to decreased liability exposure and a more efficient operating platform and business model. Bare rental allows us to operate the business with significantly less human resources and costs associated with those resources than if we were to operate a manned operation. The primary disadvantage of renting cranes on a bare basis is that we forego a portion of the rental market associated with construction firms that prefer to rent equipment manned. Operations Equipment Rental Segment We maintain one of the largest fleets of cranes and attachments and other lifting equipment in North America. Rental revenues generated from the rental of equipment were $42.0 million in 2011 or approximately 46.8% of total revenue. Equipment is rented to customers under a contract (contracts range from 4-18 months in general for the majority of our equipment), which specifies a constant monthly rate for each piece of equipment over the period of the contract. In 2011, the average monthly crawler crane rental rate was $15,781 and crane utilization was 39.8% on “days” basis. Crane utilization for our lower lifting capacity equipment, including rough terrain cranes, boomtrucks, self-erecting tower cranes, city and other tower cranes, and forklifts and other equipment, was 62.0%, 54.0%, 24.4%, 40.1% and 39.9%, respectively. For a discussion of the “days” method of measuring crane utilization, see “Fleet Overview” below. 5 Once we and a potential customer communicate regarding the customer’s need for an equipment rental, we confirm that an appropriate piece of equipment is available. We then prepare and deliver a written rental quote to the customer. The customer reviews the quote and, if acceptable, places an order. Essex Rental’s on-line, real time information system provides visibility of the entire rental fleet for the sales team including the cranes’ lease information and expected availability. All sales team quote and order activity is also available on the same information system and viewable by appropriate sales, operations, and management personnel. Upon a review of the order including a check of the customer’s credit and continued equipment availability, an order confirmation and a rental agreement are sent to the customer. Once a signed rental agreement and other required documentation (including insurance certificates) are received, the order is authorized for shipment to the customer. Our operations team sees both the quote and order activity and responds appropriately to confirm the readiness of the required equipment for shipment to the new rental, but does not begin shipping it until the lease is authorized. Once the equipment is delivered to the customer’s site, our representative inspects the equipment with the customer and an inspection report is signed verifying that the equipment was correctly delivered in accordance with the lease agreement. The rental period for the equipment usually begins when the first major item begins transport to the customer and the rental ends when the last major item is returned to our designated location. Given the size of our crane and equipment fleet and the various types of cranes and equipment, we sell pieces of used equipment both domestically and internationally to construction or, although infrequently, other rental companies. Sales of used rental equipment are discretionary and based on a variety of factors including, but not limited to, a piece of equipment’s orderly liquidation value, age, rental yield, perceived demand in the marketplace and impact of a sale on our rental businesses and cash flow. Revenues from such used rental equipment sales totaled $6.5 million in 2011 or approximately 7.3% of total revenue Although we do have a small number of in-house vehicles, acquired as part of the Coast Acquisition, to transport our cranes, attachments and other equipment to and from project sites, we generally out-source transportation to third party providers, especially for the larger cranes within the fleet. We charge a fee for arranging transportation services from the nearest storage yard with the required equipment to the construction location. Revenues from such equipment transportation services totaled $5.4 million in 2011 or approximately 6.0% of total revenues. Our contracts have provisions that provide for the customer to assume responsibility to operate and maintain the equipment to manufacturer’s specifications throughout the contract period. We may provide maintenance and repair services to customers during the contract rental period and will invoice the customer for any work carried out (to the extent such work is the customer’s responsibility). Revenues from such repair and maintenance services totaled $5.0 million in 2011 or approximately 5.5% of total revenues. Equipment Distribution Segment Coast Crane and its Canadian subsidiary, Coast Crane Ltd. sell various new and used cranes acquired through trade-in programs and other equipment. Revenues from such equipment sales totaled $14.2 million in 2011 or approximately 15.9% of total revenues Parts and Service Segment Coast Crane and its Canadian subsidiary, Coast Crane Ltd. sell various crane and other equipment parts. Revenues from such retail part sales totaled $9.8 million in 2011 or approximately 11.0% of total revenues. We also provide repair and maintenance services to owners of construction equipment. Revenues from such repair and maintenance services totaled $6.7 million in 2011 or approximately 7.5% of total revenues, a portion of which is reported within the equipment rental segment. While a piece of equipment is not rented, we are responsible for ensuring that its equipment is compliant with all manufacturers’ specifications and other regulations. Fleet Overview Our fleet consists of over 350 lattice boom crawler cranes and attachments and over 650 other cranes and pieces of construction equipment. Tower cranes, rough terrain cranes and boom trucks comprise approximately 95% of the total orderly liquidation value of the non-crawler crane fleet. The fleet’s equipment varies in age and lifting capacity. We own all of our equipment and attachments and do not lease any of these items from third parties. 6 As of December 31, 2011, the weighted average age of each class of equipment (weighted based on orderly liquidation value) and the orderly liquidation value composition of the fleet are as follows: Weighted Percentage Average of Orderly Age (Years) Liquidation Value Crawler Cranes 15.2 70.1% Rough Terrain Cranes 2.5 13.1% Industrial Cranes 4.1 0.5% Boomtrucks 3.9 5.4% Self-Erecting Tower Cranes 5.7 1.7% City & Other Tower Cranes 4.0 7.2% Forklifts and Other Eqiupment 5.6 1.9% We measure utilization using the method referred to as the “days” method. Management believes that this method, while it may reflect lower utilization rates than other methods used in the industry, is the most accurate method for measuring equipment utilization and correlates most closely with rental revenue. Under this method, a real time report is generated from the ERP system for each piece of equipment on rent in a period. The report includes the number of days each piece of equipment was on rent on a particular lease and the base monthly rental rate (excluding any overtime revenues). The total number of days on rent of all pieces of rental equipment provides the numerator for determining utilization. The denominator is all rental equipment assets owned times the number of days in the month. The “days” method is the utilization measurement that we currently use, and we anticipate that the “days” method will be the primary basis for future disclosure of utilization rates for our cranes and other construction equipment offered for rent. The following table provides a summary of utilization rates calculated using the “days” method for the years ended December 31, 2011 and 2010 for the equipment types owned during those periods. Years Ended December 31, 2011 2010 Crawler Cranes 39.8% 37.5% Rough Terrain Cranes 62.0% N/A Boomtrucks 54.0% N/A Self-Erecting Tower Cranes 24.4% N/A City and Other Tower Cranes 40.1% N/A Forklifts and Other Equipment 39.9% N/A Note: 2010 utilization rates for categories other than crawler cranes is not meaningful due to the timing of the Coast Acquisition in November 2010. Lattice boom crawler cranes have long useful economic lives, often up to 50 years or more. This is longer than other types of cranes and equipment in the lifting market space. Tower cranes and rough terrain cranes also have relatively long useful economic lives that can range up to 30 years. Our management believes this is due to the relatively high value of the crane’s structural steel (including its boom) as it relates to the total value of the crane. These structural steel items are complex fabrications with high replacement value made from high tensile strength steel. When properly maintained, these components retain their value over the life of the crane with minimal maintenance costs. At the conclusion of each rental, the rented equipment is thoroughly inspected in accordance with requirements set by the original equipment manufacturer and the Occupational Safety and Health Administration (OSHA). If maintenance or repairs are required, they are scheduled and completed prior to the next rental. At the start of the next rental, another inspection is made to ensure that the equipment is in a rent ready condition and compliant with the inspection requirements. We have extensive capabilities to perform major repair and reconditioning of the cranes and attachments. This type of activity is done on an as-needed basis to ensure that the equipment provides a high level of availability (uptime) when on rent. We currently represent industry leading manufacturers including Broderson, JLG, Little Giant, Lull, Manitex, Mantis, Potain, Tadano and Terex in many of the western states of the United States, including Alaska and Hawaii, as well as Canada and Guam, and have developed strong long-term relationships with them. In addition, we maintain direct relationships with Manitowoc and Liebherr. 7 Sales and Marketing Over our operating history, we have expanded our infrastructure of service centers and storage yards to key geographical locations across the United States in order to serve customers in a timely and efficient manner. We significantly expanded our reach into the Western and Northwestern United States, Alaska, Hawaii and Guam with the Coast Acquisition. We currently operate approximately 20 service centers and storage yards giving us the ability to service customers throughout North America. We employ a sales and marketing team across the country, each member of which covers a specific geographic region and reports directly to a senior management executive. Rather than segmenting the fleet by geography or salesperson, the fleet is allocated based upon factors such as rental financial return, customer mix and project mix. As such, each salesperson is highly incentivized to optimize the fleet’s financial returns and sales mix. We market our business to potential customers through advertising, promotion, membership in construction trade associations and attendance at various meetings and trade shows. In addition, our web sites are designed with the goal of being very useful to engineers and designers who determine how a construction project will be built, as well as equipment and project managers who are responsible for the selection of the cranes that will be used to complete the project. Essex’s management believes that our web sites accomplish this goal by providing more comprehensive information regarding our equipment and the capacities and specifications of that equipment than may be readily available from other sources. Our sales teams use their extensive relationships with customers and potential users of cranes and other construction equipment to identify potential rental opportunities. This, combined with Essex Crane’s and Coast Crane’s reputations and brand value, contributes significantly to their sales activity. In recent years, we have enhanced this traditional method of lead generation with two lead-generation sales systems. The lead generation systems are used by Essex to collect information regarding construction activity from a variety of public records, including building permits. This information is then electronically sorted and filtered, using management input to focus on jobs that most likely will require a large piece of equipment we offer. This output is sent directly to the sales team who is responsible for the geographic area in which the project will be built. Essex’s management believes that these methods provide a high degree of market visibility and awareness to the sales team and management. Additionally, Customer Relationship Management (“CRM”) systems are used to track and manage customer interaction. Essex operates a customized rental information management system through which detailed operational and financial information is available on a real time basis. The system is also used to maintain a detailed database of quoting activity for projects on which our equipment will be required. Management and sales personnel use this information to closely monitor business activity by piece of equipment, looking at customer trends and proactively responding to changes in the heavy lift marketplace. Management believes that its disciplined fleet management process, with its focus on project duration and lead time, as well as customer demand, enables the Company to maximize utilization and rental rates. Customers and end markets We serve a variety of customers throughout North America, many of which are large engineering and construction firms focused on large infrastructure and infrastructure-related projects that require significant lifting capacity and high mechanical reliability. For the year ended December 31, 2011, Essex generated approximately 21%, 17%, 17%, 15% and 10% of total revenue from the transportation, industrial/marine, general building, power generation, and sewer and water end markets, respectively. Because of the scale and duration of these projects, rental agreement periods for equipment with heavier lifting capacities range from 4-18 months. This provides us with better future revenue visibility and project lead generation times than many of our competitors. Our revenue generation model has been significantly expanded to lower lifting capacity cranes and other construction equipment that is commonly rented for shorter periods of time and generally serve residential and smaller commercial construction projects. We generated approximately $4.9 million and $0.5 million of our total revenue from foreign countries for the years ended December 31, 2011 and 2010. 8 Our end-markets incorporate construction and repair and maintenance projects in the following key sub-sectors: ·industrial /marine – offshore facilities, marine facilities and other industrial facilities; ·power – power plants, cogeneration power and wind power; ·transportation and infrastructure – airports, port facilities, bridges, roads, levees and canals; ·petrochemicals – offshore platforms, refineries, petrochemical plants and pipelines; ·sewer and water – sewers, treatment plants and pumping plants; and ·general building - sports arenas, hospitals, commercial and residential. Many of the market sectors we serve have been adversely affected by the weakening economy and difficult commercial credit environment. Management believes that, in the long-term, our strong niche market position and improvements in our fleet due to investment in new cranes combined with the diversification in our overall fleet of rental equipment and the addition of new lines of business, such as retail equipment and spare parts sales achieved by the Coast Acquisition will provide opportunities for future growth. Management bases such belief on the assumption that, in the long-term, there will be improvements in our customers’ ability to obtain financing, including credit, for infrastructure projects. We cannot assure you that our customers’ access to financing for infrastructure projects, including credit, will improve. Results for the years 2009 through 2011 were significantly lower than historical results and were negatively impacted by uncertainty in the end markets in which our customers operate caused by declining economic conditions and available credit. Utilization rates and average rental rates have declined during the same period and are also well below historical levels. As of December 31, 2011, Essex Rental’s estimated 12 month backlog stood at approximately $20.5 million. Strategy Our management anticipates that the following longer-term market trends will increase demand for cranes, attachments and other construction equipment in the future and over longer periods: ·increased levels of infrastructure spending, including the construction of major bridges, airports and water treatment facilities; ·increased demand for electric power will require construction of additional power plants, potentially including nuclear power plants; ·continued higher energy costs will increase construction activity to improve and expand efficiencies and capacities at refineries, offshore production suppliers, and petrochemical facilities; ·increased environmental awareness will increase demand for construction of alternative energy sources such as wind and solar power, and clean air requirements including SO2 scrubbers and ash precipitators; ·continued tendency for contractors to rent lattice boom crawler cranes, rough terrain cranes, tower cranes and boom trucks rather than own their own equipment; and ·modular construction methods, including pre-fabrication, which generally require greater use of cranes, will continue to increase because of potential cost savings and site efficiencies. Increase market share and pursue profitable growth opportunities. Through our fleet size, geographically dispersed service centers and storage yards, which allow us to provide equipment for projects throughout the United States and, to a lesser extent, Canada, Mexico, Guam and the South Pacific and track record of customer service, we intend to take advantage of these trends in order to maximize the opportunities for profitable growth within the North American “bare” crane rental and construction equipment rental market by: ·optimizing fleet allocation across geographic regions, customers and end-markets to maximize utilization and rental rates; ·focusing on superior customer service and providing a superior fleet of cranes and attachments as compared to our competitors; ·leveraging our leading fleet size and composition across the country to increase our customer base and share of its existing customer base’s spending in the sector; 9 ·expanding our rental products by offering other crane types that can be rented “bare”; ·increase our opportunities to engage with customers through distribution sales of new and used cranes and parts and service; ·continuing to align incentives for local sales people and managers with both profit and growth targets; ·pursuing additional selected acquisitions of other smaller, more regionally focused crane rental fleets or companies complementary to existing operations; ·expanding used equipment sales by positioning used cranes for refurbishment and re-sale; and ·establishing and maintaining existing relationships with international market players and crane manufacturers for future equipment purchase and sale opportunities. Further drive profitability, cash flow and return on capital. Our management believes there are significant opportunities to further increase the profitability of our operations by: ·continuing to re-position the crawler crane fleet by selling older, lighter tonnage cranes and purchasing newer, heavier lifting capacity cranes that command higher margins and are in greater demand due to their ability to service large infrastructure-related projects; ·actively managing the quality, reliability and availability of our fleet and offering superior customer service in order to support a competitive pricing strategy; ·evaluating each new potential rental contract opportunity based on strict return guidelines, effective assessment of risk and allocating our fleet accordingly; ·using our size and national market presence to achieve economies of scale in capital investment; and ·leveraging our extensive customer relationships at Essex Crane and Coast Crane to aid in the rental of equipment and selling of new and used equipment. Competition The heavy lift equipment rental industry is highly fragmented throughout North America, with a variety of smaller companies, many of which are family-owned, operating on a regional or local scale. Companies that have a national focus generally provide heavy lift rental services across a spectrum of crane types such as all-terrain, truck and tower cranes as well as crawlers. With a fleet of over 1,000 cranes and other construction equipment and unparalleled customer service and support, Essex supplies a wide variety of innovative lifting solutions for construction projects related to power generation, petro-chemical, refineries, water treatment and purification, bridges, highways, hospitals, shipbuilding, offshore oil fabrication and industrial plants, and commercial and residential construction. Our fleet of equipment is one of the largest fleets in North America, which allows for economies of scale advantages with regard to purchasing power and allocation of rental equipment resources to the market. At the same time, our operational structure allows our Essex Crane and Coast Crane subsidiaries to focus on specific crane types (lattice-boom crawler cranes in the case of Essex Crane and heavy lift tower and rough terrain cranes in the case of Coast Crane), which allows them to develop greater expertise in comparison to our competitors. Our principal competitors include ALL Erection & Crane Rental, Bigge Crane and Rigging, Co., Lampson International, Maxim Crane Works, M.D., Morrow Equipment Rental, Western Pacific Crane and Equipment, and AmQuip Crane Corp. Some of these competitors operate nationally and others are regional. We believe that there are six key factors differentiating us from our competitors: ·heavy lifting equipment focus – We are primarily focused on heavy lift mobile and tower cranes dedicated to infrastructure and other large construction projects. Other companies also focus on other crane types with lower lift capacities and smaller types of construction rental equipment. Although the Company acquired some smaller types of construction rental equipment (such as personnel carriers and other lift equipment) in conjunction with the acquisition of Coast Crane’s assets, these smaller types of construction rental equipment account for approximately 3% of the total fleet value; 10 ·national capabilities – some competitors offer national service capabilities, however most are regional players. Our management believes that a national presence provides the ability to fully service engineering and construction firms with a similar national footprint; ·“bare” rental – we do not rent our equipment with an operator. While some other rental companies also rent equipment bare, generally equipment is rented with an operator. Renting equipment on a bare rental basis minimizes liability for the Company, provides a more efficient operating platform and business model; ·our distribution business at Coast Crane provides the opportunity to provide product support for contractor owned cranes, which may lead to the opportunity to either sell or rent them additional cranes in the future; ·outsourced transport – unlike many of our competitors, we do not operate an in-house transport department. In management’s view, this allows us to focus on core competencies and removes the need for capital investment in truck fleets and associated infrastructure; and ·publicly traded company listed on the NASDAQ Capital Market with access to public capital to fund our growth. Competition in the heavy lift equipment rental segment is strong and is defined by equipment availability, reliability, service and price. Our management believes that our extensive crane and attachment fleet, national presence and sales force, client relationships and equipment allocation and management systems provide us with a good scale and competitive positioning within the industry relative to our peers. Risk of Loss and Insurance The operation of lattice boom crawler cranes, tower cranes and rough terrain cranes includes risks such as mechanical and structural failures, physical damage, property damage, operator overload or error, equipment loss, or business interruptions. We primarily rent our cranes and attachments on a “bare” lease and rarely supply the operator and seldom perform the routine scheduled maintenance on the equipment during the rental. We require the lessee to supply a primary insurance policy covering the loss of the equipment and general liability for claims initiated by an accident, storm, fire or theft for rental agreements while the equipment is in the customer’s possession, custody and control. We also require that Essex be named as an additional insured and the loss payee on the lessee’s insurance policy. Our lease agreement also requires the lessee to indemnify us for any injury, damage and business interruption caused by the crane or the attachment while it is being leased. We maintain secondary insurance coverage for any claim not covered by the lessee’s insurance, however, we cannot guarantee that our insurance or the insurance of our customers will cover all claims or risks or that any specific claim will be paid by an insurer. Government Regulation Federal, state and local authorities subject our facilities and operations to requirements relating to environmental protection, occupational safety and health and many other subjects. These requirements, which can be expected to change and expand in the future, impose significant capital and operating costs on our business. The environmental laws and regulations govern, among other things, the discharge of substances into the air, water and land, the handling, storage, use and disposal of hazardous materials and wastes and the cleanup of properties affected by pollutants. Environmental laws also impose obligations and liability for the investigation and cleanup of properties affected by hazardous substance spills or releases. We can be subject to liability for the disposal of substances which we generate and for substances disposed of on property which we own or operate, even if such disposal occurred before our ownership or occupancy. Accordingly, we may become liable, either contractually or by operation of law, for investigation, remediation and monitoring costs even if the contaminated property is not presently owned or operated by us, or if the contamination was caused by third parties during or prior to our ownership or operation of the property. In addition, because environmental laws frequently impose joint and several liability on all responsible parties, we may be held liable for more than our proportionate share of environmental investigation and cleanup costs. Contamination and exposure to hazardous substances can also result in claims for damages, including personal injury, property damage, and natural resources damage claims. Some of our properties contain, or previously contained, above-ground or underground storage tanks and/or oil-water separators. Given the nature of our operations (which involve the use and disposal of petroleum products, solvents and other hazardous substances for fueling and maintaining our cranes, attachments, equipment and vehicles) and the historical operations at some of our properties, we may incur material costs associated with soil or groundwater contamination. Under environmental and safety laws, we may be liable for, among other things, (i) the costs of investigating and remediating contamination at our sites as well as sites to which we sent hazardous wastes for disposal or treatment regardless of fault and (ii) fines and penalties for non-compliance. We incur ongoing expenses associated with the performance of appropriate investigation and remediation activities at certain of our locations. 11 Our operations are also subject to federal, state and local laws and regulations pertaining to occupational safety and health, most notably standards promulgated by OSHA. We are subject to various OSHA regulations that primarily deal with maintaining a safe work-place environment. OSHA regulations require us, among other things, to maintain documentation of work-related injuries, illnesses and fatalities and files for recordable events, complete workers compensation loss reports and review the status of outstanding worker compensation claims, and complete certain annual filings and postings. We may be involved from time to time in administrative and judicial proceedings and investigation with these governmental agencies, including inspections and audits by the applicable agencies related to our compliance with these requirements. During 2011 and 2010, we did not incur material expenses related to environmental investigations or remediation activities, and management does not expect to incur such expenses in the near term. There can be no assurance, however, that we will not incur such expenditures in the future. Climate Change To the extent that climate change does occur, we may experience extreme weather and changes in precipitation and temperature, all of which may result in physical damage or a decrease in demand for rental equipment located in or potentially rented in these areas affected by these conditions. Should the impact of climate change be material in nature, including destruction of our rental equipment assets or property, plant and equipment, or occur for lengthy periods of time, our financial condition or results of operations may be adversely affected. In addition, developments in federal and state legislation and regulation on climate change could result in increased capital expenditures to improve the energy efficiency of our rental equipment without a corresponding increase in revenue. Customers Our customer base is highly diversified and ranges from Fortune 500 companies to small businesses. Our largest customer accounted for less than 10% of our revenues in 2011 and our top 5 customers accounted for less than 12% of our revenues in 2011. Historically, Essex Crane has typically retained over 40% of our customer base year-over-year while adding new customers as we attempt to grow the business. Our customer base varies by branch and is determined by several factors, including the equipment mix and marketing focus of the particular branch as well as the business composition of the local economy. Our customers include: •construction companies that use equipment for constructing and renovating commercial buildings, warehouses, industrial and manufacturing plants, office parks, airports, residential developments and other facilities; •industrial companies—such as manufacturers, refineries, chemical companies, paper mills, railroads, ship builders, off-shore fabricators and utilities, including wind farms - that use equipment for plant maintenance, upgrades, expansion and construction; •municipalities that require equipment for a variety of purposes; and •contractors performing repair and maintenance to major renovation projects for owners of commercial and industrial facilities, such as power companies. Suppliers Our strategic approach with respect to our suppliers is to maintain the minimum number of suppliers per category of equipment that can satisfy our anticipated volume, location and business requirements. This approach is designed to ensure the terms we negotiate are competitive and that there is sufficient product available to meet anticipated customer demand. We utilize a comprehensive selection process to determine our equipment vendors. We consider product capabilities and industry position, product liability history and financial strength. We have been making ongoing efforts to consolidate our vendor base in order to further increase our purchasing power. We estimate that our largest supplier accounted for approximately 13.7% of our 2011 total purchases, including equipment for rental, and that our 2 largest suppliers accounted for approximately 23.9% of such purchases. We believe we have sufficient alternative sources of supply available for each of our equipment categories. 12 Seasonality Although our business is not significantly impacted by seasonality, the demand for our rental equipment tends to be lower during the winter months. The level of equipment rental activities are directly related to commercial, residential and industrial construction and maintenance activities. Therefore, equipment rental performance will be correlated to the levels of current construction activities in the United States and Western Canada. The severity of weather conditions can have a temporary impact on the level of construction activities. Equipment sales cycles are subject to some seasonality with the peak selling period during the spring season and extending through summer. Parts and service activities are less affected by changes in demand caused by seasonality. Employees As of December 31, 2011, we had 273 employees, 8 of which are senior management. Six members of our staff are affiliated with trade unions. We have not experienced any work stoppage as a result of issues with labor or with unions and believe that this fact is a testament to our relationship with our employees. To our knowledge, there is no current campaign by any union to organize additional employees of Essex. Availability of Information The Company is subject to the informational requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). The Company therefore files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). Such reports may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, D.C. 20549, or by calling the SEC at (800) SEC-0330. In addition, the SEC maintains an internet site at http://www.sec.gov that contains reports, proxy and information statements and other information. Financial and other information can also be accessed on the Investor Relations section of the Company’s website at http://www.essexrental.com. The Company makes available through its website, free of charge, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC. Also posted on Essex’s website are the Company’s corporate governance documents, the charters of the Audit Committee, Nominating Committee and Compensation Committee. The reference to our website is textual in reference only, and information on the Company’s website is not incorporated into this Form 10-K or the Company’s other securities filings and is not a part of them. Item 1A. Risk Factors Our business may be adversely affected by changing economic conditions beyond our control, including decreases in construction or industrial activities. The crane and equipment rental, and distribution industry’s revenue is closely tied to conditions in the end markets in which our customers operate and more broadly to general economic conditions. Our products are used primarily in infrastructure-related projects and other construction projects in a variety of industries (including the power, transportation infrastructure, petrochemical, municipal construction and industrial and marine industries). Consequently, the economic downturn, and particularly the weakness in our end markets may lead to a significant decrease in demand for our equipment or depress equipment rental and utilization rates and the sales prices for equipment we sell. During periods of expansion in our respective end markets, we generally have benefited from increased demand for our products. Conversely, during recessionary periods in our end markets, we have been adversely affected by reduced demand for our products. Weakness in our end markets, such as a decline in non-residential construction, infrastructure projects or industrial activity, may in the future lead to a decrease in the demand for our equipment or the rental rates or prices we can charge. Factors that may cause weakness in our end markets include but are not limited to: ·slowdowns in construction in the geographic regions in which we operate; ·reductions in residential and commercial building construction; ·reductions in corporate spending for plants, factories and other facilities; and 13 ·reductions in government spending on highways and other infrastructure projects. Future declines in construction, infrastructure projects and industrial activity could adversely affect our operating results by decreasing revenues and profit margins. Continued weakness or further deterioration in the construction and industrial sectors caused by these or other factors could have a material adverse effect on our financial position, results of operations and cash flows in the future and may also have a material adverse effect on residual values realized on the disposition of our rental fleet. Declines in our order backlog should be considered as an indication of a decline in the strength of the non-residential construction markets. Fluctuations in the stock market, as well as general economic and market conditions, may impact the market price of our securities. The market price of our securities has been and may be subject to significant fluctuations in response to general economic changes and other factors including, but not limited to: ·variations in our quarterly operating results or results that vary from investor expectations; ·changes in the strategy and actions taken by our competitors, including pricing changes; ·securities analysts’ elections to not cover our common stock, or, if analysts do elect to cover our common stock, changes in financial estimates by analysts, or a downgrade of our common stock or of our sector by analysts; ·announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; ·loss of a large supplier; ·investor perceptions of us and the equipment rental and distribution industry; ·our ability to successfully integrate acquisitions and consolidations; and ·national or regional catastrophes or circumstances and natural disasters, hostilities and acts of terrorism. Broad market and industry factors may materially reduce the market price of our securities, regardless of our operating performance. In addition, the stock market in recent years has experienced price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of companies. These fluctuations, as well as general economic and market conditions, including to those listed above and others, may affect the market price of our securities. 14 We are dependent upon key personnel whose loss may adversely impact our business and our results of operations. We depend on the expertise, experience and continued services of our senior management employees, especially Ronald Schad, our President and Chief Executive Officer, and Martin Kroll, our Chief Financial Officer and Senior Vice President, as well as senior management employees of our operating subsidiaries. Mr. Schad has acquired specialized knowledge and skills with respect to our and our subsidiaries’ operations and most decisions concerning our business are made or significantly influenced by him. The loss of any of the foregoing individuals or other senior management employees, without a proper succession plan, or an inability to attract or retain other key individuals, could materially adversely affect us. We seek to compensate and incentivize our key executives, as well as other employees, through competitive salaries and bonus plans, but there can be no assurance that these programs will allow us to retain key employees or hire new key employees. As a result, if Messrs. Schad, Kroll, or other senior executives of our operating subsidiaries were to leave, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successors obtain the necessary training and experience. In connection with the acquisition of Essex Crane, we entered into three-year employment agreements with each of Messrs. Schad, Kroll, Erwin and O’Rourke. Each such employment agreement will be renewed and extended automatically for successive one year periods, unless either party to the applicable employment agreement provides ninety (90) das advance notice that such extension will not take effect at the end of the then-applicable term. These contracts are scheduled to expire in October 2012, subject to the renewal provisions contained therein. As of the date of this filing, we have not entered into employment agreements with any other members of senior management. Our dependence on a small number of crane manufacturers poses a significant risk to our business and prospects. Essex Crane’s crane fleet has historically been comprised of only Manitowoc and Liebherr crawler cranes. Similarly, Coast Crane’s fleet of cranes available for rent has been comprised primarily of cranes provided by Manitowoc subsidiaries, including Potain, Grove and National. In addition, Coast Crane serves as a distributor of Broderson, JLG, Little Giant, Lull, Manitex, Mantis, Potain, Tadano and Terex lifting equipment. Coast Crane’s crane and equipment distribution business depends upon its exclusive dealer partnerships with leading crane and equipment manufacturing companies and many of such relationships can typically be terminated on short notice. Given Essex Crane’s reliance on two manufacturers for its entire fleet of crawler cranes and Coast Crane’s reliance on a limited number of manufacturers for a majority of its rental fleet and distribution activities, and limited alternative sources of cranes, if any of these manufacturers were unable to meet expected manufacturing timeframes due to, for example, natural disasters or labor strikes, we may experience a significant increase in lead times to acquire new equipment or may be unable to acquire such equipment at all. Any inability to acquire the model types or quantities of new equipment on a timely basis to replace older, less utilized equipment could adversely impact our future financial condition or results of operations. In addition, Essex Crane has developed strong relationships with Manitowoc and Liebherr and Coast Crane has developed strong relationships with its strategic partners. There can be no assurance that Essex Crane or Coast Crane will be able to maintain their relationships with these suppliers. Termination of Essex Crane’s or Coast Crane’s relationship with these suppliers could materially and adversely affect our business, financial condition or results of operations if such termination resulted in Essex Crane or Coast Crane being unable to obtain adequate rental and sales equipment from other sources in a timely manner or at all. The cost of new equipment we use in our rental fleet may increase, which may cause us to spend significantly more for replacement equipment, and in some cases we may not be able to procure equipment at all due to supplier constraints. Our business model is capital intensive and requires significant continual investment in new cranes and equipment to meet customer demand. As a result, our financial condition and results of operations may be significantly impacted by a material change in the pricing of new cranes and equipment that we acquire. Such changes may be driven by a number of factors which include, but are not limited to: ·steel prices – due to the high tensile steel component of the cranes, significant changes in the price of steel can materially change the cost of acquiring a crane; ·global demand – the market for crawler cranes is global and significant growth in overseas demand for cranes could materially increase the cost of new cranes regardless of U.S. economic conditions; 15 ·inflation – overall inflationary conditions in the U.S. may impact the operating costs of one of our key suppliers and therefore impact crane or other lifting equipment for customers such as Essex Crane and Coast Crane; and ·currency fluctuations – as two of our principal suppliers are based in Europe and Japan, devaluation of the U.S. dollar (as compared to the Euro or the Yen) may materially increase the cost of acquiring cranes and attachments; conversely, inflation of the value of the U.S. dollar may adversely affect our revenues from international sales of used cranes and attachments and adversely affect our revenues from sales of new and used cranes, spare parts and related equipment to the extent that inflation allows foreign suppliers to offer competing products on more attractive terms. While we can manage the size and aging of our fleet generally over time, eventually we must replace older equipment in our fleet with newer models. We would be adversely impacted if we were unable to procure cranes to allow us to replace our older and, in the case of Essex Crane, smaller capacity crawler cranes over time as anticipated. If we are unable to obtain additional capital as required, we may be unable to fund the capital outlays required for the success of our business, including those relating to purchasing equipment and to acquiring new rental locations. Although we intend to market each of Essex Crane and Coast Crane under separate trade names for the foreseeable future, our ability to compete, sustain our growth and expand our operations through new locations largely depends on access to capital. If the cash we generate from the operations of Essex Crane and Coast Crane, together with cash on hand and cash that we may borrow under their respective credit facilities, or short-term debt obtained by either Essex, Essex Finance or Coast Crane is not sufficient to implement our growth strategy and meet our capital needs, we will require additional financing. However, we may not succeed in obtaining additional financing on terms that are satisfactory to us or at all. In addition, our ability to obtain additional financing collateralized by the assets of Essex Crane and Coast Crane and our ability to obtain additional financing on a secured or unsecured basis are restricted by Essex Crane’s and Coast Crane’s respective credit facilities. If we are unable to obtain sufficient additional capital in the future, we may be unable to fund the capital outlays required for the success of our business, including those relating to purchasing crane attachments and other lifting equipment and to new service locations or storage yards. Furthermore, any additional indebtedness that we do incur may make us more vulnerable to economic downturns and may limit our ability to withstand competitive pressures. If we are successful in our efforts to expand our operations, through new locations, acquisitions or additional equipment, such expansion may result in risks and costs associated with business start-up and integration. The opening of new service locations or storage yards or the completion of any future acquisitions of other equipment rental companies may result in significant start-up or transaction expenses and risks associated with entering new markets in which we have limited or no experience. New service locations and storage yards require significant up-front capital expenditures and may require a significant investment of our management’s time to successfully commence operations. New locations may also require a significant amount of time to provide an adequate return on capital invested, if any. In addition, in the event that we were to acquire different types of cranes, attachments or other lifting equipment than those they currently rent, or different classes of rental equipment, there can be no assurance that our customers would choose to rent such items from us or would do so at such rates or on such terms, that would be acceptable to us. Our ability to realize the expected benefits from the Coast Crane acquisition or any future acquisitions of other equipment rental companies depends in large part on our ability to integrate and consolidate the new operations with our existing operations in a timely and effective manner and to otherwise implement our business plan for the combined business. In addition, we may fail or be unable to discover certain liabilities of any acquired business, including liabilities relating to noncompliance with environmental and occupational health and safety laws and regulations. Any significant diversion of management’s attention from our existing operations, the loss of key employees or customers of any acquired business, or any major difficulties encountered in opening new locations or integrating new operations, including, but not limited to those arising from inconsistencies in controls, procedures or company policies, could have an adverse effect on our business, financial condition or results of operations. 16 The equipment rental, distribution and repair service industries are competitive. The equipment rental and distribution industries are highly fragmented. The crane rental industry is served by companies who focus almost exclusively on crane and lifting equipment rental. We compete directly with regional, and local crane rental companies and a limited number of national crane rental companies (including ALL Erection & Crane, Lampson International, Morrow Equipment Rental, Amquip Crane Corp., Maxim Crane Works and Biggie Crane). There can be no assurance that we will not encounter increased competition from existing competitors or new market entrants (including a newly-formed competitor created by consolidating several existing regional competitors) that may be significantly larger and have greater financial and marketing resources. Our management believes that rental rates, fleet availability and size and quality are the primary competitive factors in the crane rental industry. Our management also believes that price, equipment mix and the quality and availability of post-sale repair and spare part services are the primary competitive factors in the crane distribution industry. From time to time, we or our competitors may attempt to compete aggressively by lowering rental rates or prices or offering more favorable rental or sale terms. Competitive pressures could adversely affect our revenues and operating results by decreasing our market share or depressing the rental rates or sale prices for our equipment. To the extent we lower rental rates or sale prices, offer different rental or sale terms or increase our fleet in order to retain or increase market share, our operating margins would be adversely impacted. Our status as a public company may be a competitive disadvantage. We are and will continue to be subject to the disclosure and reporting requirements of applicable U.S. securities laws and rules promulgated by The NASDAQ Stock Market. Many of our principal competitors are not subject to these disclosure and reporting requirements or the NASDAQ rules. As a result, we may be required to disclose certain information and expend funds on disclosure and financial and other controls that may put us at a competitive disadvantage to our principal competitors. We may encounter substantial competition in our efforts to expand our operations. An element of our growth strategy is to continue to expand by opening new service centers and equipment storage yards. The success of our growth strategy depends in part on identifying sites for new locations at attractive prices. Zoning restrictions may in the future prevent us from being able to open new service centers or storage yards at sites we have identified. We may also encounter substantial competition in our efforts to acquire other crane rental companies, which may limit the number of acquisition opportunities and lead to higher acquisition costs. The crane rental industry has inherent operational risks that may not be adequately covered by our insurance. We may not be adequately insured against all risks and there can be no assurance that our insurers will pay a particular claim. Even if our insurance coverage is adequate to cover our losses, we may not be able to timely obtain a replacement crane in the event of a loss. Furthermore, in the future, we may not be able to obtain adequate insurance coverage at reasonable rates for our fleet. Our insurance policies will also contain deductibles, limitations and exclusions which, although management believes are standard in the heavy lift crane rental industry, may nevertheless increase our costs. Moreover, certain accidents or other occurrences may result in intangible damages (such as damage to our reputation) for which insurance may not provide an adequate remedy. We may not be able to renew our insurance coverage on terms favorable to us that could lead to increased costs in the event of future claims. When our current insurance policies expire, we may be unable to renew such coverage upon terms acceptable to us, if at all. If we are able to renew our coverage we expect that the premium rates and deductibles may increase as a result of general rate increases for this type of insurance as well as our historical claims experience and that of our competitors in the industry. If we cannot obtain insurance coverage, it could adversely affect our business by increasing our costs with respect to any claims. Additionally, existing or future claims may exceed the level of our present insurance, and our insurance may not continue to be available on economically reasonable or desirable terms, if at all. 17 We may not be able to generate sufficient cash flows to meet our debt service obligations. Our ability to make payments on our indebtedness will depend on our ability to generate cash from future operations. As of December 31, 2011, Essex Crane has a revolving credit facility which provides for an aggregate borrowing capacity of $190.0 million, of which $157.8 million was outstanding, and Coast Crane has a revolving credit facility which provides for an aggregate borrowing capacity of $75.0 million, of which $64.3 million was outstanding. Each facility is secured by a first priority lien on all of the applicable borrower’s assets and, in the event of default; the lenders generally would be entitled to seize the collateral. We also have approximately $7.6 million of other term debt, $5.0 million of which is unsecured while the remaining amount is secured by specific equipment. In the event of a prolonged economic downturn, our business may not generate sufficient cash flow from operations or from other sources to enable it to repay its indebtedness and to fund its other liquidity needs, including capital expenditure requirements and may not be able to refinance any of its indebtedness on commercially reasonable terms, or at all. If we cannot service or refinance our indebtedness, we may have to take actions such as asset divestitures, seeking additional equity or reducing or delaying capital expenditures, any of which could have an adverse effect on our operations. Additionally, we may not be able to effect such actions, if necessary, on commercially reasonable terms, or at all. In the event we or any of our subsidiaries incur further debt obligations in relation to acquisitions, or for any other purpose, the exposure to the risks outlined above will increase accordingly. Decreases in the appraised value of our rental fleet and other assets securing our revolving credit facilities may result in an inability to meet our financial obligations. The amounts available for borrowing under our revolving credit facilities are determined based on the value of assets securing those obligations, including rental equipment, company vehicles, parts and equipment inventories and accounts receivables. The value of rental equipment and company vehicles are determined based on the opinion of an independent appraisal firm engaged by the respective financial institutions. A decline in the appraised value of these assets would directly impact our liquidity and as a result, we may not be able to meet our financial obligations. Our revolving credit facilities contain restrictive covenants that will limit our corporate activities. The revolving credit facilities of Essex Crane and Coast Crane impose operating and financial restrictions that will limit, among other things, their ability to: ·create additional liens on their assets; ·make investments and capital expenditures above a certain threshold; ·incur additional indebtedness; ·engage in mergers or acquisitions; ·pay dividends or redeem outstanding capital stock; ·sell any of their respective cranes or any other assets outside the ordinary course of business; and ·change their respective businesses. Essex Crane and Coast Crane will need to seek permission from their respective lenders in order for Essex Crane or Coast Crane, as applicable, to engage in some corporate actions. Essex Crane’s and Coast Crane’s lender’s interests may be different from those of Essex Crane or Coast Crane, and no assurance can be given that Essex Crane or Coast Crane will be able to obtain their lender’s permission when needed. This may prevent Essex Crane or Coast Crane from taking certain actions that are in their best interests. If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud and our stock price may be adversely affected. Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our operating results could be harmed. Any system of internal control over financial reporting, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. Therefore, we cannot assure you that in the future material weaknesses or significant deficiencies will not exist or otherwise be discovered. Any weaknesses or deficiencies could result in misstatements of our results of operations, restatements of our consolidated financial statements, a decline in our stock price and investor confidence, or other material effects on our business, reputation, results of operations, financial condition or liquidity. 18 We are subject to numerous environmental laws and regulations that may result in us incurring unanticipated liabilities, which could have an adverse effect on our operating performance. Federal, state and local authorities subject our facilities and operations to requirements relating to environmental protection. These requirements can be expected to change and expand in the future, and may impose significant capital and operating costs on our business. Environmental laws and regulations govern, among other things, the discharge of substances into the air, water and land, the handling, storage, use and disposal of hazardous materials and wastes and the cleanup of properties affected by pollutants. If the Company violates environmental laws or regulations, it may be required to implement corrective actions and could be subject to civil or criminal fines or penalties. There can be no assurance that the Company will not have to make significant capital expenditures in the future in order to remain in compliance with applicable laws and regulations or that the company will comply with applicable environmental laws at all times. Such violations or liability could have an adverse effect on our business, financial condition and results of operations. Environmental laws also impose obligations and liability for the investigation and cleanup of properties affected by hazardous substance spills or releases. The Company can be subject to liability for the disposal of substances which it generates and for substances disposed of on property which it owns or operates, even if such disposal occurred before its ownership or occupancy. Accordingly, the Company may become liable, either contractually or by operation of law, for investigation, remediation and monitoring costs even if the contaminated property is not presently owned or operated by the Company, or if the contamination was caused by third parties during or prior to the Company’s ownership or operation of the property. In addition, because environmental laws frequently impose joint and several liability on all responsible parties, the Company may be held liable for more than its proportionate share of environmental investigation and cleanup costs. Contamination and exposure to hazardous substances can also result in claims for damages, including personal injury, property damage, and natural resources damage claims. Some of the properties contain, or previously contained, above-ground or underground storage tanks and/or oil-water separators. Given the nature of the operations of the Company (which involve the use and disposal of petroleum products, solvents and other hazardous substances for fueling and maintaining its cranes, attachments and vehicles) and the historical operations at some of its properties, the Company may incur material costs associated with soil or groundwater contamination. Future events, such as changes in existing laws or policies or their enforcement, or the discovery of currently unknown contamination, may give rise to remediation liabilities or other claims that may be material. Environmental requirements may become stricter or be interpreted and applied more strictly in the future. In addition, the Company may be required to indemnify other parties for adverse environmental conditions that are now unknown to us. These future changes or interpretations, or the indemnification for such adverse environmental conditions, could result in environmental compliance or remediation costs not anticipated by us, which could have a material adverse effect on our business, financial condition or results of operations. We are subject to numerous occupational health and safety laws and regulations that may result in us incurring unanticipated liabilities, which could have an adverse effect on our operating performance. Our operations are subject to federal, state and local laws and regulations pertaining to occupational safety and health, most notably standards promulgated by the Occupational, Safety and Health Administration, or OSHA. We are subject to various OSHA regulations that primarily deal with maintaining a safe work-place environment. OSHA regulations require us, among other things, to maintain documentation of work-related injuries, illnesses and fatalities and files for recordable events, complete workers compensation loss reports and review the status of outstanding worker compensation claims, and complete certain annual filings and postings. We may be involved from time to time in administrative and judicial proceedings and investigation with these governmental agencies, including inspections and audits by the applicable agencies related to its compliance with these requirements. 19 To date, compliance by the Company with these and other applicable safety regulations has not had a material effect on our results of operations or financial condition. However, the failure of the Company to comply with these and other applicable requirements in the future could result in fines and penalties and require us to undertake certain remedial actions or be subject to a suspension of business, which, if significant, could materially adversely affect our business or results of operations. Moreover, the involvement by the Company in any audits and investigations or other proceedings could result in substantial financial cost to us and divert our management’s attention. Several recent highly-publicized accidents involving cranes (none of which involved cranes or attachments provided by the company) could result in more stringent enforcement of work-place safety regulations, especially with respect to companies which rent older cranes and attachments. Additionally, future events, such as changes in existing laws and regulations, new laws or regulations or the discovery of conditions not currently known to us, may give rise to additional compliance or remedial costs that could be material. Safety requirements may become stricter or be interpreted and applied more strictly in the future. These future changes or interpretations could have a material adverse effect on our business, financial condition or results of operations. There are a substantial number of shares of our common stock available for resale in the future that may cause a decrease in the market price of our common stock. We filed a registration statement under the Securities Act of 1933, as amended, with respect to the resale of 10,695,363 shares by the selling stockholders identified therein, which was declared effective on February 10, 2011. In accordance with applicable registration rights agreements, we are required to maintain the effectiveness of such registration statement until all of the shares registered for resale thereby have been sold or are otherwise eligible for trading in the open market. In addition, we have registered 1,575,000 shares previously issued or reserve for future issuance under our 2008 Long-Term Incentive Plan and anticipate filing a registration statement on Form S-8 with respect to up to 1,500,000 shares of common stock issuable pursuant to our 2011 Long-Term Incentive Plan. Accordingly, subject to the satisfaction of applicable vesting or exercise periods, common stock registered under such registration statements will be available for resale in the open market. The presence of these additional shares of commons stock eligible for trading in the public market may have an adverse effect on the market price or our common stock. The conversion of the Retained Interests and our outstanding warrants will result in immediate dilution of our existing stockholders and the book value of their common stock. In connection with our acquisition of Essex Crane, Holdings issued the Retained Interests to members of Essex Crane’s senior management. The Retained Interests may be exchanged for up to an aggregate of 632,911 shares of our common stock, subject to certain adjustments. In addition, on November 29, 2010, we issued 90,000 warrants to a group of related investors in a private transaction associated with the exercise of assumed debt into the unsecured promissory notes. Such warrants have an exercise price of $0.01 per share, subject to adjustment. The issuance of these shares and warrants resulted in dilution to our existing stockholders. We have also granted options to purchase an aggregate of 1,474,719 shares of our common stock pursuant to our equity compensation plans, and may grant additional options or common stock pursuant to such plans in the future. Upon the exchange of the Retained Interests, the exercise of such warrants or option, or the issuance of common stock pursuant to our equity compensation plans, the equity interest of our stockholders as a percentage of the total number of outstanding shares of common stock, and the net book value of the shares of our common stock will be significantly diluted. We may issue shares of our common stock and preferred stock to raise additional capital, including to complete a future business combination, which would reduce the equity interest of our stockholders. Our amended and restated certificate of incorporation authorizes the issuance of up to 40,000,000 shares of common stock, par value $.0001 per share, and 1,000,000 shares of preferred stock, par value $.0001 per share. We currently have 12,538,540 authorized but unissued shares of our common stock available for issuance (after appropriate reservation for the issuance of shares upon full exercise of our outstanding warrants, employee stock options and unit purchase options, and the number of shares issuable upon exchange of the Retained Interests) and all of the 1,000,000 shares of preferred stock available for issuance. Although we currently have no other commitments to issue any additional shares of our common or preferred stock, we may in the future determine to issue additional shares of our common or preferred stock to raise additional capital for a variety of purposes, including to complete a future acquisition. The issuance of additional shares of our common stock or preferred stock may significantly reduce the equity interest of stockholders and may adversely affect prevailing market prices for our common stock. Item 1B. Unresolved Staff Comments None. 20 Item 2. Properties Essex leases its corporate headquarters at 1110 Lake Cook Road, Suite 220, Buffalo Grove, Illinois 60089, which consists of 7,337 square feet of office space. Also, we currently own the following properties: ·A service center located at 2039 Fulton Springs Road, Alabaster, Shelby County, Alabama 35007. Land area totals 400,752 square feet and building area totals 28,575 feet. ·A satellite service center located at 14133 Weld County Road 9.5 Longmont, Weld County, Colorado 80504. The land area of the property totals 409,900 square feet and building area totals 16,000 square feet. ·A service center located at 5315 Causeway Boulevard Tampa, Hillsborough County, Florida 33619. Gross land area totals 204,732 square feet and building area totals 18,604 square feet. ·A service center located at 303 Peach Lane Arcola, Fort Bend County, Texas 77583. Gross land area totals 710,681 square feet and building area totals 36,342 square feet. In addition, we lease the following properties throughout the United States: ·A satellite service center comprising 33,500 square feet of outside storage space located at 6048 193rd Avenue SW, Rochester, WA 98579. ·A satellite service center comprising 74,476 square feet of outside storage space located at 1072 Harrisburg Pike, Carlisle, PA 17103. ·A service Center comprising 6,000 square feet of warehouse space and approximately three acres of outside storage space located at 15060 Ceres Avenue Fontana, CA 92335. ·A service center comprising 30,000 square feet of space located at 1601 N.E. Columbia Blvd., Portland, Oregon ; ·A service center comprising 10,000 square feet of space located at 4680 W. Capital Ave., West Sacramento, CA 95691; ·A storage yard comprising 53,260 square feet of space located at 4300 W. Capital Ave., West Sacramento, CA 95691; ·A service center comprising 18,500 square feet of space located at 19062 San Jose Ave., City of Industry, CA 91748; ·A service center comprising 14,935 square feet of space located at 14951 Catalina St., San Leandro, CA 94577; ·A service center comprising 9,450 square feet of space located at 6615 Rosedale Highway, Bakersfield, CA 93308; ·A service center comprising 16,232 square feet of space located at 8250 5th Avenue South, Seattle, WA 98108; ·A storage yard comprising 2,500 square feet of space located at 500 South Sullivan Avenue, Seattle, WA 98108; 21 ·A service center comprising 9,862 square feet of space located at 114 St. Paul Avenue, Tacoma, WA 98421; ·A service center comprising 10,050 square feet of space located at 3920 E. Boone Avenue, Spokane, WA 99202; ·A service center comprising 8,000 square feet of space located at 525 S Oregon Avenue, Pasco, WA 99301; ·A service center comprising 11,408 square feet of space located at 8900 King Street, Anchorage, AK 99515; ·A service center comprising 5,720 square feet of space located at 12570 Slaughterhouse Canyon Road, Lakeside, CA 92040; ·A service center comprising 4,000 square feet of space located at 422 East Emporia Street, Ontario, CA 91761; ·A service center comprising 8,500 square feet of space located at 91-505 Awakumoku Place, Kapolei, HI 96707; and ·A service center comprising 9,934 square feet of space located at 9538 195th Street, Surrey, BC V4N 4E5, Canada. Our growth strategy includes the establishment of service and storage centers across the United States, with a particular emphasis on new facilities in areas of the United States which our management from time to time believes present growth opportunities for our business. Our management currently believes that growth opportunities exist in the Northeast and Mid-Atlantic regions and intends to investigate potential additional facilities in those regions. We have not identified specific locations for any such new facilities. We also maintain shared offices at 500 Fifth Avenue, 50th Floor, New York, New York 10110 pursuant to an agreement with ProChannel Management LLC, an affiliate of Laurence S. Levy, Chairman of our Board of Directors. Such office is primarily used by our corporate Secretary, Carol Zelinski, and Laurence S. Levy and Edward Levy, each of whom serves on our Board of Directors. We consider our current facilities adequate for our current operations. Item 3. Legal Proceedings From time to time, the Company is party to various legal actions in the normal course of our business. Management believes that the Company is not party to any litigation that, if adversely determined, would have a material adverse effect on our business, financial condition, result of operations or cash flows. Item 4. MINE SAFETY DISCLOSURES Not applicable. 22 PART II Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market Information Effective January 13, 2010, our common stock commenced trading, and is currently traded, on the NASDAQ Capital Market under the symbol ESSX. Effective January 13, 2010 until the expiration of our publicly traded warrants, our units and publicly traded warrants were traded on the NASDAQ Capital Market under the symbols ESSXU and ESSXW, respectively. On March 4, 2011 our publicly traded warrants expired and our warrants and units ceased trading. The following table sets forth the high and low sale prices for the units, common stock and warrants for each quarterly period within the two most recent fiscal years. Units Common Stock Warrants High Low High Low High Low Year ended December 31, 2011 First Quarter (1) $n/a $n/a $7.46 $5.40 $2.33 $0.45 Second Quarter (2) n/a n/a 7.53 6.50 n/a n/a Third Quarter n/a n/a 6.74 2.46 n/a n/a Fourth Quarter n/a n/a 3.38 2.05 n/a n/a Year ended December 31, 2010 First Quarter $8.00 $5.96 $7.25 $5.00 $1.85 $0.70 Second Quarter 7.01 5.95 7.65 5.44 2.95 1.45 Third Quarter (3) n/a n/a 6.00 4.19 1.85 0.04 Fourth Quarter 5.41 5.41 5.71 4.35 0.53 0.10 (1)Note that for the first quarter of 2011 there were no reported trades in our units and, therefore, the high and low are not applicable (2)Note that our warrants expired on March 4, 2011 and, therefore, there were no warrant or unit trades subsequent to this date. The high and low are not applicable. (3)Note that for the third quarter of 2010 there were no reported trades in our units and, therefore, the high and low are not applicable. As of March 1, 2012, there were 144 holders of record of our common stock, one holder of record of warrants and one holder of record of our Units. Dividend Policy We have not paid any cash dividends on our common stock to date and do not intend to pay cash dividends in the near future. The payment of cash dividends in the future will be contingent upon our revenues, earnings, if any, capital requirements and general financial condition. In addition, we are a holding company and conduct all of our operations through Essex Crane and Coast Crane. As a result, we rely on dividends and distributions to us from our subsidiaries, Essex Crane, Coast Crane and Holdings. Essex Crane’s and Coast Crane’s existing credit facilities limit Essex Crane’s, Coast Crane’s and Holdings’ ability to declare and pay dividends or make distributions on account of their capital stock and membership interests, and any debt instruments that the Company or its subsidiaries may enter into in the future may limit our subsidiaries’ ability to pay dividends to us and our ability to pay dividends to our stockholders. Payment of dividends is within the discretion of our board of directors. It is the present intention of our board of directors to retain all earnings for liquidity management (through debt reduction), dilution management (through continued warrant and common stock repurchases), to invest in additional rental equipment and use in business operations. Accordingly, our board of directors does not anticipate declaring any dividends in the foreseeable future on our common stock. 23 Recent Sales of Unregistered Securities and Use of Proceeds There were no sales of equity securities by the Company during the fourth quarter of 2011. Purchases of Equity Securities by the Issuer There were no purchases of equity securities by the Company during the fourth quarter of 2011. Equity Compensation Plans For information regarding equity compensation plans, see Item 12 of this annual report on Form 10-K. 24 Item 6.Selected Financial Data The following table sets forth selected consolidated financial data of the Company as of and for the years ended December 31, 2011, 2010, 2009, 2008 and 2007. The following table also sets forth selected consolidated financial data of the Predecessor as of and for the ten month period ended October 31, 2008 and as of and for the year ended December 31, 2007. The information in the following table should be read together with the Company’s consolidated financial statements and accompanying notes as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009, the Predecessor’s audited consolidated financial statements and accompanying notes as of and for the ten month period ended October 31, 2008 and for the year ended December 31, 2007 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under Item 7 of this report. These historical results are not necessarily indicative of the results to be expected in the future. Essex Holdings, LLC (Predecessor) For the Ten For the Essex Rental Corp. (Successor) Months Ended Year Ended For the Years Ended December 31, October 31, December 31, 2011 2010 2009 2008 2007 2008 2007 Operations Summary Total revenue $89,584,979 $41,531,460 $52,084,392 $14,872,789 $70,978,557 $78,122,079 Cost of revenues 76,487,741 35,403,917 32,900,942 7,055,992 29,545,082 38,757,886 Gross profit 13,097,238 6,127,543 19,183,450 7,816,797 41,433,475 39,364,193 Selling, general, administrative and other expenses 28,535,612 13,919,489 11,329,156 4,185,375 456,661 13,762,884 9,244,998 Goodwill impairment - - - 23,895,733 - Income (loss) from operations (16,776,752) (7,791,946) 7,854,294 (20,264,311) (456,661) 27,670,591 30,119,195 Interest and Other Income 316,492 72,278 643 1,405,637 2,543,781 - - Interest Expense (1) (11,455,390) (7,209,449) (6,681,740) (1,124,398) (8,190,438) (14,961,069) Income (loss ) before taxes (27,922,649) (14,931,588) 1,173,197 (19,983,072) 2,087,120 19,480,153 15,158,126 Net income (loss) $(17,146,900) $(11,408,486) $1,195,806 $(11,917,121) $1,699,120 $11,417,074 $11,216,856 Weighted average shares outstanding Basic 23,824,119 16,102,339 14,110,789 13,517,010 13,224,144 Diluted 23,824,119 16,102,339 15,805,191 13,517,010 13,224,144 Earnings (loss) per share Basic $(0.72) $(0.71) $0.08 $(0.88) $0.13 Diluted $(0.72) $(0.71) $0.08 $(0.88) $0.13 Other Operating Data Depreciation $21,146,477 $12,723,951 $11,210,472 $1,809,623 $- $6,908,980 $8,034,011 Other depreciation and amortization $1,338,378 $954,602 $781,751 $139,943 $- $110,019 $133,124 Year-end Financial Position Cash $9,030,383 $3,474,314 $199,508 $139,000 $1,051,801 $691,600 $8,394 Cash held in trust fund - - - - 100,927,634 - - Rental equipment, net 328,955,023 330,378,792 260,767,678 255,692,116 - 133,172,649 124,950,463 Total assets 380,900,229 383,046,958 286,463,157 289,998,510 102,569,184 169,397,016 149,081,546 Current liabilities 16,302,048 15,454,192 15,146,529 13,883,446 2,526,315 16,966,002 12,586,433 Short-term debt obligations 673,403 783,243 5,170,614 - - - - Other long-term debt obligations 6,886,600 7,921,531 - - - - - Revolving credit facilities 222,088,941 214,959,971 131,919,701 137,377,921 - 129,895,169 129,862,723 Total liabilities 296,931,221 304,736,667 212,325,126 217,952,753 2,526,315 160,690,875 151,989,341 Common stock, subject to conversion - - - 19,932,029 - - Paid in capital (Members' equity) 122,815,398 101,052,367 84,589,119 84,383,579 78,410,547 40,270,000 40,270,000 Total stockholders' equity $83,969,008 $78,310,291 $74,138,031 $72,045,757 $80,110,840 $(8,706,141) $(2,907,795) (1) Includes the impact of undesignated interest rate swaps. 25 Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion summarizes the financial position of Essex Rental Corp. and its subsidiaries as of December 31, 2011 and for the year then ended and should be read in conjunction with our consolidated financial statements and accompanying notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion contains, in addition to historical information, forward looking statements that include risks and uncertainties (see discussion of “Forward-Looking Statements” included elsewhere in this Annual Report on Form 10-K). Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those factors set forth under Item 1A—Risk Factors of this Annual Report on Form 10-K. Overview History Essex Rental Corp. (formerly, Hyde Park Acquisition Corp.) was incorporated in Delaware on August 21, 2006 as a blank check company whose objective was to effect a merger, capital stock exchange, asset acquisition or other similar business combination with an operating business. We consummated our initial public offering on March 13, 2007. All activity from August 21, 2006 (inception) through March 13, 2007 relates to our formation and initial public offering. From March 13, 2007 through October 31, 2008, our activities were limited to identifying prospective target businesses to acquire and complete a business combination. On October 31, 2008, we consummated the acquisition of Holdings and its wholly-owned subsidiary, Essex Crane, and, as a result, we are no longer in the development stage. In August 2009, we formed a new subsidiary, Essex Finance Corp., to facilitate the acquisition of rental equipment. In November 2010, we acquired substantially all of the assets of Coast Liquidating Co. (formerly known as Coast Crane Company) through a newly formed subsidiary CC Bidding Corp., which subsequently changed its name to Coast Crane Company. The assets acquired in the Coast Acquisition consisted of all of the assets used in the operation of Coast Liquidating Co.’s specialty lifting solutions and crane rental services business, including cranes and related heavy lifting machinery and equipment and spare parts, inventory, accounts receivable, rights under executory contracts, other tangible and intangible assets and all of the outstanding shares of capital stock of Coast Crane Ltd., a British Columbia corporation, through which Coast Liquidating Co. conducted its operations in Canada. For more information regarding our acquisition of Coast Crane Company, see Note 1 to our consolidated financial statements. Business Through our operating subsidiaries, Essex Crane and Coast Crane, we are one of North America's largest providers of lifting equipment (including lattice-boom crawler cranes, truck cranes and rough terrain cranes, tower cranes, and other lifting equipment) used in a wide array of construction projects. In addition, we provide product support including installation, maintenance, repair, and parts and services for our equipment provided to customers and customer owned equipment. With a fleet of over 1,000 cranes and other construction equipment and customer service and support, we supply a wide variety of innovative lifting solutions for construction projects related to power generation, petro-chemical, refineries, water treatment and purification, bridges, highways, hospitals, shipbuilding, offshore oil fabrication and industrial plants, and commercial and residential construction. We rent our equipment “bare,” meaning without supplying an operator and, in exchange for a fee, make arrangements for the transportation and delivery of equipment. Once the crane is delivered and erected on the customer’s site, inspected and determined to be operating properly by the customer’s crane operator and management, the majority of the maintenance and repair costs are the responsibility of the customer while the equipment is on rent. This business model allows us to minimize our headcount and operating costs including reduced liability related to operator error and provides the customer with a more flexible situation where they control the crane and the operator’s work schedule. Over the past several years, we have been focused on reinvesting capital into our rental fleet. Specifically, we have sold lower lifting capacity cranes for better utilized heavier lifting capacity cranes. During the years ended December 31, 2011, 2010, 2009, 2008 and 2007 the Company invested approximately $23.8 million, $2.7 million, $19.8 million, $20.8 million and $18.8 million, respectively into new cranes and attachments for our rental fleet. These investment decisions contributed greatly to the repositioning our fleet to maximize its utilization rates and average rental rates. Although we believe the repositioning of the fleet has maximized utilization rates and average rental rates, the economic downturn has significantly adversely impacted our business activity levels. 26 The following table provides a summary of utilization rates calculated using the “days” method for the years ended December 31, 2011 and 2010 for the equipment types owned during those periods. Years Ended December 31, 2011 2010 Crawler Cranes 39.8% 37.5% Rough Terrain Cranes 62.0% N/A Boomtrucks 54.0% N/A Self-Erecting Tower Cranes 24.4% N/A City and Other Tower Cranes 40.1% N/A Forklifts and Other Equipment 39.9% N/A Note: 2010 utilization rates for categories other than crawler cranes is not meaningful due to the timing of the Coast Acquisition in November 2010. Results of Operations Year ended December 31, 2011 compared to years ended December 31, 2010 and 2009 The Company had a net loss of $17.1 million for the year ended December 31, 2011. Total revenue, cost of revenues and gross profit were $89.6 million, $76.5 million and $13.1 million, respectively, for the year ended December 31, 2011. Selling, general, administrative and other expenses of $29.9 million was composed primarily of salaries, payroll taxes benefits, sales and marketing, insurance, professional fees, rent, travel, depreciation and amortization expenses. Interest expense related to borrowings under our revolving credit facilities and other debt obligations was $11.5 million for the year ended December 31, 2011. The Company had an income tax benefit of $10.8 million for the year ended December 31, 2011 related to loss before income taxes of $27.9 million. The Company had a net loss of $11.4 million for the year ended December 31, 2010. Total revenue, cost of revenues and gross profit were $41.5 million, $35.4 million and $6.1 million, respectively, for the year ended December 31, 2010. Selling, general, administrative and other expenses of $13.9 million was composed primarily of salaries, payroll taxes benefits, sales and marketing, insurance, professional fees, rent, travel, depreciation and amortization expenses. Interest expense related to borrowings under our revolving credit facilities and other debt obligations was $7.2 million for the year ended December 31, 2010. The Company had an income tax benefit of $3.5 million for the year ended December 31, 2010 related to loss before income taxes of $14.9 million. The Company had a net income of $1.2 million for the year ended December 31, 2009. Total revenue, cost of revenues and gross profit were $52.1 million, $32.9 million and $19.2 million, respectively, for the year ended December 31, 2009. Selling, general, administrative and other expenses of $11.3 million was composed primarily of salaries, payroll taxes benefits, sales and marketing, insurance, professional fees, rent, travel, depreciation and amortization expenses. Interest expense related to borrowings under Essex Crane’s revolving credit facility was $6.7 million for the year ended December 31, 2009. The Company had an income tax benefit of $23,000 for the year ended December 31, 2009 related to income before income taxes of $1.2 million. 27 Year Ended December 31, 2011 2010 2009 Revenues $89,584,979 $41,531,460 $52,084,392 Cost of revenues 76,487,741 35,403,917 32,900,942 Gross profit 13,097,238 6,127,543 19,183,450 Selling, general, administrative and other operating expenses 29,873,990 13,919,489 11,329,156 Income (loss) from operations (16,776,752) (7,791,946) 7,854,294 Other income (expense), net (11,145,897) (7,139,642) (6,681,097) Income (loss) before income taxes (27,922,649) (14,931,588) 1,173,197 Provision (benefit) for income taxes (10,775,749) (3,523,102) (22,609) Net income (loss) $(17,146,900) $(11,408,486) $1,195,806 Business Segments Historically, prior to the acquisition of our Coast Crane subsidiary in November 2010, the Company had only one operating segment. As a result of the acquisition of Coast Crane, the Company now provides services that it had not in the past, including equipment distribution and parts and service to third parties not renting the Company’s equipment. We have identified three reportable segments: equipment rentals, equipment distribution, and parts and service. These segments are based upon how management of the Company allocates resources and assesses performance. Information provided below for the year ended December 31, 2010 has been restated to reflect the reclassification of results of operations on a reportable segment basis as a result of the change in the structure of the internal organization in 2011 as a result of the acquisition of Coast Crane’s assets in November 2010. Year ended December 31, 2011 compared to year ended December 31, 2010 Revenues Revenue for the year ended December 31, 2011 was $89.6 million, a 115.7% increase compared to revenue of $41.5 million for the year ended December 31, 2010. The increase in total revenues primarily relates to revenues generated by our Coast Crane subsidiary acquired in November 2010. The following table provides a summary of the Company’s revenues by operating segment: Year Ended December 31, 2011 2010 Segment revenues Equipment rentals $58,859,497 $38,286,314 Equipment distribution 14,206,479 1,238,722 Parts and service 16,519,003 2,006,424 Total revenues $89,584,979 $41,531,460 28 Equipment rental segment revenues, which represents 65.7% of total revenues, was $58.9 million for the year ended December 31, 2011, a 53.7% increase from $38.3 million for the year ended December 31, 2010. The equipment rental segment includes rental, transportation, rental equipment repairs and used rental equipment sales. Rental revenue, which represented 46.8% of total revenues, was $42.0 million for the year ended December 31, 2011, a 67.5% increase from $25.0 million for the year ended December 31, 2010. This increase primarily relates to an increase in equipment rental revenue generated by our Coast Crane subsidiary acquired in November 2010 of $18.1 million, which offset a decline in equipment rental revenue of $1.2 million at our Essex Crane subsidiary. Transportation revenue also increased $0.6 million for year ended December 31, 2011 as compared to the comparable period in 2010. Utilization for crawler cranes, as measured on a “days” basis, increased to 39.8% for the year ended December 31, 2011 compared to 37.5% for the prior year. There was also a slight decrease in average crawler crane rental rate of 3.7% to $15,781 (per crane per rental month) for the year ended December 31, 2011 from $16,391 for the year ended December 31, 2010. Management does not expect a meaningful increase in average rental rates until utilization rates recover significantly. Used rental equipment sales revenue was $6.5 million for the year ended December 31, 2011; a $2.3 million or 53.3% increase compared to the year ended December 31, 2010. The increase was related to an increase in used rental equipment sales by our Coast Crane subsidiary acquired in November 2010 of $4.3 million. The Company has redeployed proceeds from used rental equipment sales to purchase new rental equipment assets to rebalance its fleet. During the year ended December 31, 2011, the Company sold fifty-nine pieces of used rental equipment. During both periods, the market provided opportunities to sell lower utilized units with lower rental rates that represented excess capacity. During the year ended December 31, 2011, the Company purchased sixty-seven pieces of rental equipment, comprised of thirty-one rough terrain cranes, three crawler cranes, eleven boom trucks, one scissor lift, eight elevator lifts, and thirteen trucks that will later be converted into boom trucks. Equipment distribution segment revenue, which represents 15.9% of total revenue was $14.2 million for the year ended December 31, 2011, a $13.0 million increase as compared to the year ended December 31, 2010, and relates to equipment distribution revenue earned by our Coast Crane subsidiary acquired in November 2010. We did not generate revenue in our equipment distribution segment prior to the Coast Acquisition. Parts and service segment revenue, which represents 18.4% of total revenue, was $16.5 million for the year ended December 31, 2011, a $14.5 million increase as compared to the year ended December 31, 2010, and relates to parts and service revenues from our Coast Crane subsidiary acquired in November 2010. We did not generate revenue in our parts and service segment prior to the Coast Acquisition. Gross Profit Gross Profit for the year ended December 31, 2011 was $13.1 million, a 113.7% increase from gross profit of $6.1 million for the year ended December 31, 2010. Gross profit margin was 14.6% and 14.8% for the years ended December 31, 2011 and 2010, respectively. The increase in gross profit relates primarily to gross profit earned by our Coast Crane subsidiary acquired in November 2010. The following table provides a summary of the Company’s gross profit by operating segment: Year Ended December 31, 2011 2010 2009 Segment gross profit Equipment rentals $8,470,103 $5,250,723 $19,183,450 Equipment distribution 1,607,733 170,019 - Parts and service 3,019,402 706,801 - Total gross profit $13,097,238 $6,127,543 $19,183,450 Equipment rentals segment gross profit of $8.5 million for the year ended December 31, 2011 increased $3.2 million or 61.3% as compared to the year ended December 31, 2010. This increase in equipment rentals gross profit was due to gross profit earned by our Coast Crane subsidiary acquired in November 2010. Gain on the sale of used rental equipment increased to $1.1 million (16.3% margin) for the year ended December 31, 2011 from $0.7 million (16.5% margin) for the year ended December 31, 2010. Equipment distribution segment gross profit for the year ended December 31, 2011 was $1.6 million, a $1.4 million increase as compared to the year ended December 31, 2010, and relates to equipment distribution gross profit earned by our Coast Crane subsidiary acquired in November 2010. We did not derive gross profit from our equipment distribution segment prior to the Coast Acquisition. Parts and service segment gross profit for the year ended December 31, 2011 was $3.0 million, a $2.3 million increase as compared to the year ended December 31, 2010, and relates to parts and service gross profit earned by our Coast Crane subsidiary acquired in November 2010. We did not derive gross profit from our parts and service segment prior to the Coast Acquisition. 29 Selling, General, Administrative and Other Expenses Total selling, general, administrative and other expenses for the year ended December 31, 2011 were $29.9 million, a $16.0 million or 114.6% increase from $13.9 million for the year ended December 31, 2010. The increase was related primarily to an increase in selling, general and administrative expenses incurred by our Coast Crane subsidiary acquired in November 2010 of $15.1 million. Selling, general and administrative expenses include, legal fees, professional fees, bad debt expense, employee benefits, insurance and selling and marketing expenses. In 2010, selling, general, and administrative expenses also included approximately $1.2 million of acquisition related expenses. Selling, general and administrative expenses include $2.0 million and $1.1 million of non-cash stock based compensation expense for the years ended December 31, 2011 and 2010, respectively. Year Ended December 31, 2011 2010 SELLING, GENERAL, ADMINISTRATIVE AND OTHER OPERATING EXPENSES Selling, general and administrative $28,535,612 $12,964,887 Other depreciation and amortization 1,338,378 954,602 Total selling, general, administrative and other operating expenses $29,873,990 $13,919,489 Interest expense increased 58.9% to $11.5 million for the year ended December 31, 2011 from $7.2 million for the year ended December 31, 2010. The increase in interest expense was related primarily to interest expense incurred on additional borrowings under existing facilities and new indebtedness incurred to finance the acquisition of Coast Crane’s assets in November 2010. Year Ended December 31, 2011 2010 OTHER INCOME (EXPENSES), NET Other income (expense) $316,492 $72,278 Interest expense (11,455,390) (7,209,449) Foreign exchange loss (6,999) (2,471) Total other income (expenses), net $(11,145,897) $(7,139,642) Income tax benefit was $10.8 million for the year ended December 31, 2011 compared to a $3.5 million benefit for the year ended December 31, 2010. The increase in income tax benefit is primarily due to an increase in the pre-tax loss. The effective tax rates were 38.6% and 23.6% for the years ended December 31, 2011 and 2010, respectively. The effective tax rate increased from the prior year due to an increase in state tax rates resulting primarily from changes in apportionment resulting from the Coast Acquisition. The Company’s effective tax rate for the year ended December 31, 2011 was higher than the statutory tax rate primarily due to state and local taxes. The Company’s effective tax rate for the year ended December 31, 2010 was lower than the statutory tax rate primarily due to state and local taxes. The lower effective tax rate in 2010 related to the tax expenses related to an increase in state deferred tax rates at Essex Crane as a result of the acquisition of Coast Crane and an additional state NOL valuation allowance, which were partially offset by the reduction in unrecognized benefit associated with the effective settlement of uncertain tax positions. The Essex Crane state deferred tax rates increased in 2010 due to an increase in apportionment into higher tax states which Coast Crane operates due to unitary filing requirements. Essex had 273 full-time employees as of December 31, 2011 compared to 276 full-time employees at December 31, 2010. 30 Year ended December 31, 2010 compared to year ended December 31, 2009 Prior to the acquisition of Coast Crane in November 2010, the Company had only one operating segment related to equipment rentals. The following information is presented using the single segment presentation used in prior years. Year Ended December 31, 2010 2009 Revenues $41,531,460 $52,084,392 Cost of revenues 35,403,917 32,900,942 Gross profit 6,127,543 19,183,450 Selling, general, administrative and other operating expenses 13,919,489 11,329,156 Income (loss) from operations (7,791,946) 7,854,294 Other income (expense), net (7,139,642) (6,681,097) Income (loss) before income taxes (14,931,588) 1,173,197 Provision (benefit) for income taxes (3,523,102) (22,609) Net income (loss) $(11,408,486) $1,195,806 For the year ended December 31, 2010, we had net loss of $11.4 million compared to a net income of $1.2 million for the year ended December 31, 2009. The $12.6 million decrease in net income was primarily due to a $10.6 million decrease in revenue, a $2.5 million increase in cost of revenues, an increase in selling, general, administrative and other operating expenses of $2.6 million partially as a result of $1.2 million of acquisition related transaction costs incurred in 2010, and $0.5 million higher interest expense primarily associated with the additional debt entered into and assumed in the Coast Crane acquisition. The decrease in gross profit, increase on selling, general and administrative costs and increase in interest expense were offset by an increase in the provision benefit for income taxes of $3.5 million. Year Ended December 31, 2010 2009 REVENUES Equipment rentals $25,049,779 $34,556,696 New equipment sales 1,238,722 - Used rental equipment sales 4,255,761 6,478,197 Retail part sales 1,184,042 - Transportation 4,766,328 4,909,346 Equipment repairs and maintenance 5,036,828 6,140,153 Total revenues $41,531,460 $52,084,392 Revenues for the year ended December 31, 2010 were $41.5 million, a 20.3% decrease compared to revenues of $52.1 million for the year ended December 31, 2009. Revenue was comprised of the following components: Equipment rentals revenues, which represented 60.3% of total revenues, was $25.0 million for the year ended December 31, 2010, a 27.5% decrease from $34.6 million for the year ended December 31, 2009. This decrease was first driven by a decrease in crane utilization to 37.5% under the “days” method (or 41.3% if calculated using the “hits” method) for the year ended December 31, 2010 from 43.6% under the “days” method (or 48.2% if calculated using the “hits” method) for the year ended December 31, 2009. The decrease in utilization was a result of excess market supply of rental equipment compared to the demand brought on by the weakened economy and a difficult commercial credit environment. Second, the Company also experienced the associated decrease in the average crawler crane rental rate of 22.2% to $16,391 (per crane per rental month) for the year ended December 31, 2010 relative to $21,081 for the year ended December 31, 2009. The decrease in the average rental rate is due to the expiration of rental agreements executed at higher rental rates in the prior years. 31 ·New equipment sales revenues, which represented 3.0% of total revenues, was $1.2 million for the year ended December 31, 2010 and relates to new equipment sales by our Coast Crane subsidiary acquired in November 2010. ·Used rental equipment sales revenues, which represented 10.2% of total revenues, were $4.3 million for the year ended December 31, 2010, a 34.3% decrease from $6.5 million for the year ended December 31, 2009. These used equipment sales have presented Essex Crane with opportunities to further enhance its combination of cranes and attachments by providing an additional cash flow source for purchasing additional new rental equipment. Five lower lifting capacity crawler cranes and attachments were sold for the year ended December 31, 2010 which was a decrease from thirteen for the year ended December 31, 2009. In both periods the market presented opportunities to sell a number of the lower utilization units which have lower rental rates, and Essex Crane reinvested the proceeds of such sales into a smaller number of larger cranes and attachments which yield higher utilization rates and higher relative rental rates on the capital costs and enable Essex Crane to improve the strategic position of its rental fleet for the future. The average lifting capacity of five cranes sold was 197 tons and 158 tons for the years ended December 31, 2010 and 2009, respectively, compared to 440 tons and 256 tons for cranes purchased during the same periods, respectively. Cranes sold during the year ended December 31, 2010 were sold at an average price in excess of 120% of Orderly Liquidation Value (“OLV”). OLV is determined for collateral measurement purposes by an independent appraiser on behalf of the lead lender for the Company’s asset based revolving credit facility; ·Retail part sales revenues, which represented 2.9% of total revenue, were $1.2 million for the year ended December 31, 2010 and relates to retail part sales from our Coast Crane subsidiary acquired in November 2010. ·Transportation revenues, which represented 11.5% of total revenues were $4.8 million for the year ended December 31, 2010, a 2.9% decrease from $4.9 million for the year ended December 31, 2009. This decrease is primarily a result of lower average crane rental utilization and was impacted by the combination of cranes and attachments rented and the specific distances that equipment had to move for various rentals; and ·Equipment repairs and maintenance revenues (including rigging and other services), which represented 12.1% of total revenue, were $5.0 million for the year ended December 31, 2010, an 18.0% decrease from $6.1 million for the year ended December 31, 2009. This decrease is attributed to a lower demand for repairs, maintenance and other services resulting from lower average crane rental utilization. Year Ended December 31, 2010 2009 COST OF REVENUES Salaries, payroll taxes and benefits $5,905,279 $6,006,715 Depreciation expense 12,723,951 11,210,472 Cost of new equipment sold 994,119 - Book value of equipment sold 3,551,891 5,584,784 Cost of retail parts sold 775,338 - Transportation 4,236,326 3,743,595 Equipment repairs and maintenance 5,833,945 4,873,005 Yard operating expenses 1,383,068 1,482,371 Total cost of revenues $35,403,917 $32,900,942 Cost of revenues for the year ended December 31, 2010 was $35.4 million, a 7.6% increase from $32.9 million for the year ended December 31, 2009. Cost of revenues was 85.2% of total revenue for the year ended December 31, 2010, relative to 63.3% for the year ended December 31, 2009. The increase in cost of revenues resulted primarily from the items described below. Salary, payroll tax and benefit expenses decreased 1.7% to $5.9 million for the year ended December 31, 2010 from $6.0 million for the year ended December 31, 2009. The decrease was a direct result of a 10% salary reduction on certain operations managers which was implemented midway through 2009, reduced hours, lower overtime, some headcount reduction and reduced bonus expense. These decreases in salary, payroll tax and benefit expenses were partially offset by $0.5 million of expenses incurred in the operations of Coast Crane during the post-acquisition period. 32 Depreciation expense related to rental equipment increased 13.5% to $12.7 million for the year ended December 31, 2010 compared to $11.2 million for the year ended December 31, 2009. $1.1 million of the increase in depreciation expense is related to the Coast Crane equipment acquired in November 2010. Cost of new equipment sold was $1.0 million for the year ended December 31, 2010 and relates to new equipment cost of sales by our Coast Crane subsidiary acquired in November 2010. Net book value of rental equipment sold decreased 36.4% to $3.6 million for the year ended December 31, 2010, from $5.6 million for the year ended December 31, 2009. The decrease in net book value of equipment sold was primarily from a decrease in the number of cranes sold. Cost of retail parts sold was $0.8 million for the year ended December 31, 2010 and relates to cost of retail parts sold by our Coast Crane subsidiary in the post-acquisition operations of 2010. Transportation expenses increased 13.2% to $4.2 million for the year ended December 31, 2010, from $3.7 million for the year ended December 31, 2009. Approximately $0.1 million of the increase was related to costs incurred from the post-acquisition operations of Coast Crane in 2010. The remaining difference in transportation expenses incurred is due to differences in the combination of cranes and attachments rented and the specific distances that equipment had to move for various rentals. Equipment repairs and maintenance expenses increased 19.7% to $5.8 million for the year ended December 31, 2010, from $4.9 million for the year ended December 31, 2009. Approximately $1.0 million of the increase was related to cost incurred from the post-acquisition operations of Coast Crane in 2010. Yard operating expense decreased by 6.7% to $1.4 million for the year ended December 31, 2010, from $1.5 million for the year ended December 31, 2009. The slight decrease was primarily related to lower average crane rental utilization. Essex Crane’s gain on the sale of used rental equipment was $0.7 million (16.5% margin, calculated by dividing the gain on the sale divided by the revenue from such sale) for the year ended December 31, 2010 compared to $0.9 million (13.8% margin) for the year ended December 31, 2009. The lower level of gains on sales was due to due to the lower level of used rental equipment sales in the current period. Year Ended December 31, 2010 2009 SELLING, GENERAL, ADMINISTRATIVE AND OTHER OPERATING EXPENSES Selling, general and administrative $12,964,887 $10,547,405 Non-rental depreciation and amortization 954,602 781,751 Total selling, general, administrative and other operating expenses $13,919,489 $11,329,156 Total Selling, general, administrative and other operating expenses for the year ended December 31, 2010 was $13.9 million, a $2.6 million or 22.7% increase from $11.3 million for the year ended December 31, 2009. Total selling, general, administrative and other expenses increased due to costs associated with the post-acquisition operations of Coast Crane, approximately $1.2 million of acquisition related transaction expenses incurred an 2010 and in increase in legal and professional fees. Other components of administrative expenses include: salaries, payroll taxes and benefits, insurance and selling and marketing expenses. Year Ended December 31, 2010 2009 OTHER INCOME (EXPENSES), NET Other income (expense) $72,278 $643 Interest expense (7,209,449) (6,681,740) Foreign exchange loss (2,471) - Total other income (expenses), net $(7,139,642) $(6,681,097) 33 Interest expense of $7.2 million for the year ended December 31, 2010 increased by $0.5 million or 7.9% from $6.7 million primarily due to an increase in the balance of debt outstanding as a result of the Coast Crane acquisition in November 2010. Income tax benefit was approximately $3.5 million for the year ended December 31, 2010, compared to a $23,000 tax benefit for the year ended December 31, 2009. The higher income tax benefit for the year ended December 31, 2010 is primarily due to a loss before income taxes of $14.9 million. The effective tax rates were 23.6% and (1.9%) for the year ended December 31, 2010 and 2009, respectively. The Company’s effective rate for the year ended December 31, 2010 was lower than the statutory tax rate primarily due to state and local taxes. The decrease in the effective tax rate related to the increase in state deferred tax rates at Essex Crane as a result of the acquisition of Coast Crane and an additional state NOL valuation allowance, which were partially offset by the reduction in unrecognized benefit associated with the effective settlement of uncertain tax positions. The Essex Crane state deferred tax rates increased due to an increase in apportionment into higher tax rate states which Coast Crane operates due to unitary filing requirements. The effective rate was lower than the statutory federal tax rate for the year ended December 31, 2009 due to 2008 tax return to provision differences, an increase in uncertain tax positions and state and local taxes including a change in estimate of $0.6 million associated with the Company’s state income tax apportionments and rates. Essex had 276 full-time employees as of December 31, 2010 compared to 111 full-time employees at December 31, 2009. The increase in the number of employees is due to the acquisition of Coast Crane in November 2010. Liquidity and Capital Resources The Company has typically had substantial liquidity from its operating cash flows despite the significant downturn in the construction industry. However, the Company’s significantly lower net cash flows from operations for the year ended December 31, 2011 are due primarily to a net loss of $17.1 million and a decrease in deferred taxes. Combined net cash flows provided by operating activities of the Company for all three years presented were approximately $10.7 million. As of December 31, 2011, the Company had total debt obligations outstanding of approximately $229.6 million and had an additional $39.3 million available on our revolving credit facilities. We believe that this availability for Essex Crane and Coast Crane along with $9.0 million in cash, will provide sufficient liquidity through October 2013 and November 2014, respectively. We believe that the sources of cash from operations and the revolving credit facility should adequately fund the investment needs of the business for the foreseeable future. Our Essex Crane subsidiary has a $100.0 million interest rate swap agreement in place that locks this portion of its debt based upon LIBOR of 2.71% plus 225 basis points. Our Coast Crane subsidiary has three interest rate swap agreements in place with an aggregate notional amount of $21.0 million that locks this portion of its debt based upon a fixed rate of 5.62%. The weighted average interest rate on all debt obligations outstanding as of December 31, 2011 including the impact of the interest rate swaps was 5.09% Cash Flow from Operating Activities The Company’s cash provided by operating activities for the year ended December 31, 2011 was $1.0 million. This was primarily the result of net loss of $17.1 million, which, when adjusted for non-cash expense items, such as depreciation and amortization of $23.2 million, amortization of promissory note discount of $0.1 million, gains on the sale of rental equipment of $1.1 million, deferred income taxes of $10.6 million, change in fair value of interest rate swap of $1.0 million and stock-based compensation expense of $2.0 million, provided negative cash flows of approximately $4.5 million. The cash flows from operating activities were increased by a $1.2 million decrease in accounts receivable, a $1.1 million decrease in prepaid expenses and other assets, a $4.2 million decrease in retail equipment inventory, a $0.5 million decrease in spare parts inventory and a $0.8 million increase in accounts payable and accrued expenses. These cash flow increases were partially offset by a $0.2 million decrease in unearned revenue and a $2.2 million reduction in customer deposits. The Company’s cash used in operating activities for the year ended December 31, 2010 was $5.4 million. This was primarily the result of net loss of $11.4 million, which, when adjusted for non-cash expense items, such as depreciation and amortization of $14.2 million, gains on the sale of rental equipment of $0.7 million, deferred income taxes of $1.6 million, change in fair value of interest rate swap of $0.2 million and stock-based compensation expense of $1.2 million, provided positive cash flows of approximately $1.5 million. The cash flows from operating activities were also decreased by a $8.5 million reduction in accounts payable and accrued expenses and a $1.0 increase in prepaid expenses and other assets, offset by a $1.4 million increase in unearned rental revenue, a $0.2 million decrease in retail equipment inventory, a $0.3 million decrease in receivables and a $0.6 million decrease in spare parts inventory. Much of the cash used by operating activities related to the change in accounts payable and accrued expenses is due to liabilities assumed by the Company in conjunction with the Coast Acquisition. 34 The Company’s cash provided by operating activities for the year ended December 31, 2009 was $15.1 million. This was primarily the result of net income of $1.2 million, which, when adjusted for non-cash expense items, such as depreciation and amortization of $12.5 million, gains on the sale of rental equipment of $0.9 million, deferred income taxes of $0.1 million and stock-based compensation expense of $0.6 million, provided positive cash flows of approximately $13.4 million. The cash flows from operating activities were also increased by a $5.9 million reduction in receivables and reduced by a $0.3 million increase in spare parts inventory, a $2.5 million decrease in accounts payable and accrued expenses and a $1.4 million decrease in unearned rental revenue. Cash Flow from Investing Activities For the year ended December 31, 2011, cash used in investing activities was approximately $19.7 million. This was primarily the result of purchases of rental equipment of $23.8 million (excluding the $1.0 million of equipment purchases made directly through short-term obligations), purchases of property and equipment of $1.3 million and $1.2 million as a result of an increase in accounts receivable from rental equipment sales. These investing activity uses of cash were partially offset by $6.5 million in proceeds received for the sale of rental equipment. For the year ended December 31, 2010, cash used in investing activities was approximately $28.7 million. This was primarily the result of net cash payments of $31.8 million for the purchase of Coast Crane, purchases of rental equipment of $0.2 million (excluding the $2.6 million of rental equipment purchases made directly through short-term obligations) and purchases of property and equipment of $1.0 million. These investing activity uses of cash were partially offset by $4.3 million in proceeds received for the sale of rental equipment. For the year ended December 31, 2009, cash used in investing activities was approximately $11.8 million. This was primarily the result of purchases of rental equipment of $17.2 million, purchases of property and equipment of $1.0 million and an increase in accounts receivables related to the sale of rental equipment of $0.1 million. These investing activity uses of cash were partially offset by $6.5 million in proceeds received for the sale of rental equipment. Cash flow from financing activities Cash provided by financing activities was approximately $24.3 million for the year ended December 31, 2011. This is primarily due to proceeds received from the exercise of warrants to acquire shares of common stock of $19.8 million and net proceeds received under debt obligations of $4.9 million. Total borrowings for the year under the revolving credit facilities were $100.3 million and total payments on the revolving credit facilities were $93.2 million. The Company also used approximately $2.3 million to make scheduled principal payments and repay in full a portion of its purchase money security interest debt using proceeds from drawing the on the revolving credit facilities discussed above. The Company also paid approximately $0.3 million for deferred loan costs related to the Coast Crane revolving credit facility during the year ended December 31, 2011. Cash provided by financing activities was approximately $37.4 million for the year ended December 31, 2010. This is primarily due to net proceeds from the issuance of common stock of $13.6 million, proceeds from the exercise of warrants of $2.4 million and a net increase in total debt obligations of $22.9 million. Total borrowings for the year under the short-term debt obligations and revolving credit facilities were $74.6 million and total payments on the revolving credit facilities were $43.9 million. The Company also used $0.9 million to repurchase warrants. The proceeds from the issuance of common stock and net borrowings for the year were primarily used to fund the Coast Acquisition. In conjunction with the Coast Acquisition, the Company also assumed total additional indebtedness of approximately $61.4 million. Cash used in financing activities was approximately $3.3 million for the year ended December 31, 2009. This is primarily due to a net decrease in total debt obligations of $2.9 million. Total borrowings for the year under the short-term debt obligations and revolving credit facility were $60.7 million and total payments on the revolving credit facility were $63.6 million. The Company also used $0.4 million to repurchase warrants. 35 Revolving Credit Facilities The following information discusses significant events during the years ended December 31, 2011 and 2010 that relate to Essex Crane’s revolving credit facility and the Coast Crane credit facility entered into in conjunction with the Coast Acquisition. Also see Note 7 to the consolidated financial statements for further information related to our credit facilities. Essex Crane Revolving Credit Facility In conjunction with the acquisition of Holdings on October 31, 2008, Essex Crane amended its asset-based senior secured revolving line of credit facility, which permits it to borrow up to $190.0 million. Essex Crane may borrow up to an amount equal to the sum of 85% of eligible net receivables and 75% of the net orderly liquidation value of eligible rental equipment. The revolving credit facility is scheduled to mature in October 2013 and is collateralized by a first lien security interest in substantially all of Essex Crane’s assets. The maximum amount that could be borrowed under the Essex Crane revolving credit facility, net of letters of credit, interest rate swaps and other reserves was approximately $187.8 million at December 31, 2011, which was limited by the eligible borrowing base. The Company’s available borrowing under the revolving credit facility was $30.0 million at December 31, 2011. As of December 31, 2011 and for the year then ended, the Company was in compliance with its covenants and other provisions of the revolving line of credit facility. Some of the financial covenants including a fixed charge coverage ratio and rental equipment utilization ratio do not become active unless the available borrowing falls below the $20.0 million threshold. The Company’s available borrowing base of approximately $30.0 million comfortably exceeded the threshold at December 31, 2011. Additionally, the Company had $3.6 million of collateral in excess of the $190.0 million limit as of December 31, 2011. Any failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on the Company’s liquidity and operations. Coast Crane Revolving Credit Facility In conjunction with the Coast Acquisition on November 24, 2010, our Coast Crane subsidiary entered into a secured revolving credit facility, which permits it to borrow up to $75.0 million. Coast Crane may borrow, repay and reborrow up to an amount equal to the sum of (a) 85% of eligible Coast accounts, (b) the lesser of 50% of eligible Coast inventory and $5 million, (c) the lesser of (i) 95% of the lesser of (x) the net orderly liquidation value and (y) the invoice cost of eligible new equipment inventory and (ii) $15.0 million and (d) 85% of the net orderly liquidation value of eligible other equipment, less reserves established by the lenders and the liquidity reserve. The revolving credit facility is scheduled to mature in November 2014 and is collateralized by a first security interest in substantially all of the Coast Crane’s assets. On November 14, 2011 the Coast Crane Revolving Credit Facility was amended to include Coast Crane Ltd. as a party to the credit facility. The amendment permits Coast Crane and Coast Crane to include its and Coast Crane Ltd.’s equipment, including equipment located in Canada, in the borrowing base calculation, which was previously prohibited. As amended, Coast Crane Ltd. is also permitted to borrow up to $10.0 million under the Coast Crane credit facility, subject to a borrowing base which is calculated as the sum of (a) 85% of eligible Coast Crane Ltd. accounts, (b) the lesser of 50% of eligible Coast Crane Ltd. inventory and $750,000, (c) the lesser of (i) 95% of the lesser of (x) the net orderly liquidation value and (y) the invoice cost, of eligible new Coast Crane Ltd. equipment and (ii) $2,000,000 and (d) 85% of the net orderly liquidation value of eligible other Coast Crane Ltd. equipment, less reserves established by the lenders and the liquidity reserve. The amended agreement is collateralized by a first security interest in substantially all of Coast Crane’s and Coast Crane Ltd.’s assets. All other terms of the of the November 24, 2010 agreement remain in effect. The maximum amount that could be borrowed under the Coast Crane revolving credit facility, net of letters of credit and other reserves was approximately $75.0 million at December 31, 2011. The Company’s available borrowing under the revolving credit facility is $9.3 million at December 31, 2011. As of December 31, 2011 and for the year then ended, the Company was in compliance with its covenants and other provisions of the revolving line of credit facility. Some of the financial covenants including a fixed charge coverage ratio do not become active unless the available borrowing falls below the $8.0 million threshold. The Company’s available borrowing base of approximately $9.3 million exceeded the threshold at December 31, 2011. Additionally, the Company had $2.2 million of collateral in excess of the $75.0 million as of December 31, 2011. Any failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on the Company’s liquidity and operations. 36 Our management believes that cash generated from operations, together with amounts available under the revolving credit facilities and cash on hand of $9.0 million, will be adequate to permit us to meet our debt service obligations, ongoing costs of operations, working capital needs and capital expenditure requirements for the foreseeable future. Additionally, our Essex Crane Revolving Credit Facility and Coast Crane Revolving Credit Facility allow us to hold up to $20.0 million and $15.0 million, respectively, of other purchase money security interest debt outside of our current credit facilities. Substantially all of our rental equipment and all its other assets are subject to liens under its revolving credit facilities. There is potential that none of such assets may be available to satisfy the claims of its general creditors. Our future financial and operating performance, ability to service or refinance its debt and ability to comply with covenants and restrictions contained in its debt agreements will be subject to future economic conditions and to financial, business and other factors, many of which are beyond its control. Coast Crane Canadian Revolving Credit Facility In conjunction with the Coast Acquisition, including all of the outstanding shares of capital stock of Coast Crane, Ltd., the Company assumed the obligation sunder a Canadian Revolving Credit Facility. The principal amount of $1.5 million related to the Canadian Revolving Credit Facility was repaid in full and terminated in November 2011 in conjunction with the amendment to the Coast Crane Revolving Credit facility discussed above. Other Long-term Debt Obligations In November 2010, the we entered into an agreement with the holders of certain Coast Crane indebtedness pursuant to which such holders agreed, in consideration of our assumption of such indebtedness, to exchange such indebtedness for promissory notes issued by the Essex in the aggregate principal amount of $5,227,000. As additional consideration under the agreement, we agreed to issue 90,000 warrants to the holders of such indebtedness entitling the holder thereof reasonable to purchase up to 90,000 shares of our common stock at an exercise price of $0.01 per share, and to reimburse such holders for certain legal fees incurred in connection with the transaction. We acquired amortizing purchase money security interest debt of $3.8 million in November 2010 in conjunction with the Coast Acquisition. As of December 31, 2011 the purchase money security interest debt consists of the financing of five remaining pieces of equipment. As the loans are amortizing, approximately $0.7 million of the total $2.5 million in principal payments are due prior to December 31, 2012 and as such, this amount is classified as a current liability in the accompanying consolidated balance sheets as of December 31, 2011. Monthly principal and interest payments are required through the various maturity dates ranging from September 2015. Capitalized Expenditures Our capitalization criteria is to capitalize costs in the period they are incurred related to projects with total costs in excess of $20,000 when the projects extend the useful lives or enhance the crane’s capabilities. These capital projects are depreciated using the straight line method over an estimated useful life of 7 years. Individual rental equipment items and property, plant and equipment items purchased with costs in excess of $5,000 are also capitalized and are depreciated over the useful life of the respective item purchased. The following table provides quantitative information regarding the amount and types of costs capitalized during 2011 and 2010: For the years Ended December 31, 2011 2010 Purchases of rental equipment $23,730,914 $2,632,831 Costs to prepare cranes for sale 80,114 170,036 Purchases of property, plant & equipment 161,117 54,844 Capitalized crane repair costs 257,807 755,461 Capitalized internally developed software costs 852,070 201,880 Total capitalized expenditures $25,082,022 $3,815,052 During the years ended December 31, 2011 and 2010, we expensed repair and maintenance costs of approximately $12.4 million and $5.8 million, respectively. We expect to capitalize costs of approximately $8.8 million during the year ended December 31, 2012. Approximately $6.6 million of the total is for the purchase of rental equipment, a portion of which will be funded from proceeds from the sales of older and lighter lifting rental equipment. 37 Off Balance Sheet Arrangements Options and warrants issued in conjunction with our initial public offering and to members of Essex Crane’s senior management are equity linked derivatives and accordingly represent off-balance sheet arrangements. The options and warrants meet the scope exception within the applicable accounting guidance and are accordingly not accounted for as derivatives, but instead are accounted for as equity. In addition, the Company has operating leases that are not accounted for on the balance sheet. Contractual Obligations The following table summarizes the Company’s contractual obligations for the next five years and thereafter as of December 31, 2011: Payments Due by Period Contractual Obligations Less Than 1 Year 1-3 Years 3-5 Years More than 5 Years Total Revolving Credit Facilities Principal - 222,088,941 - - $222,088,941 Interest (a) 10,987,835 14,070,323 - - 25,058,158 Other debt obligations Principal 673,403 6,381,547 505,053 - 7,560,003 Interest 614,140 619,051 9,546 - 1,242,737 Operating Leases: Minimum lease payments 1,851,438 2,116,763 637,575 - 4,605,776 Other long-term liabilities: Capital lease obligations, including interest 7,692 3,205 - - 10,897 Total $14,134,508 $245,279,830 $1,152,174 $- $260,566,512 (a) Amounts include interest expected to be incurred on the Company's revolving credit facility based on the amount outstanding as of December 31, 2011. The weighted average interest rate as of December 31, 2011 of 4.95%, which includes the impact of the Company's interest rate swap, is assumed to be in effect through the maturity date of the revolving credit facilities. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations for the purposes of this document are based upon our audited consolidated audited financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results, however, may materially differ from the calculated estimates and this difference would be reported in its current operations. We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles. Our significant accounting policies are presented in Note 2 to our 2011 audited financial statements, and the following summaries should be read in conjunction with the audited financial statements and the related notes thereto. While all accounting policies affect the financial statements, certain accounting policies may be viewed as critical to us. Critical accounting policies are those that are both most important to the portrayal of the financial statements and results of operations and that require our management’s most subjective or complex judgments or estimates. Our management believes the policies that fall within this category are policies related to revenue recognition, rental equipment, impairment of goodwill and long-lived assets, derivative financial instruments and income taxes. Revenue Recognition The Company recognizes revenue, including multiple element arrangements, in accordance with the provisions of applicable accounting guidance. We generate revenue from the rental of cranes and related equipment and other services such as crane and equipment transportation and repairs and maintenance. In many instances, the Company provides some of the above services under the terms of a single customer Equipment Rental Agreement. The Company also generates revenue from the retail sale of equipment and spare parts. 38 Revenue arrangements with multiple elements are divided into separate units of accounting based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. The Company is able to establish vendor specific objective evidence of selling price related to rental revenues after analysis of rental agreements absent any additional services offered by the Company. The Company uses the estimated selling price for allocation of consideration to transportation services based on the costs associated with providing such services in addition to other supply and demand factors within specific sub-markets. The estimated selling prices of the individual deliverables are not materially different than the terms of the Equipment Rental Agreements. Revenue from equipment rentals are billed monthly in advance and recognized as earned, on a straight line basis over the rental period specified in the associated equipment rental agreement. Rental contract terms span several months or longer. Because the term of the contracts can extend across financial reporting periods, when rentals are billed in advance, we defer recognition of revenue and record unearned rental revenue at the end of reporting periods so that rental revenue is included in the appropriate period. Repair service revenue is recognized when the service is provided. Transportation revenue from rental equipment delivery service is recognized for the drop off of rental equipment on the delivery date and is recognized for pick-up when the equipment is returned to the Essex Crane service center, storage yard or next customer location. New and used rental equipment and part sales are recognized upon acceptance by the customer and delivery has occurred. There are estimates required in recording certain repair and maintenance revenues and also in recording any allowances for doubtful accounts. The estimates have historically been accurate in all material respects and we do not anticipate any material changes to our current estimates in these areas. Useful Lives of Rental Equipment Essex’s primary assets consist of its lattice-boom crawler cranes and attachments, rough terrain cranes, tower cranes, boom trucks and other equipment within its fleet, which are recorded at cost less accumulated depreciation. In conjunction with the acquisitions of Essex Crane and Coast Crane, Essex recorded all of its crane and attachment and other construction equipment fleet values at fair value. Essex depreciates the existing fleet over periods between 5 and 30 years on a straight line basis such that additions of new cranes to the fleet are depreciated over a 30 year time period while used cranes acquired will be amortized over a period of 7 to 25 years. Essex’s management reviews the value of its crane fleet annually in conjunction with its lenders. Allowance for Doubtful Accounts The Company maintains allowances for doubtful accounts and credit memos. The allowance for doubtful accounts is the Company’s best estimate of the amount of credit losses in accounts receivable and is included in selling, general and administrative expenses in the consolidated statements of operations. The Company periodically reviews the allowance for doubtful accounts and balances are written off against the allowance when management believes it is probable the receivable will not be recovered. Our estimate could require change based on changing circumstances, including changes in the economy or in the particular circumstances of individual customers. Accordingly, the Company may be required to increase or decrease our allowance. Business Combinations Acquisition of Coast Crane’s Assets On November 12, 2010, the United States Bankruptcy Court for the Western District of Washington approved an Asset Purchase Agreement (the "Coast Crane Purchase Agreement") between CC Bidding, an indirect wholly-owned subsidiary of the Company, and Coast Liquidating Co., a Delaware corporation, pursuant to which CC Bidding agreed to purchase substantially all of the assets, including 100% of the outstanding shares of capital stock of Coast Crane Ltd., and assume certain liabilities of Coast Liquidating Co. Coast Liquidating Co., a leading provider of specialty lifting solutions and crane rental services on the West Coast of the United States, filed a voluntary petition for relief under the United States Bankruptcy Code on September 22, 2010 (Case Number 10-21229). The Coast Acquisition was completed on November 24, 2010. 39 The primary reasons for Coast Acquisition are as follows: ·Broaden our product offerings to encourage customers to utilize our expanded product offerings for their heavy lifting construction equipment needs with an ability to leverage customer relationships between the operating subsidiaries while providing for cross selling opportunities; ·Extend our geographic footprint to the Western and Northwestern U.S., Alaska, Hawaii, Guam and the South Pacific; ·Provide new revenue streams from the distribution of new and used equipment, and providing after-market support and parts and service. This diversification results in a broader mix revenue streams, which we believe allow for more consistent earnings through economic cycles; and ·Provide an opportunity for us to obtain a significant pool of rental equipment assets in one transaction as well as a highly trained workforce with significant construction equipment expertise. The components of the total consideration transferred of $103.2 million by CC Bidding for the purchase of Coast Liquidating Co.’s assets as shown below. This includes settlement of certain liabilities in accordance with requirements under the bankruptcy proceedings. Cash consideration: Cash from proceeds of common share issuance $14,190,000 Cash from Essex Rental Corp. 20,310,000 Cash from proceeds from new revolving credit facility 49,551,816 Total cash transferred at close 84,051,816 Plus: transaction expenses paid outside of close 1,160,501 Less: transaction expenses (2,735,917) Total cash consideration 82,476,400 Liabilities assumed: Unsecured promissory note 5,227,000 Canadian revolving credit facility 2,743,160 Purchase money security interest debt 3,831,433 Interest rate swap agreements 1,600,650 Trade payables 5,835,000 Accrued benefits and employee compensation 1,494,058 Total liabilities assumed per the Purchase Agreement 20,731,301 Total consideration transferred $103,207,701 40 The allocation of total consideration transferred to the assets acquired and liabilities assumed is as follows: Assets acquired: Cash and cash equivalents $1,128,636 Accounts receivable 7,939,653 Other receivables 706,656 Equipment inventory 5,561,692 Retail spare parts 2,477,685 Prepaid expenses and other assets 1,729,032 Rental equipment 81,761,249 Property and equipment 2,433,624 Loan acquisition costs assumed 40,670 Identifiable intangible assets 2,100,000 Goodwill 1,796,126 Total assets acquired 107,675,023 Liabilities assumed: Other accounts payable 2,132,635 Accrued taxes 356,104 Accrued other expenses 226,251 Unearned revenue and customer deposits 1,378,160 Deferred tax liabilities 377,692 Total other liabilities assumed 4,470,842 Foreign currency exchange impact 3,520 Net assets acquired $103,207,701 The methodology in allocating the total consideration transferred to acquire the assets of Coast Liquidating Co. of $103.2 million, to the assets acquired and liabilities assumed is described below as follows: ·The book value of other current assets, accounts payable and accrued liabilities were determined to approximate their fair value due to their short term nature; ·Accounts receivables were recorded at their estimated fair values based on expected collectability. The gross contractual receivables of accounts and other receivables as of the date of acquisition were approximately $9.0 million. Managements best estimate of the gross accounts receivable not expected to be collected is $0.9 million; ·Management estimated the fair value of new and used equipment inventory based on recent sales prices, values of similar rental equipment assets and published market values; ·An experienced and qualified third party assisted in the valuation of Coast Liquidating Co.’s rental equipment and titled vehicles included in property and equipment using the cost and market approaches based in part on assumptions provided by management; ·An experienced and qualified third party assisted in the valuation of intangible assets including customer relationship intangible and trademark and spare parts inventory using the income approach based in part on assumptions provided by management; and ·The remaining excess purchase price paid over the net assets acquired was recorded as goodwill all of which will be deductible for tax purposes over a 15 year period. Goodwill includes the value of the assembled workforce and synergies created through the Coast Acquisition. The following table contains the amounts of revenues and earnings of Coast Crane included in the accompanying consolidated statement of operations for the year ended December 31, 2010: 41 For the Period November 24, 2010 to December 31, 2010 Total revenues $5,403,551 Gross profit 519,701 Loss from operations (959,550) Net loss (810,314) Income Taxes The Company uses an asset and liability approach, as required by the applicable accounting guidance for financial accounting and reporting of income taxes. Deferred tax assets and liabilities are computed using tax rates expected to apply to taxable income in the years in which those assets and liabilities are expected to be realized. The effect on net deferred tax assets and liabilities resulting from a change in tax rates is recognized as income or expense in the period that the change in tax rates is enacted. Management makes certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments are applied in the calculation of certain tax credits and in the calculation of the deferred income tax expense or benefit associated with certain deferred tax assets and liabilities. Significant changes to these estimates may result in an increase or decrease to Essex Rental’s tax provision in a subsequent period. Management assesses the likelihood that it will be able to recover its deferred tax assets. If recovery is not likely, the Company will increase its provision for income taxes by recording a valuation allowance against the deferred tax assets that are unlikely to be recovered. The Company follows the applicable accounting guidance related to the accounting for uncertainty in income taxes. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company files income tax returns in the United States federal jurisdiction and in most state jurisdictions. The Company is subject to U.S. federal or state income tax examinations for years 2008 through 2011 and Coast Crane Ltd is subject to Canadian income tax examinations for the tax years 2006 through 2011. Essex’ management makes certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments are applied in the calculation of certain tax credits and in the calculation of the deferred income tax expense or benefit associated with certain deferred tax assets and liabilities. Significant changes to these estimates may result in an increase or decrease to Essex’s tax provision in a subsequent period. At December 31, 2011, the Company had unused U.S. federal net operating loss carry-forwards totaling approximately $113.6 million that begin expiring in 2021. At December 31, 2011, the Company also had unused state net operating loss carry-forwards totaling approximately $61.6 million that expire between 2012 and 2031. Impairment of long-lived assets Long lived assets are recorded at the lower of amortized cost or fair value. Losses related to long-lived assets are recorded where indicators of impairment are present and the estimated undiscounted cash flows to be generated by the asset (rental and associated revenues less related operating expenses plus any terminal value) are less than the assets’ carrying value. If the carrying value of the assets will not be recoverable, as determined by the undiscounted cash flows, the carrying value of the assets is reduced to fair value. Essex, under the terms of its credit agreement, engages an independent third party to help management appraise the value of the crane and attachment fleet on at least an annual basis. We consider a number of factors including value in use for crane and attachment rental, secondary market values and possible values in alternate use. 42 Derivative Financial Instruments Essex uses derivative financial instruments for the purpose of hedging the risks associated with interest rate fluctuations on its revolving credit facility with the objective of converting a targeted amount of its floating rate debt to a fixed rate. The Company does not enter into derivative transactions for speculative purposes, and therefore holds no derivative instruments for trading purposes. Essex believes that the use of derivatives in the form of interest rate swaps is an important tool to manage its balance sheet liabilities and interest rate risk, while protecting its associated rental margins. The Company sets its equipment rental rates based in part as a percentage of the investment cost of the equipment and then uses the interest rate swap to lock in the associated interest costs of a period of time. Recently Issued and Adopted Accounting Pronouncements Please refer to Note 2 within our note to consolidated financial statements for a description of recently issued and adopted accounting pronouncements. Item 7A.Quantitative and Qualitative Disclosures About Market Risk Our earnings are affected by changes in interest rates due to the fact that interest on our revolving credit facilities is calculated based upon either LIBOR or Prime Rate plus an applicable margin as of December 31, 2011 for which we have an interest rate swaps to effectively fix the interest rate at 4.96% on $100.0 million of the $157.8 million of outstanding borrowings under Essex Crane’s senior secured credit facility and three undesignated interest rate swaps to effectively fix the interest rate at 5.62% on $21.0 million of the $64.3 million of outstanding borrowings under Coast Crane’s senior secured credit facility. The weighted average interest rate in effect on all of the Company’s borrowings at December 31, 2011 was 3.55% excluding the impact of the interest rate swaps and 5.09% taking into consideration the swaps. A 1.0% increase in the effective interest rate on our total outstanding borrowings (including our short-term debt obligations) not effectively fixed as a result of the interest rate swaps at December 31, 2011 would increase our interest expense by approximately $0.7 million on an annualized basis. Derivatives are used for hedging purposes rather than speculation. The Company does not enter into financial instruments for trading purposes. See also Note 8 to the notes to consolidated financial statements for additional discussion of derivative instruments. The fair values of the Company’s financial instruments (including such items in the financial statement captions as cash and cash equivalents, accounts receivable and accounts payable and accrued expenses approximate their carrying values based on their nature and terms. The fair value of the Company’s total debt outstanding as of December 31, 2011 was $223.6 million, excluding the impact of our interest rate swaps. If market rates of interest increased 50 basis points due to a change in the applicable margin rate of interest (a 12.5% increase from the Company’s current margin) the estimated fair value of the Company’s total debt obligations would be approximately $223.2 million. If market rates of interest decreased 50 basis points due to a change in the applicable margin rate of interest (a 12.5% decrease from the Company’s current margin) the estimated fair value of the Company’s total debt obligations would be approximately $224.2 million. The Company’s interest rate swaps had a liability fair value of approximately $2.5 million as of December 31, 2011. If market rates of interest permanently increased by 50 basis points, the fair value of the Company’s interest rate swap would result in a $2.1 million liability. If market rates of interest permanently decreased by 50 basis points, the fair value of the Company’s interest rate swap would be a $3.0 million liability. These amounts were determined by considering the impact of hypothetical interest rates on the Company’s financial instruments. Theses analyses do not consider the effects of the changes in the overall economy that could exist in such an environment. Further, in the event of changes of such magnitude, management would likely take actions to further mitigate its exposure to the changes. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Company’s financial structure or results. The Company cannot predict the effect of adverse changes in interest rates on its debt and derivative instruments and, therefore, the Company cannot predict its exposure to market risk. Consequently, further results may differ materially from the estimated adverse changes discussed above. 43 Item 8.Financial Statements and Supplementary Data The consolidated financial statements and supplementary data of Essex Rental Corp. required by this Item are described in Item 15 of this Annual Report on Form 10-K and are presented beginning on page F-1. Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A.Controls and Procedures Evaluation of Disclosure Controls and Procedures The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934) as of December 31, 2011. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2011, the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Management’s Report on Internal Control over Financial Reporting Essex Rental Corp.’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) under the Exchange Act. Because of their inherent limitations, systems of internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can only provide reasonable assurance with respect to financial statement preparation and presentation. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness, as of December 31, 2011, of the Company’s internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, management has concluded that its internal control over financial reporting was effective as of December 31, 2011. Our internal control over financial reporting has been audited as of December 31, 2011 by Grant Thornton, an independent registered public accounting firm, as stated in their report which is included herein. Changes in Internal Control over Financial Reporting There were no changes to the internal control over financial reporting of the Company identified in connection with the Company’s evaluation referred to above that occurred during the fourth quarter of 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B.Other Information None. 44 PART III Item 10.Directors, Executive Officers, and Corporate Governance of the Registrant The information required by this Item is incorporated by reference to the applicable information in our Proxy Statement related to the 2012 Annual Meeting of Stockholders (the “2012 Proxy Statement”), which will be filed with the SEC on or before April 30, 2012. Item 11.Executive Compensation The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement, which will be filed with the SEC on or before April 30, 2012. Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Equity Compensation Plans The following table provides certain information, as of December 31, 2011, about our common stock that may be issued upon the exercise of options, warrants and rights, as well as the issuance of shares granted to employees, consultants or members of our Board of Directors, under our existing equity compensation plans, the 2011 Long-Term Incentive Plan and the Hyde Park Acquisition Corp. 2008 Long-Term Incentive Plan. Number of Securities to be Weighted-average exercise Number of securities issued upon exercise of price of outstanding remaining available for outstanding options, options, warrants and future issuance under equity Plan Category warrants and rights rights compensation plans Equity compensation plans approved by stockholders 1,474,719 $5.45 1,393,439 Equity plans not approved by stockholders - - - Total 1,474,719 $5.45 1,393,439 (1) During the year ended December 31, 2011, the Company issued 166,943 restricted shares to certain employees of the Company under the Company’s 2008 Long Term Incentive Plan. The Company also granted stock options to management that can be converted to 423,750 shares upon conclusion of the vesting period. The additional information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement, which will be filed with the SEC on or before April 30, 2012. Item 13.Certain Relationships and Related Transactions The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement, which will be filed with the SEC on or before April 30, 2012. Item 14.Principal Accountant Fees and Services The information required by this Item is incorporated by reference to the applicable information in the 2012 Proxy Statement, which will be filed with the SEC on or before April 30, 2012. 45 PART IV Item 15.Exhibits and Financial Statement Schedules (a) Documents filed as a part of this report (1) Consolidated financial statements: Financial Statements Reports of Independent Registered Public Accounting Firm Consolidated Balance Sheets—December 31, 2011 and 2010 Consolidated Statements of Operations for the years ended December 31, 2011, 2010 and 2009 Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2011, 2010 and 2009 Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009 Notes to consolidated financial statements (3) Exhibits: The exhibits to this report are listed in the exhibit index below. (b) Description of Exhibits 46 Exhibit No. Description 2.1 Purchase Agreement, dated as of March 6, 2008, among Hyde Park Acquisition Corp., Essex Holdings LLC, KCP Services LLC, and the Members of Essex Holdings LLC signatory thereto. (1) 2.2 Amendment No. 1 to Purchase Agreement, dated May 9, 2008, among Hyde Park Acquisition Corp., Essex Holdings LLC, KCP Services LLC and the Members of Holdings signatory thereto. (1) 2.3 Amendment No. 2 to Purchase Agreement, dated August 14, 2008, among Hyde Park Acquisition Corp., Essex Holdings LLC, KCP Services LLC and the Members of Holdings signatory thereto. (1) 2.4 Asset Purchase Agreement, dated as of November 24, 2010, between CC Bidding Corp. and Coast Crane Company (6) 3.1 Amended and Restated Certificate of Incorporation. (4) 3.2 Amended and Restated Bylaws of the Corporation, effective as of September 28, 2007. (2) 4.1 Specimen Unit Certificate. (3) 4.2 Specimen Common Stock Certificate. (3) 4.3 Specimen Warrant Certificate. (3) 4.4 Form of Unit Purchase Option to be granted to Representative. (3) 4.5 Form of Warrant Agreement between Continental Stock Transfer & Trust Company and the Registrant. (3) 4.6 Form of Warrant Agreement between Essex Rental Corp. and the holders of certain indebtedness of CC Liquidating Company (formerly Coast Crane Company), (7) 10.1 Letter Agreement among the Registrant, EarlyBirdCapital, Inc. and Laurence S. Levy. (3) 10.2 Letter Agreement among the Registrant, EarlyBirdCapital, Inc. and Edward Levy. (3) 10.3 Letter Agreement among the Registrant, EarlyBirdCapital, Inc. and Isaac Kier. (3) 10.4 Form of Investment Management Trust Agreement between Continental Stock Transfer & Trust Company and the Registrant. (3) 10.5 Form of Stock Escrow Agreement between the Registrant, Continental Stock Transfer & Trust Company and the Initial Stockholders. (3) 10.6 Form of Letter Agreement between ProChannel Management LLC and Registrant regarding administrative support. (3) 10.7 Form of Promissory Note, dated as of August 21, 2006, issued to each of Laurence S. Levy, Edward Levy and Isaac Kier. (3) 10.8 Form of Registration Rights Agreement among the Registrant and the Initial Stockholders. (3) 10.9 Form of Subscription Agreement among the Registrant, Graubard Miller and each of Laurence S. Levy, Edward Levy and Isaac Kier. (3) 10.10 Lock-up Agreement, dated October 31, 2008, between Registrant and Ronald Schad. (4) 10.11 Lock-up Agreement, dated October 31, 2008, between Registrant and Martin Kroll. (4) 10.12 Lock-up Agreement, dated October 31, 2008, between Registrant and William O’Rourke. (4) 47 10.13 Lock-up Agreement, dated October 31, 2008, between Registrant and William Erwin. (4) 10.14 Escrow Agreement, dated October 31, 2008, among Registrant, KCP Services LLC and Key Bank National Association. (4) 10.15 Compliance Agreement, dated October 31, 2008, among Registrant, Essex Holdings LLC, KCP Services LLC, Essex Crane Rental Corp. and the members of Essex Holdings LLC. (4) 10.16 Employment Agreement, dated October 31, 2008, among Registrant, Essex Crane Rental Corp. and Ronald Schad. (4) 10.17 Employment Agreement, dated October 31, 2008, among Registrant, Essex Crane Rental Corp. and Martin Kroll. (4) 10.18 Employment Agreement, dated October 31, 2008, among Registrant, Essex Crane Rental Corp. and William O’Rourke. (4) 10.19 Employment Agreement, dated October 31, 2008, among Registrant, Essex Crane Rental Corp. and William Erwin. (4) 10.20 Amended and Restated Limited Liability Company Agreement of Essex Holdings LLC, dated October 31, 2008, among Registrant, Ronald Schad, Martin Kroll, William O’Rourke and William Erwin. (4) 10.21 Registration Rights Agreement, dated October 31, 2008, among Registrant, Ronald Schad, Martin Kroll, William O’Rourke and William Erwin. (4) 10.22 Second Amended and Restated Loan and Security Agreement, dated March 6, 2008, among Essex Crane Rental Corp., Essex Holdings LLC, Textron Financial Corporation, National City Business Credit, Inc., Sovereign Bank, Wachovia Capital Finance Corporation (Central), Wachovia Capital Markets, LLC and the Financial Institutions named therein. (1) 10.23 Hyde Park Acquisition Corp. 2008 Long Term Incentive Plan (1) 10.24 Form of Subscription Agreement, dated October 29, 2010, between Essex Rental Corp. and each of Calm Waters Partnership, Matthew Campbell, Daeg Partners, LP, Equitable Holding Corp. and KC Gamma Opportunity Fund, LP (together with T. Rowe Price Small-Cap Value Fund, the “Private Placement Investors”). (7) 10.25 Subscription Agreement, dated October 29, 2010, between Essex Rental Corp. and T. Rowe Price Small-Cap Value Fund. (7) 10.26 Form of Registration Rights Agreement, dated November 24, 2010, between Essex Rental Corp. and each Private Placement Investor. (7) 10.27 Amended and Restated Credit Agreement (the “Credit Agreement”), dated November 14, 2011, by and among Coast Crane Company, Coast Crane Ltd., CC Acquisition Holding Corp., General Electric Capital Corporation, as Agent for the several financial institutions from time to time party to the Credit Agreement and for itself as a lender, PNC Bank National Association and Wells Fargo Bank, National Association, as lenders, and the other persons party thereto that are designated as Credit Parties thereunder. (8) 10.28 Agreement, dated November 5, 2010, between Essex Rental Corp. and the holders of certain indebtedness of CC Liquidating Company (formerly Coast Crane Company). (7) 10.29 Asset Purchase Agreement, dated as of November 1, 2010, between CC Bidding Corp. and Coast Crane Company. (6) 10.30 Form of Promissory Notes issued to the holders of certain indebtedness of CC Liquidating Company (formerly Coast Crane Company) in the aggregate principal amount of $5,227,000. (7) 10.31 Registration Rights Agreement, dated December 22, 2010, amount Essex Rental Corp., Kirtland Capital Company III LLC and Kirtland Capital Partners III L.P. (7) 48 16 Letter from McGladrey & Pullen, LLP to the Securities and Exchange Commission, dated December 16, 2008. (5) 21 Subsidiaries of Registrant (7) 23.1 Consent of Grant Thornton LLP (*) 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*) 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (*) 32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (*) 101.INS XBRL Instance Document (**) 101.SCH XBRL Taxonomy Extension Schema Document (**) 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document (**) 101.DEF XBRL Taxonomy Extension Definition Linkbase Document (**) 101.LAB XBRL Taxonomy Extension Label Linkbase Document (**) 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document (**) (1) Incorporated by reference to the Registrant Definitive Proxy Statement on Schedule 14A, filed with the Securities and Exchange Commission on October 8, 2008, regarding the Special Meeting of the Registrant’s Stockholders held on October 31, 2008. (2) Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on September 28, 2007. (3) Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (SEC File 333-138452). (4) Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 6, 2008. (5) Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 16, 2008. (6) Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 17, 2010. (7) Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission on March 16, 2011. (8) Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the Securities and Exchange Commission on November 17, 2011. (*) Filed herewith. (**) Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability. 49 Report of Independent Registered Public Accounting Firm Board of Directors and Shareholders Essex Rental Corp. We have audited the accompanying consolidated balance sheets of Essex Rental Corp. (a Delaware corporation) and Subsidiaries (collectively, the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2011. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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 consolidated financial position of Essex Rental Corp. and Subsidiaries as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2011, 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 14, 2012 expressed an unqualified opinion. /s/ Grant Thornton LLP Chicago, Illinois March 14, 2012 F-1 Report of Independent Registered Public Accounting Firm Board of Directors and Shareholders Essex Rental Corp. We have audited Essex Rental Corp. (a Delaware Corporation) and Subsidiaries’ internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Essex Rental Corp.’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 in Item 9A. Our responsibility is to express an opinion on Essex Rental Corp.’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 based on the assessed 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 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. 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 generally accepted accounting principles, 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 its inherent limitations, 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 or procedures may deteriorate. In our opinion, Essex Rental Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control—Integrated Framework issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Essex Rental Corp. and Subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2011, and our report dated March 14, 2012 expressed an unqualified opinion. /s/ Grant Thornton LLP Chicago, Illinois March 14, 2012 F-2 ESSEX RENTAL CORP. CONSOLIDATED BALANCE SHEETS December 31, December 31, 2011 2010 ASSETS CURRENT ASSETS Cash and cash equivalents $9,030,383 $3,474,314 Accounts receivable, net of allowances 14,311,343 12,801,772 Other receivables 2,712,353 4,223,435 Deferred tax assets 3,478,114 2,402,709 Inventory Retail equipment inventory 2,212,530 5,386,074 Retail spare parts, net 1,506,680 1,882,003 Prepaid expenses and other assets 1,944,068 3,069,976 TOTAL CURRENT ASSETS 35,195,471 33,240,283 Rental equipment, net 328,955,023 330,378,792 Property and equipment, net 7,876,432 8,727,456 Spare parts inventory, net 3,380,090 3,540,360 Identifiable finite lived intangibles, net 1,893,920 3,143,063 Goodwill 1,796,126 1,796,126 Loan acquisition costs, net 1,803,167 2,220,878 TOTAL ASSETS $380,900,229 $383,046,958 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $4,893,500 $2,810,672 Accrued employee compensation and benefits 1,750,956 1,482,747 Accrued taxes 3,592,912 4,504,765 Accrued interest 833,642 436,947 Accrued other expenses 830,295 1,836,246 Unearned rental revenue 1,106,781 1,272,847 Customer deposits 142,581 2,320,007 Short-term debt obligations 673,403 783,243 Interest rate swaps 2,470,779 - Current portion of capital lease obligation 7,199 6,718 TOTAL CURRENT LIABILITIES 16,302,048 15,454,192 LONG-TERM LIABILITIES Revolving credit facilities 222,088,941 214,959,971 Promissory notes 5,034,741 4,938,611 Other long-term debt obligations 1,851,859 2,982,920 Deferred tax liabilities 51,650,482 61,124,038 Interest rate swaps - 5,266,586 Capital lease obligation 3,150 10,349 TOTAL LONG-TERM LIABILITIES 280,629,173 289,282,475 TOTAL LIABILITIES 296,931,221 304,736,667 Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock, $.0001 par value, Authorized 1,000,000 shares, none issued - - Common stock, $.0001 par value, Authorized 40,000,000 shares; issued and outstanding 24,428,092 shares at December 31, 2011 and 20,472,489 shares at December 31, 2010 2,443 2,047 Paid in capital 122,815,398 101,052,367 Accumulated deficit (37,577,983) (20,431,083) Accumulated other comprehensive loss, net of tax (1,270,850) (2,313,040) TOTAL STOCKHOLDERS' EQUITY 83,969,008 78,310,291 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $380,900,229 $383,046,958 The accompanying notes are an integral part of these financial statements F-3 ESSEX RENTAL CORP. CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 2011 2010 2009 REVENUES Equipment rentals $41,970,190 $25,049,779 $34,556,696 Retail equipment sales 14,206,479 1,238,722 - Used rental equipment sales 6,523,789 4,255,761 6,478,197 Retail parts sales 9,834,844 1,184,042 - Transportation 5,413,609 4,766,328 4,909,346 Equipment repairs and maintenance 11,636,068 5,036,828 6,140,153 TOTAL REVENUES 89,584,979 41,531,460 52,084,392 COST OF REVENUES Salaries, payroll taxes and benefits 10,635,150 5,905,279 6,006,715 Depreciation 21,146,477 12,723,951 11,210,472 Retail equipment sales 11,878,546 994,119 - Used rental equipment sales 5,462,818 3,551,891 5,584,784 Retail parts sales 7,230,864 775,338 - Transportation 5,081,504 4,236,326 3,743,595 Equipment repairs and maintenance 12,452,736 5,833,945 4,873,005 Yard operating expenses 2,599,646 1,383,068 1,482,371 TOTAL COST OF REVENUES 76,487,741 35,403,917 32,900,942 GROSS PROFIT 13,097,238 6,127,543 19,183,450 Selling, general and administrative expenses 28,535,612 12,964,887 10,547,405 Other depreciation and amortization 1,338,378 954,602 781,751 INCOME (LOSS) FROM OPERATIONS (16,776,752) (7,791,946) 7,854,294 OTHER INCOME (EXPENSES) Other income 316,492 72,278 643 Interest expense (11,455,390) (7,209,449) (6,681,740) Foreign currency exchange losses (6,999) (2,471) - TOTAL OTHER INCOME (EXPENSES) (11,145,897) (7,139,642) (6,681,097) INCOME (LOSS) BEFORE INCOME TAXES (27,992,649) (14,931,588) 1,173,197 PROVISION (BENEFIT) FOR INCOME TAXES (10,775,749) (3,523,102) (22,609) NET INCOME (LOSS) $(17,146,900) $(11,408,486) $1,195,806 Weighted average shares outstanding: Basic 23,824,119 16,102,339 14,110,789 Diluted 23,824,119 16,102,339 15,805,191 Earnings (loss) per share: Basic $(0.72) $(0.71) $0.08 Diluted $(0.72) $(0.71) $0.08 The accompanying notes are an integral part of these financial statements. F-4 ESSEX RENTAL CORP. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Accumulated Accumulated Additional (Deficit) Other Total Comprehensive Common Stock Paid-In Retained Comprehensive Stockholders' Income Shares Amount Capital Earnings Loss (1) Equity (Loss) Balance - January 1, 2009 14,106,886 $1,410 $84,383,579 $(10,218,403) $(2,120,829) $72,045,757 $(14,037,950) Repurchases and retirement of 323,200 warrants - - (378,896) - - (378,896) Common stock issued to employees and director 17,677 2 106,213 - - 106,215 Stock based compensation for stock options granted to executive management - - 478,223 - - 478,223 Change in fair value of interest rate swap, net of tax of $427,393 - - - - 690,926 690,926 690,926 Net income for the year ended December 31, 2009 - - - 1,195,806 - 1,195,806 1,195,806 Balance - December 31, 2009 14,124,563 $1,412 $84,589,119 $(9,022,597) $(1,429,903) $74,138,031 $1,886,732 Repurchases and retirement of 519,905 warrants - - (853,516) - - (853,516) Exercise of warrants for common stock 473,646 47 2,368,219 - - 2,368,266 Common stock issued - cashless warrant tender offer 2,547,558 255 (255) - - - Common stock issued to employees as compensation 23,522 2 133,505 - - 133,507 Common stock issued for professional services 3,200 1 15,521 - - 15,522 Common stock issued in private placement transaction 3,300,000 330 14,189,670 - - 14,190,000 Equity issuance costs - - (773,601) - - (773,601) Stock based compensation for stock options granted to executive management - - 1,087,305 - - 1,087,305 Fair value of detachable warrants issued in conjunction with unsecured promissory notes - - 296,400 - - 296,400 Change in fair value of interest rate swap, net of tax of $626,987 (Restated) - - - - (892,110) (892,110) (892,110) Foreign currency translation adjustments - - - 8,973 8,973 8,973 Net loss for the year ended December 31, 2010 - - - (11,408,486) - (11,408,486) (11,408,486) Balance - December 31, 2010 $20,472,489 $2,047 $101,052,367 $(20,431,083) $(2,313,040) $78,310,291 $(12,291,623) The accompanying notes are an integral part of these financial statements. F-5 ESSEX RENTAL CORP. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued) Accumulated Accumulated Additional (Deficit) Other Total Comprehensive Common Stock Paid-In Retained Comprehensive Stockholders' Income Shares Amount Capital Earnings Loss (1) Equity (Loss) Balance - January 1, 2011 20,472,489 $2,047 $101,052,367 $(20,431,083) $(2,313,040) $78,310,291 Exercise of warrants for common stock 3,955,603 396 19,777,619 - - 19,778,015 Stock based compensation for executive management stock options and employee restricted shares granted - - 1,985,412 - - 1,985,412 Change in fair value of interest rate swap, net of tax of $690,862 - - - - 1,061,781 1,061,781 1,061,781 Foreign currency translation adjustments - - - - (19,591) (19,591) (19,591) Net loss for the year ended December 31, 2011 - - - (17,146,900) - (17,146,900) (17,146,900) Balance - December 31, 2011 24,428,092 $2,443 $122,815,398 $(37,577,983) $(1,270,850) $83,969,008 $(16,104,710) (1) The portion of Accumulated Other Comprehensive Loss related to changes in the fair value of the Company’s designated interest rate swap was ($1,260,232), ($2,322,013) and ($1,429,903) for the years ended December 31, 2011, 2010 and 2009, respectively. The portion of Accumulated Other Comprehensive Loss related to foreign currency translation adjustments was ($19,591), $8,973 and $0 for the years ended December 31, 2011, 2010 and 2009, respectively. The accompanying notes are an integral part of these financial statements. F-6 ESSEX RENTAL CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2011 2010 2009 CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $(17,146,900) $(11,408,486) $1,195,806 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization of tangible assets 21,854,730 13,157,670 11,331,394 Amortization of loan acquisition costs and other intangibles 1,385,523 1,035,601 1,155,744 Amortization of promissory notes discount 96,130 8,011 - Gain on sale of rental equipment (1,060,971) (703,870) (893,413) Deferred income taxes (10,615,361) (1,600,049) 73,418 Share based compensation expense 1,985,412 1,220,812 584,438 Professional fees paid through issuance of common shares - 15,522 - Change in fair value of interest rate swaps (1,043,164) (159,455) - Changes in operating assets and liabilities: Accounts receivable, net (346,571) 111,877 6,376,566 Other receivables 1,511,082 168,023 (517,030) Prepaid expenses and other assets 1,125,908 (974,695) 30,681 Retail equipment inventory 4,187,863 182,879 - Spare parts inventory 535,593 611,559 (279,378) Accounts payable and accrued expenses 829,928 (8,516,276) (2,530,691) Unearned rental revenue (166,066) 259,999 (1,383,109) Customer deposits (2,177,426) 1,160,898 - NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 955,710 (5,429,980) 15,144,426 CASH FLOWS FROM INVESTING ACTIVITIES Acquisition of business, net of cash acquired - (31,795,947) - Purchases of rental equipment (23,811,028) (242,020) (17,164,399) Purchases of property and equipment (1,270,994) (1,016,762) (988,949) Accounts receivable from rental equipment sales (1,163,000) 107,042 (107,042) Proceeds from sale of rental equipment 6,523,789 4,255,761 6,478,197 NET CASH USED IN INVESTING ACTIVITIES (19,721,233) (28,691,926) (11,782,193) The accompanying notes are an integral part of these financial statements. F-7 ESSEX RENTAL CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) For the Years Ended December 31, 2011 2010 2009 CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from revolving credit facilities $100,312,623 $74,600,102 $58,100,748 Proceeds from purchase money security interest debt - - 2,554,637 Payments on revolving credit facilities (93,168,798) (43,925,681) (63,558,968) Payments on purchase money security interest debt (2,253,401) (7,796,731) - Payments on capital lease obligation (7,692) (7,692) (4,595) Proceeds from the issuance of common stock - 14,190,000 - Payment of equity issuance costs - (644,219) - Proceeds from the exercise of warrants 19,778,015 2,368,266 - Payments to repurchase warrants - (853,516) (378,896) Payments for deferred loan costs (340,575) (558,339) (14,651) NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 24,320,172 37,372,190 (3,301,725) Effect of exchange rate changes in cash 1,420 24,522 - NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,556,069 3,274,806 60,508 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,474,314 199,508 139,000 CASH AND CASH EQUIVALENTS, END OF PERIOD $9,030,383 $3,474,314 $199,508 SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING / FINANCING ACTIVITIES Equity issuance fee in accrued expenses $- $129,382 $- Debt issuance costs in accrued expenses $- $238,375 $- Promissory notes and common stock warrants exchanged for assumed debt $- $5,227,000 $- Portion of Coast Crane debt paid-off with proceeds from new Coast Crane revolving credit facility $- $49,551,516 $- Assumption of other long-term debt obligations $- $3,831,433 $- Revolving credit facility assumed $- $2,743,160 $- Equipment obtained through capital lease $974 $1,423 $27,931 Equipment purchased directly through short-term debt obligation $1,012,500 $2,560,847 $2,615,977 Unrealized (gain) loss on designated derivative instruments, net of tax $1,061,781 $892,110 $(690,926) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest, swaps and debt issuance costs $11,371,426 $6,864,814 $6,338,956 Cash (received) paid for income taxes, net $(754,266) $23,344 $(122,435) The accompanying notes are an integral part of these financial statements. F-8 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1.Business and Principles of Consolidation The accompanying consolidated financial statements include the accounts of Essex Rental Corp. (“Essex Rental”) and its wholly owned subsidiaries Essex Holdings, LLC ("Holdings"), Essex Crane Rental Corp. ("Essex Crane"), Essex Finance Corp. (“Essex Finance”), CC Acquisition Holding Corp. (“CC Acquisition”), Coast Crane Company, formerly known as CC Bidding Corp. (“Coast Crane” or “CC Bidding”) and Coast Crane Ltd. (“Coast Crane Ltd.”), (collectively the "Company"). All intercompany accounts and transactions have been eliminated in consolidation. On November 24, 2010, CC Bidding, a Delaware corporation and an indirectly wholly-owned subsidiary of the Company completed the acquisition (the “Coast Acquisition”) of substantially all of the assets of Coast Crane Company, a Delaware corporation (“Coast Liquidating Co.”). The assets acquired in the Coast Acquisition consisted of all of the assets used by Coast Liquidating Co. in the operation of its specialty lifting solutions and crane rental services business, including cranes and related heavy lifting machinery and equipment and spare parts, inventory, accounts receivable, rights under executory contracts, other tangible and intangible assets and all of the outstanding shares of capital stock of Coast Crane Ltd., a British Columbia corporation, through which Coast Liquidating Co. conducted its operations in Canada. Following the completion of the Coast Acquisition, CC Bidding changed its name to “Coast Crane Company” and filed trademark and tradename protection with the United States and state governments. The Company, through its subsidiaries, Essex Crane and Coast Crane, is engaged primarily in renting lattice boom crawler cranes and attachments, tower cranes and attachments, rough terrain cranes, boom trucks and other related heavy lifting machinery and equipment to the construction industry mainly throughout the United States of America, including Hawaii and Alaska, Guam and Canada for use in building and maintaining power plants, refineries, bridge and road construction, alternative energy, water treatment facilities and other industrial, commercial and infrastructure related projects. The Company, through its subsidiary Coast Crane, is also engaged in servicing and distributing heavy lifting machinery and other construction related equipment and parts. The accompanying financial statements of the Company include all adjustments (consisting of normal recurring adjustments) which management considers necessary for the fair presentation of the Company’s operating results, financial position and cash flows as of and for all periods presented. Acquisition of Coast Crane’s Assets On November 12, 2010, the United States Bankruptcy Court for the Western District of Washington approved an Asset Purchase Agreement (the "Coast Crane Purchase Agreement") between CC Bidding, an indirect wholly-owned subsidiary of the Company, and Coast Liquidating Co., a Delaware corporation, pursuant to which CC Bidding agreed to purchase substantially all of the assets, including 100% of the outstanding shares of capital stock of Coast Crane Ltd., and assume certain liabilities, of Coast Liquidating Co. Coast Liquidating Co., a leading provider of specialty lifting solutions and crane rental services on the West Coast of the United States, filed a voluntary petition for relief under the United States Bankruptcy Code on September 22, 2010 (Case Number 10-21229). The Coast Acquisition was completed on November 24, 2010. The primary reasons for the Company’s acquisition of Coast Crane’s assets are as follows: ·Broaden the Company’s product offerings to encourage customers to utilize the Company’s expanded product offerings for their heavy lifting construction equipment needs with an ability to leverage customer relationships between the operating subsidiaries while providing for cross selling opportunities; ·Extend the Company’s geographic footprint to the Western and Northwestern U.S., Alaska, Hawaii, Guam and the South Pacific; ·Provide new revenue streams from the distribution of new and used equipment and providing after-market support and parts and services. The diversification results in a broader mix of revenue streams, which we believe allow for more consistent earnings through economic cycles; and F-9 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) ·Provide an opportunity for the Company to obtain a significant pool of rental equipment assets in one transaction as well as a highly trained workforce with significant construction equipment expertise. The components of the total consideration transferred of $103.2 million by CC Bidding for the purchase of Coast Crane’s assets are as follows. This includes settlement of certain liabilities in accordance with requirements under the bankruptcy proceedings. Cash consideration: Cash from proceeds of common share issuance $14,190,000 Cash from Essex Rental Corp. 20,310,000 Cash from proceeds from new revolving credit facility 49,551,816 Total cash transferred at close 84,051,816 Plus: transaction expenses paid outside of close 1,160,501 Less: transaction expenses (2,735,917) Total cash consideration 82,476,400 Liabilities assumed: Unsecured promissory note 5,227,000 Canadian revolving credit facility 2,743,160 Purchase money security interest debt 3,831,433 Interest rate swap agreements 1,600,650 Trade payables 5,835,000 Accrued benefits and employee compensation 1,494,058 Total liabilities assumed per the Purchase Agreement 20,731,301 Total consideration transferred $103,207,701 The allocation of total consideration transferred to the assets acquired and liabilities assumed is as follows: Assets acquired: Cash and cash equivalents $1,128,636 Accounts receivable 7,939,653 Other receivables 706,656 Equipment inventory 5,561,692 Retail spare parts 2,477,685 Prepaid expenses and other assets 1,729,032 Rental equipment 81,761,249 Property and equipment 2,433,624 Loan acquisition costs assumed 40,670 Identifiable intangible assets 2,100,000 Goodwill 1,796,126 Total assets acquired 107,675,023 Liabilities assumed: Other accounts payable 2,132,635 Accrued taxes 356,104 Accrued other expenses 226,251 Unearned revenue and customer deposits 1,378,160 Deferred tax liabilities 377,692 Total other liabilities assumed 4,470,842 Foreign currency exchange impact 3,520 Net assets acquired $103,207,701 F-10 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The methodology in allocating the total consideration transferred to acquire the assets of Coast Liquidating Co. of $103.2 million, to the assets acquired and liabilities assumed is described below as follows: (These allocations were subject to adjustment in the twelve months following the date of acquisition based upon the discovery of information not known at the date of acquisition or refinement of estimates used in the allocation of purchase price. There were no adjustments made in the twelve months subsequent to acquisition.) ·The book value of other current assets, accounts payable and accrued liabilities were determined to approximate their fair value due to their short term nature; ·Accounts receivables were recorded at their estimated fair values based on expected collectability. The gross contractual receivables of accounts and other receivables as of the date of acquisition were approximately $9.0 million. Management’s best estimate of the gross accounts receivable not expected to be collected is $1.1 million; ·Management estimated the fair value of new and used equipment inventory based on recent sales prices, values of similar rental equipment assets and published market values; ·An experienced and qualified third party assisted in the valuation of the Company’s rental equipment and titled vehicles included in property and equipment using the cost and market approaches based in part on assumptions provided by management; ·An experienced and qualified third party assisted in the valuation of intangible assets including customer relationship intangible and trademark and spare parts inventory using the income approach based in part on assumptions provided by management; and ·The remaining excess purchase price paid over the net assets acquired was recorded as goodwill all of which will be deductible for tax purposes over a 15 year period. Goodwill includes the value of the assembled workforce and synergies associated with the Coast Acquisition. The following table contains the amounts of revenues and earnings of CC Bidding included in the accompanying consolidated statement of operations for the year ended December 31, 2010: For the Period November 24, 2010 to December 31, 2010 Total revenues $5,403,551 Gross profit 519,701 Loss from operations (959,550) Net loss (810,314) Pro Forma Information (Unaudited) The following table contains unaudited pro forma consolidated income information of the Company for the years ended December 31, 2010 and 2009 as if the acquisition of Coast Crane had occurred as of the beginning of each reporting period. The pro forma adjustments recorded associated with the fair value of assets acquired relate to additional depreciation expense resulting from the increase in fair value of rental equipment and property and equipment and additional interest expense associated with the debt incurred to finance the acquisition: F-11 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Year Ended December 31, 2010 2009 Total revenues $108,462,689 $170,396,760 Gross profit 15,273,316 36,238,357 Income (loss) from operations (15,089,819) 4,926,509 Net loss (18,466,728) (7,886,905) Basic and diluted net loss per common share $(0.97) $(0.45) 2.Significant Accounting Policies Use of Estimates The preparation of these financial statements requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could materially differ from those estimates. Significant estimates include the allowance for doubtful accounts and credit memos, spare parts inventory obsolescence reserve, useful lives for rental equipment and property and equipment, deferred income taxes, personal property tax accrual, loss contingencies and the fair value of interest rate swaps and other financial instruments. Change in Accounting Estimates During the year ended December 31, 2011, the Company changed its estimate of the useful lives of certain types of rental equipment acquired as part of the Coast Acquisition in November 2010. The change in useful lives was reflected in our Quarterly Report on Form 10-Q for the period ending March 31, 2011 and was based on new information learned prior to filing that Form 10-Q. The impact of this change on gross profit and net loss for the year was an increase of approximately $0.5 million and a decrease of $0.3 million, respectively. The impact on basic and diluted loss per share was a decrease of $0.01 per share. Fair Value of Financial Instruments, Including Derivative Instruments The valuation of financial instruments requires the Company to make estimates and judgments that affect the fair value of the instruments. The Company, where possible, bases the fair values of its financial instruments, including its derivative instruments, on listed market prices and third party quotes. Where these are not available, the Company bases its estimates on current instruments with similar terms and maturities or on other factors relevant to the financial instruments. Segment Reporting We have determined, in accordance with applicable accounting guidance regarding operating segments that we have three reportable segments. We derive our revenues from three principal business activities: (1) equipment rentals; (2) equipment distribution; and (3) parts and service. These segments are based upon how we allocate resources and assess performance. See Note 14 to the consolidated financial statements regarding our segment information. Revenue Recognition The Company recognizes revenue, including multiple element arrangements, in accordance with the provisions of applicable accounting guidance. We generate revenue from the rental of cranes and related equipment and other services such as crane and equipment transportation and repairs and maintenance of equipment on rent. In many instances, the Company provides some of the above services under the terms of a single customer Equipment Rental Agreement. The Company also generates revenue from the retail sale of equipment and spare parts and repair and maintenance services provided with respect to non-rental equipment. F-12 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Revenue arrangements with multiple elements are divided into separate units of accounting based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. The Company is able to establish vendor specific objective evidence of selling price related to rental revenues after analysis of rental agreements absent any additional services offered by the Company. The Company uses the estimated selling price for allocation of consideration to transportation services based on the costs associated with providing such services in addition to other supply and demand factors within specific sub-markets. The estimated selling prices of the individual deliverables are not materially different than the terms of the Equipment Rental Agreements. Revenue from equipment rentals are billed monthly in advance and recognized as earned, on a straight line basis over the rental period specified in the associated equipment rental agreement. Rental contract terms may span several months or longer. Because the term of the contracts can extend across financial reporting periods, when rentals are billed in advance, we defer recognition of revenue and record unearned rental revenue at the end of reporting periods so that rental revenue is included in the appropriate period. Repair service revenue is recognized when the service is provided. Transportation revenue from rental equipment delivery service is recognized for the drop off of rental equipment on the delivery date and is recognized for pick-up when the equipment is returned to the Essex Crane service center, storage yard or next customer location. New and used rental equipment and part sales are recognized upon acceptance by the customer and delivery has occurred. Revenue from repair and maintenance services provided with respect to non-rental equipment is recognized when the service is provided. There are estimates required in recording certain repair and maintenance revenues and also in recording any allowances for doubtful accounts. The estimates have historically been accurate in all material respects and we do not anticipate any material changes to our current estimates in these areas. Cash and Cash Equivalents The Company considers all demand deposits, money market accounts and investments in certificates of deposit with a maturity of three months or less at the date of purchase to be cash equivalents. Shipping and Handling Costs and Taxes Collectible from Customers The Company classifies shipping and handling amounts billed to customers as revenues and the corresponding expenses are included in cost of revenues in the consolidated statements of operations. The Company accounts for taxes due from customers on a net basis and as such, these amounts are excluded from revenues in the consolidated statements of operations. Accounts Receivable and Allowance for Doubtful Accounts Accounts receivable are recorded at the invoice price net of an estimate of allowance for doubtful accounts and reserves for credit memos, and generally do not bear interest. The allowance for doubtful accounts is the Company’s best estimate of the amount of credit losses in accounts receivable and is included in selling, general and administrative expenses in the consolidated statements of operations. The Company periodically reviews the allowance for doubtful accounts and balances are written off against the allowance when management believes it is probable the receivable will not be recovered. The Company’s allowance for doubtful accounts and credit memos was approximately $2,916,000 and $1,742,000 as of December 31, 2011 and 2010, respectively. Bad debt expense was approximately $1,000,000, $496,000 and $600,000 for the years ended December 31, 2011, 2010 and 2009, respectively. F-13 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Year Ended December 31, 2011 2010 Beginning balance $1,741,601 $1,545,295 Provision 2,937,933 1,955,198 Write-offs and recoveries (1,763,639) (1,758,892) Ending balance $2,915,895 $1,741,601 Concentrations of Credit Risk Financial instruments that potentially subject the Company to a significant concentration of credit risk consist primarily of cash and cash equivalents. The Company may maintain deposits in federally insured financial institutions in excess of federally insured limits. However, management believes the Company is not exposed to significant credit risk due to the financial position of the depository institutions in which those deposits are held. Another financial instrument account that potentially subjects the Company to a significant concentration of credit risk primarily relates to accounts receivable. Concentrations of credit risk with respect to accounts receivable is limited because a large number of geographically diverse customers make up the Company’s customer base. No single customer represented more than 10% of total revenue or outstanding receivables for any of the periods presented. The Company controls credit risk through credit approvals, credit limits and other monitoring procedures. The Company also manages credit risk through bonding requirements on its customers and/or liens on projects that the rental equipment is used to complete. Inventory Inventory is stated at the lower of cost or market. Spare parts inventory is used to service rental equipment and is sold on a retail basis. Spare parts inventory used to support the crawler crane rental fleet is classified as a non-current asset as it is primarily used to support rental equipment repair operations. Spare parts inventory used to service rental equipment is recorded as repairs and maintenance expense in the period the parts were issued to a repair project, or, usage is reclassified as additional cost of the rental equipment if the repair project meets certain capitalization criteria as discussed below. Equipment inventory is accounted for using the specific-identification method and retail parts and spare parts inventory are accounted for using the average cost method, which approximates the first-in, first-out method. The carrying value of the spare parts inventory is reduced by a reserve representing management’s estimate for obsolete and slow moving items. This obsolescence reserve is an estimate based upon the Company’s analysis by type of inventory, usage and market conditions at the consolidated balance sheet dates. The obsolescence reserve was approximately $1,088,000 and $279,000 as of December 31, 2011 and 2010, respectively. Rental Equipment Rental equipment is stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the equipment, which range from 5 to 30 years. In excess of 95% of the assets have a useful life greater than 15 years. Projects with costs in excess of $20,000 for equipment improvements that extend the useful lives or enhance a crane’s capabilities are capitalized in the period they are incurred and depreciated using the straight line method over an estimated useful life of 7 years. Individual rental equipment items purchased with costs in excess of $5,000 are also capitalized and are depreciated over the useful lives of the respective item purchased. During the years ended December 31, 2011 and 2010, the Company capitalized rental equipment maintenance expenditures of approximately $0.2 million and $0.8 million, respectively. F-14 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Gains and losses on retirements and disposals of rental equipment are included in income from operations. Ordinary repair and maintenance costs are included in cost of revenues in the consolidated statements of operations. Property and Equipment Property and equipment is stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the assets’ estimated useful lives, which are as follows: Buildings 30 years Building improvements 10 years Office equipment 3 to 7 years Automobiles, trucks, trailers and yard equipment 4 to 5 years Information systems equipment and software 3 years Machinery, furniture and fixtures 4 to 7 years Expenditures for betterments and renewals in excess of $5,000 that extend the useful lives or enhance the assets’ capabilities are capitalized and are depreciated on the straight line basis over the remaining lives of the assets. Gains and losses on retirements and disposals of property and equipment are included in the consolidated statements of operations. The Company capitalized property, plant and equipment expenditures, excluding capitalized software costs, of approximately $0.1 million and $0.8 million during the years ended December 31, 2011 and 2010, respectively. External costs incurred by the Company to develop computer software for internal use are capitalized in accordance with applicable accounting guidance. The Company capitalized $0.8 million and $0.2 million for the years ended December 31, 2011 and 2010, respectively. Capitalized software development costs include software license fees, consulting fees and certain internal payroll costs and are amortized on a straight line basis over their useful lives. During 2011, the Company placed approximately $0.8 million of capitalized costs in service associated with the development of a new Enterprise Resource Planning system (“ERP system”) at Coast Crane. The ERP system implementation was completed in the second half of 2011 and is being amortized on a straight line basis over its 3 year useful life beginning in the third quarter of 2011. Loan Acquisition Costs Loan acquisition costs include underwriting, legal and other direct costs incurred in connection with the issuance of the Company’s debt. These costs are capitalized and amortized using the straight line method over the remaining period of the debt, which is not materially different from the effective interest method, and included in interest expense in the consolidated statements of operations. Goodwill and Other Intangible Assets Under ASC 350, “Intangibles – Goodwill and Other”, we evaluate goodwill for impairment at the reporting unit level at least annually, or more frequently if triggering events occur or other impairment indicators arise which might impair recoverability. To determine if there is any impairment, management determined whether the fair value of the reporting unit is greater than its carrying value. If the fair value of a reporting unit is less than its carrying value, then the implied fair value of goodwill must be estimated and compared to its carrying value to measure the amount of impairment, if any. The Company determined that there was no impairment of its goodwill as of December 31, 2011 and 2010. F-15 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company used the purchase method of accounting for its acquisition of Coast Crane’s assets. The acquisition resulted in an allocation of purchase price to goodwill and other intangible assets. The cost of the Coast Acquisition was first allocated to identifiable assets based on estimated fair values. The excess of the purchase price over the fair value of identifiable assets acquired in the amount of $1,796,126 was recorded as goodwill. Identifiable finite lived intangible assets consist of customer relationships and trademarks obtained in the acquisition of Coast Crane’s assets. The customer relationship intangible and trademark assets are both being amortized on a straight-line basis over their estimated useful lives of 7 years and 5 years, respectively. Long-lived Assets Long lived assets are recorded at the lower of amortized cost or fair value. As part of an ongoing review of the valuation of long-lived assets and finite-lived intangibles, the Company assesses the carrying value of these assets if such facts and circumstances suggest that they may be impaired. During the fourth quarter of 2011, the Company determined that the operating results of the company, declining stock price and budget shortfalls were an indication of potential impairment. As a result, the Company performed an assessment of its long-lived assets, including finite lived intangibles and rental equipment, as determined by an undiscounted cash flow analysis over the remaining future life of the assets. The Company determined that there was no impairment of its long-lived assets as of December 31, 2011. The Company determined that there were no triggering events during the years ended December 31, 2010 and 2009. Derivative Financial Instruments and Hedging Activities The Company uses derivative financial instruments for the purpose of hedging the risks associated with interest rate fluctuations on its revolving credit facility with the objective of converting a targeted amount of its floating rate debt to a fixed rate. The Company has not entered into derivative transactions for speculative purposes, and therefore holds no derivative instruments for trading purposes. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking each hedge transaction. All derivative instruments are carried at fair value on the consolidated balance sheets in accordance with applicable accounting guidance. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the consolidated balance sheets as either a freestanding asset or liability, with a corresponding offset recorded in accumulated other comprehensive income within the consolidated statements of stockholders’ equity, net of tax. Amounts are reclassified from accumulated other comprehensive income to the consolidated statements of operations in the period or periods the hedged transaction affects earnings. Derivative gains and losses under cash flow hedges not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately within the consolidated statements of operations. At the hedge’s inception and at least quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instruments have been highly effective in offsetting changes in fair values or cash flows of the hedged items and whether they are expected to be highly effective in the future. If it is determined a derivative instrument has not been or will not continue to be highly effective as a hedge, hedge accounting is discontinued. No hedge ineffectiveness was recognized within the consolidated statements of operations during the years ended December 31, 2011, 2010 or 2009. The Company assumed three interest rate swaps with a combined notional amount of $21.0 million in conjunction with its purchase of Coast Crane’s assets and did not contemporaneously document the hedge designation on the date of assumption in order to qualify for hedge accounting treatment for economic reasons and the forecasted inherent hedge ineffectiveness that would have resulted from the differences in terms of the assumed swaps and the new revolving credit facility. As such, the derivative financial instruments assumed have been recorded at fair value in the accompanying consolidated balance sheets in short-tem liabilities with changes in the underlying fair value reported as a component of other income (expenses) in the Company’s consolidated statements of operations. F-16 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Income Taxes The Company uses an asset and liability approach for financial accounting and reporting of income taxes. Deferred tax assets and liabilities are computed using tax rates expected to apply to taxable income in the years in which those assets and liabilities are expected to be realized. The effect on deferred tax assets and liabilities resulting from a change in tax rates is recognized as income or expense in the period that the change in tax rates is enacted. Management makes certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments are applied in the calculation of certain tax credits and in the calculation of the deferred income tax expense or benefit associated with certain deferred tax assets and liabilities. Significant changes to these estimates may result in an increase or decrease to the Company’s tax provision in a subsequent period. Management assesses the likelihood that it will be able to recover its deferred tax assets. If recovery is not likely, the Company will increase its provision for income taxes by recording a valuation allowance against the deferred tax assets that are unlikely to be recovered. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. F-17 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Stock based compensation Stock based compensation is accounted for in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), which results in compensation expense being recorded over the requisite service or vesting period based on the fair value of the share based compensation at the date of grant. Foreign Currency Translation The functional currency of the Company’s Canadian subsidiary is the Canadian dollar. Assets and liabilities of the foreign subsidiary are translated into U.S. dollars at year-end exchange rates, and revenue and expenses are translated at average rates prevailing during the year. Gains or losses from these translation adjustments are included in accumulated other comprehensive income (loss), a separate component of stockholders’ equity. Recently Issued and Adopted Accounting Pronouncements In January 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance that expands the required disclosures about fair value measurements. This guidance provides for new disclosures requiring the Company to (i) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers and (ii) present separately information about purchases, sales, issuances and settlements in the reconciliation of Level 3 fair value measurements. This guidance also provides clarification of existing disclosures requiring the Company to (i) determine each class of assets and liabilities based on the nature and risks of the investments rather than by major security type and (ii) for each class of assets and liabilities, disclose the valuation techniques and inputs used to measure fair value for both Level 2 and Level 3 fair value measurements. This guidance was effective on January 1, 2010, except for the presentation of purchases, sales, issuances and settlements in the reconciliation of Level 3 fair value measurements, which is effective on January 1, 2011. This guidance has not had a material impact on the Company’s consolidated financial statements. In February 2010, the FASB issued a standard with amendments to the accounting guidance related to subsequent events. The amendments remove the requirements for an SEC filer to disclose a date, in both issued and revised financial statements, through which subsequent events have been reviewed. Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. GAAP. This standard is effective for interim or annual financial periods ending after June 15, 2010 and the Company adopted this new standard during the quarter ended June 30, 2010 which did not have a material effect on the Company’s consolidated financial statements. In May 2011, the FASB issued authoritative guidance to achieve common fair value measurements and disclosure requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”). Some of the provisions of the new accounting guidance include requiring (1) that only nonfinancial assets should be valued based on a determination of their best use, (2) disclosure of quantitative information about unobservable inputs used in Level 3 fair value measurements and (3) disclosure of the level within the fair value hierarchy for each class of assets or liabilities not measured at fair value in the statement of financial position but for which the fair value is disclosed. This guidance is effective during interim and annual periods beginning after December 15, 2011. This guidance is not expected to have a material impact on the Company’s consolidated financial statements. In June 2011, the FASB issued authoritative guidance regarding the format of disclosures of comprehensive income. Under the new guidance, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity, but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. This guidance will be adopted for the Company’s 2012 fiscal year. F-18 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In September 2011, the FASB issued authoritative guidance regarding the methodology used to test goodwill for impairment. This new guidance allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this new guidance, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The guidance includes a number of events and circumstances for an entity to consider in conducting the qualitative assessment. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011 with early adoption permitted. The Company elected not to implement this guidance for the year ended December 31, 2011 and, instead, performed the full quantitative goodwill impairment analysis. 3.Rental Equipment Rental equipment consists of the following: Year Ended December 31, 2011 2010 Rental equipment $372,596,764 $354,601,219 Less: accumulated depreciation (43,641,741) (24,222,427) Rental equipment, net $328,955,023 $330,378,792 Essex Rental’s depreciation expense related to rental equipment was $20,025,437, $12,322,230 and $10,821,685 for the years ended December 31, 2011, 2010 and 2009, respectively and is included in cost of revenues in the accompanying consolidated statements of operations. Rental periods on rental equipment commonly extend beyond the minimum rental period required by each respective rental agreement due to construction delays, project scope increases or other project related issues. Future contractual minimum rental revenues as required by executed rental agreements as of December 31, 2011 are as follows: 2012 $7,793,900 2013 215,000 Total minimum rental revenue $8,008,900 F-19 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 4.Property and Equipment Property and equipment consists of the following: Year Ended December 31, 2011 2010 Land $2,575,000 $2,575,000 Buildings and improvements 2,557,679 2,557,695 Automobiles, trucks, trailers and yard equipment 3,358,237 3,375,376 Information Systems equipment and software 1,668,514 816,444 Office equipment 157,586 128,069 Machinery, furniture and fixtures 261,520 252,498 Construction in progress 494,285 441,659 Total property and equipment 11,072,821 10,146,741 Less: accumulated depreciation (3,196,389) (1,419,285) Property and equipment, net $7,876,432 $8,727,456 The amount of costs incurred and capitalized for projects not yet completed was $0.5 million and $0.4 million at December 31, 2011 and 2010, respectively. The Company’s depreciation expense related to property and equipment was $1,832,645, $835,440 and $509,709 for the years ended December 31, 2011, 2010 and 2009, respectively. Depreciation expense related to automobiles, trucks, trailers, yard equipment and machinery has been included in cost of revenues in the accompanying consolidated statements of operations as it is directly related to revenue generation while the remaining categories are included in other operating expenses. 5.Loan Acquisition Costs The Company capitalized $203,304 of loan acquisition costs related to the modification of the Coast Crane Revolving Credit Facility, which also resulted in the termination of the Canadian Revolving Credit Facility, during the year ended December 31, 2011. The 2011 loan acquisition costs are being amortized over the remaining term of the Coast Revolving Credit Facility. Approximately $15,000 of unamortized loan acquisition costs related to the Canadian Revolving Credit Facility were charged to interest expense as the obligation was repaid in full and terminated in conjunction with the amendment to the Coast Crane Revolving Credit Facility on November 14, 2011. On November 24, 2010, the Company assumed Coast Crane Ltd.’s Canadian revolving credit facility and related loan acquisition costs of $40,670. The Company also incurred $664,274 of loan acquisition costs related to the new Coast Crane revolving credit facility and $132,440 in November 2010 related to the $5.2 million unsecured promissory note. Loan costs associated with the new Coast Crane Revolving Credit Facility are being amortized over the four year term of the new revolving credit facility. Loan costs associated with the unsecured promissory notes are being amortized over the three year term of the unsecured promissory note. F-20 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Loan acquisition costs consist of the following: Year Ended December 31, 2011 2010 Gross carrying amount $3,611,363 $3,312,525 Less: accumulated amortization (1,808,196) (1,091,647) Loan acquisition costs, net $1,803,167 $2,220,878 The Company’s loan acquisition costs amortized to interest expense for the years ended December 31, 2011, 2010 and 2009 were $758,750, $514,719 and $494,915, respectively. Estimated future amortization expense related to loan acquisitions costs at December 31, 2011 are as follows for the years ending December 31: 2012 $815,555 2013 733,069 2014 254,543 Total $1,803,167 6.Intangible Assets Goodwill of $1,796,126 was recorded associated with the acquisition of Coast Crane’s assets on November 24, 2010 for the excess of the total consideration transferred over the fair value of identifiable assets acquired, net of liabilities assumed. In addition, a customer relationship intangible and trademark intangible were recorded at fair value associated with the Coast acquisition and the 2008 acquisition of Holdings. The fair value of the customer relationship intangible and trademark intangible related to Coast acquisition were $1.5 million and $0.6 million, respectively. The following table presents the gross carrying amount, accumulated amortization and net carrying amount of the Company’s other identifiable finite lived intangible assets at December 31, 2011: Gross Net Carrying Accumulated Carrying Amount Amortization Amount Other identifiable intangible assets: Essex Crane customer relationship intangible $849,417 $(774,628) $74,789 Essex Crane trademark 874,321 (793,047) 81,274 Coast Crane customer relationship intangible 1,500,000 (232,143) 1,267,857 Coast Crane trademark 600,000 (130,000) 470,000 $3,823,738 $(1,929,818) $1,893,920 F-21 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table presents the gross carrying amount, accumulated amortization and net carrying amount of the Company’s other identifiable intangible assets at December 31, 2010: Gross Net Carrying Accumulated Carrying Amount Amortization Amount Other identifiable intangible assets: Essex Crane customer relationship intangible $1,159,352 $(632,904) $526,448 Essex Crane trademark 1,186,756 (647,046) 539,710 Coast Crane customer relationship intangible 1,500,000 (13,095) 1,486,905 Coast Crane trademark 600,000 (10,000) 590,000 $4,446,108 $(1,303,045) $3,143,063 The gross carrying amount of the Essex Crane customer relationship intangible was reduced by $309,935 and $295,680 for the years ended December 31, 2011 and 2010, respectively as a result of the recognition of the tax benefit related to excess tax deductible goodwill. The gross carrying amount of the Essex Crane trademark intangible was reduced by $312,435 and $300,613, for the years ended December 31, 2011 and 20010, respectively as a result of the recognition of the tax benefit related to excess tax deductible goodwill. The Company’s amortization expense associated with other intangible assets was $626,773, $520,883 and $660,829 for the years ended December 31, 2011, 2010 and 2009, respectively. The following table presents the estimated future amortization expense related to intangible assets as of December 31, 2011 and is subject to change based on the recognition of the tax benefit related to excess tax deductible goodwill: 2012 $398,127 2013 390,739 2014 353,796 2015 340,545 2016 and thereafter 410,713 Total $1,893,920 7.Revolving Credit Facilities and Other Debt Obligations The Company’s revolving credit facilities and other debt obligations consist of the following: Principal Outstanding at Weighted December 31, Average Interest Maturity 2011 2010 as of 12/31/2011 (1) Date Ranges Essex Crane revolving credit facility $157,751,206 $158,300,090 2.55% Oct-13 Coast Crane revolving credit facility 64,337,735 53,909,026 5.31% Nov-14 Canadian revolving credit facility (2) - 2,750,855 N/A May-12 Unsecured promissory notes (related party) (3) 5,034,741 4,938,611 11.90% Dec-13 Purchase money security interest debt 1,851,859 2,982,920 3.78% Sep-15 Purchase money security interest debt - short-term 673,403 783,243 3.78% within 1 year Total debt obligations outstanding $229,648,944 $223,664,745 (1)Weighted average interest rates exclude the impact of the Company's interest rate swaps. (2)On November 14, 2011, Coast Crane Company and its wholly owned Canadian subsidiary, Coast Crane Ltd., entered into the Amended and Restated Credit Agreement. Proceeds of the first borrowing under the Credit Agreement were used to repay in full the principal balance outstanding on the Canadian Revolving Credit Facility, which was terminated in connection with the amendment of the Credit Agreement. See "Canadian Revolving Credit Facility" discussion within this footnote for further discussion. (3)Includes the impact on interest expense from the accretion of the discount related to the detachable warrants issued with the debt. See "Unsecured Promissory Notes" discussion within this footnote for further discussion. F-22 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Aggregate payments of principal on debt obligations outstanding as of December 31, 2011 for each of the next five years and thereafter based on contractual installment payment terms and maturities are as follows: 2012 $673,403 2013 163,459,350 2014 65,011,138 2015 505,053 $229,648,944 F-23 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Essex Crane Revolving Credit Facility In conjunction with the acquisition of Holdings on October 31, 2008, Essex Crane amended its senior secured revolving line of credit facility (“Essex Crane Revolving Credit Facility”), which permits it to borrow up to $190.0 million. Essex Crane may borrow up to an amount equal to the sum of 85% of eligible net receivables and 75% of the net orderly liquidation value of eligible rental equipment. The revolving credit facility is collateralized by a first priority security interest in substantially all of Essex Crane’s assets. Borrowings under the Essex Crane Revolving Credit Facility accrue interest at the borrower’s option of either (a) the bank’s prime rate (3.25% at December 31, 2011) plus an applicable margin or (b) a Eurodollar rate based on the rate the bank offers deposits of U.S. Dollars in the London interbank market (“LIBOR”) (0.29% at December 31, 2011) plus an applicable margin. The Company is also required to pay a monthly commitment fee with respect to the undrawn commitments under the revolving credit facility. At December 31, 2011and 2010 the applicable prime rate margin, euro-dollar LIBOR margin, and unused line commitment fee were 0.25%, 2.25% and 0.25%, respectively. See Note 8 Derivatives and Hedging Activities – Interest Rate Swap Agreements for additional detail. The maximum amount that could be borrowed under the revolving credit facility, net of letters of credit, interest rate swaps and other reserves was approximately $187.8 million and $186.0 million as of December 31, 2011 and 2010, respectively. The Company’s available borrowing under the revolving credit facility was approximately $30.0 million and $27.7 million as of December 31, 2011 and 2010, respectively. As of December 31, 2011 and 2010, there was $3.6 million and $5.8 million, respectively, of available formulated collateral in excess of the maximum amount of $190.0 million. In addition, the Company may borrow upto $20.0 million in purchase money security interest debt under the terms of the revolving credit facility. As of December 31, 2011 and for the year then ended, the Company was in compliance with its covenants and other provisions of the Essex Crane revolving line of credit facility. Some of the financial covenants including a fixed charge coverage ratio and rental equipment utilization ratio do not become active unless the available borrowing falls below the $20.0 million threshold. The Company’s available borrowing base of approximately $30.0 million well exceeded the threshold at December 31, 2011. Any failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on the Company’s liquidity and operations. Coast Crane Revolving Credit Facility On November 24, 2010, Coast Crane, formerly known as CC Bidding, and CC Acquisition Holding, the direct parent of Coast Crane, entered into a new revolving credit facility in conjunction with the Coast Acquisition (the “Coast Crane Credit Facility”). The Coast Crane Credit Facility provides for a revolving loan and letter of credit facility in the maximum aggregate principal amount of $75.0 million with a $2.0 million aggregate principal sublimit for letters of credit. Coast Crane may borrow, repay and reborrow under the Coast Crane Credit Facility. Coast Crane’s ability to borrow under the Coast Crane Credit Facility is subject to, among other things, a borrowing base calculated based on the sum of (a) 85% of eligible accounts, (b) the lesser of 50% of eligible spare parts inventory and $5.0 million, (c) the lesser of 95% of the lesser of (x) the net orderly liquidation value and (y) the invoice cost, of eligible new equipment inventory and $15.0 million and (d) 85% of the net orderly liquidation value of eligible other equipment, less reserves established by the lenders and the liquidity reserve. Interest accrues on the outstanding revolving loans under the revolving credit facility at either a per annum rate equal to (a) LIBOR plus 3.75%, with a 1.50% LIBOR floor or (b) the Base rate plus 2.75%, at Coast Crane’s election. Coast Crane will be obligated to pay a letter of credit fee on the outstanding letter of credit accommodations based on a per annum rate of 3.75%. Interest on the revolving loans and fees on the letter of credit accommodations will be payable monthly in arrears. Coast Crane will also be obligated to pay an unused line fee on the amount by which the maximum credit under the revolving credit facility exceeds the aggregate amount of revolving loans and letter of credit accommodations based on a per annum rate of 0.50%. At December 31, 2011 and 2010, the applicable LIBOR rate, Base rate, and unused line commitment fee were 1.50%, 3.25% and 0.50%, respectively. F-24 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) On November 14, 2011 the Coast Crane Revolving Credit Facility was amended to include Coast Crane Ltd. as a signatory to the credit facility. The amendment also provided the right to include Coast Crane and Coast Crane Ltd. equipment, including equipment located in Canada, in the borrowing base calculation, which was previously prohibited. The amended agreement is collateralized by a first security interest in substantially all of Coast Crane’s and Coast Crane Ltd.’s assets. All other terms of the of the November 24, 2010 agreement remain in effect. The maximum amount that could be borrowed under the Coast Crane Revolving Credit Facility, net of reserves was approximately $75.0 million and $65.9 million as of December 31, 2011 and 2010, respectively. The Company’s available borrowing under the Coast Crane Revolving Credit Facility was approximately $9.3 million and $12.0 million as of December 31, 2011 and 2010, respectively. As of December 31, 2011, there was $2.2 million of available formulated collateral in excess of the maximum borrowing amount of $75.0 million. In addition, the Company may borrow upto $15.0 million of purchase money security interest debt under the terms of the credit facility. Proceeds of the first borrowing under the original Coast Crane Credit Facility in the amount of $49,551,816 were used to pay part of the cash portion of the purchase price, costs, expenses and fees payable in connection with the Coast Acquisition and the negotiation and entry into the Coast Crane Credit Facility. Proceeds of the first borrowing under the amended Coast Crane Credit Facility in the amount of $1,499,884 were used to pay off the remaining balance on the Canadian Revolving Credit Facility at the time of termination. As of December 31, 2011 and for the year then ended, the Company was in compliance with its covenants and other provisions of the Coast Crane revolving line of credit facility. Some of the financial covenants including a fixed charge coverage ratio, commencing with the first quarter ending March 31, 2011, do not become active unless the available borrowing falls below the $8.0 million threshold. Coast Crane’s available borrowing base of approximately $9.3 million exceeded the threshold at December 31, 2011. Any failure to be in compliance with any material provision or covenant of these agreements could have a material adverse effect on the Company’s liquidity and operations. Canadian Revolving Credit Facility In conjunction with the Coast Acquisition on November 24, 2010, our Coast Crane subsidiary entered into a secured revolving credit facility, which permits it to borrow up to $75.0 million. Coast Crane may borrow, repay and reborrow up to an amount equal to the sum of (a) 85% of eligible Coast accounts, (b) the lesser of 50% of eligible Coast inventory and $5 million, (c) the lesser of (i) 95% of the lesser of (x) the net orderly liquidation value and (y) the invoice cost of eligible new equipment inventory and (ii) $15.0 million and (d) 85% of the net orderly liquidation value of eligible other equipment, less reserves established by the lenders and the liquidity reserve. The revolving credit facility is scheduled to mature in November 2014 and is collateralized by a first security interest in substantially all of the Coast Crane’s assets. On November 14, 2011 the Coast Crane Revolving Credit Facility was amended to include Coast Crane Ltd. as a party to the credit facility. The amendment permits Coast Crane and Coast Crane to include its and Coast Crane Ltd.’s equipment, including equipment located in Canada, in the borrowing base calculation, which was previously prohibited. As amended, Coast Crane Ltd. is also permitted to borrow up to $10.0 million under the Coast Crane credit facility, subject to a borrowing base which is calculated as the sum of (a) 85% of eligible Coast Crane Ltd. accounts, (b) the lesser of 50% of eligible Coast Crane Ltd. inventory and $750,000, (c) the lesser of (i) 95% of the lesser of (x) the net orderly liquidation value and (y) the invoice cost, of eligible new Coast Crane Ltd. equipment and (ii) $2,000,000 and (d) 85% of the net orderly liquidation value of eligible other Coast Crane Ltd. equipment, less reserves established by the lenders and the liquidity reserve. The amended agreement is collateralized by a first security interest in substantially all of Coast Crane’s and Coast Crane Ltd.’s assets. All other terms of the of the November 24, 2010 agreement remain in effect. Unsecured Promissory Notes In November 2010, the Company entered into an agreement with the holders of certain Coast Crane indebtedness pursuant to which such holders agreed, in consideration of the assumption of such indebtedness by the Company, to exchange such indebtedness for one or more promissory notes issued by the Company in the aggregate principal amount of $5,227,000. As additional consideration under the agreement, the Company agreed to issue 90,000 warrants to the holders of such indebtedness entitling the holder thereof to purchase up to 90,000 shares of Essex Rental common stock at an exercise price of $0.01 per share, and to reimburse such holders for certain legal fees incurred in connection with the transaction. F-25 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In accordance with accounting guidance related to debt issued with conversion or other options, the fair value of the detachable warrants of $296,400 is recorded as a discount to the principal balance outstanding with an offset to additional paid-in capital on the consolidated statements of stockholder’s equity and will be amortized on a straight-line basis over the three year life of the notes as additional interest expense on the consolidated statement of operations, which is not materially different than the effective interest method. The unamortized balance of this discount was $192,259 and $288,389 as of December 31, 2011 and 2010, respectively. Interest accrues on the outstanding promissory notes at a per annum rate of 10% and is payable annually in arrears. Purchase Money Security Interest Debt As of December 31, 2011 the purchase money security interest debt consists of the financing of five remaining pieces of equipment. These amortizing debt obligations were assumed by the Company in conjunction with the Coast acquisition. During the year ended December 31, 2011, the Company repaid in full approximately $0.5 million of the obligations outstanding related to two pieces of equipment that the Company sold. Interest accrues on the outstanding loans at LIBOR plus 3.25% and is payable monthly in arrears. As the loans are amortizing, approximately $0.7 million of the total $2.5 million in principal payments are due prior to December 31, 2012 and as such, this amount is classified as a current liability in the accompanying consolidated balance sheets as of December 31, 2011. The Company may borrow upto $20.0 million and $15.0 million of purchase money security interest debt under the Essex Crane revolving credit facility and Coast Crane revolving credit facility, respectively. During the year ended December 31, 2011, the Company entered into a new $1.0 million debt obligation related to the financing of a new crawler crane purchase. The obligation was secured by the crane purchased, was set to mature in July 2016 and accrued interest at a rate of 3.99% per annum. During the year ended December 31, 2011, the obligation was repaid in full and the crawler crane was sold through the Company’s retail distribution segment. As of December 31, 2010, the purchase money security interest debt consisted of the financing of seven pieces of equipment with an outstanding balance of approximately $3.8 million. The interest rate at December 31, 2010 was LIBOR plus 3.25%. 8. Derivatives and Hedging Activities – Interest Rate Swap Agreement Risk Management Objective of Using Derivatives The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its debt funding and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings. Cash Flow Hedges of Interest Rate Risk The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. As of December 31, 2011 and 2010, the Company had four interest rate swaps outstanding, which involves receipt of variable-rate amounts from counterparties in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amounts. F-26 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Essex Crane Interest Rate Swap In November 2008, the Company entered into an interest rate swap agreement with the lead lender of its Essex Crane revolving credit facility to hedge its exposure to interest rate fluctuations. The swap agreement has a notional principal amount of $100.0 million and matures in November 2012. Under the agreement, the Company pays a 2.71% fixed interest rate plus the applicable margin under the revolving credit facility (or a total interest rate of 4.96%). This interest rate swap is designated as a cash flow hedge. The swap agreement established a fixed rate of interest for the Company and requires the Company or the bank to pay a settlement amount depending upon the difference between the 30 day floating LIBOR rate and the swap fixed rate of 2.71%. The differential to be paid or received under the swap agreement has been accrued and paid as interest rates changed and such amounts were included in interest expense for the respective period. Interest payment dates for the revolving loan were dependent upon the interest rate options selected by the Company. Interest rates on the revolving credit facility were determined based on Wells Fargo’s prime rate or LIBOR rate, plus a margin depending on certain criteria in the agreement. As of December 31, 2011, the Company had effectively fixed through 2012, from a cash flow perspective, the interest rate on approximately 63% of Essex Crane’s credit facility. As of December 31, 2011 and 2010, the interest rate on the effectively fixed portion of the credit facility was 4.96%. The interest rate on the portion of the credit facility not effectively fixed by interest rate swap contracts was 2.57% and 2.94% at December 31, 2011 and 2010, respectively. The weighted average interest rate of the Essex Crane Revolving Credit Facility, including the impact of the interest rate swap was 4.09% and 4.23% as of December 31, 2011 and 2010, respectively. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. There was no hedge ineffectiveness recognized during the years ended December 31, 2011, 2010 or 2009. For the years ended December 31, 2011 and 2010, the change in net unrealized loss on the derivative designated as a cash flow hedge reported as a component of other accumulated comprehensive income was an increase of $1,752,643 ($1,061,781 net of tax) and $1,519,097 ($892,110 net of tax), respectively. Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. During the twelve month period ending December 31, 2012, the Company estimates that an additional $2.5 million will be reclassified as an increase to interest expense. Coast Crane Interest Rate Swaps The Company assumed three interest rate swaps in conjunction with the Coast Acquisition. The assumed interest rate swaps have a notional amount of $7.0 million each and expire on May 18, 2012. Under the agreements, the Company pays fixed interest of 5.62% and receives three-month LIBOR. The Company did not contemporaneously document the hedge designation on the date of assumption in order to quality for hedge accounting treatment due to economic reasons and the projected inherent hedge ineffectiveness. The changes in fair values of the assumed swaps for the year ended December 31, 2011 and 2010 was an unrealized gain of approximately $1,043,164 and $159,455 and was reported within interest expense of other income (expenses) in its consolidated statement of operations. Essex Rental Corp. Summary The weighted average interest rate of the Company’s total debt outstanding, including the impact of the interest rate swaps was 5.09% and 4.83% at December 31, 2011 and 2010, respectively. The impact of the interest rate swaps resulted in an increase in interest expense of approximately $2.6 million, $2.6 million and $2.4 million for the year ended December 31, 2011. The impact of the interest rate swaps resulted in an increase in interest expense of approximately $2.6 million for the year ended December 31, 2011. The table below presents the fair value of the Company’s derivative financial instruments as adjusted for the risk of non-performance as well as their classification on the consolidated balance sheets as of December 31, 2011 and 2010: F-27 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Disclosure of Fair Value of Liability Derivatives Fair Value as of Balance Sheet December 31, Location 2011 2010 Derivative designated as hedging instrument Current liabilities $2,072,748 $- Interest Rate Swap Long-term liabilities - 3,825,391 Undesignated economic derivatives Interest Rate Swaps Current liabilities 398,031 - Interest Rate Swaps Long-term liabilities - 1,441,195 Total fair value of liability derivatives $2,470,779 $5,266,586 The tables below present the effect of the Company’s derivative financial instruments on the consolidated statements of operations for the years ended December 31, 2011, 2010 and 2009. These amounts are presented as accumulated other comprehensive income (loss) (“OCI”). Derivatives in Cash Flow Hedging Relationships Amount of Gain or (Loss) Recognized in OCI on Derivative (Effective Portion) Location of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) Amount of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing) Amount of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing) For the Year Ended December 31, 2011 Interest Rate Swap $(766,238) Interest expense $(2,518,879) Other income / (expense) $- For the Year Ended December 31, 2010 Interest Rate Swap $(3,995,774) Interest expense $(2,476,677) Other income / (expense) $- For the Year Ended December 31, 2009 Interest Rate Swap $(1,281,650) Interest expense $(2,399,969) Other income / (expense) $- Credit-risk-related Contingent Features Each of the Company’s operating subsidiaries, Essex Crane and Coast Crane, separately have agreements with each of their derivative counterparties that contain a provision where if the subsidiary defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then such subsidiary could also be declared in default on their derivative obligations. As of December 31, 2011, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was approximately $2.5 million. As of December 31, 2011, the Company has not posted any collateral related to these agreements other than a reserve against available borrowings of $2.1 million as of December 31, 2011 related to the fair value of the outstanding interest rate swap under the Essex Crane Revolving Credit Facility. If the Company had breached any of these provisions at December 31, 2011, it would have been required to settle its obligations under the agreements at their termination value of approximately $2.6 million. F-28 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 9. Fair Value The FASB issued a statement on Fair Value Measurements which, among other things, defines fair value, establishes a consistent framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis and clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the standard establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: ·Level 1 - Observable inputs such as quoted prices in active markets: ·Level 2- Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and ·Level 3 - Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions. The Company’s interest rate swaps are recorded at fair value on a recurring basis and had a liability fair value of approximately $2.5 million and $5.3 million at December 31, 2011 and 2010, respectively. The fair value of the interest rate swaps is determined using the market standard methodology of netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based the expectation of future interest rates derived from observed market interest rate curves. In addition, to comply with the provisions of applicable accounting guidance related to fair value measurements, the Company's valuations also consider the impact of both its own and the respective counterparty’s non-performance risk. In adjusting the fair value of its derivative contract for the effect of non-performance risk, the Company has considered any applicable credit enhancements. Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of December 31, 2011 and 2010, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative position and has determined that the credit valuation adjustment is not significant to the overall valuation. As a result, the Company classifies its derivative valuations in Level 2 of the fair value hierarchy. The following tables provide a summary of the fair value measurements at December 31, 2011 and 2010 for each major category of assets and liabilities measured at fair value on a recurring basis: Fair Value Measurements at Reporting Date Using Quoted Prices in Active Markets for Identical Assets/Liabilities Significant Other Observable Inputs Significant Unobservable Inputs Description 12/31/2011 (Level 1) (Level 2) (Level 3) Liabilities: Interest Rate Swaps $2,740,779 - $2,740,779 - F-29 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Fair Value Measurements at Reporting Date Using Quoted Prices in Active Markets for Identical Assets/Liabilities Significant Other Observable Inputs Significant Unobservable Inputs Description 12/31/2010 (Level 1) (Level 2) (Level 3) Liabilities: Interest Rate Swaps $5,266,586 - $5,266,586 - The detachable warrants issued to the holders of the unsecured promissory notes were valued using the Black-Scholes pricing model. The model is sensitive to changes in assumptions which can materially affect the fair value estimate. The Company’s method of estimating expected volatility was based on the volatility of its outstanding shares of common stock. The expected dividend yield was estimated based on the Company’s expected dividend rate over the term of the warrants. The expected term of the warrants was based on management’s estimate, and the risk-free interest rate is based on U.S. Treasuries with a term approximating the expected life of the warrants. The expected volatility, dividend, term and risk free interest rate used to value the warrants granted in 2010 were 60.0%, 0.0%, 3 years and 0.81%, respectively. The Company classifies the fair value of the detachable warrants in Level 2 of the fair value hierarchy. The fair value of the Company’s total debt obligations was approximately $223.6 million as of December 31, 2011 calculated using a discounted cash flows approach at a market rate of interest. The inputs used in the calculation are classified within Level 2 of the fair value hierarchy. The fair values of the Company’s financial instruments, other than the interest rate swap and debt obligations, including cash and cash equivalents approximate their carrying values. The Company bases its fair values on listed market prices or third party quotes when available. If not available, then the Company bases its estimates on instruments with similar terms and maturities. 10. Earnings per Share The following tables set forth the computation of basic and diluted earnings per share: For the Years Ended December 31, 2011 2010 2009 Net income (loss) $(17,146,900) $(11,408,486) $1,195,806 Weighted average shares outstanding: Basic 23,824,119 16,102,339 14,110,789 Effect of dilutive securities: Warrants - - 1,694,402 Options - - - Diluted 23,824,119 16,102,339 15,805,191 Basic earnings (loss) per share $(0.72) $(0.71) $0.08 Diluted earnings (loss) per share $(0.72) $(0.71) $0.08 Basic earnings per share ("EPS") is computed by dividing the net income by the weighted average number of common shares outstanding during the period. Included in weighted average number of shares outstanding for the years ended December 31, 2011, 2010 and 2009 is 632,911 shares of common stock for the effective conversion of the retained interest in Holdings into common stock of the Company. Diluted EPS adjusts basic EPS for the effects of Warrants, Units and Options; only in the periods in which such effect is dilutive. F-30 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) As part of the initial public offering in March 2007, the Company issued an Underwriter Purchase Option (“UPO”) to purchase 600,000 Units at an exercise price of $8.80 per unit. Each unit consists of one share of the Company’s common stock and one warrant. Each warrant entitles the holder to purchase from the Company one share of common stock at an exercise price of $5.00 per share. Upon exercise of the warrant, the warrant expires. The UPO expired unexercised on March 4, 2012. The UPO Units that could be converted into 1,200,000 weighted average common shares for the years ended December 31, 2011, 2010 and 2009 were outstanding but were not included in the computation of diluted earnings per share because the effects would be anti-dilutive. The weighted average shares of restricted stock outstanding that could be converted into 81,687 weighted average common shares outstanding for the year ended December 31, 2011 were not included in the computation of diluted earnings per share because the effect would be antidilutive. Weighted average options outstanding that could be converted into 107,703 and 43,360 weighted average common shares for the years ended December 31, 2011 and 2010, respectively were not included in the computation of diluted earnings per share because the effects would be anti-dilutive. Calculated on a weighted average basis on the number of days outstanding, warrants that could be converted into 114,096 and 8,089,049 weighted average common shares for the years ended December 31, 2011 and 2010, respectively were outstanding but were not included in the computation of diluted earnings per share because the effects would be anti-dilutive. The weighted average amount for the year ended December 31, 2011 includes a large number of warrants that were exercised or expired on March 4, 2011 pursuant to the original terms of the warrant agreements. The weighted average amount for the year ended December 31, 2010 includes a large number of warrants that were converted to common stock in connection with the Company’s offer to permit the Company’s warrant holders to tender their warrants for exercise, on a cashless basis. Pursuant to the offer, approximately 7.6 million warrants were converted into shares of common stock as of June 29, 2010 (the expiration date of the offer) and therefore these warrants were outstanding for a significant portion of the year ended December 31, 2010 and accordingly increased the weighted average shares outstanding. As of December 31, 2011, there were 90,000 Warrants, 1,474,719 Stock Options, and the UPO for 600,000 Units (as described above) outstanding, which are exercisable at weighted average exercise prices of $0.01, $5.45, and $8.80, respectively. As of December 31, 2010, there were 4,149,556 Warrants, 1,050,969 Stock Options, and the UPO for 600,000 Units outstanding, which were exercisable at weighted average exercise prices of $4.89, $5.40, and $8.80, respectively. F-31 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 11. Income Taxes Income tax (benefit) expense consists of the following: Year Ended December 31, 2011 2010 2009 Current income taxes: Federal $(10,602) $(1,053,185) $(240,192) State and local (117,387) (48,030) 144,160 Foreign (30,308) (23,939) - Deferred income taxes: Federal (10,130,941) (5,716,344) (107,781) State and local (1,047,162) 2,721,055 (516,397) Foreign (61,719) 1,048 - Benefit applied to reduce other identifiable intangibles 622,370 596,293 697,601 Total income tax (benefit) expense $(10,775,749) $(3,523,102) $(22,609) The Company’s current income tax benefit for 2011 relates to a slight decrease in unrecognized tax benefits. The Company’s deferred income tax benefit for 2011 primarily relates to the reduction in deferred tax liability for rental equipment and property and equipment and an increase in net operating loss. The Company’s current income tax benefit for 2010 primarily related to a decrease in unrecognized tax benefits associated with the settlement of uncertain tax positions. The Company’s deferred income tax benefit for 2010 primarily relates to the reduction in deferred tax liability for rental equipment and property and equipment and an increase in net operating loss. The Company’s current income tax benefit for 2009 relates to 2008 tax return to provision differences, an increase in uncertain tax positions and state and local taxes. The Company’s deferred income tax benefit for 2009 relates primarily to amortization of the Company’s tax deductible goodwill and a change in estimate associated with the Company’s state income tax apportionments and rates. F-32 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table is reconciliation between the federal statutory tax rate and the Company’s actual effective tax rate: For the Years Ended December 31, 2011 2010 2009 Federal statutory rate 35.0% 35.0% 35.0% State and local taxes 3.4% 0.9% (40.7)% Change in state deferred tax rates resulting from Coast Acquisition 0.8% (18.4)% 0.0% Change in state valuation allowance (0.4)% (0.9)% 4.7% Uncertain tax positions 0.0% 7.1% 4.7% Meals, entertainment and other (0.2)% (0.1)% (5.6)% Effective income tax rate 38.6% 23.6% (1.9)% The Company’s effective tax rate for the year ended December 31, 2011 was higher than the statutory rate primarily due to state and local taxes. The increase in the effective tax rate related to a small decrease in the state deferred tax rates at Essex Crane, which was partially offset by an additional state NOL valuation allowance. The Essex Crane state deferred rate decreased slightly due to a reduction in forecasted apportionment from higher tax rate states to lower tax rate states. The Company’s effective rate for the year ended December 31, 2010 was lower than the statutory tax rate primarily due to state and local taxes. The decrease in the effective tax rate related to the increase in state deferred tax rates at Essex Crane as a result of the acquisition of Coast Crane and an additional state NOL valuation allowance, which were partially offset by the reduction in unrecognized benefit associated with the effective settlement of uncertain tax positions. The Essex Crane state deferred tax rates increased due to an increase in apportionment into higher tax rate states which Coast Crane operates due to unitary filing requirements. The Company’s effective rate for the year ended December 31, 2009 was lower than the statutory tax rate primarily due to state and local taxes. The Company’s state deferred tax assets and liabilities were adjusted in 2009 associated with a change in estimate associated with its state income tax apportionments and rates resulting in a net state tax benefit. F-33 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The tax effects of temporary differences that give rise to deferred tax assets and liabilities are as follows: For the Year Ended December 31, 2011 2010 Deferred tax assets: Accounts receivable $1,200,515 $954,691 Accrued expenses 1,868,539 1,338,293 Goodwill and other intangibles 5,150,511 6,164,279 Inventory 357,697 176,442 Net operating loss carry-forwards 42,670,384 24,138,062 Tax credits and other 1,270,702 1,969,783 52,518,348 34,741,550 Valuation allowance (312,669) (195,838) Total deferred tax assets, net 52,205,679 34,545,712 Deferred tax liabilities: Rental equipment and property and equipment and other (100,378,047) (93,267,041) Total deferred tax liabilities (100,378,047) (93,267,041) Net deferred tax liabilities $(48,172,368) $(58,721,329) For the Years Ended December 31, 2011 2010 Amounts included in the consolidated balance sheets: Current deferred tax assets $3,478,114 $2,402,709 Long-term deferred tax liabilities (51,650,482) (61,124,038) Net deferred tax liabilities $(48,172,368) $(58,721,329) The Company establishes a valuation allowance when it is more likely than not that it will not be able to realize the benefit of the deferred tax assets, or when future deductibility is uncertain. Periodically, the valuation allowance is reviewed and adjusted based on management’s assessment of realizable deferred tax assets. The Company increased its valuation allowance related to state net operating loss carry-forwards (NOLs) by $0.1 million during the year ended December 31, 2011 as management determined that it is more likely than not a significant portion of state NOLs will expire before utilized. At December 31, 2011, the Company had unused Federal net operating loss carry-forwards totaling approximately $113.6 million and begin to expire in 2021. At December 31, 2011, the Company also had unused state net operating loss carry-forwards totaling approximately $61.6 million that expire between 2012 and 2031. The Company also has remaining unrecorded excess tax goodwill of approximately $3.3 million at December 31, 2011 associated with the acquisition of Holdings and excess tax goodwill of $0.7 million associated with the acquisition of Coast Crane. The excess tax goodwill related to Holdings is amortized over the remaining four year term as a reduction to the balance in other identifiable intangibles until its balance is reduced to zero and then as a benefit to the income tax provision when realized on the tax return. The excess tax goodwill related to Coast Crane is being amortized over the remaining thirteen year term. F-34 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company had approximately $0.1 million of unrecognized tax benefits, net of federal income tax benefit, at December 31, 2011 and 2010, all of which will impact the Company’s effective tax rate if recognized. The decrease in unrecognized benefits in 2010 was the result of the favorable settlement of an IRS examination. The majority of the remaining unrecognized tax benefits at December 31, 2011 are expected to reverse in 2012. A reconciliation of the approximate beginning and ending amounts of gross unrecognized tax benefits is as follows: Year Ended December 31, 2011 2010 Balance at beginning of year $100,000 $1,200,000 Increase for changes to tax positions in prior years, net - - Decrease for settlement of prior uncertain tax positions - (1,100,000) Balance at end of year $100,000 $100,000 The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits in income tax expense. To the extent interest is not assessed with respect to uncertain tax positions, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision. The Company had no accrual for interest or penalties for the years ended December 31, 2011, 2010 and 2009 as the Company has significant net operating loss carry-forwards which would be reduced if any payment were due under audit. The Company is generally subject to federal and state examination for the years 2008 through 2011. 12. Stock Based Compensation The Company may issue up to 1,500,000 shares of common stock pursuant to its 2011 Long-term Incentive Plan to employees, non-employee directors and consultants of the Corporation. Options to purchase shares of common stock are granted at its market price on the grant date and expire ten years from issuance. The Company may issue up to 1,575,000 shares of common stock pursuant to its 2008 Long-term Incentive Plan to employees, non-employee directors and consultants of the Corporation. Options to purchase shares of common stock are granted at its market price on the grant date and expire ten years from issuance. Stock Options Stock options granted to employees have a 10 year life and vest one-third annually beginning one year from the date of issue. The Company calculates stock option compensation expense based on the grant date fair value of the award and recognizes expense on a straight-line basis over the three year service period of the award. The Company has granted to certain key members of management options to purchase 423,750 shares at $5.58 per share, 485,969 shares at $6.45 per share, and 565,000 shares at $4.50 per share on grant dates of January 14, 2011, March 18, 2010, and December 18, 2008, respectively. The fair values of the stock options granted are estimated at the date of grant using the Black-Scholes option pricing model. The model is sensitive to changes in assumptions which can materially affect the fair value estimate. The Company’s method of estimating expected volatility for the 2010 option grant was based on the volatility of its peers since the Company only had operations for a short period of time as of the grant date. The Company’s method of estimating the expected volatility for the 2011 option grant was based on the volatility of its own common shares outstanding. The expected dividend yield was estimated based on the Company’s expected dividend rate over the term of the options. The expected term of the options was based on management’s estimate, and the risk-free rate is based on U.S. Treasuries with a term approximating the expected life of the options. F-35 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Based on the results of the model, the weighted average fair value of the stock options granted were $3.19, $3.76 and $2.54 per share for the options granted on January 14, 2011, March 18, 2010, and December 18, 2008, respectively, using the following assumptions: Grant Date 2011 2010 2008 Expected dividend yield 0.00% 0.00% 0.00% Risk-free interest rate 2.31% 2.79% 1.43% Expected volatility 60.00% 61.00% 61.00% Expected life of option 6 years 6 years 6 years Grant date fair value $1,351,763 $1,827,243 $1,434,671 The table below summarizes the stock option activity for the years ending December 31, 2011, 2010 and 2009: Stock Options Common Weighted Shares Subject Average to Options Exercise Price Balance at December 31, 2008 565,000 $4.50 Granted - - Exercised - - Expired/forfeited - - Balance at December 31, 2009 565,000 4.50 Granted 485,969 6.45 Exercised - - Expired/forfeited - - Balance at December 31, 2010 1,050,969 5.40 Granted 423,750 5.58 Exercised - - Expired/forfeited - - Balance at December 31, 2011 1,474,719 $5.45 F-36 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table summarizes information regarding options outstanding and exercisable at December 31, 2011: Options Outstanding (1) Options Exercisable (2) Weighted Weighted Average Weighted Average Weighted Remaining Average Remaining Average Contratual Exercise Contratual Exercise Options Term (Years) Price Options Term (Years) Price 2008 Options Grant 565,000 6.97 $4.50 565,000 2010 Options Grant 485,969 8.22 6.45 161,989 2011 Options Grant 423,750 9.05 5.58 - 1,474,719 7.98 $5.45 726,989 7.25 $4.93 Vested and expected to vest as of December 31, 2011 1,474,719 7.98 $5.45 (1)The aggregate intrinsic value of options outstanding that are vested and expected to vest as of December 31, 2011 is $0 calculated using the Company's closing share price of $2.95. (2)The aggregate intrinsic value of options exercisable as of December 31, 2011 is $0 calculated using the Company's closing share price of $2.95. There were 376,667 options and 188,333 options exercisable at December 31, 2010 and 2009, respectively, with a weighted average exercise price of $4.50. Restricted Shares of Common Stock On January 3, 2011, the Company granted to certain Coast Crane employees 166,943 shares of restricted common stock with an aggregate grant date fair value of $926,485. These shares vest 50% on January 1, 2012 and 50% on January 2013 and as such, none were vested as of December 31, 2011. The table below summarizes the restricted shares activity under the 2008 Long-term Incentive Plan related to stock options for the years ending December 31, 2011, 2010 and 2009: Restricted Shares Common Weighted Shares Subject Average to Grants Fair Value Balance at December 31, 2010 - - Granted 166,943 $5.55 Vested - - Expired/forfeited - - Balance at December 31, 2011 166,943 $5.55 The Company issued 23,522 and 16,377 shares of common stock under the Hyde Park Acquisition Corp. 2008 Long-term Incentive Plan during the years ended December 31, 2010 and 2009, respectively, to certain employees as compensation. The weighted average grant price of the shares issued was $5.59 and $6.16 for the years ended December 31, 2010 and 2009, respectively. The aggregate grant date fair value of approximately $0.1 million for the year ended December 31, 2010 was recorded as compensation within selling, general and administrative expenses and salaries, payroll taxes and benefits in the consolidated statements of operations with an offset recorded in additional paid in capital in the consolidated statements of stockholders’ equity. These shares, which amount to 42% of the amount of reduced cash salaries, were issued as part of a temporary salary reduction program pursuant to which our chief executive officer, members of executive management and other key managers receiving salaries elected to reduce the amount of their salaries paid in cash by 30 percent, 20 percent and 10 percent, respectively. The shares issued pursuant to the salary reduction program vested immediately upon grant and are restricted from sale for a period of two years from the date of grant. The voluntary temporary salary reduction program commenced in May 2009 and was terminated in November 2010. F-37 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company recorded $1,985,412, $1,087,305 and $478,223 of non-cash compensation expense associated with stock options and restricted shares in selling, general and administrative expenses for the years ended December 31, 2011, 2010 and 2009, respectively. There was approximately $2.0 million and $1.7 million of total unrecognized compensation cost as of December 31, 2011 and 2010, respectively related to non-vested stock option and restricted share awards. The remaining cost is expected to be recognized ratably over the remaining respective vesting periods. 13. Common Stock and Warrants In May 2010, our Board of Directors approved an offer allowing warrant holders to tender their warrants for exercise on a cashless basis by exchanging their warrants for shares of the Company’s common stock. The offer was approved in accordance with the recommendation of a committee comprised of the independent members of the Board who do not own warrants. In June 2010, the Board of Directors extended and amended the offer. Under the terms of the amended offer, the Board temporarily modified the terms of the Company’s outstanding warrants, to provide warrant holders with the opportunity to exercise their warrants on a cashless basis by exchanging three warrants for one share of the Company’s common stock. The number of properly tendered warrants that would be accepted by the Company in the offer was limited to 8,000,000 warrants. The amended offer expired on June 29, 2010. Pursuant to the offer, a total of 7,642,674 warrants were tendered for cashless exercise. Included in the tendered warrants were 936,840 warrants tendered by our officers and directors. In accordance with the offer, our officers and directors participated in the offer to the same extent as other warrant holders, which was at a participation rate of 65.3%. As a result of the exercise of warrants, 2,547,558 shares of common stock were issued in 2010. In October 2008, our Board of Directors authorized a stock and warrant repurchase program, under which the Company may purchase, from time to time, in open market transactions at prevailing prices or through privately negotiated transactions as conditions permit, up to $12.0 million of the Company’s outstanding common stock and warrants. Repurchases of our common stock and warrants are funded with cash flows of the business. The Company repurchased 519,905 warrants to acquire common stock for approximately $0.9 million during the year ended December 31, 2010. There was approximately $9.0 million remaining available for future common stock and warrant purchases subsequent to these purchases. In May 2010, the Company suspended its share and warrant repurchase program in conjunction with the cashless exercise warrant offer. On October 29, 2010, the Company entered into subscription agreements providing for the sale of an aggregate of 3,300,000 shares of the Company’s common stock, par value $0.0001 per share, at a price of $4.30 per share, or $14,190,000 in the aggregate, in a private offering (the “Private Placement”). The closing of the Private Placement and issuance of shares of common stock pursuant to the subscriptions was contingent upon CC Bidding being the successful bidder for, and consummating the acquisition of, the assets of Coast Crane. The proceeds of the offering were used to fund part of the cash portion of the purchase price for Coast Crane's assets. The shares were issued as of the closing date of the Coast Crane Acquisition on November 24, 2010. The Company incurred issuance costs of $638,550 for placement agent services and incurred legal fees of $135,051 for legal services rendered to the Company in connection with the Private Placement. In November 2010, in conjunction with the issuance of the unsecured promissory notes, the Company issued 90,000 warrants entitling the holders to purchase from the Company one share of common stock at an exercise price of $0.01, which expire on December 31, 2013. The fair value of the warrants on the issuance date was $296,400. See Note 8 for further discussion. F-38 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company issued 3,955,603 shares of common stock upon the exercise of warrants in exchange for cash proceeds of $19,778,000 during the year ended December 31, 2011. The Company issued 473,646 shares of common stock upon the exercise of warrants in exchange for cash proceeds of approximately $2.4 million during the year ended December 31, 2010. Upon the expiration of the warrants on March 4, 2011, 103,953 unexercised warrants expired worthless. The Company issued 3,200 shares of common stock during the year ended December 31, 2010 for professional services related to the Company’s common shares being listed on the NASDAQ Capital Market. 14. Segment Information Historically, prior to the acquisition of our Coast Crane subsidiary in November 2010, the Company had only one operating segment. As a result of the acquisition of Coast Crane, the Company now provides services that it had not in the past, including equipment distribution and parts and service to third parties not renting the Company’s equipment. We have identified three reportable segments: equipment rentals, equipment distribution, and parts and service. These segments are based upon how management of the Company allocates resources and assesses performance. The equipment rental segment includes rental, transportation, used rental equipment sales and repairs of rental equipment. There were no sales between segments for any of the periods presented. Selling, general, and administrative expenses as well as all other income and expense items below gross profit are not generally allocated to our reportable segments. We do not compile discrete financial information by our segments other than the information presented below. The following table presents information about our reportable segments related to revenues and gross profit: Years Ended December 31, 2011 2010 2009 Segment revenues Equipment rentals $58,859,497 $38,286,314 $52,089,392 Equipment distribution 14,206,479 1,238,722 - Parts and service 16,519,003 2,006,424 - Total revenues $89,584,979 $ 41,531,460 $ 52,089,392 Segment gross profit Equipment rentals $8,470,103 $ 5,250,723 $ 19,183,450 Equipment distribution 1,607,733 170,019 - Parts and service 3,019,402 706,801 - Total gross profit $13,097,238 $ 6,127,543 $ 19,183,450 F-39 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following table presents information about our reportable segments related to total assets: December 31, 2011 December 31, 2010 Segment identified assets Equipment rentals $351,401,140 $358,568,696 Equipment distribution 2,647,061 5,578,000 Parts and service 6,847,679 4,388,388 Total segment identified assets 360,895,880 368,535,084 Non-segment identified assets 20,004,349 14,511,874 Total assets $380,900,229 $383,046,958 The Company operates primarily in the United States. Our sales to international customers for the years ended December 31, 2011 and 2010 were 5.5% and 1.2% of total revenues, respectively. No one customer accounted for more than 10% of our revenues on an overall or segmented basis except as described below. Within the equipment distribution segment, three customers individually accounted for approximately 14.7%, 12.6%, and 10.4% of revenues on a segmented basis. The concentration of revenues from these customers within the equipment distribution segment is directly attributable to the large dollar value of individual transactions and the small number of individual transactions. 15. Commitments, Contingencies and Related Party Transactions The Company leases real estate and office equipment under operating leases which continue through 2015. The Company’s rent expense under non-cancelable operating leases totaled $1,924,184, $564,799 and $394,963 for the years ended December 31, 2011, 2010 and 2009, respectively. Future minimum lease payments for the Company’s non-cancellable operating leases at December 31, 2011 including operating leases are as follows: 2012 $1,851,438 2013 1,405,074 2014 711,689 2015 554,493 2016 83,082 Total $4,605,776 Since December 2010, the Company occupies office space at 500 Fifth Avenue, 50th Floor, New York, NY 10110, provided by Hyde Park Real Estate LLC, an affiliate of Laurence S. Levy, our chairman of the board. Such affiliate has agreed that it will make such office space, as well as certain office and administrative services, available to the Company, as may be required by the Company from time to time. The Company has agreed to pay such entity $7,500 per month for such services with terms of the arrangement being reconsidered from time to time. Prior to December 2010, the Company maintained an office at 461 Fifth Avenue, 25th Floor, New York, New York pursuant to an agreement with ProChannel Management LLC, also an affiliate of Laurence S. Levy. The Company’s statements of operations for the years ended December 31, 2011, 2010 and 2009 include $90,000 of rent expense related to these agreements. In November 2010, the Company entered into an agreement with the holders of certain Coast Crane indebtedness pursuant to which such holders agreed, in consideration of the assumption of such indebtedness by the Company, to exchange such indebtedness of $5.2 million for unsecured promissory notes issued by the Company in the aggregate principal amount of $5.2 million plus the receipt of up to 90,000 warrants to purchase Essex common stock at $0.01 per share. The unsecured promissory notes mature in December 2013. The holders of the unsecured promissory notes are related parties to the Company as they own a significant amount of the Company’s outstanding shares of common stock. F-40 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company maintains reserves for personal property taxes. These reserves are based on a variety of factors including: duration of rental in each county jurisdiction, tax rates, rental contract terms, customer filings, tax-exempt nature of projects or jurisdictions, statutes of limitations and potential related penalties and interest. Additionally, most customer rental contracts contain a provision that provides that personal property taxes are an obligation to be borne by the lessee. Where provided in the rental contract, management will invoice the customer for any personal property taxes paid by the Company. An estimated receivable has been provided in connection with this liability, net of an estimated allowance. This customer receivable has been presented as other receivables in current assets while the property tax reserve has been included in accrued taxes. Management estimated the gross personal property taxes liability and related contractual customer receivable of the Company to be approximately $3.2 million and $2.6 million respectively, at December 31, 2011. Management estimated the gross personal property taxes liability and related contractual customer receivable of the Company to be approximately $4.2 million and $3.2 million respectively, at December 31, 2010. The Company is subject to a number of claims and proceedings that generally arise in the normal conduct of business. The Company believes that any liabilities ultimately resulting from these claims will not, individually or in the aggregate, have a material adverse effect on our financial position, results of operations or cash flows. 16. 401(k) Profit Sharing Plan and Medical Benefits The Company has a defined contribution plan under Section 401(k) of the Internal Revenue Code available to all eligible employees. The plan requires the Company to 100% match the first 3% of a participant’s contributions and 50% match the next 2% of a participant’s contributions thereby totaling a maximum matching 4% if an employee contributes 5% of their compensation. These contributions vest immediately upon contribution. Company 401(k) contributions were $564,167, $173,820 and $172,244 for the years ended December 31, 2011, 2010 and 2009, respectively. The Company provides medical benefits to its employees and their dependants and is self-insured for Essex Crane employees for annual individual claims of up to $90,000 at which time a stop loss insurance policy covers any excess. 17. Concentrations A substantial portion of purchases of rental equipment, new equipment and majority of spare parts come from two vendors. The loss of either of these vendors is not expected to have a material negative impact on operations as there are other manufacturers and sources from which the Company may acquire rental equipment and spare parts, if necessary. No one customer accounted for more than 10% of our revenues at the consolidated level. 18. Summarized Quarterly Financial Data (Unaudited) The Company has been engaged primarily in renting lattice boom crawler cranes and attachments to the construction industry. Since November 24, 2010, the date the Company acquired the assets of Coast Crane, it has also been engaged in renting, servicing and distributing heavy lifting equipment and other construction related equipment and parts. F-41 ESSEX RENTAL CORP. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following is a summary of our unaudited quarterly financial results of operations for the years ended December 31, 2011 and 2010: First Second Third Fourth Quarter Quarter Quarter Quarter 2011 Total revenues $21,487,170 $22,344,505 $23,283,773 $22,469,531 Gross profit (1) 3,348,536 2,860,285 3,597,264 3,291,153 Loss from operations (4,359,077) (4,613,227) (3,361,021) (4,163,427) Loss before benefit for income taxes (7,051,826) (7,366,915) (6,149,644) (7,074,264) Net loss (4,662,252) (4,526,032) (3,653,534) (4,130,362) Basic net loss per share (2) $(0.21) $(0.19) $(0.15) $(0.18) Diluted net loss per share (2) $(0.21) $(0.19) $(0.15) $(0.18) (1)The amounts presented for the first three quarters of 2011 are not equal to the same amounts previously reported in the respective Form 10-Q’s filed with the SEC for each period as a result of the reclassification of certain depreciation charges to cost of revenues. Below is a reconciliation of the amounts previously reported. (2)Because of the method used in calculating per share data, the summation of the quarterly per share data may not necessarily total the per share data computed for the entire year. First Second Third Quarter Quarter Quarter Total gross profit previously reported in Form 10-Q $3,527,977 $3,040,323 $3,776,652 Total depreciation expense subsequently reclassified to cost of revenues (179,441) (180,038) (179,388) Total gross profit disclosed in Form 10-K $3,348,536 $2,860,285 $3,597,264 First Second Third Fourth Quarter Quarter Quarter Quarter 2010 Total revenues $8,307,309 $9,046,146 $8,751,474 $15,426,531 Gross profit 1,191,242 1,154,310 1,479,471 2,302,520 Loss from operations (1,500,541) (1,694,400) (1,459,712) (3,137,293) Loss before benefit for income taxes (3,120,157) (3,349,640) (3,184,543) (5,277,248) Net loss (1,987,739) (2,228,525) (2,205,193) (4,987,029) Basic net loss per share (1) $(0.14) $(0.15) $(0.13) $(0.27) Diluted net loss per share (1) $(0.14) $(0.15) $(0.13) $(0.27) (1) Because of the method used in calculating per share data, the summation of the quarterly per share data may not necessarily total to the per share data computed for the entire year. 19. Subsequent Events The Company has evaluated subsequent events through the date of this filing. Subsequent to December 31, 2011, the Company issued 38,206 shares of common stock to certain board members for participation in the Strategic Planning and Finance Committee of the Board of Directors. F-42 Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ESSEX RENTAL CORP Date: March 14, 2012 By: /s/ Ronald Schad Ronald Schad, Chief Executive Officer Pursuant to the requirements of the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Signatures Title Date /s/ Laurence S. Levy Chairman March 14, 2012 Laurence S. Levy /s/ Edward Levy Director March 14, 2012 Edward Levy /s/ Daniel H. Blumenthal Director March 14, 2012 Daniel H. Blumenthal /s/ John G. Nestor Director March 14, 2012 John G. Nestor /s/ Ronald Schad Chief Executive Officer (Principal March 14, 2012 Ronald Schad Executive Officer) and Director /s/ Martin Kroll Chief Financial Officer (Principal March 14, 2012 Martin Kroll Financial Officer and Principal Accounting Officer)

STREAMLINE HEALTH SOLUTIONS INC.

10-K

https://www.sec.gov/Archives/edgar/data/1008586/0000950152-07-003118.txt

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended January 31, 2007 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 0-28132 Streamline Health Solutions, Inc. (Exact name of registrant as specified in its charter) Delaware 31-1455414 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 10200 Alliance Road, Suite 200 Cincinnati, OH 45242-4716 (Address of principal executive offices) (Zip Code) (513) 794-7100 (Registrant s telephone number, including area code) LanVision Systems, Inc. (Former name, former address, and former fiscal year, if changed since last report) Securities registered pursuant to Section 12 (b) of the Act: Common Stock, $.01 par value ( Title of Class ) The NASDAQ Stock Market LLC (Name of exchange on which listed) Securities registered pursuant to Section 12 (g) of the Act: None 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 þ 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 þ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark 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 the 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. þ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. Large accelerated filer o Accelerated filer o Non-accelerated filer þ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ The aggregate market value of the voting stock held by nonaffiliates of the registrant, computed using the closing price as reported by The NASDAQ Stock Market for the Registrant s Common Stock on July 31, 2006, was $28,489,331. The number of shares outstanding of the Registrant s Common Stock, $.01 par value, as of April 2, 2007: 9,211,399. DOCUMENTS INCORPORATED BY REFERENCE Certain portions of the Registrant s Definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 23, 2007 are incorporated by reference into Part III of this Form 10-K to the extent stated herein. Except with respect to information specifically incorporated by reference in this Form 10-K, the Definitive Proxy Statement is not deemed to be filed as a part hereof. Table of Contents FORWARD-LOOKING STATEMENTS In addition to historical information contained herein, this Annual Report on Form 10-K contains forward-looking statements relating to the Company s plans, strategies, expectations, intentions, etc. and are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements contained herein are no guarantee of future performance and are subject to certain risks and uncertainties that are difficult to predict and actual results could differ materially from those reflected in the forward-looking statements. These risks and uncertainties include, but are not limited to, the timing of contract negotiations and executions, the impact of competitive products and pricing, product demand and market acceptance, new product development, key strategic alliances with vendors that resell Streamline Health products, the ability of Streamline Health to control costs, availability of products obtained from third-party vendors, the healthcare regulatory environment, healthcare information system budgets, availability of healthcare information systems trained personnel for implementation of new systems, as well as maintenance of legacy systems, fluctuations in operating results and other risk factors that might cause such differences including those discussed herein, including, but not limited to, discussions in the sections entitled Part I, Item 1 Business , Item 1A Risk Factors , Part II, Item 7 Management s Discussion and Analysis of Financial Condition and Results of Operations and Item 8 Financial Statements and Supplemental Data. In addition, other written or oral statements that constitute forward-looking statements may be made by or on behalf of the Company. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management s analysis only as of the date thereof. The Registrant undertakes no obligation to publicly revise these forward-looking statements, to reflect events or circumstances that arise after the date hereof. Readers should carefully review the risk factors described in this and other documents Streamline Health Solutions, Inc. files from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. PART I Item 1. Business General Streamline Health Solutions, Inc. ( Streamline Health® or the Company ) formerly known as LanVision Systems, Inc. is a healthcare information technology company, which is focused on developing and licensing proprietary software solutions that improve document-centric information flows and complement and enhance existing transaction-centric hospital healthcare information systems. The Company s workflow and document management solutions bridge the gap between current, predominantly paper-based processes and transaction-based healthcare information systems by 1) electronically capturing document-centric information from disparate sources, 2) electronically directing that information through vital business processes, and 3) providing access to the information to authenticated users (such as physicians, nurses, administrative and financial personnel and payers) across the continuum of care. Streamline Health s systems are designed for enterprise wide deployment to seamlessly connect disparate departmental systems, or silos of independent technologies which create Friction PointsTM, in a common interoperable document management workflow solution. The Company s workflow-based products and services offer solutions to specific healthcare business processes within the Health Information Management (HIM) and revenue cycle, such as: remote coding, abstracting and chart completion, remote physician order processing, pre-admission registration scanning, insurance verification, secondary billing services, explanation of benefits processing, release of information processing and other departmental workflow processes. The Company s products and services also create an integrated document-centric repository of historical health information that is complementary to, and can be seamlessly bolted on to existing transaction-centric clinical, financial and management information systems, allowing healthcare providers to aggressively move toward fully Electronic Medical Record (EMR) processes while improving service levels and convenience for all stakeholders. These integrated systems allow providers and administrators to dramatically improve the availability of patient information while decreasing direct costs associated with document retrieval, work-in-process, chart completion, document retention and archiving. 1 Table of Contents The Company s software solutions can be provided on a subscription basis via remote application-hosting services or licensed and installed locally. Streamline Health provides ASPeNSM, Application Service Provider-based remote hosting services to, The University Hospital, a member of the Health Alliance of Greater Cincinnati, M.D. Anderson Cancer Center, and Children s Medical Center of Columbus, OH, among others. In addition, Streamline Health has licensed its workflow and document management solutions, which are installed at leading healthcare providers including Stanford Hospital and Clinics, the Albert Einstein Healthcare Network, Beth Israel Medical Centers, the University of Pittsburgh Medical Center, Medical University Hospital Authority of South Carolina, and Memorial Sloan-Kettering Cancer Center, among others. The Company s applications allow authenticated users, such as physicians, nurses, administrative and financial personnel, and payers with access to patient healthcare information that exists in disparate systems across the continuum of care and improve operational efficiencies through business process re-engineering and automating labor-intensive and demanding paper environments. Streamline Health s applications and services are complementary to existing clinical and financial systems, and use document imaging and advanced workflow tools to ensure users can electronically access both structured (transaction-centric) and unstructured (document-centric) patient data and all the various forms of clinical and financial healthcare information from a single permanent and secure repository, including clinician s handwritten notes, laboratory reports, photographs, insurance cards, etc. The Company s workflow solutions offer value to all of the constituents in the healthcare delivery process by enabling them to simultaneously access and utilize Streamline Health s advanced technological workflow applications to process information, on a real-time basis from virtually any location, including the Physician s desktop, using web-based technology. Streamline Health s solutions integrate its own proprietary imaging platform, application workflow modules and image and web-enabling tools that allow for the seamless merger of back office functionality with existing Clinical and Financial Information Systems at the desktop. The Company offers its own document imaging/management infrastructure (Foundation Suite) that is built for high volume transaction processing and is specifically designed for the healthcare industry. In addition to providing access to information not previously available at the desktop, Streamline Health s applications fulfill the administrative and regulatory needs of the Health Information Management, Patient Financial Services and other hospital departments. Furthermore, these systems have been specifically designed to integrate with any Clinical Information System. For example, Streamline Health has integrated its products with selected systems from Siemens Medical Solutions USA Inc. (Siemens), Cerner Corporation, and IDX Information Systems Corporation (IDX) (now part of GE Medical see below) applications, thus enabling customers to use our solutions without the expense of replacing entire software systems to gain the software functionality. By offering electronic access to all the patient information components of the medical record, this integration completes one of the most difficult tasks necessary to provide a true Electronic Medical Record. Streamline Health s systems deliver on-line enterprise wide access to fully updated patient information, which historically was maintained on a variety of media, including paper, magnetic disk, optical disk, and microfilm. The Company operates in one segment as a provider of health information technology solutions that streamline healthcare information flows within a healthcare facility. The financial information required by Items 101(b) of Regulation S-K is contained in Item 6 Selected Financial Information of this Form 10-K. Historically, Streamline Health has derived most of its revenues from recurring application-hosting services, recurring maintenance fees, professional services and system sales involving the licensing, either directly or through remarketing partners, of its Health Information Management Workflow and Revenue Cycle Management Workflow solutions to Integrated Healthcare Delivery Networks (IDN). In a typical transaction, Streamline Health, or its remarketing partners, enter into a perpetual license or fee-for-service subscription agreement for Streamline Health s software application suite and may license or sell other third-party software and hardware components to the IDN. Additionally, Streamline Health provides professional services, including implementation, training, and product support. Streamline Health earns its highest margins on proprietary Streamline Health software and application-hosting services and the lowest margins on third-party hardware and software. Sales to customers may include different configurations of Streamline Health software, hardware, third party software, and professional services, resulting in 2 Table of Contents varying margins among contracts. The margins on professional services revenues fluctuate based upon the negotiated terms of the agreement with each customer and Streamline Health s ability to fully utilize its professional services, maintenance, and support services staff. Beginning in 1998, Streamline Health began offering customers the ability to obtain its workflow solutions on an application-hosting basis as an Application Service Provider (ASP). Streamline Health established a hosting data center and installed Streamline Health s suite of workflow products, called ASPeN (Application Service Provider eHealth Network) within the hosting data center. Under this arrangement, customers electronically capture information and securely transmit the data to the hosting data center. The ASPeN services store and manage the data using Streamline Health s suite of applications, and customers can view, print, fax, and process the information from anywhere using the Streamline Health web-based applications. Streamline Health charges and recognizes revenue for these ASPeN services on a per transaction or subscription basis as information is captured, stored, retrieved and processed. The decisions by a healthcare provider to replace, substantially modify, or upgrade its information systems are a strategic decision and often involve a large capital commitment requiring an extended approval process. Since inception, Streamline Health has experienced extended sales cycles. It is not uncommon for sales cycles to take six to eighteen months from initial contact to the execution of an agreement. As a result, the sales cycles can cause significant variations in quarter-to-quarter operating results. These agreements cover the licensing, implementation and maintenance of the system, which typically takes place in one or more phases. The licensing agreements generally provide for the licensing of Streamline Health s proprietary software and third-party software with a perpetual or term license fee on either an unlimited number of users (site license) or a specific number of users (concurrent users license) that is adjusted upward depending on the number of concurrent users using the software. Site-specific customization, interfaces with existing customer systems and other consulting services are sold on a fixed fee or a time and materials basis. Alternatively, with Streamline Health s ASP services solution, the application-hosting services agreements generally provide for utilizing Streamline Health s software and third-party software on a fee per transaction or recurring subscription basis. ASPeN services was designed to overcome obstacles in the buying decision such as large capital commitment, length of implementation, and the scarcity of time for Healthcare Information Systems personnel to implement new systems. Streamline Health believes that large IDN s and smaller healthcare providers are looking for this type of ASP application because of the ease of implementation and lower entry-level costs. Streamline Health believes its business model is especially well suited for the medium to small acute care facility marketplace as well as the ambulatory marketplace and is actively pursuing remarketing agreements, in addition to those discussed below, with other Healthcare Information Systems and staff outsourcing providers to distribute Streamline Health s workflow solutions. Generally, revenues from systems sales are recognized when an agreement is signed and products are made available to end-users. Revenue recognition related to routine installation, integration and project management are deferred until the work is performed. Revenues from consulting, training, and application-hosting services are recognized as the services are performed. Revenues from short-term support and maintenance agreements are recognized ratably over the term of the agreements. Billings to customers recorded prior to the recognition of the revenue are classified as deferred revenues. Revenues recognized prior to progress billings to customers are recorded as contract receivables. In 2002, Streamline Health entered into a five year Remarketing Agreement with IDX Information Systems Corporation, which was acquired by GE Healthcare, a unit of the General Electric Company in January 2006. Under the terms of the Remarketing Agreement, IDX was granted a non-exclusive worldwide license to distribute all Streamline Health workflow software including accessANYwareTM, Coding Workflow, and ASPeN application-hosting services to IDX customers and prospective customers, as defined in the Remarketing Agreement. The Agreement has an automatic annual renewal provision and, after the initial five year period, can be cancelled by IDX upon 90 days written notice to the Company. The Company believes that the agreement will be renewed and will not be terminated. Under the terms of a Remarketing Agreement with IDX (now part of GE Healthcare), Streamline Health records this revenue when the products are made available to end-users. Royalties are remitted to Streamline Health 3 Table of Contents based upon IDX sublicensing Streamline Health s software to its customers. Thirty percent of the royalty is due 45 days following the end of the month in which IDX executes an end-user license agreement with its customer. The remaining seventy percent of the royalty is due from IDX, in varying amounts based on specific milestones, 45 days following the end of the month in which a milestone occurs. Streamline Health s quarterly operating results have varied in the past and will continue to do so in the future because of various reasons including: demand for Streamline Health s products and services, long sales cycles, and extended installation and implementation cycles based on customer s schedules. Sales are often delayed because of customers budgets and competing capital expenditure needs as well as personnel resource constraints within an integrated delivery network. Delays in anticipated sales or installations have a significant impact on Streamline Health s quarterly revenues and operating results, because substantial portions of the operating expenses are fixed. The U.S. Department of Health and Human Services, in its National Health Expenditure Projections released in January 2003, believes that health spending expenditures will reach $3.1 trillion in 2012, growing at an average annual rate of 7.3% during the forecasted period 2002-2012. As a share of the Gross Domestic Product, health spending is projected to reach 17.7% by 2012 up from its 2002 level of 14.1%. Total spending on healthcare was $1.9 trillion in 2004, over four times the amount spent on defense (source: National Coalition on Health Care). Hospital spending accounted for 28% of the growth in personal health spending between 1997 and 2000 and increased to 38% by 2002 2004. The federal Centers for Medicare and Medicaid Services projections indicate that by 2015, health spending will account for 20% of the gross domestic product, up from 16% in 2005 and the growth in spending is projected to average 7.2% a year. In response to this growth, the healthcare industry is undergoing significant change as competition and cost-containment measures imposed by governmental and private payers have created significant pressures on healthcare providers to control healthcare costs while providing quality patient care. At the same time, the healthcare delivery system is experiencing a shift from a highly fragmented group of non-allied healthcare providers to integrated healthcare networks, which combine all of the services, products and equipment necessary to address the needs of healthcare customers. As a result, healthcare providers are seeking to cut costs, increase productivity and enhance the quality of patient care through improved access to information throughout the entire hospital or integrated healthcare network. In 2004, President Bush called for all Americans to have electronic health records by 2014. Since then he has emphasized health-care information technology in some very high-profile speeches, including his 2007 State of the Union address, calling it critical to making the United States health-care system more efficient, affordable, and safe. Today, the majority of the patient records are paper-based. The inefficiencies of paper-based records increase the cost of patient care. Physicians often cannot gain access to medical records at the time of patient visits, and multiple users cannot simultaneously access the record when only a single copy of the paper-based patient record is available. Based upon Streamline Health s experience in installing its systems, a typical 500 bed hospital can produce 15,000 to 20,000 pages of new patient information each day even with computerized admission, billing, laboratory and radiology systems, and individual physician document retrieval requests can be as high as 100 documents per physician per day. The volume of medical images in the patient record is expanding as well. In addition to images such as x-rays and CAT scans, MRI s, new image forms such as digitized slides, videos and photographs proliferate. Thus, the ability to store and retrieve images of voluminous paper records and medical images on a timely basis is a critical feature of a complete Computerized Patient Record. In order to simultaneously reduce costs and enhance the level of patient care, hospitals and other healthcare providers are requiring comprehensive, cost-effective information systems that deliver rapid access to fully updated and complete patient information. Traditional Healthcare Information Systems are inadequate because: (i) they do not capture large amounts of the patient records which are paper-based and stored in various sites throughout the enterprise; (ii) computerized patient data is generated using a variety of disparate systems which cannot share information; and (iii) multimedia medical information such as x-rays, CAT scans, MRI s, video and audio information are frequently inaccessible at the point of patient care. Accordingly, hospitals and other healthcare providers have begun to increase their information systems expenditures. In 2001, the eleventh Annual Healthcare Information and Management Systems Society (HIMSS) Leadership Survey, healthcare business issues were driving Information Technology priorities with over half of the respondents indicating that cost pressures would 4 Table of Contents continue to be a driving force in improving operational efficiencies. Included in the top ten Information Technology priorities was the implementation of Computerized Patient Records. Respondents believe that implementing eHealth and HIPAA (Health Insurance Portability and Accountability Act of 1996) strategies (See Regulations Relating to Confidentiality below) will consume most of the Information Technology budget, because use of interactive eHealth solutions has become a competitive advantage. Providers, payers and suppliers know that the consequences of ignoring an eHealth Strategy will result in the loss of market share. Streamline Health believes that the HIPAA regulations are an additional impetus for IDN s to embrace Streamline Health products and services as a means of ensuring compliance with Federal Regulations. Document imaging and workflow (management) technologies are essential elements of a complete EMR because they allow for the storage of unstructured data (i.e., patient record elements other than data or text, such as hand written physician or nursing notes and physician orders, photographs, images of a document) and they enable digitized x-rays, CAT scans, MRI s, video and audio information to be accessed and delivered to the caregiver at the point of patient care. Streamline Health believes the demand for its Health Information Management Workflow solutions, which can supply document-imaging capabilities to the EMR, will increase in future years. In addition to mandated HIPAA regulations, the healthcare industry is being strongly encouraged by many professional medical organizations to make greater use of information technology. A report by the Institute of Medicine (IOM) of the National Academies, entitled To Err is Human: Building a Better Health System, envisioned a revamped system that, among other things, makes greater use of information technology to enable providers and institutions to move away from paper-based medical record systems to take advantage of new information technology. The American Medical Association, American Academy of Family Physicians, American College of Physicians, American Society of Internal Medicine, and the American College of Surgeons, issued a joint statement supporting the IOM recommendations. Regulatory Matters The U.S. Department of Health and Human Services (HSS) asked the Institute of Medicine of the National Academy of Sciences to design a standardized model of an electronic health record, in a move that may help spur nationwide acceptance of EMR s. The impact of such a change, if implemented by HSS, on current Streamline Health products and services is unknown at this time. However, Streamline Health believes that its software and systems are sufficiently flexible to accommodate changing regulatory requirements. Also, in 2004, President Bush put forth the goal of establishing EMR s for most Americans within 10 years. A national health-technology coordinator has been appointed who reports to the Secretary of HSS. His responsibility is specifically to create a plan to guide the highly fragmented industry toward an interoperable electronic medical records system. As noted in a Wall Street Journal article dated July 21, 2004, Putting such a system in place can cost a major hospital $20 million or more. HSS estimated then that in the U.S., only about 13% of hospitals had adopted electronic health records for patients. As a result, the health-care industry lags far behind most other industries in using computers. In 2005, President Bush appointed a national coordinator for Health Information Technology in the Health and Human Services Department. His task is to give every American an electronic medical record of their health care by 2014, and link all the records into one giant medical Internet, called the National Health Information Network. HHS will build the network s backbone and set the standards for swapping data. Physicians and hospitals will have to pay for the computers, software, and other infrastructure, which according to HSS is estimated at up to $150 billion over five years. President s Information Technology Advisory Committee In 2004, the President s Information Technology Advisory Committee issued its report entitled Revolutionizing Health Care Through Information Technology, which focused on the most fundamental and pervasive problem of healthcare delivery: the paper-based medical record. In the report, they stated the potential of information technology to reduce the number of medical errors, reduce cost, and improve patient care is enormous. 5 Table of Contents The essence of our recommendations is a framework for 21st century health care information infrastructure that revolutionizes medical records systems. The four core elements of this framework are: (1) Electronic health records for all Americans that provide every patient and his or her caregivers the necessary information required for optimal care while reducing costs and administrative overhead. (2) Computer-assisted clinical decision support to increase the ability of health care providers to take advantage of state-of-the-art medical knowledge as they make treatment decisions (enabling the practice of evidenced-based medicine). (3) Computerized provider order entry such as for tests, medicine, and procedures both for outpatient care and within the hospital environment. (4) Secure, private, interoperable, electronic health information exchange, including both highly specific standards for capturing new data and tools for capturing non-standard-compliant electronic information from legacy systems. Streamline Health s current products and services can currently be used to implement some of the recommendations or provide interim solutions to some of the aspects recommended in items 1, 3 & 4 above, especially with regard to legacy, paper based, medical information, order entry systems, other than medication, and security of exchanging health information. Based on the Federal initiatives noted above, Streamline Health believes that its product and services are able to support these and other similar initiatives, and its products are currently available and installed at leading healthcare facilities throughout the U.S. Regulations Relating to Confidentiality Federal and state laws regulate the confidentiality of patient records and the circumstances under which such records may be released. These regulations govern both the disclosure and use of confidential patient health information. Regulations governing electronic health data privacy are continuing to evolve. The Health Insurance Portability and Accountability Act of 1996, enacted August 22, 1996, is designed to improve the efficiency of healthcare by standardizing the interchange of specified electronic data, and to protect the security and confidentiality of Protected Health Information (PHI). The legislation requires that covered entities comply with national standards for certain types of electronic health information transactions and the data elements used in such transactions, and adopt policies and practices to ensure the integrity and confidentiality of PHI. Regulations adopted pursuant to HIPAA include rules addressing several areas. Compliance with the new Privacy Rule was required by most covered entities (other than small health plans) by April 2003. The final Privacy Rule also extended the scope of enforcement to PHI residing on non-electronic media, such as paper, as well as to email, oral and written communications. The regulations under the Security Rule were effective in April 2003, with a compliance date of April 2005. Small health plans had until April 2006 to comply with the Security Rule. The regulations issued to date have not had a material adverse affect on our business. Streamline Health cannot predict the potential impact of new or revised regulations that have not yet been released or made final, or any other regulations that might be adopted. Congress may adopt legislation that may change, override, conflict with, or preempt the currently issued regulations. Additionally, legislation governing the dissemination of patient health information is also from time to time proposed and debated at the state level. These laws or regulations, when adopted, could restrict the ability of customers to obtain, use, or disseminate patient health information. Streamline Health believes that the features and architecture of Streamline Health s products are such that it currently supports or should be able to make the necessary modifications to its products, if required, to ensure support of the HIPAA regulations, and other legislation or regulations. However, if the regulations are unduly restrictive, this could cause delays in the delivery of new versions of products and adversely effect the licensing of Streamline Health s products. Overall, Streamline Health believes the HIPAA regulations will continue to stimulate healthcare organizations to purchase computer-based EMR systems that automate the collection, use, and disclosure of patient health information, while maintaining appropriate 6 Table of Contents security and audit controls over the information. However, there can be no assurance that an increase in the purchase of new systems or additional use of Streamline Health application-hosting services will occur. Rapid Technological Change and Evolving Market The market for Streamline Health s products and services is characterized by rapidly changing technologies, regulatory requirements, evolving industry standards and new product introductions and enhancements that may render existing products obsolete or less competitive. As a result, Streamline Health s position in the healthcare information technology market could change rapidly due to unforeseen changes in the features and functions of competing products, as well as the pricing models for such products. Streamline Health s future success will depend, in part, upon Streamline Health s ability to enhance its existing products and services and to develop and introduce new products and services to meet changing requirements. Changes and Consolidation in the Healthcare Industry Streamline Health derives substantially all of its revenues from the licensing of software, providing professional services and maintenance services and providing application-hosting services within the healthcare industry. Accordingly, the success of Streamline Health is dependent upon the regulatory and economic conditions in the healthcare industry. Many healthcare providers are consolidating to establish integrated delivery networks to take advantage of economies of scale, greater marketing power and greater leverage in negotiating with vendors who supply the industry with the goods and services they require. The impact of such consolidations, Streamline Health believes, will benefit Streamline Health as more healthcare organizations investigate methods to streamline operations, including outsourcing non-core services to reduce costs and improve the quality of patient care through the use of information technology, especially in the paper intensive area of Patient Medical Records and Patient Financial Services. Key Personnel Streamline Health s success depends, to a significant degree, on its management, sales and technical personnel. Streamline Health must recruit, motivate and retain highly skilled managers, and sales force, consulting and technical personnel, including application programmers, database specialists, consultants and system architects skilled in the technical environments in which Streamline Health s products operate. Competition for such technical expertise is intense. Our failure to attract and retain qualified personnel could have a material adverse impact on the Company. Limited Protection of Proprietary Technology The success of Streamline Health depends on the protection of its intellectual property rights relating to its proprietary technology. Streamline Health relies on a combination of confidentiality, nondisclosure, license, and employment agreements, trade secret laws, copyrights, and restrictions on the disclosure of its intellectual property. Notwithstanding these precautions, others may copy, reverse engineer or design independently, technology similar to Streamline Health s products. It may be necessary to litigate to enforce or defend Streamline Health s proprietary technology or to determine the validity of the intellectual property rights of others. Streamline Health could also be required to defend itself against claims made by third parties for intellectual property right infringement. Any litigation, could be successful or unsuccessful, may result in substantial cost and require significant attention by management and technical personnel. Warranties and Indemnities Streamline Health s products are very complex and may not be error free, especially when first released. Failure of any Streamline Health product to operate in accordance with its specifications and documentation could constitute a breach of the license agreement and require Streamline Health to correct the deficiency. If such deficiency is not corrected within the agreed upon contractual limitations on liability and cannot be corrected in a timely manner, it could constitute a material breach of a contract allowing the termination thereof and possibly subjecting Streamline Health to a financial liability. Also, Streamline Health indemnifies its customers against 7 Table of Contents third-party infringement claims. If such claims are made, even if they are without merit, they could be expensive to defend. If Streamline Health becomes liable to a third-party for infringement of their intellectual property, Streamline Health could be required to pay substantial amounts as damages, obtain a license to use the infringing technologies, develop its own noninfringing technologies, or cease using the infringing intellectual property. Competition Several companies historically have dominated the Healthcare Clinical Information System software market and several of these companies have either acquired, developed or are developing their own document imaging and workflow technologies. The industry is undergoing consolidation and realignment as companies position themselves to compete more effectively. Strategic alliances between vendors offering Health Information Management Workflow and document imaging technologies and vendors of other healthcare systems are increasing. Barriers to entry to this market include technological and application sophistication, the ability to offer a proven product, a well-established customer base and distribution channels, brand recognition, the ability to operate on a variety of operating systems and hardware platforms, the ability to integrate with pre-existing systems and capital for sustained development and marketing activities. Streamline Health believes that these barriers taken together represent a moderate to high level barrier to entry. Foreign competition has not been a significant factor in the market, to date. Streamline Health has many competitors including Clinical Information System vendors that are larger and more established and have substantially more resources than Streamline Health. In addition, information and document management companies serving other industries may enter the market. Suppliers and companies with whom Streamline Health may establish strategic alliances may also compete with Streamline Health. Such companies and vendors may either individually, or by forming alliances excluding Streamline Health, place bids for large agreements in competition with Streamline Health. A decision on the part of any of these competitors to focus additional resources in the image-enabling, workflow, and other markets addressed by Streamline Health could have a material adverse effect on Streamline Health. Streamline Health believes that the principal competitive factors in its market are customer recommendations and references, company reputation, system reliability, system features and functionality (including ease of use), technological advancements, customer service and support, breadth and quality of the systems, the potential for enhancements and future compatible products, the effectiveness of marketing and sales efforts, price and the size and perceived financial stability of the vendor. In addition, Streamline Health believes that the speed with which companies in its market can anticipate the evolving healthcare industry structure and identify unmet needs are important competitive factors. There can be no assurance that Streamline Health will be able to compete successfully in the future against existing or potential competitors. Streamline Health believes that its principal competitors are: American Management Systems, Incorporated; Cerner Corporation; Eclipsys Corporation; Hyland Software, Inc.; McKesson HBOC, Inc.; MedPlus, Inc. (a subsidiary of Quest Diagnostics Incorporated); Perceptive Vision, Inc.; Siemens Medical Solutions USA, Inc. (a subsidiary of Siemens AG); and SoftMed Systems, Inc., which was recently acquired by 3M. The Streamline Health Solution Streamline Health s products and services streamline information flows and provide Health Information Management Workflow, Patient Financial Services and other departmental Workflow solutions for the patient and other information access needs of hospitals and integrated healthcare delivery networks. Streamline Health s systems enable medical and administrative personnel to rapidly and efficiently capture, store, manage, route, retrieve and process vast amounts of clinical, financial, patient and other information. Streamline Health s systems: (i) capture and store electronic data from disparate hospital information systems through real-time, computerized interfaces; (ii) provide applications for efficiently scanning and automatically indexing paper-based records; (iii) allow storage of a patient s lifetime medical record on secure media which also provides rapid access to high volumes of data enterprise wide; (iv) provide technologically advanced workflow automation software to facilitate the re-engineering of business processes; and (v) incorporate 8 Table of Contents physician-oriented interfaces that allow the user to easily locate and retrieve patient information in the hospital or clinical setting, including the point of patient care. Streamline Health s Health Information Management Workflow and Patient Financial Services Workflow solutions provide financial, administrative, and clinical benefits to the healthcare provider and facilitate more effective patient care. These benefits include: (i) improved access to patient information to assist in making informed clinical and financial decisions; (ii) reduced costs for administrative personnel due to increased workflow efficiency, as data can be routed within an organization to all users who need to process that information simultaneously or in sequence as required; (iii) increased productivity through the elimination of file contention by providing multiple users simultaneous access to patient medical records;(iv) reduced costs and improved care through the reduction of unnecessary testing and admissions; (v) improved cash flow through accelerated account receivable collections and reductions in technical denials (which occur when a third-party payer refuses payment because of the provider s inability to substantiate billing claims due to loss of portions or all of the patient record); (vi) expedited treatment decisions, and fewer redundant tests as a result of timely access to complete information; (vii) fewer medical record errors by minimizing misfiled, lost and improperly completed records; and (viii) increased security of patient information through improved controls on access to confidential data and the creation of audit trails that identify the persons who accessed or even tried to access such information. The Streamline Health Strategy Streamline Health s objective is to continue to be a leading provider of Health Information Management and Patient Financial Services Workflow solutions to the healthcare industry. Important elements of Streamline Health s business strategy include: Expand Distribution Channels Streamline Health estimates the total market for Streamline Health s document management products and services could be in excess of $16 billion, and the market is less than 15% penetrated. A 2001 healthcare industry report stated that in order to comply with the HIPAA healthcare information electronic transmission regulations, healthcare systems will need to adjust existing systems or purchase new Information Technology systems, hire and retrain staff, and make significant changes to the current processes associated with maintaining patient privacy, the cost of which is estimated to be somewhere between three to four times the amount of expenditures required for Year 2000 remediation, or an amount in excess of $25 billion. Streamline Health strongly believes its highly evolved, secure and technologically advanced web browser-based ASP solutions will position Streamline Health to take advantage of, what it continues to believe will be, significantly increasing market opportunities for Streamline Health and its distribution partners in the future. In 2002, Streamline Health entered into a five-year Remarketing Agreement with IDX (now GE Healthcare), which offers a wide variety of patient care products to integrated delivery networks, group practices, academic medical centers, radiological centers, and hospitals nationwide. IDX has installed its products at more than 2,600 customer sites with systems deployed to serve over 120,000 physicians. Under the terms of the Agreement, IDX was granted a non-exclusive worldwide license to distribute all Streamline Health applications and ASPeN services to IDX customers and prospective customers, as defined in the Agreement. GE Healthcare sells Streamline Health s Health Information Management and enterprise document management and document Workflow solutions as an integrated component of the GE Centricity® Enterprise clinical and financial information systems. The Agreement has an automatic annual renewal provision and, after the initial five year period, can be cancelled by IDX upon 90 days written notice to the Company. The Company believes that the agreement will be renewed and will not be terminated. It is Streamline Health s intention to develop additional remarketing alliances with other Healthcare Information Systems, Medical Records management, and Medical Records outsourcing vendors and to explore other means of expanding Streamline Health s distribution channels. 9 Table of Contents Application Service Provider Application-hosting Services In 1998, Streamline Health began offering customers the ability to obtain its workflow solutions on an application-hosting basis as an ASP. Streamline Health established a hosting data center and installed Streamline Health s suite of workflow products, called ASPeN within the hosting data center, which utilizes Streamline Health s web browser-based applications across an Internet/Intranet, to deliver high quality, transaction-based services to healthcare providers from a centrally located data center. ASPeN enables its healthcare customers to achieve enhanced patient care, improved security, and accessibility to patient records at significant cost savings with minimal up-front capital investment, maintenance, and support costs. Customers realize benefits more quickly with less economic risk. Customers are charged on a per transaction or subscription basis, which is an attractive alternative to purchasing an in-house system. This service is made possible through the advancement of web browser-based technology, state-of-the-art communication technology and advanced software design. Maintain Technological Leadership Through the Development of New Software Applications and Increased Functionality of Existing Applications Streamline Health intends to continue its product development efforts and increase the functionality of existing applications along with the development of new applications using workflow technologies. In particular, Streamline Health intends to increase the functionality of its web-based applications. Streamline Health has continued to add new features, functionality and workflow applications to its suite of products, including revenue cycle management solutions such as remote coding, remote physician order processing, pre-admission registration scanning, insurance verification, denial management, secondary billing services, explanation of benefits processing, etc. (See A brief description of Streamline Health s products below.) Streamline Health has released its latest generation product, accessANYware, a web-based application with a user interface that includes the best features of Streamline Health s entire product portfolio. The accessANYware application utilizes a common database for medical records and patient financial services, thereby improving system administration and eliminating redundant data entry. Streamline Health has implemented its first hospital revenue cycle product, Coding Workflow, an application that provides workflow automation of the coding and abstracting process by allowing hospital personnel to electronically access documents to be coded and abstracted from remote locations, including the employee s home. The Coding Workflow product can also be integrated with third-party encoding or abstracting software thus avoiding redundant data entry. Streamline Health believes only the most robust, flexible, dependable products will survive in the healthcare market, and Streamline Health has attempted to establish itself as a leader in document imaging/management and workflow applications through strong product development. Image-Enable Clinical Data Repositories and Other Applications Software Today, healthcare information is often stored on numerous dissimilar host-based and departmental systems that are spread throughout an enterprise and are not integrated. Additionally, these current systems do not address the data stored on paper or the increasing volume of medical images such as CAT scans, MRI s, digitized slides, exploratory scopes, photographs, audio, etc. Streamline Health believes the efficiencies and productivity of hospitals and integrated healthcare delivery networks can be greatly enhanced by seamlessly integrating their historical information systems with document imaging and workflow applications. Physicians, clinicians, and other healthcare users then have access to the complete patient medical record, including the structured data, such as laboratory results, and related unstructured data, or a doctor s hand written notes. Streamline Health has image-enabled many popular Clinical Data Repositories, such as those offered by Oacis Healthcare Holdings Corp., GE Healthcare, and Cerner Corporation. Streamline Health is marketing image-enabling technology through its accessANYware and the Streamline Health Integration Tools. Streamline Health intends to continue to aggressively market its unique image-enabling solutions to end-users and other third-party software application providers. Streamline Health has several large scale, enterprise wide image enabled sites, including Memorial Sloan-Kettering Cancer Center, which utilizes Streamline Health s solution on over 7,000 workstations and over 1,150 simultaneous users at any point in time. 10 Table of Contents Systems and Services Streamline Health s systems employ an open architecture that supports a variety of operating systems, including Microsoft Windows XP, Windows 2000 and 2003, and UNIX. Streamline Health s systems can be configured with various hardware platforms, including INTEL-compatible personal computers. Streamline Health s systems include a user interface designed specifically by Streamline Health for physicians and other medical and administrative personnel in hospitals and integrated healthcare networks. Streamline Health s systems operate on multiple imaging platforms, including Siemens and FileNet in addition to its own proprietary document imaging platform. Streamline Health s Health Information Management Workflow solutions incorporate advanced features, including workflow and security features, which allow customers to restrict direct access to confidential patient information, secure patient data from unauthorized indirect access and have audit trail features. A brief description of Streamline Health s products follows: Streamline Health products and services are built using advanced document imaging/management and workflow automation technologies to create robust Medical Records and Revenue Cycle Workflow solutions. Document imaging technology makes paper-based information, as well as medical images, sound and video information as readily available and easy to process as traditional electronic data. In addition to intelligent electronic routing of documents, workflow automation offers sophisticated management tools and reporting to increase efficiency and support of business process re-engineering efforts. Streamline Health s products and services were designed to be complementary with existing third-party HIS and ASP-based services, providing value-added functionality to these third-party applications, including the following: The ability to gain seamless electronic access to medical records, business office documents and medical images (unstructured data); Workflow-based automated chart deficiency analysis and completion; Workflow-based automated release of information and billing; Workflow-based remote coding and seamless integration to third-party encoder and abstracter software; Workflow-based physician order routing for scheduling; Workflow-based financial screening and routing of patient financial ability to pay information; Computer-aided data extraction solutions using OCR technology to scan, extract, verify, and input into existing information systems data; Streamline Health has developed innovative application tool sets to image and web-enable existing HIS clinical and patient financial services applications, thereby allowing users to have a common graphical user interface on a universal workstation. Streamline Health has also developed its own document imaging middleware to efficiently provide the object-oriented business processes common to all of its applications, such as scanning/indexing, faxing/printing, data archiving migration, security and auditing. Through its application software, document imaging middleware, and its workflow, image and web-enabling tools, Streamline Health allows the seamless merging of its Medical Record and Patient Financial Services department back office functionality with existing clinical information systems at the desktop. For maximum flexibility, accessANYware, the current Streamline Health product portfolio, is packaged into four distinct offerings: (i) the Health Information Management (HIM) Suite, (ii) the Patient Financial Services (PFS) Suite, (iii) the Enterprise Suite; and (iv) a set of Productivity Tools. The accessANYware family of products is Streamline Health s fifth-generation document-centric repository of historical health information that is complementary to and can be seamlessly bolted on to existing transaction-centric clinical, financial and management information systems, allowing healthcare providers to aggressively move toward a true EMR. It allows authorized users to perform document searching, retrieval, viewing, processing, printing and faxing, as well as report generation all from a single login. 11 Table of Contents HEALTH INFORMATION MANAGEMENT Suite The HIM Suite includes accessANYware Patient Folders, Completion Workflow, Release Workflow, and Coding Workflow. accessANYware Patient Folders accessANYware Patient Folders is a web-based application that provides hospital organizations the ability to electronically store, search and retrieve medical records from any location within the facility, physician offices, off-site clinics and even from home. In addition, accessANYware Patient Folders provides a complete web-based chart deficiency management system that includes analysis, electronic signature and management reports all from a single login. accessANYware Patient Folders allows the user to securely view the entire medical record from a visit view or a category-based longitudinal view of historical patient information. Completion Workflow The Completion Workflow application is a chart deficiency management workflow that provides management reporting along with providing analysts and clinicians the ability to remotely analyze, electronically sign and complete deficient records. In addition to a single login, accessANYware delivers a single user interface and integrated database. Therefore, from a single system login, users with appropriate security have the ability to search and retrieve information regarding patients and cases (for chart analysis), view, print and fax patient documents, as well as analyze or complete deficient documents. The functions presented to the user vary with the user s security. For example, if the user is a clinician, he/she is presented with an inbox function that displays a list of incomplete charts (awaiting completion) and a list of linked patients assigned to them. The clinician then has the option to complete deficient charts or retrieve patient information via searching or by clicking on the linked patients within their inbox. This access may occur from any workstation within the facility, the physician s office, or some other remote site. With proper security, the user is able to view, print and fax patient information. Release Workflow Streamline Health clients also have the option of further enhancing the productivity of their operations through the release workflow module which fulfills internal and external requests for patient information and allows for automatic invoicing capability. It also provides the ability to electronically search for, print, mail or fax information to third parties that request copies of patient records. Coding Workflow Due to an acute shortage of available coding personnel, there currently exists a great demand for solutions to attract and retain qualified coders and to make the coding process more efficient. The Coding Workflow module provides workflow automation of the coding and abstracting process by allowing hospital personnel to electronically access documents to be coded and abstracted from remote locations, including the employee s home. It may also be integrated with third-party encoding or abstracting software, avoiding redundant data entry. PATIENT FINANCIAL SERVICES Suite The PFS Suite includes accessANYware Non Patient Folders, Referral Order Workflow, and Cash Posting Workflow. accessANYware Non Patient Folders accessANYware Non Patient Folders is a web-based application that allows any department of a healthcare organization the ability to store, retrieve and process document-centric information using a site-defined electronic folder hierarchy with a user-friendly interface. accessANYware Non Patient 12 Table of Contents Folders provides document imaging and workflow capabilities for a hospital organization s enterprise-wide departmental needs, such as Patient Financial Services, Business Office, Human Resources, Materials Management, Medical Staff Office, Purchasing and virtually any other department that has document intensive storage, retrieval and processing needs. Referral Order Workflow Referral Order Workflow provides automatic routing of physician orders to the appropriate personnel for scheduling patient appointments. Cash Posting Workflow Cash Posting Workflow provides the ability to import electronic remittances directly into individual patient accounts; OCR to scan and electronically capture Explanation of Benefits (EOB) information resulting in the ability to post payments directly from the remittance document image, and cash posting assistant to index EOB s to the account folder while posting. Enterprise Suite The Enterprise Suite is a full offering of Streamline Health products including the HIM Suite, the PFS Suite, and the Streamline Health Integration Tools. The Streamline Health Integration Tools (STRM-ITTM) STRM-IT supports powerful image-enabling and workflow technology that allows healthcare users to immediately and simultaneously access any patient information, including multimedia and paper-based information, through their existing third-party clinical or billing applications. As a result, any application across the entire enterprise can be image-enabled, including the host Healthcare Information Systems, Patient Billing Systems, Clinical Data Repositories and others. When the Clinical Data Repository is image-enabled, users can access any piece of information on the same workstation and from the same screen display, including the point of patient care. This means users can view traditional electronic data and images simultaneously on the same screen without signing in and out of multiple applications. ASPeN...Application Service Provider eHealth Network Streamline Health s Hosting Services (ASPeN) offers healthcare organizations an ever increasing, cost-effective solution to manage its information. Through the use of the Internet and private line telecommunications, Streamline Health provides its healthcare customers with fast and secure access to its data stored at Streamline Health s data center, for a monthly subscription fee. The hosted pricing model helps its healthcare customers to overcome the barriers of high capital and start-up costs as well as the technological burdens of implementing and managing a document workflow system. Professional Services Streamline Health provides a full complement of professional services to implement its software applications. Streamline Health believes that high quality consulting and professional implementation services are important to attracting new customers and maintaining existing customer satisfaction. These services include implementation and training, project management, business process re-engineering, and custom software development. The implementation and training services include equipment and software installation, system integration and comprehensive training. The project management services include needs and cost/benefit analysis, hardware and software configuration and business process re-engineering. The custom software development services include interface, workflow and report development. 13 Table of Contents Research and Development Streamline Health continues to focus its research and development efforts to develop new application software and increase the functionality of existing applications. Customer requirements and desires significantly influence Streamline Health s research and development efforts. Product research and development expense was $2,716,163, $2,733,293, and $2,061,207 in 2006, 2005 and 2004, respectively. In addition, Streamline Health also capitalized approximately $2,130,000, $1,450,000, and $1,000,000 of software development expenditures in 2006, 2005, and 2004, respectively. Existing Customers Streamline Health s customers include healthcare providers located throughout the United States. Streamline Health has implemented or is in the process of implementing one or more of its systems in the following representative list of healthcare institutions: Albert Einstein Healthcare Network, Philadelphia, PA Beth Israel Medical Center, New York, NY Children s Medical Center of Dallas, Dallas, TX Christiana Care Health Services, New Castle, DE Medical University Hospital Authority: Medical University of South Carolina, Columbia, SC Memorial Sloan-Kettering Cancer Center, New York, NY OhioHealth Corporation: Grant/Riverside Methodist Hospitals, Columbus, OH ProMedica Health Systems, Toledo, OH Sarasota Memorial Hospital, Sarasota, FL Stanford Hospital and Clinics, Palo Alto, CA Texas Health Resources, Inc., Arlington, TX UPMC Health System, Pittsburgh, PA ASPeN Application-hosting Customers include: Children s Hospital, Columbus, OH Health Alliance of Greater Cincinnati, Cincinnati, OH M. D. Anderson Cancer Center, Houston, TX University of California, School of Medicine, San Francisco, CA Pattie A. Clay Regional Medical Center, Richmond, KY RevenueMed, Inc., Alpharetta, GA GE Healthcare has also sublicensed Streamline Health s suite of products or its ASPeN Services to eleven healthcare organizations. In fiscal year 2006, GE Healthcare, M. D. Anderson Cancer Center and Texas Health Resources, Inc., accounted for 28%, 11% and 8%, respectively, of Streamline Health s total revenues. In fiscal year 2005, Texas Health Resources, Inc., GE Healthcare, and M. D. Anderson Cancer Center, accounted for 18%, 12% and 11%, respectively, of Streamline Health s total revenues. In fiscal year 2004, GE Healthcare, M. D. Anderson Cancer Center, and OhioHealth Corporation accounted for 21%, 13% and 13%, respectively, of Streamline Health s total revenues. The small number of customers, the dependence on remarketing partner GE Healthcare, and extended sales cycles has contributed to variability in quarterly and annual operating results. Streamline Health expects that as its customer base continues to increase and sales through its Remarketing Agreements increase, the actions of any one customer will have less of an effect on its quarterly and annual operating results. The loss of a major customer or the remarketing partner GE Healthcare could have a material adverse effect on Streamline Health. 14 Table of Contents Signed Agreements Backlog See also ITEM 7, MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Backlog, for an explanation of the current year backlog compared with the prior year backlog. Streamline Health enters into master agreements with its customers to specify the scope of the system to be installed and/or services to be provided by Streamline Health, the agreed upon aggregate price and the timetable for implementation. The master agreement typically provides that Streamline Health will deliver the system in phases, thereby allowing the customer flexibility in the timing of its receipt of systems and to make adjustments that may arise based upon changes in technology or changes in customer needs. The master agreement also allows the customer to request additional components as the installation progresses, which additions are then separately negotiated as to price and terms. Historically, customers have ultimately purchased systems and services in addition to those originally contemplated by the master agreement, although there can be no assurance that this trend will continue in the future. At January 31, 2007, Streamline Health has master agreements and purchase orders from remarketing partners for systems and related services (excluding support and maintenance, and transaction-based revenues for the application-hosting services) that have not been delivered, installed which, if fully performed, will generate future revenues of approximately $5,226,000. The related products and services are expected to be delivered over the next two to three years. Furthermore, Streamline Health has entered into application-hosting agreements, which are expected to generate revenues in excess of $5,256,000 through their respective renewal dates in fiscal years 2007 through 2012. Streamline Health s master agreements also generally provide for a limited initial maintenance period and require the customer to subscribe for maintenance and support services on a monthly, quarterly, or annual basis. Maintenance and support revenues for fiscal years 2006, 2005, and 2004 were approximately $5,617,000, $5,104,000, and $5,220,000, respectively. Maintenance and support revenues are expected to increase in the future. At January 31, 2007, Streamline Health had Maintenance Agreements and purchase orders from remarketing partners for maintenance, which if fully performed, will generate future revenues of approximately $4,469,000, through their respective renewal dates in fiscal year 2007 and 2008. The commencement of revenue recognition varies depending on the size and complexity of the system, the implementation schedule requested by the customer and usage by customers of the application-hosting services. Therefore, Streamline Health is unable to accurately predict the revenue it expects to achieve in any particular period. Streamline Health s master agreements generally provide that the customer may terminate its agreement upon a material breach by Streamline Health, or may delay certain aspects of the installation. There can be no assurance that a customer will not cancel all or any portion of a master agreement or delay installations. A termination or installation delay of one or more phases of an agreement, or the failure of Streamline Health to procure additional agreements, could have a material adverse effect on Streamline Health s business, financial condition, and results of operations. Royalties Streamline Health incorporates software licensed from various vendors into its proprietary software. In addition, third-party, stand-alone software is required to operate Streamline Health s proprietary software. Streamline Health licenses these software products, and pays the required royalties and/or license fees when such software is delivered to Streamline Health s customers. Employees As of January 31, 2007, Streamline Health had 105 full-time employees, an increase of 11 during the fiscal year. In addition, Streamline Health utilizes independent contractors to supplement its staff, as needed. None of Streamline Health s employees are represented by a labor union or subject to a collective bargaining agreement. Streamline Health has never experienced a work stoppage and believes that its employee relations are good. 15 Table of Contents Copies of documents filed by Streamline Health Solutions, Inc. with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, etc., and all amendments to those reports, if any, can be found at the web site www.streamlinehealth.net as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. Copies can be downloaded free of charge from the Streamline Health web site or directly from the Securities and Exchange Commission web site, http://www.sec.gov/cgi-bin/srch-edgar. Also, copies of Streamline Health s annual report on Form 10-K will be made available, free of charge, upon written request to the Company. Item 1A. Risk Factors See also, PART I, ITEM 1, BUSINESS. The following is a list of risk factors that affect the Company. They are not listed in any particular order or relative importance and no inferences should be given to the listing order. The variability of quarterly operating results can be significant. The Company s future revenues and operating results may vary significantly from quarter-to-quarter as a result of a number of factors, many of which are outside the control of the Company. These factors include the relatively large size of customer agreements, unpredictability in the number and timing of system sales, length of the sales cycle, delays in installations and changes in customer s financial condition or budgets. The Company needs to manage its growth. The Company is currently experiencing a period of growth and expansion which has placed, and could continue to place, a significant strain on the Company s services and support operations, sales and administrative personnel and other resources. Streamline Health believes that it must expand the workforce to develop new products enhance existing products and serve the needs of its existing and anticipated customer base. The Company s ability to successfully expand its operations will depend, in large part, upon its ability to attract and retain highly qualified employees. The Company s ability to manage its planned growth effectively also will require the Company to continue to improve its operational, management, and financial systems and controls, to train, motivate, and manage its employees and to increase its operating expenses in anticipation that such growth will increase future revenues. The Company could be less profitable than expected. Because of the relatively fixed operating expenses and overhead, the future profitability of the Company is dependent on increasing revenues which may not materialize as anticipated. Sales have been concentrated in a small number of customers. The Company s revenues have been concentrated in a relatively small number of large customers, and the Company has historically derived a substantial percentage of its total revenues from a few customers. There can be no assurance that a customer will not cancel all or any portion of a master agreement or delay installations. A termination or installation delay of one or more phases of an agreement, or the failure of Streamline Health to procure additional agreements, could have a material adverse effect on Streamline Health s business, financial condition, and results of operations. The Company s major reseller could choose to discontinue reselling Streamline Health products, and significant customers could elect to discontinue using our products. The Company needs to ensure that it expands the distribution channels to reduce the reliance on a single major reseller and expand the customer base to ensure that the loss of a customer is not a significant loss in total revenues. 16 Table of Contents Streamline Health faces significant competition, including from companies with significantly greater resources. The Company currently competes with many other companies for the licensing of similar software products and related services. Many of these companies are larger than Streamline Health and have significantly more resources to invest in their business. Streamline Health s intellectual property rights are valuable, and any inability to protect them could reduce the value of Streamline Health s products and services. The Company trademarks and copyrights its intellectual property, which represents an important asset to the Company. Streamline Health does not have any patent protection on any of its software. The Company relies upon license agreements, employment agreements, confidentiality, nondisclosure agreements, etc. to maintain the confidentiality of Streamline Health s proprietary information and trade secrets. If the Company fails to adequately protect the intellectual property through trademarks and copyrights, license agreements, employment agreements, confidentiality, nondisclosure agreements, etc., the intellectual property rights may be misappropriated by others, invalidated, or challenged, and our competitors could duplicate the Company s technology or may otherwise limit any competitive technology advantage the Company may have. Also, the Company could be subject to intellectual property infringement claims as the number of software patents and copyrighted and trademarked materials are produced as our software functionality is expanded. Any claim, even if not meritorious, would be expensive to defend, and if the Company were to become liable for infringing third party intellectual property rights, the Company could be liable for substantial damage awards, and potentially be required to cease using the technology, produce noninfringing technology or obtain a license to use such technology. Due to the rapid pace of technology change, the Company believes its future success is likely to depend upon continued innovation, technical expertise, marketing skills and customer support and services rather than on legal protection of our property rights. However, the Company has in the past, and intends in the future, to aggressively assert its intellectual property rights when necessary. Rapid technology changes and short product life cycles could harm Streamline Health s business. The technology underlying Streamline Health s product is subject to rapid change including the potential introduction of new products and technologies, which may have a material, adverse impact on its business, operating results, and financial condition. The Company needs to maintain an ongoing research and development program to continue to develop new products and apply new technologies to the existing products. The impact of new or changes in existing federal, state, and local regulations governing healthcare information. Healthcare regulations issued to date have not had a material adverse affect on business. However, the Company cannot predict the potential impact of new or revised regulations that have not yet been released or made final, or any other regulations that might be adopted. Congress may adopt legislation that may change, override, conflict with, or preempt the currently issued regulations. Additionally, legislation governing the dissemination of patient health information is also from time-to-time proposed and debated at the state level. These laws or regulations, when adopted, could restrict the ability of customers to obtain, use, or disseminate patient health information. Streamline Health believes that the features and architecture of Streamline Health s products are such that it currently supports or should be able to make the necessary modifications to its products, if required, to ensure support of the HIPAA regulations, and other legislation or regulations. The loss of key personnel could adversely affect Streamline Health s business. Streamline Health s success depends, to a significant degree, on its management, sales force and technical personnel. The Company must recruit, motivate, and retain highly skilled managers, consulting and technical personnel, including application programmers, database specialists, consultants, and system architects who have the requisite expertise in the technical environments in which our products operate. Competition for such technical expertise is intense. 17 Table of Contents Streamline Health software may not be error free and could result in claims of breach of contract and liabilities. Streamline Health software products are very complex and may not be error free, especially when first released. Although the Company performs extensive testing, failure of any product to operate in accordance with its specifications and documentation could constitute a breach of the license agreement and require Streamline Health to correct the deficiency. If such deficiency is not corrected within the agreed upon contractual limitations on liability and cannot be corrected in a timely manner, it could constitute a material breach of a contract allowing the termination thereof and possibly subjecting the Company to liability. Streamline Health s license agreement generally limits the Company s liability arising from such claims but such limits may not be enforceable in some jurisdictions or under some circumstances. A significant uninsured or under-insured judgment against the Company could have a material adverse impact on the Company. The application-hosting services and support services could experience interruptions. The Company provides hosting services for certain clients, including the storage of critical patient and administrative data. In addition, it provides support services to clients through the client support facility. The Company has redundancies, such as backup generators and redundant telecommunications lines, built into its operations to prevent disruptions. However, complete failure of all generators or impairment of all telecommunications lines or severe casualty damage to the building or equipment inside the buildings housing our data center or client support facilities could cause a disruption in operations and adversely affect clients who depend on the application hosting services. Any interruption in operations at its data center or client support facility could cause the Company to lose existing clients, impede our ability to obtain new clients, result in revenue loss, cause potential liability to our clients, and increase our operating costs. Third party products are essential to Streamline Health s software. Streamline Health software incorporates software licensed from various vendors into its proprietary software. In addition, third-party, stand-alone software is required to operate the Company s proprietary software. The loss of the ability to use these third party products, or ability to obtain substitute third party software at comparable prices, could have a material adverse affect on the ability to license Streamline Health software. The Company could be liable to customers or third parties. The Company s systems provide access to patient information used by physicians and other medical personnel in providing medical care. The medical care provided by physicians and other medical personnel are subject to numerous medical malpractice and other claims. The Company attempts to limit any potential liability of the Company to customers by limiting the warranties on its systems in the Company s agreements with healthcare provider. However, such agreements do not protect the Company from third party claims by patients who may seek damages from any or all persons or entities connected to the process of delivering patient care. The Company maintains insurance, which provide limited protection from such claims, if they are successfully litigated. Although no such claims have been brought against the Company to date regarding injuries related to the use of our software solutions, such claims may be made in the future. A significant uninsured or under-insured judgment against the Company could have a material adverse impact on the Company. The Company needs to continuously anticipate future events, such as changes in regulations that could affect its products, and the probability of natural disasters, catastrophes, war, or terrorism etc. The Company may not correctly anticipate such future events which could have a material adverse impact on the Company. In addition, risks and uncertainties not currently known to the Company or that the Company currently deems to be immaterial also may materially adversely affect the Company, its financial condition and/or operating results. 18 Table of Contents Item 1B. Unresolved Staff Comments None Item 2. Properties Streamline Health s principal offices are located at 10200 Alliance Road, Suite 200, Cincinnati, OH 45242-4716. The offices consist of approximately 21,700 square feet of space under a lease that expires in July 2010. In addition, Streamline Health leases dedicated collocation high security data center space in the Cincinnati, OH area, for its ASPeN Services, application-hosting data center operations, which lease expires in June 2007, but has automatic renewal provisions. The current rental expense for all of these facilities approximates $368,000 annually. Streamline Health believes that its facilities are adequate for its current needs and that suitable alternative space is available to accommodate expansion of Streamline Health s operations. Item 3. Legal Proceedings Streamline Health is, from time to time, a party to various legal proceedings and claims, which arise, in the ordinary course of business. Streamline Health is not aware of any legal matters that will have a material adverse effect on Streamline Health s consolidated results of operations or consolidated financial position. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The names, ages, and positions held by the Executive Officers of Streamline Health on April 2, 2007 are: Elected to Name Age Position(1) Present Position(2) J. Brian Patsy 56 Chairman of the Board, President, Chief Executive Officer, and Director 1989 William A. Geers 53 Vice President Product Development and Chief Operating Officer 2004 Paul W. Bridge, Jr. 63 Chief Financial Officer, Treasurer and Corporate Secretary 2001 Donald E. Vick, Jr. 43 Controller, Assistant Treasurer and Assistant Secretary 2002 (1) All current officers of Streamline Health hold office until their successors are elected and qualified or until any removal or resignation. Officers of Streamline Health are elected by the Board of Directors and serve at the discretion of the Board. For purposes of the descriptions of the background of Streamline Health s Executive Officers, the term Company refers to both Streamline Health Solutions, Inc. and its predecessors LanVision Systems, Inc. and LanVision, Inc. (2) Represents date of election to Registrant or its predecessor. J. Brian Patsy is a founder of the Company and has served as the President and a Director since Streamline Health s inception in October 1989. Mr. Patsy was appointed Chairman of the Board and Chief Executive Officer in March 1996. Mr. Patsy has over 33 years of experience in the information technology industry. William A. Geers joined the Company in 1996, as the Director, Indirect Operations, Sales & Marketing. In 2000, he was appointed Vice President Product Development. In December 2004, he was elected Vice President Product Development and Chief Operating Officer. 19 Table of Contents Paul W. Bridge, Jr. joined the Company in 1996, as Controller. In January 2001, he was appointed Chief Financial Officer. From 1993 until he joined Streamline Health, Mr. Bridge served as Controller of Cincom Systems, Inc., an international software development and marketing company. Mr. Bridge is a Certified Public Accountant (inactive). Donald E. Vick, Jr. joined the Company in 1997, as Assistant Controller. In 2002, he was appointed Controller and Assistant Treasurer. In 2005 he was also appointed Assistant Secretary. Prior to joining Streamline Health, Mr. Vick served as Assistant Controller of Cincom Systems, Inc., an international software development and marketing company. Mr. Vick is a Certified Public Accountant. There are no family relationships between any Director or Executive Officer and any other Director or Executive Officer of the Registrant. PART II Item 5. Market for Registrant s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities (a) The Company s Common Stock trades on The NASDAQ Capital Market under the symbol STRM. The table below sets forth the high and low sales prices for Streamline Health Solutions, Inc. Common Stock for each of the quarters in fiscal years 2006 and 2005, as reported by The NASDAQ Stock Market, Inc. Fiscal Year 2006 High Low 4th Quarter (November 1, 2006 through January 31, 2007) $ 6.00 $ 4.91 3rd Quarter (August 1, 2006 through October 31, 2006) 5.81 4.78 2nd Quarter (May 1, 2006 through July 31, 2006) 7.49 4.51 1st Quarter (February 1, 2006 through April 30, 2006) 8.70 6.55 Fiscal Year 2005 High Low 4th Quarter (November 1, 2005 through January 31, 2006) $ 7.00 $ 3.51 3rd Quarter (August 1, 2005 through October 31, 2005) 6.38 2.53 2nd Quarter (May 1, 2005 through July 31, 2005) 3.25 2.65 1st Quarter (February 1, 2005 through April 30, 2005) 5.18 2.62 The market price of the Common Stock could be subject to significant fluctuations based on factors such as announcements of new products or customers by Streamline Health or its competitors, quarterly fluctuations in Streamline Health s financial results or other competitors financial results, changes in analysts estimates of Streamline Health s financial performance, general conditions in the healthcare information technology industry and conditions in the financial markets. In addition, the stock market, in general, has experienced price and volume fluctuations which have particularly affected the market price of high technology companies and which have been often unrelated to the operating performance of a specific company. Many technology companies, including Streamline Health, experience significant fluctuations in the market price of their equity securities. There can be no assurance that the market price of the Common Stock will not decline, or otherwise continue to experience significant fluctuations in the future. (b) According to the stock transfer agent records, Streamline Health had 140 stockholders of record as of April 2, 2007. Because brokers and other institutions on behalf of stockholders hold many of such shares, Streamline Health is unable to determine with complete accuracy the current total number of stockholders represented by these record holders. Streamline Health estimates that it has approximately 2,700 stockholders, based on information provided by the Company s stock transfer agent from their search of individual participants in security position listings. (c) Streamline Health has not paid any cash dividends on its Common Stock since its inception and does not intend to pay any cash dividends in the foreseeable future. 20 Table of Contents MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT S COMMON EQUITY AND RELATED STOCK MATERS The graph below compares the cumulative total stockholder return on Common Stock with the cumulative total return on the NASDAQ US Total Return Index and on the NASDAQ Computer and Data Processing Services Stock Index for the period commencing January 31, 2002 and ending January 31, 2007, assuming an investment of $100 and the reinvestment of any dividends. The comparison in the graph below is based upon historical data and is not indicative of, nor intended to forecast the future performance of Common Stock. 1/31/021 1/31/031 1/31/041 1/31/051 1/31/061 1/31/071 Streamline Health Solutions, Inc. Common Stock $ 100.00 $ 83.43 $ 88.00 $ 87.71 $ 200.00 $ 161.14 NASDAQ US Total Return Index $ 100.00 $ 68.91 $ 107.25 $ 107.45 $ 120.87 $ 129.65 NASDAQ Computer and Data Processing Services Stock Index $ 100.00 $ 67.75 $ 93.77 $ 96.81 $ 108.52 $ 120.47 1 Assumes that $100.00 was invested on January 31, 2002 in Common Stock at the closing price of $3.50 per share and at the closing sales price of each index on that date and that all dividends were reinvested. No dividends have been declared on Common Stock. Stockholder returns over the indicated period should not be considered indicative of future stockholder returns. The information required above by Item 201(e) of Regulation S-K is not considered filed with the Securities and Exchange Commission, and should not be deemed to be incorporated by reference into any filing under the Securities Act or the Securities Exchange Act, except to the extent that Regent specifically incorporates it by reference. 21 Table of Contents Item 6. Selected Financial Data The following table sets forth consolidated financial data with respect to Streamline Health for each of the five years in the period ended January 31, 2007. The information set forth below should be read in conjunction with Management s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this Form 10-K. Fiscal Year(1) 2006 2005 2004 2003 2002 (In thousands, except per share data) INCOME STATEMENT DATA: Total revenues $ 15,867 $ 16,127 $ 12,751 $ 12,804 $ 13,462 Total operating expenses 15,685 14,389 11,815 10,450 10,574 Operating profit(2) 182 1,738 936 2,354 2,888 Net earnings(2) & (3) 96 2,551 558 1,019 1,012 Basic net earnings per share of Common stock .01 .28 .06 .11 .11 Diluted net earnings per share of Common stock .01 .27 .06 .11 .11 Shares used in computing basic per share data 9,195 9,121 9,068 8,997 8,934 Shares used in computing diluted per share data 9,722 9,425 9,233 9,207 9,197 BALANCE SHEET DATA: Cash and cash equivalents $ 3,317 $ 4,634 $ 4,181 $ 6,227 $ 7,242 Working capital 2,748 3,347 3,892 1,901 5,294 Total assets 15,301 16,433 11,993 15,290 15,337 Long-term debt, including current portion 1,000 2,000 2,000 1,000 3,000 Total stockholders equity 8,644 8,351 5,712 5,079 3,967 Cash dividends declared (1) All references to a fiscal year refer to the fiscal year of Streamline Health commencing February 1 of that calendar year and ending on January 31 of the following year. (2) Operating profit and net earnings in 2003 include reimbursement of $230,000 in legal expenses upon settlement of Streamline Health proprietary technology claims and a $290,000 favorable change in the estimate for certain franchise tax liabilities as a result of the tax authority audit of certain prior year s tax returns. Operating profit and net earnings in 2004 include a $300,000 reduction in reserves due to changes in estimates and in 2006, $100,000 reduction in reserves due to changes in estimates. (3) Net earnings in 2005, 2004 and 2003 include a tax benefit of $897,000, $420,000 and $558,000, respectively, relating to the reduction in the valuation allowances for the deferred tax assets relating to the net operating loss carry forward based upon reasonable future earnings before income tax projections. 22 Table of Contents Item 7. Management s Discussion and Analysis of Financial Condition and Results of Operations See also PART 1, ITEM 1, BUSINESS for general and specific descriptions of Streamline Health s business. See also PART 1, ITEM 1A RISK FACTORS for a general description of factors that affect Streamline Health s business. Application of Critical Accounting Policies (See also Notes to Consolidated Financial Statements) Streamline Health s discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires Streamline Health to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent liabilities. On an on-going basis, Streamline Health evaluates its estimates, including those related to product revenues, bad debts, capitalized software development costs, income taxes, warranty obligations, support contracts, contingencies and litigation. Streamline Health bases its estimates on historical experience and on various other assumptions that Streamline Health believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and revenue recognition. Actual results may differ from these estimates under different assumptions or conditions. Streamline Health believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. Revenue Recognition Streamline Health records revenues for customer contracts, including special payment agreements and royalties from third-party resellers in accordance with Statement of Position 97-2, Software Revenue Recognition. Revenue is derived from: (i) the licensing and sale of systems, either directly to end-users or through third-party resellers, comprising internally developed software, third-party software and hardware components; (ii) product support, maintenance and professional services; and, (iii) application-hosting services that provide high quality, transaction or subscriptions based document imaging/management/workflow services from a central data center. Generally, revenues from software license fees and hardware sales to end-users are recognized when a master agreement is signed and products are made available to end-users. Revenues from agreements that contain multiple-element arrangements are allocated to the various elements based on the fair value of the elements. Revenues related to routine installation and integration and project management are deferred until the work is performed. Revenues from consulting, education, and application-hosting services are recognized as the services are performed. Revenues from short-term support and maintenance agreements are recognized ratably over the term of the agreements. Billings to customers recorded prior to the recognition of revenue are classified as deferred revenues. Revenues recognized prior to progress billings to customers are recorded as contract receivables. Under the terms of a Remarketing Agreement with IDX (now part of GE Healthcare), Streamline Health records this revenue when the products are made available to end-users. Royalties are remitted to Streamline Health based upon IDX sublicensing Streamline Health s software to its customers. Thirty percent of the royalty is due 45 days following the end of the month in which IDX executes an end-user license agreement with its customer. The remaining seventy percent of the royalty is due, in varying amounts based on specific milestones, 45 days following the end of the month in which a milestone occurs. Each contract is reviewed quarterly with the appropriate Streamline Health Client Manager to determine the appropriateness of the revenue recognition criteria applied to the individual contracts based upon the most currently available information as to the status of the contract, the customer comments, if any, and the status of any open or unresolved issues with the customer. Bad Debts Accounts and contract receivables are comprised of amounts owed Streamline Health for licensed software, professional services, including maintenance services and application-hosting activities. Contracts with individual customers and resellers determine when receivables are due and payable. In determining the allowance for doubtful 23 Table of Contents accounts, each unpaid receivable is reviewed quarterly with the appropriate Streamline Health Client Manager to determine the payment status based upon the most currently available information as to the status of the receivables, the customer comments, if any, and the status of any open or unresolved issues with the customer preventing the payment thereof. Corrective action, if necessary, is taken by Streamline Health to resolve open issues related to unpaid receivables. During these quarterly reviews, Streamline Health determines the required allowances for doubtful accounts for estimated losses resulting from the unwillingness or inability of its customers or resellers to make required payments. If the financial condition of Streamline Health s customers or resellers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Streamline Health s customers typically have been well-established hospitals, medical facilities, or major Healthcare Information Systems companies that resell Streamline Health s products, which have good credit histories, and payments have been received within normal time frames for the industry. However, some healthcare facilities have experienced significant operating losses and limited cash resources as a result of limits on third-party reimbursements from insurance companies and governmental entities. Extended payment of Streamline Health receivables is not uncommon. Capitalized Software Development Costs Software development costs are accounted for in accordance with Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Software to be Sold, Leased or Otherwise Marketed. Costs associated with the planning and designing phase of software development, including coding and testing activities necessary to establish technological feasibility are classified as product research and development and are expensed as incurred. Once technological feasibility has been determined, a portion of the costs incurred in development, including coding, testing, and product quality assurance, are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Streamline Health capitalized approximately $2,130,000, $1,450,000, and $1,000,000 in 2006, 2005 and 2004, respectively. Research and development expense, net of capitalized software development expenditures, was $2,716,163, $2,733,293, and $2,061,207 in 2006, 2005 and 2004, respectively. Amortization is provided on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. Amortization commences when a product is available for general release to customers. Unamortized capitalized costs determined to be in excess of the net realizable value of a product are expensed at the date of such determination. Amortization expense was approximately $1,083,000, $800,000, and $633,000 in 2006, 2005, and 2004, respectively. Streamline Health reviews, on an on-going basis, the carrying value of its capitalized software development expenditures, net of accumulated amortization. Streamline Health believes that to replicate the existing software would cost significantly more than the stated net book value of $3,753,361 at January 31, 2007. Over the last three years, Streamline Health has spent approximately $12,090,000 in research and development, of which $4,580,000, or 38%, has been capitalized. Amortization of capitalized software expenditures during the last three years has amounted to approximately $2,516,000 or a net increase in capitalized software of approximately $2,064,000 during the last three years. Many of the programs related to capitalized software development continue to have great value to Streamline Health s current products and those under development, as the concepts, ideas, and software code are readily transferable and are incorporated into new products. Equity Awards Stock-Based Compensation The Company was required to adopt the revised standards of Statement of Financial Accounting Standards No. 123(R), Accounting for Stock-Based Compensation, which requires the expensing the fair value of the equity award effective the first quarter of fiscal year 2006. The Company has determined that the impact on future earnings for existing outstanding equity awards is not material. However, future grants of equity awards could have a material impact on reported expenses depending upon the number, value and vesting period of future awards. 24 Table of Contents Income Taxes In June, 2006, the Financial Accounting Standards Board issued Interpretation No, 48, Accounting for Uncertainties in Income Taxes (FIN 48), an interpretation of Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of February 1, 2007, as required. The cumulative effect, if any, of adopting FIN 48 will be recorded in retained earnings and or other accounts as applicable. The Company has not determined the effect, if any, the adoption of FIN 48 will have on the Company s financial position and results of operations. The net income tax expense was $31,180 in 2006 and the tax benefit was $867,361, and $455,753, in 2005 and 2004, respectively. The net current deferred tax asset was $625,000 and the non-current deferred tax asset was $1,250,000 at January 31, 2007 and the net current deferred tax asset was $601,000 and the non current deferred tax asset was $1,274,000 at January 31, 2006. A key assumption in the determination of the book tax benefit or (provision) is the amount of the valuation allowance required to reduce the related deferred tax assets. A valuation allowance reduces the deferred tax assets to a level which will, more likely than not, be realized. Whether the deferred tax assets will be realized depends on the generation of future taxable income during the periods in which the deferred tax asset become deductible. The net deferred tax assets reflect management s estimate of the amount which will, more likely than not, reduce future taxable income. As of January 31, 2007, Streamline Health believes that a valuation allowance is required to reduce a portion of the deferred tax assets, primarily relating to certain net operating loss carry forwards, for the following reasons: Although Streamline Health generated approximately $1,913,000 of earnings before income taxes during the three-year period ended January 31, 2007, there can be no assurance that Streamline Health will be able to achieve consistent profitability on a quarterly or annual basis or be able to sustain or increase its revenue growth in future periods and believes historical operating results may not be indicative of the future performance of Streamline Health in the near or long-term. Streamline Health has incurred net losses as indicated by the carry forwards of approximately $28,000,000. Based on the expenses associated with current and planned staffing levels, continued profitability and utilization of carry forwards to be evaluated as more likely than not is dependent upon increasing revenues. As of January 31, 2007, Streamline Health estimates that a valuation allowance of approximately $8,309,000 was required to reduce the deferred tax assets, primarily relating to loss carry forwards, to a level Streamline Health currently believes will be utilized to offset future earnings before income taxes based on the current backlog and forecasts over the next two years. The valuation allowance is required due to the inability to predict on a longer term basis that Streamline Health will more likely than not attain levels of profitability required to utilize additional carry forwards. Contractual Obligations Payments by Fiscal Year Total 2007 2008 2009 2010 2011 Long-term debt $ 1,000,000 $ $ $ 1,000,000 $ $ Capitalized leases 155,652 98,306 57,346 Operating leases 1,286,843 414,469 364,796 342,484 165,094 Total $ 2,442,495 $ 512,775 $ 422,142 $ 1,342,484 $ 165,094 $ Capitalized Leases During fiscal year 2005, Streamline Health acquired additional computer equipment for the application-hosting services data center, which are accounted for as capitalized leases. The amount of the computer equipment 25 Table of Contents leased assets is $267,237. The lease is payable monthly in installments of $8,192, through August 2008. The present value of the future lease payments upon lease inception was $267,237 using the interest rates implicit in the lease agreement at the inception of the lease. Long-term Debt In January 2007, Streamline Health entered into a three year working capital revolving loan agreement, with an option for two one year extensions. The loan is secured by all of the assets of Streamline Health and the loan agreement restricts Streamline Health from incurring additional indebtedness for borrowed money, including capitalized leases, etc. without lender consent. The Company is required to meet certain financial covenants, including minimum level of tangible net worth, fixed charge coverage ratio, working capital ratio and funded indebtedness to earnings before interest, taxes, depreciation and amortization. These covenants may limit the borrowing under this credit agreement. Streamline Health complied with all of the provisions of its loan agreements during the year. In connection with the issuance of the long-term debt in 1998, Streamline Health issued Warrants to purchase 750,000 shares of Common Stock of Streamline Health at $3.87 per share at any time through July 16, 2008. The Warrants are subject to customary antidilution and registration rights provisions. Operating Leases Streamline Health rents office, data center space and equipment under noncancelable operating leases that expire, at various times, during the next five fiscal years. The minimum payments, by year, are detailed in the Contractual Obligations table above. Warranties and Indemnities Streamline Health provides for the estimated cost of the product warranties at the time revenue is recognized. Should products fail to meet certain performance standards for an initial warranty period, Streamline Health s estimated warranty liability might need to be increased. Streamline Health bases its warranty estimates on the nature of any performance complaint, the effort necessary to resolve the issue, customer requirements and any potential concessions which may be required to be granted to a customer which result from performance issues. Streamline Health s ASPeN application-hosting services guarantees specific up-time and response time performance standards, which, if not met may result in reduced revenues, as a penalty, for the month in which the standards are not met. Streamline Health s standard agreements with its customers also usually include intellectual property infringement indemnifications provisions to indemnify them from and against third-party claims, and for liabilities, damages, and expenses arising out of Streamline Health s operation of its business or any negligent act or omission of Streamline Health. To date Streamline Health has always maintained the ASPeN performance standards and has not been required to make any material penalty payments to customers or indemnify any customers for any material third-party claims. At January 31, 2007 and 2006, Streamline Health has a warranty reserve in the amount of $250,000. Each contract is reviewed quarterly with the appropriate Streamline Health Client Manager to determine the need for a warranty reserve based upon the most currently available information as to the status of the contract, the customer comments, if any, and the status of any open or unresolved issues with the customer. Off Balance Sheet Arrangements Streamline Health does not have any off balance sheet arrangements. 26 Table of Contents Results of Operations The following table sets forth, for each fiscal year indicated, certain operating data as percentages: Consolidated Statements of Income(1) Fiscal Year(2) 2006 2005 2004 Systems sales 27.0 % 37.9 % 23.2 % Services, maintenance and support 52.4 43.1 56.4 Application-hosting services 20.6 19.0 20.4 Total revenues 100.0 100.0 100.0 Cost of sales 45.2 39.9 47.5 Selling, general and administrative 36.6 32.4 29.0 Product research and development 17.1 16.9 16.2 Total operating expenses 98.9 89.2 92.7 Operating profit(3) 1.1 10.8 7.3 Other income (expense), net (.5 ) (0.3 ) (6.5 ) Income tax net benefit(4) 5.3 3.6 Net earnings(3 & 4) 0.6 % 15.8 % 4.4 % Cost of systems sales 56.7 % 36.9 % 78.6 % Cost of services, maintenance and support 43.4 % 45.0 % 39.0 % Cost of application-hosting services 34.5 % 34.3 % 35.3 % (1) Because a significant percentage of the operating costs are expensed as incurred, a variation in the timing of systems sales and installations and the resulting revenue recognition can cause significant variations in operating results. As a result, period-to-period comparisons may not be meaningful with respect to the past operations nor are they necessarily indicative of the future operations of Streamline Health in the near or long-term. The data in the table is presented solely for the purpose of reflecting the relationship of various operating elements to revenues for the periods indicated. (2) All references to a fiscal year refer to the fiscal year commencing on February 1 of that calendar year and ending on January 31 of the following year. (3) Operating profit and net earnings in 2004 include a $300,000 reduction in reserves due to a change in estimates and in 2006, a $100,000 reduction in reserves due to changes in estimates. (4) Net earnings in 2005 and 2004 include a tax benefit of $897,000 and $420,000, respectively, relating to the reduction in the valuation allowances for the deferred tax assets relating to the net operating loss carry forward based upon reasonable future earnings before income tax projections. Comparison of fiscal year 2006 with 2005 Revenues. Total revenues for fiscal year 2006 were $15,866,973 compared with revenues of $16,126,808 in fiscal year 2005, a decrease of approximately $260,000, or 2%. The decrease was primarily due to an approximately 47% or $2,100,000 decrease in software licensing revenues, offset by an approximately $1,840,000, increase in all other revenue categories other than software. Because software revenues generate the highest margins this lower revenues resulted in significantly reduced operating profits for the fiscal year when compared to the prior year. Revenues from systems sales in fiscal year 2006 were $4,278,792, a decrease of $1,833,935, or 30% of systems sales in fiscal year 2005 primarily resulting from the significant decrease in software licensing revenues as discussed above. 27 Table of Contents Revenues from services, maintenance, and support in fiscal year 2006 were $8,314,979, an increase of $1,364,797, or 20% over fiscal year 2005. Professional services revenues in fiscal year 2006 were $2,697,927, an increase of $852,505, of the professional services revenues in fiscal year 2005. Maintenance and support revenues in fiscal year 2006 were $5,617,052, an increase of $512,292, or 10%, over maintenance and support revenues in fiscal year 2005. The increase in professional services revenues was due to increased customer installations. The increase in maintenance and support results from the addition of new customers who pay annual maintenance. Revenues from application-hosting services were $3,273,202 or an increase of $209,303, or 7% over fiscal year 2005. The increase was due primarily to increased revenues from existing customers. Application-hosting services revenues at some locations are usage based and fluctuations in admissions, length of stay, return patient visits, etc. affect the system usage and the corresponding application-hosting services revenues. In fiscal year 2006, three customers accounted for 26% of the total revenues compared with 38% in fiscal year 2005, exclusive of our remarketing partners. Total revenues from Siemens were $420,921 in fiscal year 2006 compared with $382,594 in fiscal year 2005. No additional revenues are anticipated from Siemens in the future. Total revenues from IDX were $4,395,189 in fiscal year 2006, ($1,003,000 was hardware sales, $919,000 was software and $1,421,415 in maintenance and support revenues) compared with $1,988,412 in fiscal 2005. The increase in IDX revenues included increased software revenues, significantly increased hardware and third party software sales and increased professional services and maintenance revenues. A substantial portion of fiscal year total 2006 revenues came from fulfillment of backlog and add-on business, primarily expansion and upgrades of systems for Streamline Health s existing customers. Cost of Sales. Cost of sales consists of cost of systems sales, cost of services, maintenance and support, and cost of application-hosting services. Cost of systems sales includes amortization of capitalized software expenditures, royalties, and the cost of third-party hardware and software. Cost of systems sales, as a percentage of systems sales, varies from period-to-period depending on hardware and software configurations of the systems sold. The cost of systems sales as a percentage of associated revenues in fiscal year 2006 and 2005 were 57% and 37%, respectively. The higher costs in 2006 reflect a significantly lower volume of Streamline Health software, with high margins and a significantly higher volume of hardware and third party software with significantly lower margins, when compared with 2005 when a greater portion of system sales included more software and less hardware and third party software. Cost of services, maintenance, and support includes salaries and benefits for support and professional services personnel and the cost of third-party maintenance contracts. Cost of services, maintenance and support as a percentage of services, maintenance and support revenues in 2006 and 2005 were 43% and 45%, respectively. The lower relative cost reflects increased professional services revenues without a corresponding increase in expenses. The cost of application-hosting services in 2006 and 2005 as a percentage of revenues was 34% and 34%, respectively, and represents primarily salaries and benefits, depreciation and the cost of the collocation high security application hosting data center. Selling, General and Administrative. Selling, general and administrative expenses consist primarily of personnel and related costs, travel and living expenses, tradeshows, etc. for selling and marketing activities and general corporate and administrative activities. In fiscal year 2006, selling, general, and administrative expenses were $5,802,656 compared with $5,218,303 in fiscal year 2005. The year-to-year increase is primarily attributable to increased sales and marketing staff as the Company expanded its staff to respond to increasing inquiries and sales opportunities, additional expenses for tradeshows, marketing collateral and market costs associated with the re-branding of the Company as Streamline Health to strengthen the focus on new market opportunities involving business process improvement via workflow automation technologies. Product Research and Development. Product research and development expenses in fiscal year 2006 were $2,716,163 compared with $2,733.293 in fiscal year 2005. During 2006, Streamline Health increased its technical staff and added additional contractors to concentrate its development efforts primarily on its new products and new workflow technologies. Streamline Health capitalized approximately $2,130,000 in software development expenditures in fiscal year 2006, compared with $1,450,000 in 2005. The increase in capitalized software in 2006, reflects the increased 2006 development activities related to new products or enhancements to existing products. 28 Table of Contents Operating Profit. Operating profit in fiscal year 2006 was $181,590 compared with $1,738,322 in fiscal year 2005. The $1,556,732, or 90% decrease, results primarily from an approximately $1,834,000 decrease in high margin software licensing revenues discussed above and increased expenses during the fiscal year. Other Income (Expense). Interest income consists primarily of interest on cash balances. The interest income declined during 2006 because of lower cash balances. Interest expense in 2006 was related to the then current term loan and capitalized leases. The decrease in the interest expense in 2006 results primarily from the reduction of the outstanding debt during the year. Provision for Income Taxes. Streamline Health is in a tax loss carry forward position. The tax loss carry forward approximates $28,000,000, which begins to expire in 2013. Streamline Health also has an Alternative Minimum Tax credit carry forward of approximately $74,000, which has an unlimited carry forward period. The income tax provision in fiscal years 2005 and 2003 includes the Alternative Minimum Tax paid by the Company, as all income could not be offset against the Alternative Minimum Tax loss carry forward. In fiscal year 2005, and 2004 Streamline Health recorded a tax benefit in the amount of $897,000, and $420,000, respectively, as a result of a reduction in the valuation allowance on the deferred tax assets relating primarily to the tax loss carry forward based on future earnings before income tax projections. Net Earnings. Net earnings in fiscal year 2006 were $96,461 compared with net earnings of $2,551,072 in fiscal year 2005. The decrease results primarily from decreased software revenues and higher operating expenses. The decrease in cash resulted primarily from the reduction in long-term debt during the year. The decrease in accounts and contract receivables, both current and non-current is due to significantly lower software licensing revenues during the fourth quarter of 2006 compared with the fourth quarter of 2005. The decrease in property and equipment, net is due to the disposal of obsolete equipment in 2006. The disposal had no impact on operations as it was all fully depreciated as the time of disposal. The decrease in accounts payable is due to a large sale of third party hardware and software in the last few days of the prior fiscal year, which were not paid for until the first quarter fiscal 2006. There was no similar increase in 2006 accounts payable because there was no similar large hardware sale in the fourth quarter of 2007. The decrease in accrued compensation in 2006 is due to lower accrued commissions on significantly decreased fourth quarter revenues and decreased accrued bonuses as a result of the Company not meeting its fourth quarter Operating Profit threshold for the payment of bonuses when compared with 2005. Comparison of fiscal year 2005 with 2004 Revenues. Total revenues for fiscal year 2005 were $16,126,808 compared with revenues of $12,750,658 in fiscal year 2004, an increase of approximately $3,376,000, or 26%. The increase was primarily due to approximately a 391% or $3,587,000 increase in software licensing revenues, and approximately $465,000, or 18% in application hosting revenues, substantially all of which was due to expansion of our systems at existing customers, offset by a decrease of approximately $439,000 in hardware and third party software revenues, and $236,000 in services, maintenance, support and other revenues. Revenues from systems sales in fiscal year 2005 were $6,112,727, an increase of $3,147,465, or 106% of systems sales in fiscal year 2004 primarily resulting from the significant increase in software licensing revenues as discussed above. Revenues from services, maintenance, and support in fiscal year 2005 were $6,950,182, a decrease of $236,122 over fiscal year 2004. Professional services revenues in fiscal year 2005 were $1,845,422, a decrease of $121,320, of the professional services revenues in fiscal year 2004. Maintenance and support revenues in fiscal year 2005 were $5,104,760, a decrease of $114,802, over maintenance and support revenues in fiscal year 2004. The decrease in professional services revenues was due to some delays in customer installations. The decrease in maintenance and support results from some discontinuation of support on some items by some customers. Revenues from application-hosting services were $3,063,899 an increase of $464,807, or 18% over fiscal year 2004. The increase was due to increased revenues from existing customers. Application-hosting services revenues 29 Table of Contents at some locations were usage based and fluctuations in admissions, length of stay, return patient visits, etc. affect the system usage and the corresponding application-hosting services revenues. In fiscal year 2005, three customers accounted for 38% of the total revenues compared with 34% in fiscal year 2004, exclusive of our remarketing partners. Total revenues from Siemens were $382,594 in fiscal year 2005 compared with $451,255 in fiscal year 2004 and through IDX, $1,988,412 in fiscal year 2005 compared with $2,760,900 in fiscal 2004. A substantial portion of fiscal year 2005 revenues came from fulfillment of backlog and add-on business, primarily expansion and upgrades of systems for Streamline Health s existing customers, and 15% came from resellers, compared with 25% in fiscal year 2004. The decrease in the percentage of revenues from resellers reflect the declining maintenance revenues from Siemens customers and less than expected new system revenues from IDX in 2005. Cost of Sales. Cost of sales consists of cost of systems sales, cost of services, maintenance and support, and cost of application-hosting services. Cost of systems sales includes amortization of capitalized software expenditures, royalties, and the cost of third-party hardware and software. Cost of systems sales, as a percentage of systems sales, varies from period-to-period depending on hardware and software configurations of the systems sold. The cost of systems sales as a percentage of associated revenues in fiscal year 2005 and 2004 were 37% and 79%, respectively. The lower costs in 2005 reflect a significantly higher volume of Streamline Health software, with high margins when compared with 2004 when a greater portion of system sales included more hardware and third party software. Cost of services, maintenance, and support includes salaries and benefits for support and professional services personnel and the cost of third-party maintenance contracts. Cost of services, maintenance and support as a percentage of services, maintenance and support revenues in 2005 and 2004 were 45% and 39%, respectively. The higher relative cost reflects increased staffing necessary in providing the services. The cost of application-hosting services in 2005 and 2004 as a percentage of revenues was 34% and 35%, respectively, and represents primarily salaries and benefits, depreciation and the cost of the collocation high security application hosting data center. The decline in the relative cost percentage reflects higher revenues without a corresponding increase in costs as the operating costs are relatively fixed and additional clients do not require a corresponding large increase in operating costs. Selling, General and Administrative. Selling, general and administrative expenses consist primarily of personnel and related costs, travel and living expenses, tradeshows, etc. for selling and marketing activities and general corporate and administrative activities. In fiscal year 2005, selling, general, and administrative expenses were $5,218,303 compared with $3,701,443 in fiscal year 2004. The year-to-year increase is primarily attributable to increased sales and marketing staff as the Company expanded its staff to respond to increasing inquiries and sales opportunities, additional expenses for tradeshows, marketing collateral and market costs associated with the re-branding of the Company as Streamline Health to strengthen the focus on new market opportunities involving business process improvement via workflow automation technologies, and increased sales commissions and bonus expenses, resulting from increased revenues and operating profits. Product Research and Development. Product research and development expenses in fiscal year 2005 were $2,733,293 compared with $2,061,207 in fiscal year 2004. During 2005, Streamline Health increased its technical staff and added additional contractors to concentrate its development efforts primarily on its new products and new workflow technologies. Streamline Health capitalized approximately $1,450,000 in software development expenditures in fiscal year 2005, compared with $1,000,000 in 2004. Operating Profit. Operating profit in fiscal year 2005 was $1,738,322 compared with $935,893 in fiscal year 2004. The $802,429, or 85% increase, results primarily from an approximately $3,587,000 increase in high margin software licensing revenues discussed above notwithstanding the significant increases in operating expenses. Other Income (Expense). Interest income consists primarily of interest on cash balances. Interest expense in 2005 is related to the current term loan and capitalized leases. The 2004 interest expense includes approximately $784,000 in interest on the unpaid balance of the 1998 long-term debt, and additional interest on the unpaid long-term accrued interest payable relating to the 1998 long-term debt. The decrease in the interest expense in 2005 results primarily from the repayment of the 1998 high interest rate long-term debt and the accrued and unpaid accrued interest relating thereto in July 2004 and replacing it with significantly lower cost debt. 30 Table of Contents Provision for Income Taxes. Streamline Health is in a tax loss carry forward position. The income tax provision in fiscal years 2005 includes the Alternative Minimum Tax paid by the Company, as all income could not be offset against the Alternative Minimum Tax loss carry forward. In fiscal year 2005 and 2004, Streamline Health recorded a tax benefit in the amount of $897,000, and $420,000, respectively, as a result of a reduction in the valuation allowance on the deferred tax assets relating primarily to the tax loss carry forward based on future earnings before income tax projections. Net Earnings. Net earnings in fiscal year 2005 were $2,551,072 compared with net earnings of $557,676 in fiscal year 2004. The increase results primarily from increased software revenues and partially offset by higher operating expenses, combined with lower interest expense for fiscal year 2005 as a result of the repayment of the high interest rate debt in July 2004 and the increased tax benefit, as a result of the adjustment of the deferred tax asset valuation allowance. The increase in accounts and contract receivables, both current and non-current is due to the significant licensing revenues recorded in January 2006. The payment terms also include deferred payments due in fiscal 2007. The increase in property and equipment, net is due to the relocation and expansion of the office facilities to accommodate the increased staff, and additional computer equipment for the Application-hosting data center in fiscal 2005. The increase in accounts payable is due to the sale of third party hardware and software in January 2006, which was not paid for until fiscal 2006. The increase in accrued compensation is due to an increase in accrued commissions on significantly increased fourth quarter revenues and increased accrued bonuses as a result of the Company meeting its annual Operating Profit threshold for the payment of bonuses in fiscal 2005. The Company paid no such Operating Profit bonuses in fiscal 2004 as the Operating Profit threshold was not met. Backlog At January 31, 2007 Streamline Health has master agreements and purchase orders from customers and remarketing partners for systems and related services (excluding support and maintenance, and transaction-based application-hosting revenues), which have not been delivered or installed which, if fully performed, would generate future revenues of approximately $5,226,000 compared with $4,159,000 at January 31, 2006. The related products and services are expected to be delivered over the next two to three years. The increase in the backlog is the result of signing new agreements with new and existing customers late in the fourth quarter of 2005 and early 2006 which have not been fully implemented. In addition, customers contract for maintenance and support services on a monthly, quarterly, or annual basis. At January 31, 2007, Streamline Health had maintenance agreements, purchase orders, from remarketing partners for maintenance, which if fully performed, will generate future revenues of approximately $4,469,000, compared with $3,533,000 at January 31, 2006, through their respective renewal dates in fiscal year 2007 and 2008. The increase results from the addition of new customers or expansion of systems with existing customers. In 2006, maintenance and support revenues approximated $5,617,000 compared with $5,104,000 in 2005 and are expected to increase in fiscal year 2007. At January 31, 2007, Streamline Health has entered into application-hosting agreements, which are expected to generate revenues in excess of $5,256,000 through their respective renewal dates in fiscal years 2007 through 2012. The application-hosting backlog is higher than the $4,784,000 in 2005 as the multi year agreements were renewed and new clients added. Revenues from the IDX/GE Healthcare Remarketing Agreement for the last three years amounted to approximately $9,145,000, or 20% of the total revenues for the last three fiscal years. Streamline Health relies on IDX/GE Healthcare for a significant amount of its revenues, the loss of which would have a material adverse affect on future results of operations. Streamline Health believes a greater percentage of its future revenues will come from remarketing agreements with, IDX/GE Healthcare, and other HIS related vendors. Streamline Health continues to actively pursue remarketing agreements with other companies. 31 Table of Contents Streamline Health believes the large HIS vendors, hospitals and integrated healthcare delivery networks now have a better understanding of the valuable role the document management and workflow technologies play in providing truly computerized information and the benefits of such systems in utilizing advanced workflow solutions. As more healthcare providers become aware of and better understand the significant economic and operating benefits of utilizing document management and workflow applications, Streamline Health believes the future demand for its products and services will increase. Many companies have emerged to provide healthcare applications through private Intranets or secure applications on the Internet. Additionally, the traditional HIS companies have developed clinical information systems for the Internet. Streamline Health s applications are well suited for integration with such clinical systems and are optimized for use on the Internet and private Intranets. Through Streamline Health s ASPeN Services, application-hosting customers can rapidly deploy and access healthcare information using web browser-based technology from a central data center on a per transaction or subscription basis thereby minimizing up-front capital expenditures. Streamline Health believes healthcare organizations will continue to increase their use of healthcare applications through the Internet, and Streamline Health s products are an integral part of providing a complete EMR across the Internet. Streamline Health continues to actively pursue strategic relationships with other healthcare Application Service Providers. Management believes that revenue growth can be fueled by: the expansion of our sales force and marketing efforts, an increase in incremental revenue from existing and new strategic distribution partners, an increase in interest by healthcare organizations in Streamline Health products and services to assist in compliance with the Federal HIPAA standards as they relate to the confidentiality and security of medical records, and incremental new revenues derived from new lines of business for Streamline Health in the remote coding, revenue cycle and other workflows for the hospital marketplace. The revenue cycle workflows are a logical extension of the product line because of the ability of the Financial Services departments of hospitals to access and process patient information from the EMR. Due to an acute shortage of available coding personnel, there currently exists a great demand for solutions to attract and retain qualified coders and to make the coding process more efficient. Since commencing operations in 1989, Streamline Health has incurred substantial cumulative operating losses. Although Streamline Health achieved operating profitability during the last seven years, Streamline Health incurred net losses in most fiscal years prior to fiscal year 2000. Based upon the expenses associated with current and planned staffing levels, continued profitability is dependent upon increasing revenues. Although the Company believes that it can continue to be profitable, there can be no assurance that Streamline Health will be able to neither achieve consistent profitability on a quarterly or annual basis nor be able to sustain or increase its revenue growth in future periods and believes historical operating results may not be indicative of the future performance of Streamline Health in the near or long-term. Liquidity and Capital Resources During the last five fiscal years, Streamline Health has funded its operations, working capital needs, and capital expenditures primarily from a combination of cash generated by operations, a $3,500,000 bank loan in 2004 and the current revolving credit facility. Streamline Health s liquidity is dependent upon numerous factors including: (i) the timing and amount of revenues and collection of contractual amounts from customers, (ii) amounts invested in research and development, capital expenditures, and (iii) the level of operating expenses, all of which can vary significantly from quarter-to-quarter. Streamline Health s customers typically have been well-established hospitals or medical facilities or major HIS companies that resell Streamline Health products, which have good credit histories and payments have been received within normal time frames for the industry. However, some healthcare organizations have experienced significant operating losses as a result of limits on third-party reimbursements from insurance companies and governmental entities. Agreements with customers often involve significant amounts and contract terms typically require customers to make progress payments. Streamline Health has no significant obligations for capital resources, other than its $1,000,000 of revolving debt, the noncancelable operating leases of approximately $1,287,000 payable over the next four years and 32 Table of Contents capitalized leases of approximately $156,000, payable over the next two years. Capital expenditures for property and equipment in 2007 are not expected to exceed $500,000. During the last three years, Streamline Health has expended approximately $1,853,000 for capital expenditures, increased its sales and marketing expenses, product research and development and support and consulting expenses, and made net debt and deferred interest repayments of approximately $7,625,000. This resulted in significant net cash outlays over the last four years. Although Streamline Health reduced staffing levels and related expenses during 2003 and 2004, the stringent expense controls and reduced staffing, caused by the necessity to retire the long-term debt, hampered the growth of revenues in fiscal year 2003 and 2004. Accordingly, to continue to achieve increasing revenues and profitability it was necessary for the Company to significantly increase the sales and marketing expenses in fiscal 2005 and 2006. The Company believes that this strategic initiative to expand sales and marketing should produce improved results in 2007 and beyond as the expanded sales and marketing efforts begin to produce results. However, there can be no assurance Streamline Health will be able to do so. At January 31, 2007, Streamline Health had cash of $3,316,614, of which $1,000,000 was used in February 2007 to repay the then outstanding balance of the revolving loan. Streamline Health has carefully monitored operating expenses during the last five fiscal years. Notwithstanding the current levels of revenues and operating profit, for the foreseeable future, Streamline Health will need to continually assess its revenue prospects compared to its then current expenditure levels. If it does not appear likely that revenues will increase, it may be necessary to reduce operating expenses or raise cash through additional borrowings, the sale of assets, or other equity financing. Certain of these actions will require current lender approval. However, there can be no assurance Streamline Health will be successful in any of these efforts. If it is necessary to significantly reduce operating expenses, this could have an adverse effect on future operating performance. Streamline Health believes that its present cash position, combined with cash generation currently anticipated from operations and the availability of the revolving credit facility will be sufficient to meet anticipated cash requirements for the short term. However, continued expansion of the Company will require additional resources. The Company may need to refinance its current debt, obtain an additional infusion of capital, or a combination of both, depending on the extent of the expansion of the Company and future revenues. However, there can be no assurance Streamline Health will be able to do so. To date, inflation has not had a material impact on Streamline Health s revenues or expenses. Net cash provided by operations in fiscal 2006 exceeded $2,500,000, down from approximately $2,770,000 in the prior fiscal year. See the Consolidated Statements of Cash Flows for the individual components comprising the net cash provided by operating activities. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Streamline Health currently invests its cash balances, in excess of its current needs in an interest bearing account. Streamline Health does not invest for the purposes of trading in securities. Additionally, Streamline Health does not have any significant market risk exposure at January 31, 2007. 33 Item 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE COVERED BY REPORT OF REGISTERED PUBLIC ACCOUNTING FIRM Page Report of Registered Public Accounting Firm 35 Consolidated Balance Sheets at January 31, 2007 and 2006 36 Consolidated Statements of Income for the three years ended January 31, 2007 37 Consolidated Statements of Changes in Stockholders Equity for the three years ended January 31, 2007 38 Consolidated Statements of Cash Flows for the three years ended January 31, 2007 39 Notes to Consolidated Financial Statements 40 Schedule II Valuation and Qualifying Accounts 53 EX-11.1 EX-21.1 EX-23.1 EX-24.1 EX-31.1 EX-31.2 EX-32.1 EX-32.2 All other financial statement schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto. 34 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors Streamline Health Solutions, Inc. We have audited the accompanying consolidated balance sheets of Streamline Health Solutions, Inc. as of January 31, 2007 and 2006, and the related consolidated statements of income, changes in stockholders equity, and cash flows for each of the three years in the period ended January 31, 2007. Our audits also included the financial statement schedule of Streamline Health Solutions, Inc. listed in item 15(a). These financial statements and schedule are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements and schedule 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. We were not engaged to perform an audit of the Company s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Streamline Health Solutions, Inc. at January 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended January 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth herein. Cincinnati, Ohio March 27, 2007 /s/ Ernst & Young LLP 35 Table of Contents CONSOLIDATED BALANCE SHEETS January 31, 2007 2006 ASSETS Current assets: Cash $ 3,316,614 $ 4,634,219 Accounts receivable, net of allowance for doubtful accounts of $200,000, respectively 2,281,313 2,117,495 Contract receivables 1,357,433 2,268,913 Other, including deferred taxes of $625,000 and $601,000, respectively 1,170,430 967,731 Total current assets 8,125,790 9,988,358 Property and equipment: Computer equipment 2,132,853 2,120,321 Computer software 847,328 989,556 Office furniture, fixtures and equipment 733,320 736,858 Leasehold improvements 568,098 522,863 4,281,599 4,369,598 Accumulated depreciation and amortization (2,704,329 ) (2,666,784 ) 1,577,270 1,702,814 Contract receivables 554,888 728,541 Capitalized software development costs, net of accumulated amortization of $5,116,568 and $4,033,232, respectively 3,753,361 2,706,697 Other, including deferred taxes of $1,250,000 and $1,274,000, respectively 1,289,536 1,306,741 $ 15,300,845 $ 16,433,151 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 619,362 $ 1,055,539 Accrued compensation 432,142 1,139,587 Accrued other expenses 541,904 744,112 Deferred revenues 3,693,668 2,617,184 Current portion of capitalized leases 91,002 84,951 Current portion of long-term debt Debt 1,000,000 Total current liabilities 5,378,078 6,641,373 Capitalized leases 56,049 147,051 Long-term debt 1,000,000 1,000,000 Other 222,484 293,409 Stockholders equity: Convertible redeemable preferred stock, $.01 par value per share, authorized, 8,500 shares issued and outstanding (see above) 5,000,000 shares authorized, no shares issued Common stock, $.01 par value per share, 25,000,000 shares authorized, 4,488,000 shares issued and outstanding at year end of fiscal 1995 and 1996. authorized, 9,211,399 and 9,159,541 shares issued, respectively 92,114 91,595 Capital in excess of par value 35,286,238 35,090,302 Accumulated (deficit) (26,734,118 ) (26,830,579 ) Total stockholders equity 8,644,234 8,351,318 $ 15,300,845 $ 16,433,151 See accompanying notes. 36 Table of Contents CONSOLIDATED STATEMENTS OF INCOME Fiscal Year 2006 2005 2004 Revenues: Systems sales $ 4,278,792 $ 6,112,727 $ 2,965,262 Services, maintenance and support 8,314,979 6,950,182 7,186,304 Application-hosting services 3,273,202 3,063,899 2,599,092 Total revenues 15,866,973 16,126,808 12,750,658 Operating expenses: Cost of systems sales 2,426,595 2,256,046 2,331,176 Cost of services, maintenance and support 3,609,386 3,130,374 2,804,202 Cost of application-hosting services 1,130,583 1,050,470 916,737 Selling, general and administrative 5,802,656 5,218,303 3,701,443 Product research and development 2,716,163 2,733,293 2,061,207 Total operating expenses 15,685,383 14,388,486 11,814,765 Operating profit 181,590 1,738,322 935,893 Other income (expense): Interest income 77,337 93,322 70,344 Interest expense (131,286 ) (147,933 ) (904,314 ) Earnings before income taxes 127,641 1,683,711 101,923 Income tax benefit (expense) (31,180 ) 867,361 455,753 Net earnings $ 96,461 $ 2,551,072 $ 557,676 Basic net earnings per common share $ .01 $ .28 $ .06 Number of shares used in basic per common share computation 9,195,415 9,121,369 9,067,816 Diluted net earnings per common share $ .01 $ .27 $ .06 Number of shares used in diluted per common share computation 9,722,346 9,425,050 9,233,320 See accompanying notes. 37 Table of Contents CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY Convertible Capital in Total redeemable Common excess of Accumulated stockholders preferred Stock stock par value (deficit) equity Balances at January 31, 2004 $ $ 90,300 $ 34,928,047 $ (29,939,327 ) $ 5,079,020 Stock issued to Employee Stock Purchase Plan and exercise of stock options 545 74,914 75,459 Net earnings 557,676 557,676 Balances at January 31, 2005 90,845 35,002,961 (29,381,651 ) 5,712,155 Stock issued to Employee Stock Purchase Plan and exercise of stock options 750 87,341 88,091 Net earnings 2,551,072 2,551,072 Balances at January 31, 2006 91,595 35,090,302 (26,830,579 ) 8,351,318 Stock issued to Employee Stock Purchase Plan and exercise of stock options 519 84,799 85,318 Share-based compensation expense 111,137 111,137 Net earnings 96,461 96,461 Balances at January 31, 2007 $ $ 92,114 $ 35,286,238 $ (26,734,118 ) $ 8,644,234 See accompanying notes. 38 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS Fiscal Year 2006 2005 2004 Operating activities: Net earnings $ 96,461 $ 2,551,072 $ 557,676 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 1,819,233 1,470,659 1,147,149 Share-based compensation expense 111,137 Net deferred income taxes (897,000 ) (420,000 ) Change in allowance for doubtful accounts (200,000 ) Cash provided by (used for) assets and liabilities: Accounts, contract and installment receivables 921,315 (1,808,739 ) 2,252,869 Other assets (178,699 ) 10,385 (18,371 ) Accounts payable (436,177 ) 169,449 248,868 Accrued expenses (909,653 ) 888,272 (197,769 ) Deferred revenues 1,076,484 385,742 (126,089 ) Net cash provided by operating activities 2,500,101 2,769,840 3,244,333 Investing activities: Purchases of property and equipment (610,353 ) (867,620 ) (374,818 ) Capitalization of software development costs (2,130,000 ) (1,450,000 ) (999,996 ) Other (77,720 ) 116,191 (135,773 ) Net cash (used for) investing activities (2,818,073 ) (2,201,429 ) (1,510,587 ) Financing activities: Proceeds from revolving credit facility 1,000,000 3,500,000 Repayment of long-term debt (2,000,000 ) (2,500,000 ) Repayment of long-term accrued interest (4,635,169 ) Payment of capitalized leases (84,951 ) (203,356 ) (220,199 ) Exercise of stock options and stock purchase plan 85,318 88,091 75,459 Net cash (used for) financing activities (999,633 ) (115,265 ) (3,779,909 ) Increase (Decrease) in cash and cash equivalents (1,317,605 ) 453,146 (2,046,163 ) Cash and cash equivalents at beginning of year 4,634,219 4,181,073 6,227,236 Cash and cash equivalents at end of year $ 3,316,614 $ 4,634,219 $ 4,181,073 Supplemental cash flow disclosures: Interest paid $ 129,674 $ 148,338 $ 5,517,465 Income taxes paid (refund) $ 66,537 $ (27,972 ) $ 49,615 Leasehold improvements (included in property and equipment) paid for by the landlord as a lease inducement $ $ 326,000 $ Capital lease $ $ 267,237 $ See accompanying notes. 39 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Streamline Health Solutions, Inc. (Streamline Health or the Company) operates in one segment as a provider of Healthcare Information Workflow Technology through the licensing of its Electronic Health Information Management, Patient Financial Services and other Workflow software applications and the use of such applications through its application-hosting services as an Application Service Provider. Streamline Health s products enable hospitals and integrated healthcare delivery systems in the United States to capture, store, manage, route, retrieve, and process vast amounts of patient clinical, financial and other healthcare provider information. Fiscal Year All references to a fiscal year refer to the fiscal year commencing February 1 in that calendar year and ending on January 31 of the following year. Consolidation The consolidated financial statements include the accounts of Streamline Health Solutions, Inc. and its subsidiary, Streamline Health, Inc. All significant intercompany transactions are eliminated. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. In the fourth quarter of fiscal year 2006, Streamline Health recorded a $100,000 favorable change in the estimate for miscellaneous reserves. In the fourth quarter of fiscal year 2004, Streamline Health recorded a $300,000 favorable change in the estimate for the allowance for doubtful accounts and miscellaneous reserves. In fiscal years 2004, 2005 and 2006, the Company made certain estimates of its future earnings before income taxes in determining the amount of the valuation allowance required for the deferred income tax assets relating to the net operating loss carry forward (See Note 4). Revenue Recognition Revenue is derived from: the licensing and sale of systems, either directly to end-users or through third-party resellers, comprising internally developed software, third-party software and hardware components; product support, maintenance and professional services; and application-hosting services that provide high quality, transaction or subscription based document imaging/management services from a central data center. Streamline Health s revenue recognition policies conform to Statement of Position 97-2, Software Revenue Recognition. Generally, revenue from software license fees and hardware sales to end-users is recognized when a master agreement is signed and products are made available to end-users. Revenues from agreements that contain multiple-element arrangements are allocated to the various elements based on the fair value of the specific elements. Revenues related to routine installation and integration and project management are deferred until the work is performed. Streamline Health follows this method since reasonably dependable estimates of the revenues and costs applicable to various stages of a contract can be made. Revenues from consulting, education, and application-hosting services are recognized as the services are performed. Revenues from short-term support and maintenance agreements are recognized ratably over the term of the agreements. Billings to customers recorded prior to the recognition of revenues are classified as deferred revenues. Revenues recognized prior to progress billings to customers are recorded as contract receivables. Cash Cash includes demand deposits. 40 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Receivables Accounts and contract receivables are comprised of amounts owed Streamline Health for licensed software, professional services, including maintenance services and application-hosting activities and are net of an allowance for doubtful accounts of $200,000 at January 31, 2007 and January 31, 2006, respectively. Contracts with individual customers and resellers determine when receivables are due. In determining the allowance for doubtful accounts, each unpaid receivable is reviewed quarterly with the appropriate Streamline Health Client Manager to determine the payment status based upon the most currently available information as to the status of the receivables, the customer comments, if any, and the status of any open or unresolved issues with the customer preventing the payment thereof. Corrective action, if necessary, is taken by Streamline Health to resolve open issues related to unpaid receivables. During these quarterly reviews, Streamline Health determines the required allowances for doubtful accounts for estimated losses resulting from the unwillingness or inability of its customers or resellers to make required payments. Concentrations Financial instruments, which potentially expose Streamline Health to concentrations of credit risk, as defined by Statement of Financial Accounting Standards No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, consist primarily of accounts receivable. Streamline Health s accounts receivable are concentrated in the healthcare industry. However, Streamline Health s customers typically have been well-established hospitals, medical facilities, or major Health Information Systems companies that resell Streamline Health s products that have good credit histories and payments have been received within normal time frames for the industry. However, some hospitals and medical facilities have experienced significant operating losses as a result of limits on third-party reimbursements from insurance companies and governmental entities and extended payment of receivables from these entities is not uncommon. To date, Streamline Health has relied on a limited number of customers and remarketing partners for a substantial portion of its total revenues. Streamline Health expects that a significant portion of its future revenues will continue to be generated by a limited number of customers and its remarketing partners. The failure to obtain new customers or expand sales through remarketing partners, the loss of existing customers or reduction in revenues from existing customers could materially and adversely affect Streamline Health s operating results (See Note 6). Streamline Health currently buys all of its hardware and some major software components of its Healthcare Information Systems from third-party vendors. Although there are a limited number of vendors capable of supplying these components, management believes that other suppliers could provide similar components on comparable terms. A change in suppliers, however, could cause a delay in system implementations and a possible loss of revenues, which could adversely affect operating results. Other Current Assets Other current assets are primarily: prepaid insurance, commissions, maintenance, deposits, deferred Federal income tax assets and prepaid expenses related to future revenues (See Note 4). Property and Equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line depreciation, over the estimated useful lives of the related assets. Estimated useful lives are as follows: Computer equipment and software 3-4 years Office equipment 5 years Office furniture and fixtures 7 years Leasehold improvements Life of lease 41 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In 2005, Streamline Health entered into a sixty-six month operating lease for office space. In connection with the lease, the property owner provided certain lease inducements to the Company, including a $326,000 build out allowance and use of the premises for six months rent free. The Company has accounted for the value of these inducements by recording the build out allowance as a leasehold improvement with a corresponding lease incentive liability. The total amount of the lease payments are amortized as rent expense on a straight line basis over the term of the lease. The leasehold improvement asset and the lease incentive liability are each amortized on a straight line basis over the term of the lease to depreciation and as an offset to rent expense, respectively. Any timing differences between the actual monthly lease payments and the straight line rent expense is recorded as an adjustment to the lease incentive liability. Depreciation expense for 2006, 2005, and 2004 was $735,897, $670,655, and $514,149, respectively. Leased computer equipment and software meeting certain criteria are capitalized and the present value of the related lease payments is recorded as a liability. Depreciation of the capitalized lease assets is computed on the straight-line method over the term of the lease. Normal repair and maintenance is expensed as incurred. Replacements are capitalized and the property and equipment accounts are relieved of the items being replaced or disposed of, or if no longer of value. The related cost and accumulated deprecation of the disposed assets are eliminated and any gain or loss on disposition is included in the results of operations in the year of disposal. Capitalized Software Development Costs Software development costs are accounted for in accordance with Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Software to be Sold, Leased or Otherwise Marketed. Costs associated with the planning and designing phase of software development, including coding and testing activities necessary to establish technological feasibility are classified as product research and development and are expensed as incurred. Once technological feasibility has been determined, a portion of the costs incurred in development, including coding, testing, and product quality assurance, are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. Streamline Health capitalized approximately $2,130,000, $1,450,000, and $1,000,000 in 2006, 2005 and 2004, respectively. Research and development expense, net of capitalized amounts, was $2,716,163, $2,733,293, and $2,061,207 in 2006, 2005 and 2004, respectively. Amortization is provided on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. Amortization commences when a product is available for general release to customers. Unamortized capitalized costs determined to be in excess of the net realizable value of a product are expensed at the date of such determination. Amortization expense was approximately $1,083,000, $800,000, and $633,000 in 2006, 2005, and 2004, respectively. Other non-current assets Other non-current assets at January 31, 2007 and 2006 consist primarily of deferred tax assets (See Note 4). Accrued Other Expenses Accrued other expenses at January 31, 2007, and 2006 include warranty reserves, accrued franchise and property taxes, professional fees and other similar liabilities. Income Taxes The provisions for income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the 42 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Stock Options and Stock Appreciation Rights Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, establishes a fair value method of financial accounting and reporting for stock-based compensation plans. Streamline Health elected to continue to account for stock options under the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and, accordingly, adopted the disclosure only provisions of Statement 123 through fiscal year 2005. No stock-based compensation cost is reflected in the net earnings for fiscal years 2005 and 2004, as all options granted under the plans had exercise prices equal to the fair market value of the underlying common stock on the date of grant. The table below illustrates the effect on net earnings and earnings per share as if Streamline Health had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, to stock-based employee compensation. The Company adopted the revised standards of Statement of Financial Accounting Standards No. 123(R), Accounting for Stock-Based Compensation, effective the first quarter of fiscal year 2006, which requires expensing the fair value of the equity awards. The Company elected to adopt the Modified-Prospective Transition method. Under this method, the Company is required to recognize compensation cost for share-based payments based on their grant-date fair value from the beginning of the fiscal period in which the recognition provisions are first applied. As a result of adopting Statement 123(R) on February 1, 2006, the Company incurred total additional annual compensation expense of $111,137 in the amount of $22,966, $30,062, $27,875 and $30,234 in the four fiscal quarters, respectively. The fair value of the 2006 stock-based compensation was estimated at the date of grants using a Black-Scholes option pricing model with the following weighted average assumptions for fiscal year 2006: risk-free interest rate of 4.25%, a dividend yield of zero percent; a weighted average volatility factor of the expected market price of Streamline Health s Common Stock of .823, and a weighted average expected life of stock options of five years. Future grants of equity awards accounted for as stock-based compensation could have a material impact on reported expenses depending upon the number, value and vesting period of future awards. At January 31, 2007 Streamline Health had two stock-based compensation plans, which are more fully disclosed in Note 7 of the Notes to Consolidated Financial Statements. Pro forma information regarding the net earnings and net earnings per common share is required by Statement 123 for fiscal years 2005 and 2004 and has been determined as if Streamline Health had accounted for its stock options under the fair value method of that Statement. The fair value of these options was estimated at the date of grant using a Black-Scholes option- pricing model with the following weighted average assumptions for fiscal year 2005 and 2004: risk-free interest rate of 4.25% for both years; a dividend yield of zero percent for both years; a volatility factor of the expected market price of Streamline Health s Common Stock of .842 in 2005 and .864 in 2004, and a weighted average expected life of the options of five years for both years. 43 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because Streamline Health s stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in Streamline Health s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options. Fiscal Year 2005 2004 Net earnings, as reported $ 2,551,072 $ 557,676 Deduct: Total stock based compensation expense determined under the fair value based method for all awards, net of related tax effects (74,227 ) (66,503 ) Pro forma net earnings $ 2,476,845 $ 491,173 Earnings per share: Basic as reported $ .28 $ .06 Basic pro forma $ .27 $ .06 Diluted as reported $ .27 $ .06 Diluted pro forma $ .26 $ .06 Net Earnings Per Common Share The net earnings per common share are computed in accordance with Statement of Financial Accounting Standards No. 128, Earnings per Share. The basic net earnings per common share are computed based on the weighted average number of common shares outstanding during each period. The diluted net earnings per common share reflects the potential dilution that could occur if Stock Options, Stock Purchase Plan commitments and Warrants were exercised into Common Stock, under certain circumstances, that then would share in the earnings of Streamline Health. The following is the calculation of the basic and diluted net earnings per share of common stock. Fiscal Year 2006 2005 2004 Net earnings $ 96,461 $ 2,551,072 $ 557,676 Average shares outstanding used in basic per common share computations 9,195,415 9,121,369 9,067,816 Stock options 428,976 631,271 287,352 Warrants assumed converted 750,000 750,000 Assumed treasury stock buyback (652,045 ) (1,077,590 ) (121,848 ) Convertible redeemable preferred stock assumed converted Number of average shares used in diluted per common share computation 9,722,346 9,425,050 9,233,320 Basic net earnings per share of common stock $ .01 $ .28 $ .06 Diluted net earnings per share of common stock $ .01 $ .27 $ .06 The diluted earnings per share for the fiscal year 2006, exclude the effect of 32,524 outstanding Stock Options because the inclusion would be antidilutive. 44 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The diluted earnings per share for the fiscal year 2005, exclude the effect of 40,000 outstanding Stock Options because the inclusion would be antidilutive. The diluted earnings per share for the fiscal year 2004, exclude the effect of 249,589 outstanding Stock Options and the 750,000 Warrants because the inclusion would be antidilutive. 2. Operating Leases Streamline Health rents office and data center space and equipment under noncancelable operating leases that expire at various times through fiscal year 2010. Future minimum lease payments under noncancelable operating leases for the next five fiscal years are approximately as follows: 2007, $414,000; 2008, $365,000; 2009, $342,000; 2010, $165,000 each year. Rent expense was approximately $350,000, $287,000, and $253,000 for fiscal years 2006, 2005, and 2004, respectively. In February 2005, Streamline Health entered into a sixty-six month lease for office space. In connection with the lease, the property owner provided a $326,000 build out allowance. As a further inducement to rent the facilities, the owner provided the Company with the use of the premises for six months rent free. The Company pays a base rent and a proportional amount of the building operating expenses, currently estimated at approximately $308,000 per year. The lease has no renewal provisions and predetermined increases in the base rent in 2007 and again in 2009. 3. Long-term Debt and Capitalized Leases In January 2007, Streamline Health prepaid its then existing term debt and entered into a new three year $5,000,000 working capital revolving line of credit facility, with an option for two one-year extensions. The loan is secured by all of the assets of Streamline Health and the loan agreement restricts Streamline Health from incurring additional indebtedness for borrowed money, including capitalized leases, etc. without lender consent. The Company is required to meet certain financial covenants, including minimum level of tangible net worth, minimum working capital, fixed charge ratio coverage and funded indebtedness to earnings before interest, taxes, depreciation and amortization ratio (EBITDA). These requirements may limit the borrowing under this credit agreement. At January 31, 2007, the Company had the ability to utilize $3,800,000 of the line of credit. Interest on this facility ranges from Prime minus 1% to Prime based on the amount borrowed to EBITDA. The Company pays a commitment fee on the unused portion of the facility of .35%. Simultaneously with the signing of the new agreement, the Company borrowed $1,000,000 under the new agreement to prepay the then existing term loan balance that was due in July 2007, which resulted in lowering the interest rate to prime minus 1% on the outstanding debt. In February 2007, the Company repaid the then outstanding balance of the revolving credit facility. In 1998, Streamline Health issued a $6,000,000 note. In connection with the issuance of the note, Streamline Health issued Warrants to purchase 750,000 shares of Common Stock of Streamline Health at $3.87 per share at any time through July 16, 2008. The Warrants are subject to customary antidilution and registration rights provisions. Streamline Health believes the fair market value of the revolving credit facility loan balance approximates the carrying value based on the term, interest rate and maturity that Streamline Health believes is currently available to it. During the third quarter of fiscal year 2005, Streamline Health acquired additional computer equipment for the application-hosting services data center, which are accounted for as capitalized leases. The amount of the computer equipment leased assets is $267,237. The lease is payable monthly in installments of $8,192, through August 2008. The present value of the future lease payments upon lease inception was $267,237 using the interest rates implicit in the lease agreement at the inception of the lease. 45 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following is an analysis of the assets under capital lease at the fiscal year end: 2006 2005 Computer equipment $ 267,237 $ 267,237 Accumulated depreciation (89,079 ) (22,270 ) $ 178,158 $ 244,967 Total depreciation and amortization expense on assets under capital leases was $66,809 in 2006, $164,646 in 2005, and $156,525 in 2004. Total obligations under capital leases are as follows: $98,306 in 2007 and $57,346 in 2008. The total obligations of the minimum lease payments, less the amount representing interest of $8,601 is reflected in the balance sheet as a current obligation of $91,002 and a non-current obligation of $56,049. 4. Income Taxes In 2005, Streamline Health was subject to Alternative Minimum Taxes. The income tax benefit (provision) for income taxes differs from the Federal statutory rate as follows: Fiscal Year 2006 2005 2004 Federal tax (expense) benefit at Statutory rate $ (43,398 ) $ (572,461 ) $ (35,673 ) Current state and local taxes, net of federal benefit (28,224 ) (2,673 ) 16,549 Change in valuation allowance 37,943 1,384,351 (1,341,759 ) Non-deductible interest 1,797,251 Other 2,499 58,144 19,385 $ (31,180 ) $ 867,361 $ 455,753 Income taxes consist of the following: Fiscal Year 2006 2005 2004 Federal tax expense: Current $ $ (25,589 ) $ 10,293 Deferred 881,882 412,921 856,293 423,214 State tax expense: Current (31,180 ) (4,050 ) 25,460 Deferred 15,118 7,079 (31,180 ) 11,068 32,539 Federal and state income tax (expense) benefit $ (31,180 ) $ 867,361 $ 455,753 46 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Streamline Health provides deferred income taxes for temporary differences between assets and liabilities recognized for financial reporting and income tax purposes. The income tax effects of these temporary differences are as follows: Fiscal Year 2006 2005 Deferred tax asset: Net operating loss carry forwards $ 9,826,988 $ 9,827,661 Accounts payable and accrued liabilities 243,571 299,080 Property and equipment 39,811 25,345 Other 73,581 73,597 10,183,951 10,225,683 Less valuation allowance (8,308,951 ) (8,350,683 ) Net deferred tax assets 1,875,000 1,875,000 Deferred tax liabilities: Net deferred tax asset $ 1,875,000 $ 1,875,000 In all fiscal years prior to 2003, Streamline Health established a full valuation allowance against all of the deferred tax assets. As of January 31, 2007, Streamline Health reduced the valuation allowance for the deferred tax assets primarily related to the carry forward by $1,875,000 based upon reasonable future earnings before income tax projections. A valuation allowance of $8,308,951 is still required to reduce the deferred tax assets, primarily relating to loss carry forwards, to a level currently believed will be utilized to offset future earnings before income taxes based upon the current backlog and forecasts over the next two years. The valuation allowance is required due to the inability to predict on a longer term basis that Streamline Health will more likely than not attain levels of profitability required to utilize additional loss carry forwards. At January 31, 2007, Streamline Health had a net operating loss carry forward of approximately $28,000,000, which begins to expire in 2013. Streamline Health also has an Alternative Minimum Tax credit carry forward of approximately $74,000, which has an unlimited carry forward period. Certain changes in stock ownership can result in a limitation on the amount of net operating loss carry forward that can be utilized each year. 5. Retirement Plan Streamline Health has established a 401(k) retirement plan that covers all employees. Company contributions to the plan may be made at the discretion of the Board of Directors. Effective February 1, 2006, the Company began to match 100% up to the first 4% of compensation deferred by each employee in the 401(k) plan. The total compensation expense for this matching contribution was $291,719 in 2006. 6. Major Customers During fiscal year 2006, three customers, exclusive of our remarketing partners, accounted for 11%, 8%, and 7% of total revenues. During fiscal year 2005, three customers, exclusive of our remarketing partners, accounted for 18%, 11%, and 10% of total revenues. During fiscal year 2004, three customers, exclusive of our remarketing partners, accounted for 13%, 13%, and 7% of total revenues. At January 31, 2007 and 2006, 38% and 60%, respectively, of Streamline Health s accounts receivable were due from three customers excluding remarketing partners. At January 31, 2007 and 2006 approximately, 20% and 6%, respectively, of Streamline Health s accounts receivables were due from remarketing partners. 47 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 7. Stock-based Compensation Plans As discussed in note 1, effective February 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Accounting for Stock-Based Compensation. Streamline Health s 1996 Employee Stock Option Plan authorized the grant of options to employees for Streamline Health s Common Stock. The options granted have terms of ten years or less and generally vest and become fully exercisable ratably over three years of continuous employment from the date of grant. At January 31, 2007, options to purchase 361,500 shares of Streamline Health s Common Stock have been granted and are outstanding under the Plan. No more options can be granted under this Plan. Streamline Health s 1996 Non-Employee Directors Stock Option Plan authorized the grant of options for shares of Streamline Health s Common Stock. The options granted have terms of ten years or less, and vest and become fully exercisable ratably over three years of continuous service as a Director from the date of grant. At January 31, 2007, options to purchase 15,000 shares of Streamline Health Common Stock have been granted and are outstanding under the Plan. No more options can be granted under this Plan. In May 2005, the shareholders approved the 2005 Incentive Compensation Plan which authorizes the Company to issue up to 1,000,000 equity awards (Stock Options, Stock Appreciation Rights ( SAR s ), and Restricted Stock) to directors and employees of the Company. At January 31, 2007, Options to purchase 85,000 shares of Streamline Health Common Stock have been granted and are outstanding under the Plan. SAR s are settled in Common Stock of the Company. Upon exercise of the SAR, the holder is entitled to receive shares of Common Stock equal to an amount determined by multiplying: (a) The difference between the fair market value of a share of common stock of the Company on the date of exercise over the price at the date of grant; by (b) The number of shares with respect to which the SAR is exercised. A summary of Streamline Health s stock option activity and related information is as follows: Fiscal Year 2006 2005 2004 Weighted Weighted Weighted average average average exercise exercise Exercise Options price Options price Options Price Outstanding beginning of year 476,167 $ 2.76 536,942 $ 3.01 545,977 $ 2.90 Granted 45,000 5.74 50,000 2.91 30,000 2.67 Exercised (24,667 ) .97 (63,000 ) .97 (33,035 ) 1.20 Expired (35,000 ) 11.61 Forfeited (47,775 ) 8.08 (6,000 ) 1.21 Outstanding end of year 461,500 2.50 476,167 2.76 536,942 3.01 Exercisable end of year 368,666 $ 2.04 430,833 $ 2.78 475,275 $ 3.10 Weighted average fair value of options granted during year $ 3.31 $ 2.91 $ 1.87 The following table summarizes the options as of January 31, 2007: Options Weighted average Approximate Outstanding Exercisable exercise price remaining life in years 461,500 368,666 $ 2.04 (1) 3 48 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (1) The exercise prices range from $0.53 to $6.25, of which 73,500 shares are between $5.00 and $6.25 per share, 155,500 shares are between $2.39 and $4.75 per share, and 232,500 shares are between $0.53 and $1.95 per share. A summary of Streamline Health s Stock Appreciation Rights (SAR s) is as follows: 2006 2005 Outstanding beginning of year 25,000 Granted 25,000 Exercised Expired (25,000 ) Outstanding end of year 25,000 Weighted average grant price $ 6.78 The SAR s vest when certain performance criteria are met. The performance objectives are such that the recipient earns 100% or 0% of the number of SAR s granted. Performance based SAR expense is recognized over the performance period based on the stock price at each reporting date, when satisfaction of the performance criteria is deemed probable. As the performance criteria as of January 31, 2007 was not achieved, no expense was recognized in 2006. At January 31, 2007, there was approximately $180,000 of compensation cost that has not yet been recognized related to nonvested stock-based awards. That cost is expected to be recognized over a remaining weighted average period of two years. Cash received from exercise of options and the employee stock purchase plan was $85,318, $88,091 and $75,459, respectively, in 2006, 2005 and 2004. The 1996 Employee Stock Option Plan and the 2005 Incentive Compensation Plan contains change of control provisions whereby any outstanding equity awards under the plans subject to vesting, which have not fully vested as of the date of the change in control, shall automatically vest and become immediately exercisable. One of the change in control provisions is deemed to occur if there is a change in beneficial ownership, or authority to vote, directly or indirectly, securities representing 20% or more of the total of all of Streamline Health s then outstanding voting securities, unless through a transaction arranged by, or consummated with the prior approval of the Board of Directors. Other change in control provisions relate to mergers and acquisitions or a determination of change in control by Streamline Health s Board of Directors. 8. Employee Stock Purchase Plan Streamline Health has an Employee Stock Purchase Plan under which employees may purchase up to 500,000 shares of Common Stock. Under the plan, eligible employees may elect to contribute, through payroll deductions, up to 10% of their base pay to a trust during any plan year, July 1 through June 30, of the following year. At June 30 of each year, the plan issues for the benefit of the employees shares of Common Stock at the lesser of (a) 85% of the Fair Market Value of the Common Stock on July 1, of the prior year, or (b) 85% of the Fair Market Value of the Common Stock on June 30, of the current year. At January 31, 2007, 339,330 shares remain that can be purchased under the plan. During fiscal year 2006, 27,191 shares were purchased at the price of $2.26 per share; 2005, 12,006 shares were purchased at the price of $2.26 per share; and in 2004, 21,468 shares were purchased at the price of $1.66 per share. The purchase price at June 30, 2007, will be 85% of the lower of (a) the closing price on July 3, 2006 ($5.27) or (b) 85% of the closing price on June 30, 2007. 49 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 9. Commitments and Contingencies Maintenance Agreements, Warranties, and Indemnities Streamline Health warrants to customers that its software will meet certain performance requirements for an initial limited warranty period. Streamline Health has maintenance agreements to provide services in future periods after the expiration of the initial limited warranty period. Streamline Health invoices customers in accordance with the agreements and records the invoicing as deferred revenues and recognizes the revenues ratably over the term of the maintenance agreements. Streamline Health s standard agreements with its customers usually include intellectual property infringement indemnification provisions to indemnify them from and against third-party claims, and for liabilities, damages, and expenses arising out of Streamline Health s operation of its business or any negligent act or omission of Streamline Health. At January 31, 2007 and 2006, Streamline Health has a warranty reserve in the amount of $250,000. Application-hosting Services Streamline Health enters into long-term agreements to provide document imaging/management and workflow services to its healthcare customers on an outsourced basis from a central data center. Streamline Health guarantees specific up-time and response time performance standards, which, if not met may result in reduced revenues, as a penalty, for the month in which the standards are not met. Employment Agreements Streamline Health has entered into employment agreements with its officers and employees that generally provide annual salary, a minimum bonus, discretionary bonus, stock incentive provisions, and severance arrangements. Reserved Common Stock Streamline Health has reserved 1,630,830 shares of the Common Stock authorized for issuance in connection with various Equity Award Plans and the Employee Stock Purchase Plan, and 750,000 shares for the Warrants issued in connection with the 1998 long-term debt. Litigation There are, from time to time, claims pending against Streamline Health Solutions, Inc. and its subsidiary. Based on a review of such litigation with legal counsel, Streamline Health believes any resulting liability would not have a material affect on Streamline Health s consolidated financial position or results of operations. 50 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 10. Quarterly Results of Operations (Unaudited) The following sets forth selected quarterly financial information for fiscal years 2006, 2005, and 2004. First Second Third Fourth Quarter Quarter Quarter Quarter 2006 (In thousands, except per share data) Revenues $ 3,848 $ 4,583 $ 3,592 $ 3,844 $ 15,867 Gross profit 2,104 2,502 1,864 2,230 8,700 Operating profit (loss) (e) (f) (71 ) 240 (297 ) 310 182 Net earnings (loss) (e) (f) (80 ) 214 (334 ) 296 96 Basic net (loss) earnings per share (a) (.01 ) .02 (.04 ) .03 .01 Diluted net (loss) earnings per share (a) (.01 ) .02 (.04 ) .03 .01 Weighted average shares outstanding outstanding 9,168 9,190 9,211 9,211 9,195 Stock Price (b) High $ 8.70 $ 7.49 $ 5.81 $ 6.00 $ 8.70 Low $ 6.55 $ 4.51 $ 4.78 $ 4.91 $ 4.51 Quarter and year-end close $ 6.95 $ 5.71 $ 5.13 $ 5.64 $ 5.64 Cash dividends declared (c) $ $ $ $ $ First Second Third Fourth Quarter Quarter Quarter Quarter 2005 Revenues $ 2,697 $ 4,066 $ 3,164 $ 6,200 $ 16,127 Gross profit 1,404 2,419 1,664 4,203 9,690 Operating profit (loss) (254 ) 547 (463 ) 1,908 1,738 Net earnings (loss) (d) (277 ) 519 (454 ) 2,763 2,551 Basic net (loss) earnings per share (a) (.03 ) .06 (.05 ) .30 .28 Diluted net (loss) earnings per share (a) (.03 ) .06 (.05 ) .29 .27 Weighted average shares outstanding outstanding 9,087 9,108 9,131 9,153 9,121 Stock Price (b) High $ 5.18 $ 3.25 $ 6.38 $ 7.00 $ 7.00 Low $ 2.62 $ 2.65 $ 2.53 $ 3.51 $ 2.53 Quarter and year-end close $ 3.29 $ 2.90 $ 4.26 $ 7.00 $ 7.00 Cash dividends declared (c) $ $ $ $ $ 51 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) First Second Third Fourth Quarter Quarter Quarter Quarter 2004 Revenues $ 2,642 $ 2,558 $ 2,538 $ 5,012 $ 12,750 Gross profit 1,385 1,385 1,416 2,512 6,698 Operating profit (loss) (e) (42 ) (84 ) (118 ) 1,180 936 Net earnings (loss) (d) (e) (421 ) (462 ) (156 ) 1,597 558 Basic net (loss) earnings per share (a) (.05 ) (.05 ) (.02 ) .18 .06 Diluted net (loss) earnings per share (a) (.05 ) (.05 ) (.02 ) .17 .06 Weighted average shares outstanding outstanding 9,036 9,068 9,082 9,084 9,068 Stock Price (b) High $ 4.30 $ 3.42 $ 3.85 $ 3.20 $ 4.30 Low $ 2.55 $ 2.38 $ 2.50 $ 2.46 $ 2.38 Quarter and year-end close $ 2.83 $ 2.65 $ 2.97 $ 3.07 $ 3.07 Cash dividends declared (c) $ $ $ $ $ (a) Quarterly amounts may not be additive. (b) Obtained from The NASDAQ Stock Market, Inc. (c) Streamline Health has not paid a dividend on its Common Stock since its inception and does not intend to pay any cash dividends in the foreseeable future. (d) Includes, in the fourth quarter, an $897,000, and $420,000 favorable change in a reduction of the valuation allowance for deferred tax assets in 2005 and 2004 respectively. (e) In the fourth quarter of fiscal year 2006, Streamline Health recorded a $100,000 favorable change in the estimate for miscellaneous reserves. In the fourth quarter of fiscal year 2004, Streamline Health recorded a $300,000 favorable change in the estimate for the allowance for doubtful accounts and miscellaneous reserves. (f) As a result of adopting Statement 123(R) on February 1, 2006, the Company incurred total additional annual compensation expense of $111,137 in the amount of $22,966, $30,062, $27,875 and $30,234 in the four fiscal quarters, respectively. 52 Table of Contents Schedule II Valuation and Qualifying Accounts and Reserves Streamline Health Solutions, Inc. For the three years ended January 31, 2007 Additions Balance at Charged to Charged to Beginning costs and Other Balance at Description of Period Expenses Accounts Deductions End of Period (In thousands) Year ended January 31, 2007: Allowance for doubtful accounts $ 200 $ $ $ $ 200 Warranty reserve 250 250 Year ended January 31, 2006: Allowance for doubtful accounts 200 200 Warranty reserve 250 250 Year ended January 31, 2005: Allowance for doubtful accounts 400 (200 )(1) 200 Warranty reserve 250 250 (1) Represents change in the estimate for the allowance for doubtful accounts. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures No change in Streamline Health s auditors has taken place within the twenty-four months prior to, or in any period subsequent to, Streamline Health s January 31, 2007 Financial Statements. Item 9A. Controls and Procedures Streamline Health maintains disclosure controls and procedures that are designed to ensure that there is reasonable assurance that the information required to be disclosed in Streamline Health s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC s rules and forms, and that such information is accumulated and communicated to Streamline Health s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based on the definition of disclosure controls and procedures in Exchange Act Rules 13a-15(e) and 15d-15(e). In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of Streamline Health s senior management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Streamline Health s disclosure controls and procedures to provide reasonable assurance of achieving the desired objectives of the disclosure controls and procedures. Based on that evaluation, Streamline Health s management, including the Chief Executive and Chief Financial Officer, concluded that there is reasonable assurance that Streamline Health s disclosure controls and procedures were effective as of the end of the period covered by this report and there have been no material changes in Streamline Health s internal control or in the other controls during the quarter ended January 31, 2007 that could materially affect, or is reasonably likely to materially affect, internal controls over financial reporting. Item 9B. Other Information None 53 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Goverance The information required by Items 401, 405 and 407(c)(3),(d)(4) and (d)(5) of Regulation S-K is incorporated herein by reference from Streamline Health s Definitive Proxy Statement for its Annual Stockholder s Meeting to be held on May 23, 2007 from the information appearing under the captions Election of Directors , Board of Directors meetings and Committees Stock Ownership by Certain Beneficial Owners and Management , and Compliance with Section 16(a) of the Exchange Act . Certain information regarding Streamline Health s Executive Officers is set forth in Part I, of this Form 10-K under the caption Executive Officers of the Registrant. The information relating to the Code of Ethics required by Items 406 of Regulation S-K is included herein by reference to Exhibit 14.1 to this Form 10-K. Streamline Health has adopted the Code of Ethics that applies to all of its directors, officers (including its chief executive officer, chief financial officer, chief accounting officer, controller and any person performing similar functions) and employees. Streamline Health has also made the Code of Ethics available on its website at www.streamlinehealth.net and will provide a copy, free of charge, upon request. Item 11. Executive Compensation The information required by Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated herein by reference from Streamline Health s Definitive Proxy Statement for its Annual Stockholder s Meeting to be held on May 23, 2007 from the information appearing under the captions Executive Compensation , except that the information required by Item 407(e)(5) of Regulation S-K which appears within such caption under the subheading Compensation Committee Report is specifically not incorporated herein by reference into this Form 10-K or into any other filing by Streamline Health under the Securities Act of 1933 or the Securities Exchange Act of 1934. Item 12. Securities Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by Item 403 of Regulation S-K is incorporated herein by reference from Streamline Health s Definitive Proxy Statement for its Annual Stockholder s Meeting to be held on May 23, 2007 from the information appearing under the caption Stock Ownership by Certain Beneficial Owners and Management . Securities authorized for issuance under equity compensation plans required by Item 201(d) of Regulation S-K are as follows: Number of Number of securities securities to be remaining available issued upon Weighted-average for future issuance exercise of exercise price of under equity outstanding outstanding compensation plans options, warrants options, warrants (excluding securities Plan category and rights and rights reflected in column (a)) (a) (b) (c) Equity compensation plans approved by security holders 461,500(1 & 2 ) $ 2.50 915,000(3 & 4 ) Total 461,500(1 & 2 ) $ 2.50 915,000(3 & 4 ) (1) Includes 15,000 options that can be exercised under the 1996 non-employee Director s Stock Option Plan and 361,500 options that can be exercised under the 1996 Employee Stock Option Plan. (2) Includes 85,000 options which can be exercised by directors under the 2005 Incentive Compensation Plan. (3) Excludes 339,330 shares that can be issued under the 1996 Employee Stock Purchase Plan, which is more fully described in footnote 8 of the enclosed Notes to Consolidated Financial Statements. (4) Excludes Warrants issued in connection with the 1998 Long-term debt to acquire 750,000 shares at $3.87, which is more fully described in footnote 3 of the enclosed Notes to Consolidated Financial Statements. See ITEM 7, MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Long-term Debt for additional information. 54 Table of Contents (5) The Company does not have any equity compensation plans that have not been approved by the Company s Stockholders. Item 13. Certain Relationships, Related Transactions and Directors Independence The information required by Item 404 and 407(a) of Regulation S-K is incorporated herein by reference from Streamline Health s Definitive Proxy Statement for its Annual Stockholder s Meeting to be held on May 23, 2007 from the information appearing under the captions Transactions with relates persons, promoters, and certain control persons and Board of Directors Meetings and Committees . Item 14. Principal Accounting Fees and Services The following table sets forth the aggregate fees for the Company for the fiscal years 2006 and 2005 for audit and other services provided by Streamline Health s accounting firm, Ernst & Young LLP. 2006 2005 Audit Fees $ 116,000 $ 109,000 Audit-Related Fees Tax Fees 36,400 35,000 All Other Fees 45,000 Total Fees $ 197,400 $ 144,000 The Company has engaged Ernst & Young LLP to provide tax consulting and compliance services and consulting services regarding the internal control audit related requirements of the Sarbanes-Oxley Act, in addition to the audit of the financial statements. The Company s Audit Committee has considered whether the provision of the tax and consulting services is compatible with maintaining the independence of Ernst & Young LLP. All of the fees paid to Ernst & Young LLP are pre-approved by the Audit Committee of the Board of Directors. PART IV Item 15. Exhibits, Financial Statement Schedules Financial Statements (a)1. The financial statements listed in ITEM 8 in the Index to Consolidated Financial Statements on page 34 are filed as part of this report. (a)2. The Financial Statement Schedule on page 53 is filed as part of this report. (b). Exhibits See Index to Exhibits on page 57 of this report. The exhibits are filed with or incorporated by reference in this report. 55 Table of Contents SIGNATURES Pursuant to the requirements of section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Streamline Health Solutions, Inc. By: /s/ William A. Geers William A. Geers Chief Operating Officer DATE: April 2, 2007 Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the date indicated. /s/ J. Brian Patsy J. Brian Patsy Chief Executive Officer And Director (Principal Executive Officer) April 2, 2007 /s/ Jonathan R. Phillips Jonathan R. Phillips Director April 2, 2007 /s/ Edward J. VonderBrink Edward J. VonderBrink Director April 2, 2007 ** Richard C. Levy, M.D. Director April 2, 2007 /s/ Andrew L. Turner Andrew L. Turner Director April 2, 2007 /s/ Paul W. Bridge, Jr. Paul W. Bridge, Jr. Chief Financial Officer (Principal Financial and Accounting Officer) April 2, 2007 **By: /s/ J. Brian Patsy J. Brian Patsy Attorney-in-fact April 2, 2007 56 INDEX TO EXHIBITS EXHIBITS Exhibit No. Description of Exhibit 3.1(a) Certificate of Incorporation of Streamline Health Solutions, Inc. f/k/a/ LanVision Systems, Inc. Previously filed with the Commission and incorporated herein by reference from, the Registrant s (LanVision System, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996. 3.1(b) Certificate of Incorporation of Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc., amendment No. 1 Previously filed with the Commission and incorporated herein by reference from the Registrant s Form 10-Q, as filed with the Commission on September 8, 2006. 3.2 Bylaws of Streamline Health Solutions, Inc. f/k/a/LanVision Systems, Inc. Previously filed with the Commission and incorporated herein by reference from, the Registrant s (LanVision System, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996. 3.3 Certificate of the Designations, Powers, Preferences and Rights of the Convertible Preferred Stock (Par Value $.01 Per Share) of Streamline Health Solutions, Inc. f/k/a/ LanVision Systems, Inc. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 4.1 Specimen Common Stock Certificate of Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 4.2 Specimen Preferred Stock Certificate of Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 4.3 Revolving Note, and associated documents, dated January 20, 2007, between Streamline Health, Inc. (a wholly owned subsidiary of the Registrant) and 57 Table of Contents Exhibit No. Description of Exhibit the Fifth Third Bank. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10 of the Registrant s Form 8-K, as filed with the commission on January 25, 2007.) 10.1 # Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. 1996 Employee Stock Option Plan. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 10.2(a) # Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. 1996 Non-Employee Directors Stock Option Plan. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 10.2(b) # First Amendment to Streamline Health Solutions, Inc. f/k/a/LanVision Systems, Inc. 1996 Non-Employee Directors Stock Option Plan. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 4.1(b) of, the Registrant s (LanVision Systems, Inc.) Registration Statement on Form S-8, file number 333-20765, as filed with the Commission on January 31, 1997.) 10.2(c) # Second Amendment to Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. 1996 Non-Employee Directors Stock Option Plan. (Previously filed with the Commission, and incorporated herein by reference from, Amendment No. 1 to the Registrant s (LanVision Systems, Inc.) Statement on Form S-8, file number 333-20765, as filed with the Commission on March 1, 2001.) 10.3 # Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. 1996 Employee Stock Purchase Plan. (Previously filed with the Commission, and incorporated herein by reference from, the Registrant s (LanVision Systems, Inc. ) Registration Statement on Form S-1, File Number 333-01494, as filed with the Commission on April 15, 1996.) 10.4 # 2005 Incentive Compensation Plan of Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the Commission on May 26, 2005.) 10.5 # Employment Agreement between Streamline Health, Inc. f/k/a LanVision, Inc. and Donald E. Vick effective December 3, 1996. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.5 of 58 Table of Contents Exhibit No. Description of Exhibit the Registrant s (LanVision Systems, Inc.) Form 10-K for the fiscal year ended January 31, 2002, as filed with the commission on April 29, 2002.) 10.5(a) # Amendment No. 1 to the Employment Agreement between Streamline Health, Inc. f/k/a LanVision, Inc. and Donald E. Vick effective January 27, 2006 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.4 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on January 31, 2006.) 10.6 # Employment Agreement among Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc., Streamline Health, Inc. f/k/a LanVision, Inc. and Paul W. Bridge, Jr., effective February 1, 2004 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 10-Q for the fiscal quarter ended July 31, 2004, as filed with the commission on September 10, 2004.) 10.6(a) # Amendment No. 1 to the Employment Agreement between Streamline Health, Inc. f/k/a LanVision, Inc. and Paul W. Bridge, Jr. effective January 27, 2006 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.3 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on January 31, 2006.) 10.7 # Employment Agreement among Streamline Health, Inc. f/k/a/ LanVision Systems, Inc., Streamline Health, Inc. f/k/a LanVision, Inc. and J. Brian Patsy effective February 1, 2003 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.7 of the Registrant s (LanVision Systems, Inc.) Form 10-K for the fiscal year ended January 31, 2004, as filed with the commission on April 8, 2004.) 10.7(a) # Amendment No. 1 dated January 27, 2005 to the Employment Agreement among J. Brian Patsy, Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. and Streamline Health Inc. f/k/a LanVision, Inc. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on February 1, 2005.) 10.7(b) # Amendment No. 2 dated January 27, 2006 to the Employment Agreement among J. Brian Patsy, Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. and Streamline Health, Inc. f/k/a LanVision, Inc. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on January 31, 2006.) 10.8(a) # Employment Agreement among Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc., Streamline Health, Inc. f/k/a LanVision, Inc. and 59 Table of Contents Exhibit No. Description of Exhibit William A. Geers effective February 1, 2004 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.2 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on December 9, 2004.) 10.8(b) # Amendment No. 1 dated December 8, 2004 to the Employment Agreement among William A. Geers, Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. and Streamline Health, Inc. f/k/a LanVision, Inc. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.3 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on December 9, 2004.) 10.8(c) # Amendment No. 2 dated January 27, 2006 to the Employment Agreement among William A. Geers, Streamline Health Solutions, Inc. f/k/a LanVision Systems, Inc. and Streamline Health, Inc. f/k/a LanVision, Inc. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.2 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the commission on January 31, 2006.) 10.9(a) Lease for office space between Streamline Health, Inc. f/k/a LanVision, Inc. (a wholly owned subsidiary) and The Western and Southern Life Insurance Company dated July 30, 2004 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 10-Q for the fiscal quarter ended July 31, 2004, as filed with the commission on September 10, 2004.) 10.9(b) Registrant s Guarantee of Lease Agreement between Streamline Health, Inc. f/k/a LanVision, Inc. and The Western and Southern Life Insurance Company (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 10-Q for the fiscal quarter ended July 31, 2004, as filed with the commission on September 10, 2004.) 10.9(c) First Amendment to Lease and Acceptance of Delivery to the Lease for office space between Streamline Health, Inc. f/k/a LanVision, Inc. (a wholly owned subsidiary) and The Western and Southern Life Insurance Company, effective January 31, 2005. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 11.11(c) of the Registrant s (LanVision Systems, Inc.) Form 10-K for the fiscal year ended January 31, 2005, as filed with the commission on April 8, 2005.) 10.10(a)** Reseller Agreement between IDX Information Systems Corporation and Streamline Health, Inc. f/k/a LanVision, Inc. entered into on January 30, 2002. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.11 of the Registrant s (LanVision Systems, Inc.) 60 Table of Contents Exhibit No. Description of Exhibit Form 10-K for the fiscal year ended January 31, 2002, as filed with the commission on April 29, 2002.) 10.10(b) First amendment to the Reseller Agreement between IDX Information Systems Corporation and Streamline Health, Inc. f/k/a LanVision, Inc. entered into on January 30, 2002 (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10 of the Registrant s (LanVision Systems, Inc.) Form 10-Q for the quarter ended April 30, 2002, as filed with the commission on June 4, 2002.). 10.11 Form of Indemnification Agreement for all directors and officers. (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.1 of the Registrant s (LanVision Systems, Inc.) Form 8-K, as filed with the Commission on June 7, 2006. 10.12 # Schedule of Directors Compensation (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 10.14 of the Registrant s (LanVision Systems, Inc.) Form 10-K for the fiscal year ended January 31, 2005, as filed with the commission on April 8, 2005.) 11.1 Statement Regarding Computation of Per Share Earnings *** 14.1 Code of Ethics (Previously filed with the Commission, and incorporated herein by reference from, Exhibit 14.1 of the Registrant s (LanVision Systems, Inc.) Form 10-K for the fiscal year ended January 31, 2004, as filed with the commission on April 8, 2004.) 21.1 Subsidiaries of the Registrant *** 23.1 Consent of Registered Public Accounting Firm *** 24.1 Power of attorney *** 31.1 Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *** 31.2 Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *** 32.1 Certification by Chief Executive Officer pursuant to U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *** 32.2 Certification by Chief Financial Officer pursuant to U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *** 61 Table of Contents ** The Company has applied for Confidential Treatment of portions of this agreement with the Securities and Exchange Commission *** Included herein # Management Contracts and Compensatory Arrangements. 62

WITTER DEAN CORNERSTONE FUND II

10-K

https://www.sec.gov/Archives/edgar/data/736999/0000736999-04-000001.txt

Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 [No Fee Required] For the year ended December 31, 2003 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 [No Fee Required] For the transition period from ________________to___________________ Commission File Number 0-13298 DEAN WITTER CORNERSTONE FUND II (Exact name of registrant as specified in its Limited Partnership Agreement) NEW YORK 13-3212871 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) Demeter Management Corporation 825 Third Avenue, 9th Floor New York, NY 10022 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (212) 310-6444 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered None None Securities registered pursuant to Section 12(g) of the Act: Units of Limited Partnership Interest (Title of Class) Indicate by check-mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ Indicate by check-mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) 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 of this Form 10-K. [X] Indicate by check-mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes No X State the aggregate market value of the Units of Limited Partnership Interest held by non-affiliates of the registrant. The aggregate market value shall be computed by reference to the price at which Units were sold as of the last business day of the registrant's most recently completed second fiscal quarter: $23,287,391 at June 30, 2003. DOCUMENTS INCORPORATED BY REFERENCE (See Page 1) DEAN WITTER CORNERSTONE FUND II INDEX TO ANNUAL REPORT ON FORM 10-K DECEMBER 31, 2003 Page No. DOCUMENTS INCORPORATED BY REFERENCE . . . . . . . . . . . . . . . . . 1 Part I. Item 1. Business. . . . . . . . . . . . . . . . . . . . . . . . 2-5 Item 2. Properties. . . . . . . . . . . . . . . . . . . . . . . . 5 Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . 5 Item 4. Submission of Matters to a Vote of Security Holders . . . 5 Part II. Item 5. Market for the Registrant's Partnership Units and Related Security Holder Matters . . . . . . . . . . 6-7 Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . 8 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . 9-22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk. . . . . . . . . . . . . . . . . . . . . 22-35 Item 8. Financial Statements and Supplementary Data . . . . . . . 36 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . . . . . . . . . . 36 Item 9A. Controls and Procedures . . . . . . . . . . . . . . . . . 37 Part III. Item 10. Directors and Executive Officers of the Registrant. . 38-43 Item 11. Executive Compensation. . . . . . . . . . . . . . . . . . 43 Item 12. Security Ownership of Certain Beneficial Owners and Management. . . . . . . . . . . . . . . . . . . .. . .44 Item 13. Certain Relationships and Related Transactions. . . . . . 44 Item 14. Principal Accounting Fees and Services . . . . . . . .44-45 Part IV. Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . . . . . . . . .46-47 DOCUMENTS INCORPORATED BY REFERENCE Portions of the following documents are incorporated by reference as follows: Documents Incorporated Part of Form 10-K Partnership's Prospectus dated August 28, 1996, together with the Supplement to the Prospectus dated May 14, 1999 I Annual Report to the Dean Witter Cornerstone Funds II, III and IV Limited Partners for the year ended December 31, 2003 II, III and IV PART I Item 1. BUSINESS (a) General Development of Business. Dean Witter Cornerstone Fund II (the "Partnership") is a New York limited partnership organized to engage in the speculative trading of futures contracts, options on futures contracts and forward contracts on foreign currencies and other commodity interests. The Partnership commenced operations on January 2, 1985. The Partnership is one of the Dean Witter Cornerstone Funds, comprised of the Partnership, Dean Witter Cornerstone Fund III and Dean Witter Cornerstone Fund IV (collectively, the "Cornerstone Series"). The Partnership's general partner is Demeter Management Corporation ("Demeter"). The non-clearing commodity broker is Morgan Stanley DW Inc. ("Morgan Stanley DW"). The clearing commodity brokers are Morgan Stanley & Co. Incorporated ("MS & Co.") and Morgan Stanley & Co. International Limited ("MSIL"). Demeter, Morgan Stanley DW, MS & Co. and MSIL are wholly-owned subsidiaries of Morgan Stanley. The trading managers to the Partnership are Northfield Trading L.P. and John W. Henry & Company, Inc. (collectively, the "Trading Managers"). The Partnership's net asset value per unit of limited partnership interest ("Unit(s)") at December 31, 2003 was $4,981.39, representing an increase of 0.4 percent from the net asset value per Unit of $4,963.25 at December 31, 2002. For a more detailed description of the Partnership's business, see subparagraph (c). (b) Financial Information about Segments. For financial infor- mation reporting purposes, the Partnership is deemed to engage in one industry segment, the speculative trading of futures, forwards and options. The relevant financial information is presented in Items 6 and 8. (c) Narrative Description of Business. The Partnership is in the business of speculative trading of futures, forwards and options pursuant to trading instructions provided by the Trading Managers. For a detailed description of the different facets of the Partnership's business, see those portions of the Partnership's prospectus, dated August 28, 1996, (the "Prospectus") together with the supplement to the Prospectus dated May 14, 1999, (the "Supplement") incorporated by reference in this Form 10-K, set forth below. Facets of Business 1. Summary 1. "Summary of the Prospectus" (Pages 1-9 of the Pros- pectus). 2. Commodities Market 2. "The Commodities Market" (Pages 80-84 of the Prospectus). 3. Partnership's Commodity 3. "Investment Program, Use Trading Arrangements and of Proceeds and Trading Policies Policies" (Pages 45-47 of the Prospectus) and "The Trading Managers" (Pages 51-74 of the Prospectus and Pages S-20 - S-32 of the Supplement). 4. Management of the Part- 4. "The Cornerstone Funds" nership (Pages 19-24 of the Prospectus and Pages S-2 - S-5 of the Supplement). "The General Partner" (Pages 77-79 of the Prospectus and Pages S-32 - S-34 of the Supplement) and "The Commodity Brokers" (Pages 79-80 of the Prospectus and Pages S-34 - S-36 of the Supplement). "The Limited Partnership Agreements" (Pages 86-90 of the Prospectus). 5. Taxation of the Partner- 5. "Material Federal Income ship's Limited Partners Tax Considerations" and "State and Local Income Tax Aspects" (Pages 92- 99 of the Prospectus and Page S-37 of the Supplement). (d) Financial Information about Geographic Areas. The Partnership has not engaged in any operations in foreign countries; however, the Partnership (through the commodity brokers) enters into forward contract transactions where foreign banks are the contracting party and trades futures, forwards and options on foreign exchanges. (e) Available Information. The Partnership files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to these reports with the Securities and Exchange Commission ("SEC"). You may read and copy any document filed by the Partnership at the SEC's public reference room at Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The Partnership does not maintain an internet website, however, the SEC maintains a website that contains annual, quarterly, and current reports, proxy statements and other information that issuers (including the Partnership) file electronically with the SEC. The SEC's website address is http://www.sec.gov. Item 2. PROPERTIES The Partnership's executive and administrative offices are located within the offices of Morgan Stanley DW. The Morgan Stanley DW offices utilized by the Partnership are located at 825 Third Avenue, 9th Floor, New York, NY 10022. Item 3. LEGAL PROCEEDINGS None. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II Item 5. MARKET FOR THE REGISTRANT'S PARTNERSHIP UNITS AND RELATED SECURITY HOLDER MATTERS (a) Market Information. There is no established public trading market for Units of the Partnership. (b) Holders. The number of holders of Units at December 31, 2003 was approximately 1,632. (c) Distributions. No distributions have been made by the Partnership since it commenced trading operations on January 2, 1985. Demeter has sole discretion to decide what distributions, if any, shall be made to investors in the Partnership. Demeter currently does not intend to make any distributions of Partnership profits. (d) Use of Proceeds. The offering for the Partnership originally commenced on May 31, 1984 and was closed to new investors September 30, 1994. Units of the Partnership were sold afterwards solely through "exchanges" between existing investors within the Cornerstone Series at 100% of net asset value per Unit. Effective with the April 30, 2000 monthly closing, the exchange privilege within the Cornerstone Series was terminated. However, limited partners retained the ability to execute exchanges out of a Cornerstone fund into other funds outside the Cornerstone Series subject to certain restrictions set forth in the applicable Limited Partnership Agreements. Morgan Stanley DW pays all expenses in connection with the exchanging of Units without reimbursement and therefore, 100% of the proceeds from exchanges out of the Partnership are applied to the working capital of the funds outside the Cornerstone Series receiving the exchanges in. Please refer to the "Investment Programs, Use of Proceeds and Trading Policies" section of the Prospectus. Item 6. SELECTED FINANCIAL DATA (in dollars) For the Years Ended December 31, 2003 2002 2001 2000 1999 Revenues (including interest) 2,515,377 5,181,204 1,898,394 4,963,877 1,381,603 Net Income (Loss) 134,035 2,951,248 (358,852) 2,490,547 (1,597,851) Net Income (Loss) Per Unit (Limited & General Partners) 18.14 602.86 (58.74) 454.26 (227.17) Total Assets 22,301,695 23,879,130 22,934,774 25,149,757 27,066,982 Total Limited Partners' Capital 21,548,446 22,899,223 22,185,827 24,168,885 26,243,505 Net Asset Value Per Unit 4,981.39 4,963.25 4,360.39 4,419.13 3,964.87 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity. The Partnership deposits its assets with Morgan Stanley DW as non-clearing broker and MS & Co. and MSIL as clearing brokers in separate futures, forwards and options trading accounts established for each Trading Manager, which assets are used as margin to engage in trading and may be used as margin solely for the Partnership's trading. The assets are held in either non-interest bearing bank accounts or in securities and instruments permitted by the Commodity Futures Trading Commission for investment of customer segregated or secured funds. Since the Partnership's sole purpose is to trade in futures, forwards and options, it is expected that the Partnership will continue to own such liquid assets for margin purposes. The Partnership's investment in futures, forwards, and options may, from time to time, be illiquid. Most U.S. futures exchanges limit fluctuations in prices during a single day by regulations referred to as "daily price fluctuations limits" or "daily limits". Trades may not be executed at prices beyond the daily limit. If the price for a particular futures or options contract has increased or decreased by an amount equal to the daily limit, positions in that futures or options contract can neither be taken nor liquidated unless traders are willing to effect trades at or within the limit. Futures prices have occasionally moved the daily limit for several consecutive days with little or no trading. These market conditions could prevent the Partnership from promptly liquidating its futures or options contracts and result in restrictions on redemptions. There is no limitation on daily price moves in trading forward contracts on foreign currencies. The markets for some world currencies have low trading volume and are illiquid, which may prevent the Partnership from trading in potentially profitable markets or prevent the Partnership from promptly liquidating unfavorable positions in such markets, subjecting it to substantial losses. Either of these market conditions could result in restrictions on redemptions. Illiquidity has not materially affected the Partnership's assets. There are no known material trends, demands, commitments, events or uncertainties at the present time that will result in, or that are reasonably likely to result in, the Partnership's liquidity increasing or decreasing in any material way. Capital Resources. The Partnership does not have, nor expect to have, any capital assets. Redemptions of additional Units in the future will affect the amount of funds available for investment in futures, forwards, and options in subsequent periods. It is not possible to estimate the amount, and therefore the impact, of future redemptions of Units. There are no known material trends, favorable or unfavorable, that would affect, nor any expected material changes to, the Partnership's capital resource arrangements at the present time. The Partnership does not have any off-balance sheet arrangements, nor does it have contractual obligations or commercial commitments to make future payments that would affect its liquidity or capital resources. Results of Operations. General. The Partnership's results depend on the Trading Managers and the ability of the Trading Managers' trading programs to take advantage of price movements or other profit opportunities in the futures, forwards and options markets. The following presents a summary of the Partnership's operations for each of the three years in the period ended December 31, 2003 and a general discussion of its trading activities during each period. It is important to note, however, that the Trading Managers trade in various markets at different times and that prior activity in a particular market does not mean that such market will be actively traded by the Trading Managers or will be profitable in the future. Consequently, the results of operations of the Partnership are difficult to discuss other than in the context of the Trading Managers' trading activities on behalf of the Partnership and how the Partnership has performed in the past. Past performance is not necessarily indicative of future results. The Partnership's results of operations are set forth in its financial statements prepared in accordance with accounting principles generally accepted in the United States of America, which require the use of certain accounting policies that affect the amounts reported in these financial statements, including the following: The contracts the Partnership trades are accounted for on a trade-date basis and marked to market on a daily basis. The difference between their cost and market value is recorded on the Statements of Operations as "Net change in unrealized profit/loss" for open (unrealized) contracts, and recorded as "Realized profit/loss" when open positions are closed out, and the sum of these amounts constitutes the Partnership's trading revenues. The market value of a futures contract is the settlement price on the exchange on which that futures contract is traded on a particular day. The value of foreign currency forward contracts is based on the spot rate as of the close of business, New York City time, on a given day. Interest income revenue, as well as management fees, incentive fees and brokerage commissions expenses of the Partnership are recorded on an accrual basis. Demeter believes that, based on the nature of the operations of the Partnership, no assumptions relating to the application of critical accounting policies other than those presently used could reasonably affect reported amounts. The Partnership recorded revenues including interest totaling $2,515,377 and expenses totaling $2,381,342, resulting in net income of $134,035 for the year ended December 31, 2003. The Partnership's net asset value per Unit increased from $4,963.25 at December 31, 2002 to $4,981.39 at December 31, 2003. Total redemptions for the year were $1,566,534 and the Partnership's ending capital was $22,049,409 at December 31, 2003, a decrease of $1,432,499 from ending capital at December 31, 2002 of $23,481,908. The most significant trading gains of approximately 12.1% were recorded in the currency markets, mainly throughout the fourth quarter, from long positions in a variety of major and minor currencies versus the U.S. dollar. A confluence of factors including concerns regarding U.S. budget and trade deficits, a dip in consumer confidence, an outbreak of Mad Cow Disease in the U.S., and fears of a potential terrorist attack forced the U.S. dollar to retreat. The Partnership's largest gains were achieved during December from long positions in the euro, British pound, and Australian and New Zealand dollars versus the U.S. dollar. Weakness in the U.S. dollar during the first quarter also contributed to currency gains for the year. Additional gains of approximately 2.5% were incurred in the metals markets by long futures positions in base and precious metals. During December, profits were made on long futures positions in base metals, such as copper, aluminum and nickel, as well as from long futures positions in precious metals such as gold and silver. Copper and nickel prices rose to six and fourteen year highs respectively, benefiting from increased demand from China and the strengthening of the global economy. Meanwhile, gold and silver prices continued to soar as investors sought a safe haven from the falling U.S. dollar and an increased risk of terrorism. In the global stock index markets, gains of approximately 1.3% contributed to the Partnership's gains for the year. During June, long positions in European stock index futures resulted in profits as prices strengthened amid the release of positive economic data and expectations of a U.S. interest rate cut. Long positions in Japanese stock index futures also produced gains as prices rallied amid increased foreign demand for Japanese equities. Long positions in Asian stock index futures resulted in further gains during August as Asian equity prices drew strength from robust Japanese economic data and gains in the U.S. equity markets. A portion of the Partnership's overall gains for the year was offset by losses of approximately 7.2% in the agricultural markets. During August, positions in cotton futures returned losses as prices moved without consistent direction. Additional losses were recorded from positions in corn futures during August and September as volatile prices resulted from supply data and weather related concerns. Long positions in coffee futures during September and sugar positions during December compounded sector losses. In the energy markets, losses of approximately 4.4%, largely incurred during October, also offset a portion of the Partnership's gains for the year. During October, the Partnership entered the month with short natural gas positions, but these positions proved unprofitable as prices rallied during the first part of the month. In response to rising natural gas prices, the Partnership reversed its position from short to long, only to see prices decline in the latter part of the month. December also added to losses from short natural gas futures positions. Additional losses were incurred from short crude oil positions during September and October as prices moved higher in response to supply fears resulting primarily from geopolitical tensions. Additional losses of approximately 2.2% were incurred in the global interest rate markets, primarily during the fourth quarter. Long positions in European interest rate futures recorded losses during October as bond prices were negatively impacted by the release of positive U.S. economic data and inflation concerns. During December, short European interest rate futures positions suffered losses as economic data released throughout the month indicated that inflation in the U.S. remained under control, despite the strengthening of the U.S. economy and reinforcing the belief that the U.S. Federal Reserve would remain committed to keeping U.S. rates at their current low levels. The Partnership recorded revenues including interest totaling $5,181,204 and expenses totaling $2,229,956, resulting in net income of $2,951,248 for the year ended December 31, 2002. The Partnership's net asset value per Unit increased from $4,360.39 at December 31, 2001 to $4,963.25 at December 31, 2002. Total redemptions for the year were $2,167,076, and the Partnership's ending capital was $23,481,908 at December 31, 2002, an increase of $784,172 from ending capital at December 31, 2001 of $22,697,736. The most significant trading gains of approximately 11.8% were recorded in the currency markets from long positions in the euro, Norwegian krone, and Swiss franc relative to the U.S. dollar as the value of the dollar weakened during the second quarter, as well as in December, amid investors' fears concerning increased tensions in the Middle East and prolonged uncertainty regarding the U.S. economy. Elsewhere in the currency markets, gains were recorded from long positions in the Australian dollar and South African rand versus the U.S. dollar as the value of both currencies strengthened amid rising gold prices. Additional gains of approximately 2.2% were recorded in the global interest rate futures markets from long positions in Japanese interest rate futures as prices trended higher during the second and third quarters amid continued uncertainty regarding a Japanese economic recovery. Smaller gains of approximately 0.8% were recorded in the energy futures markets from long positions in natural gas futures during March, August, September, and December as prices trended higher on supply concerns and weather related factors. A portion of the Partnership's gains was offset by losses of approximately 2.0% in the agricultural futures markets from positions in sugar and coffee futures as prices moved erratically throughout most of the year. Smaller losses in the agricultural futures markets were incurred from long positions in cotton futures as prices moved without consistent direction during the first and third quarters amid shifting supply and demand concerns. In the metals futures markets, losses of approximately 1.2% were recorded from positions in copper and aluminum futures as an uncertain economic outlook resulted in trendless price activity among industrial metals throughout most of the year. As of August 30, 2002, the Partnership received a settlement award payment from the Sumitomo Copper Litigation Settlement Administrator in the amount of $76,613. The Partnership recorded revenues including interest totaling $1,898,394 and expenses totaling $2,257,246, resulting in a net loss of $358,852 for the year ended December 31, 2001. The Partnership's net asset value per Unit decreased from $4,419.13 at December 31, 2000 to $4,360.39 at December 31, 2001. Total redemptions for the year were $1,631,103 and the Partnership's ending capital was $22,697,736 at December 31, 2001, a decrease of $1,989,955 from ending capital at December 31, 2000 of $24,687,691. The most significant trading losses of approximately 9.5% were recorded in the energy markets throughout the first nine months of the year from trading in crude oil futures and its related products as a result of volatility in oil prices due to a continually changing outlook for supply, production and demand. In the metals markets, losses of approximately 1.1% were experienced primarily from trading in silver futures. Additional losses were incurred during October and November from long gold futures positions as prices reversed lower on the heels of sharp gains in the U.S. stock market. In the agricultural markets, losses of approximately 1.0% were recorded primarily during July from previously established short corn futures positions as prices increased on forecasts for hotter and drier weather in the U.S. midwest. Smaller losses of approximately 0.9% were experienced in the soft commodities markets from short positions in sugar futures as prices reversed higher on supply concerns. A portion of the Partnership's overall losses was partially offset by gains of approximately 8.8% recorded in the currency markets throughout a majority of the fourth quarter from previously established short positions in the South African rand as its value trended lower relative to the U.S. dollar as investors targeted the emerging market currency while global economic jitters persisted. Additional profits of approximately 2.0% were recorded in the global interest rate futures markets primarily during September from long positions in U.S. interest rate futures as prices rose following an interest rate cut by the U.S. Federal Reserve and as investors sought a safe haven from declining stock prices. For an analysis of unrealized gains and (losses) by contract type and a further description of 2003 trading results, refer to the Partnership's Annual Report to Limited Partners for the year ended December 31, 2003, which is incorporated by reference to Exhibit 13.01 of this Form 10-K. The Partnership's gains and losses are allocated among its partners for income tax purposes. Market Risk. Financial Instruments. The Partnership is a party to financial instruments with elements of off-balance sheet market and credit risk. The Partnership trades futures, forwards and options in interest rates, stock indices, currencies, agriculturals, energies and metals. In entering into these contracts, the Partnership is subject to the market risk that such contracts may be significantly influenced by market conditions, such as interest rate volatility, resulting in such contracts being less valuable. If the markets should move against all of the positions held by the Partnership at the same time, and if the Trading Managers were unable to offset positions of the Partnership, the Partnership could lose all of its assets and the limited partners would realize a 100% loss. In addition to the Trading Managers' internal controls, the Trading Managers must comply with the Partnership's trading policies that include standards for liquidity and leverage that must be maintained. The Trading Managers and Demeter monitor the Partnership's trading activities to ensure compliance with the trading policies and Demeter can require the Trading Managers to modify positions of the Partnership if Demeter believes they violate the Partnership's trading policies. Credit Risk. In addition to market risk, in entering into futures, forwards and options contracts there is a credit risk to the Partnership that the counterparty on a contract will not be able to meet its obligations to the Partnership. The ultimate counterparty or guarantor of the Partnership for futures contracts traded in the United States and the foreign exchanges on which the Partnership trades is the clearinghouse associated with such exchange. In general, a clearinghouse is backed by the membership of the exchange and will act in the event of non-performance by one of its members or one of its member's customers, which should significantly reduce this credit risk. There is no assurance that a clearinghouse, exchange or other exchange member will meet its obligations to the Partnership, and Demeter and the commodity brokers will not indemnify the Partnership against a default by such parties. Further, the law is unclear as to whether a commodity broker has any obligation to protect its customers from loss in the event of an exchange or clearinghouse defaulting on trades effected for the broker's customers. In cases where the Partnership trades off-exchange forward contracts with a counterparty, the sole recourse of the Partnership will be the forward contracts counterparty. Demeter deals with these credit risks of the Partnership in several ways. First, it monitors the Partnership's credit exposure to each exchange on a daily basis. The commodity brokers inform the Partnership, as with all their customers, of its net margin requirements for all its existing open positions and Demeter has installed a system which permits it to monitor the Partnership's potential net credit exposure, exchange by exchange, by adding the unrealized trading gains on each exchange, if any, to the Partnership's margin liability thereon. Second, the Partnership's trading policies limit the amount of its net assets that can be committed at any given time to futures contracts and require a minimum amount of diversification in the Partnership's trading, usually over several different products and exchanges. Historically, the Partnership's exposure to any one exchange has typically amounted to only a small percentage of its total net assets and on those relatively few occasions where the Partnership's credit exposure climbs above an acceptable level, Demeter deals with the situation on a case by case basis, carefully weighing whether the increased level of credit exposure remains appropriate. Material changes to the trading policies may be made only with the prior written approval of the limited partners owning more than 50% of Units then outstanding. Third, with respect to forward contract trading, the Partnership trades with only those counterparties which Demeter, together with Morgan Stanley DW, have determined to be creditworthy. The Partnership presently deals with MS & Co. as the sole counterparty on forward contracts. See "Financial Instruments" under "Notes to Financial Statements" in the Partnership's Annual Report to Limited Partners for the year ended December 31, 2003, which is incorporated by reference to Exhibit 13.01 of this Form 10-K. Inflation has not been a major factor in the Partnership's operations. Item 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Introduction The Partnership is a commodity pool engaged primarily in the speculative trading of futures, forwards and options. The market-sensitive instruments held by the Partnership are acquired for speculative trading purposes only and, as a result, all or substantially all of the Partnership's assets are at risk of trading loss. Unlike an operating company, the risk of market- sensitive instruments is central, not incidental, to the Partnership's main business activities. The futures, forwards and options traded by the Partnership involve varying degrees of related market risk. Market risk is often dependent upon changes in the level or volatility of interest rates, exchange rates, and prices of financial instruments and commodities, factors that result in frequent changes in the fair value of the Partnership's open positions, and consequently in its earnings, whether realized or unrealized, and cash flow. Profits and losses on open positions of exchange- traded futures, forwards and options are settled daily through variation margin. The Partnership's total market risk may increase or decrease as it's influenced by a wide variety of factors, including, but not limited to, the diversification among the Partnership's open positions, the volatility present within the markets, and the liquidity of the markets. The Partnership's past performance is not necessarily indicative of its future results. Any attempt to numerically quantify the Partnership's market risk is limited by the uncertainty of its speculative trading. The Partnership's speculative trading may cause future losses and volatility (i.e. "risk of ruin") that far exceed the Partnership's experiences to date or any reasonable expectations based upon historical changes in market value. Quantifying the Partnership's Trading Value at Risk The following quantitative disclosures regarding the Partner- ship's market risk exposures contain "forward-looking statements" within the meaning of the safe harbor from civil liability provided for such statements by the Private Securities Litigation Reform Act of 1995 (set forth in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). All quantitative disclosures in this section are deemed to be forward-looking statements for purposes of the safe harbor, except for statements of historical fact. The Partnership accounts for open positions on the basis of mark to market accounting principles. Any loss in the market value of the Partnership's open positions is directly reflected in the Partnership's earnings and cash flow. The Partnership's risk exposure in the market sectors traded by the Trading Managers is estimated below in terms of Value at Risk ("VaR"). The Partnership estimates VaR using a model based upon historical simulation (with a confidence level of 99%) which involves constructing a distribution of hypothetical daily changes in the value of a trading portfolio. The VaR model takes into account linear exposures to risk including equity and commodity prices, interest rates, foreign exchange rates, and correlation among these variables. The hypothetical changes in portfolio value are based on daily percentage changes observed in key market indices or other market factors ("market risk factors") to which the portfolio is sensitive. The one-day 99% confidence level of the Partnership's VaR corresponds to the negative change in portfolio value that, based on observed market risk factors, would have been exceeded once in 100 trading days, or one day in 100. VaR typically does not represent the worst case of outcome. Demeter uses approximately four years of daily market data (1,000 observations) and revalues its portfolio (using delta-gamma approximations) for each of the historical market moves that occurred over this time period. This generates a probability distribution of daily "simulated profit and loss" outcomes. The VaR is the appropriate percentile of this distribution. For example, the 99% one-day VaR would represent the 10th worst outcome from Demeter's simulated profit and loss series. The Partnership's VaR computations are based on the risk representation of the underlying benchmark for each instrument or contract and do not distinguish between exchange and non-exchange dealer-based instruments. They are also not based on exchange and/or dealer-based maintenance margin requirements. VaR models, including the Partnership's, are continuously evolving as trading portfolios become more diverse and modeling techniques and systems capabilities improve. Please note that the VaR model is used to numerically quantify market risk for historic reporting purposes only and is not utilized by either Demeter or the Trading Manager in their daily risk management activities. Please further note that VaR as described above may not be comparable to similarly titled measures used by other entities. The Partnership's Value at Risk in Different Market Sectors The following table indicates the VaR associated with the Partnership's open positions as a percentage of total net assets by primary market risk category at December 31, 2003 and 2002. At December 31, 2003 and 2002, the Partnership's total capital- ization was approximately $22 million and $23 million, respectively. Primary Market December 31, 2003 December 31, 2002 Risk Category Value at Risk Value at Risk Currency (2.50)% (2.18)% Interest Rate (0.96) (0.81) Equity (0.87) (0.42) Commodity (1.74) (1.38) Aggregate Value at Risk (3.32)% (2.67)% The VaR for a market category represents the one-day downside risk for the aggregate exposures associated with this market category. The Aggregate Value at Risk listed above represents the VaR of the Partnership's open positions across all the market categories, and is less than the sum of the VaRs for all such market categories due to the diversification benefit across asset classes. Because the business of the Partnership is the speculative trading of futures, forwards and options, the composition of its trading portfolio can change significantly over any given time period, or even within a single trading day, which could positively or negatively materially impact market risk as measured by VaR. The table below supplements the December 31, 2003 VaR set forth above by presenting the Partnership's high, low and average VaR, as a percentage of total net assets for the four quarter-end reporting periods from January 1, 2003 through December 31, 2003. Primary Market Risk Category High Low Average Currency (2.50)% (0.75)% (1.78)% Interest Rate (0.96) (0.57) (0.84) Equity (0.87) (0.34) (0.56) Commodity (1.74) (0.56) (1.38) Aggregate Value at Risk (3.32)% (1.13)% (2.52)% Limitations on Value at Risk as an Assessment of Market Risk The face value of the market sector instruments held by the Partnership is typically many times the applicable margin requirements. Margin requirements generally range between 2% and 15% of contract face value. Additionally, the use of leverage causes the face value of the market sector instruments held by the Partnership to typically be many times the total capitalization of the Partnership. The value of the Partnership's open positions thus creates a "risk of ruin" not typically found in other investments. The relative size of the positions held may cause the Partnership to incur losses greatly in excess of VaR within a short period of time, given the effects of the leverage employed and market volatility. The VaR tables above, as well as the past performance of the Partnership, give no indication of such "risk of ruin". In addition, VaR risk measures should be viewed in light of the methodology's limitations, which include the following: ? past changes in market risk factors will not always result in accurate predictions of the distributions and correlations of future market movements; ? changes in portfolio value caused by market movements may differ from those of the VaR model; ? VaR results reflect past trading positions while future risk depends on future positions; ? VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day; and ? the historical market risk factor data used for VaR estimation may provide only limited insight into losses that could be incurred under certain unusual market movements. The VaR tables provided present the results of the Partnership's VaR for each of the Partnership's market risk exposures and on an aggregate basis at December 31, 2003 and 2002 and for the four quarter-end reporting periods during calendar year 2003. VaR is not necessarily representative of the historic risk, nor should it be used to predict the Partnership's future financial performance or its ability to manage or monitor risk. There can be no assurance that the Partnership's actual losses on a particular day will not exceed the VaR amounts indicated above or that such losses will not occur more than once in 100 trading days. Non-Trading Risk The Partnership has non-trading market risk on its foreign cash balances not needed for margin. These balances and any market risk they may represent are immaterial. The Partnership also maintains a substantial portion (approximately 79% as of December 31, 2003) of its available assets in cash at Morgan Stanley DW. A decline in short-term interest rates would result in a decline in the Partnership's cash management income. This cash flow risk is not considered to be material. Materiality, as used throughout this section, is based on an assessment of reasonably possible market movements and any associated potential losses, taking into account the leverage, optionality and multiplier features of the Partnership's market-sensitive instruments, in relation to the Partnership's net assets. Qualitative Disclosures Regarding Primary Trading Risk Exposures The following qualitative disclosures regarding the Partnership's market risk exposures - except for (A) those disclosures that are statements of historical fact and (B) the descriptions of how the Partnership manages its primary market risk exposures - constitute forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. The Partnership's primary market risk exposures, as well as the strategies used and to be used by Demeter and the Trading Managers for managing such exposures, are subject to numerous uncertainties, contingencies and risks, any one of which could cause the actual results of the Partnership's risk controls to differ materially from the objectives of such strategies. Government interventions, defaults and expropriations, illiquid markets, the emergence of dominant fundamental factors, political upheavals, changes in historical price relationships, an influx of new market participants, increased regulation and many other factors could result in material losses, as well as in material changes to the risk exposures and the risk management strategies of the Partnership. Investors must be prepared to lose all or substantially all of their investment in the Partnership. The following were the primary trading risk exposures of the Partnership at December 31, 2003, by market sector. It may be anticipated, however, that these market exposures will vary materially over time. Currency. The primary market exposure of the Partnership at December 31, 2003 was to the currency sector. The Partnership's currency exposure is to exchange rate fluctuations, primarily fluctuations which disrupt the historical pricing relationships between different currencies and currency pairs. Interest rate changes as well as political and general economic conditions influence these fluctuations. The Partnership's primary exposure at December 31, 2003 was to outright U.S. dollar positions. Outright positions consist of the U.S. dollar vs. other currencies. These other currencies include major and minor currencies. Demeter does not anticipate that the risk profile of the Partnership's currency sector will change significantly in the future. The currency trading VaR figure includes foreign margin amounts converted into U.S. dollars with an incremental adjustment to reflect the exchange rate risk inherent to the U.S.-based Partnership in expressing VaR in a functional currency other than U.S. dollars. Interest Rate. The second largest market exposure of the Partnership at December 31, 2003 was to the global interest rate sector. Exposure was primarily spread across the Japanese, U.S. and European interest rate sectors. Interest rate movements directly affect the price of the sovereign bond futures positions held by the Partnership and indirectly affect the value of its stock index and currency positions. Interest rate movements in one country, as well as relative interest rate movements between countries, materially impact the Partnership's profitability. The Partnership's primary interest rate exposure is generally to interest rate fluctuations in the U.S. and the other G-7 countries. The G-7 countries consist of France, the U.S., Britain, Germany, Japan, Italy and Canada. However, the Partnership also takes futures positions in the government debt of smaller nations - e.g., Australia. Demeter anticipates that the G-7 countries and Australian interest rates will remain the primary interest rate exposures of the Partnership for the foreseeable future. The speculative futures positions held by the Partnership may range from short to long-term instruments. Consequently, changes in short, medium or long-term interest rates may have an effect on the Partnership. Equity. The third largest market exposure of the Partnership at December 31, 2003 was to equity price risk in the G-7 countries. The stock index futures traded by the Partnership are by law limited to futures on broadly-based indices. At December 31, 2003, the Partnership's primary exposures were to the Euro Stoxx 50 (Europe), DAX (Germany) and NASDAQ (U.S.) stock indices. The Partnership is primarily exposed to the risk of adverse price trends or static markets in the U.S. and European stock indices. Static markets would not cause major market changes, but would make it difficult for the Partnership to avoid trendless price movements resulting in numerous small losses. Commodity. Energy. At December 31, 2003, the Partnership's energy exposure was primarily to futures contracts in crude oil and its related products, and natural gas. Price movements in these markets result from geopolitical developments, particularly in the Middle East, as well as weather patterns and other economic fundamentals. Significant profits and losses, which have been experienced in the past, are expected to continue to be experienced in the future. Natural gas has exhibited volatility in prices resulting from weather patterns and supply and demand factors and will likely continue in this choppy pattern. Metals. The Partnership's metals exposure at December 31, 2003 was to fluctuations in the price of precious metals, such as gold and silver, and base metals, such as copper, nickel, aluminum and zinc. Economic forces, supply and demand inequalities, geopolitical factors and market expectations influence price movements in these markets. The Trading Managers, from time to time, take positions when market opportunities develop, and Demeter anticipates that the Partnership will continue to do so. Soft Commodities and Agriculturals. At December 31, 2003, the Partnership had exposure to the markets that comprise these sectors. Most of the exposure was to the cotton, sugar, corn and cocoa markets. Supply and demand inequalities, severe weather disruptions and market expectations affect price movements in these markets. Qualitative Disclosures Regarding Non-Trading Risk Exposure The following was the only non-trading risk exposure of the Partnership at December 31, 2003: Foreign Currency Balances. The Partnership's primary foreign currency balances at December 31, 2003 were in Hong Kong dollars, euros and British pounds. The Partnership controls the non-trading risk of foreign currency balances by regularly converting them back into U.S. dollars upon liquidation of their respective positions. Qualitative Disclosures Regarding Means of Managing Risk Exposure The Partnership and the Trading Managers, separately, attempt to manage the risk of the Partnership's open positions in essentially the same manner in all market categories traded. Demeter attempts to manage market exposure by diversifying the Partnership's assets among different market sectors and trading approaches, and by monitoring the performance of the Trading Managers daily. In addition, the Trading Managers establish diversification guidelines, often set in terms of the maximum margin to be committed to positions in any one market sector or market- sensitive instrument. Demeter monitors and controls the risk of the Partnership's non- trading instrument, cash. Cash is the only Partnership investment directed by Demeter, rather than the Trading Managers. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements are incorporated by reference to the Partnership's Annual Report which is filed as Exhibit 13.01 hereto. Supplementary data specified by Item 302 of Regulation S-K: Summary of Quarterly Results (Unaudited) Quarter Revenues/ Net Net Income/ Ended (Net Losses) Income/(Loss) (Loss) Per Unit 2003 March 31 $ 2,744,027 $ 1,818,283 $ 383.26 June 30 (228,825) (730,500) (159.22) September 30 (794,806) (1,216,956) (267.65) December 31 794,981 263,208 61.75 Total $ 2,515,377 $ 134,035 $ 18.14 2002 March 31 $(1,229,444) $(1,722,970) $(333.85) June 30 4,192,870 3,640,313 726.51 September 30 2,141,607 1,458,337 295.95 December 31 76,171 (424,432) (85.75) Total $ 5,181,204 $ 2,951,248 $ 602.86 Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. Item 9A. CONTROLS AND PROCEDURES (a) As of the end of the period covered by this annual report, the President and Chief Financial Officer of the general partner, Demeter, have evaluated the effectiveness of the Partnership's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d- 15(e) of the Exchange Act), and have judged such controls and procedures to be effective. (b) There have been no significant changes in the Partnership's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There are no directors or executive officers of the Partnership. The Partnership is managed by Demeter. Directors and Officers of the General Partner The directors and executive officers of Demeter are as follows: Jeffrey A. Rothman, age 42, is the Chairman of the Board of Directors and President of Demeter. Mr. Rothman is the Executive Director of Morgan Stanley Managed Futures, responsible for overseeing all aspects of the firm's managed futures department. He is also the Chairman of the Board of Directors of Morgan Stanley Futures & Currency Management Inc. Mr. Rothman has been with the managed futures department for seventeen years. Throughout his career, Mr. Rothman has helped with the development, marketing and administration of approximately 39 commodity pools. Mr. Rothman is an active member of the Managed Funds Association and serves on its Board of Directors. Mr. Rothman has a B.A. degree in Liberal Arts from Brooklyn College, New York. Richard A. Beech, age 52, is a Director of Demeter. Mr. Beech has been associated with the futures industry for over 25 years. He has been at Morgan Stanley DW since August 1984 where he is presently an Executive Director and head of Futures, Forex & Metals. Mr. Beech began his career at the Chicago Mercantile Exchange, where he became the Chief Agricultural Economist doing market analysis, marketing and compliance. Prior to joining Morgan Stanley DW, Mr. Beech worked at two investment banking firms in operations, research, managed futures and sales management. Mr. Beech has a B.S. degree in Business Administration from Ohio State University and an M.B.A. degree from Virginia Polytechnic Institute and State University. Raymond A. Harris, age 47, is a Director of Demeter and of Morgan Stanley Futures & Currency Management Inc. Mr. Harris is currently Managing Director and head of Client Solutions for Morgan Stanley Individual Investor Group. Mr. Harris joined Morgan Stanley in 1982 and served in financial and operational assignments for Dean Witter Reynolds. In 1994, he joined the Discover Financial Services division, leading restructuring and product development efforts. Mr. Harris became Chief Administrative Officer for Morgan Stanley Investment Management in 1999. In 2001, he was named head of Global Products and Services for Investment Management. Mr. Harris has an M.B.A. in Finance from the University of Chicago and a B.A. degree from Boston College. Frank Zafran, age 48, is a Director of Demeter and of Morgan Stanley Futures & Currency Management Inc. Mr. Zafran is an Executive Director of Morgan Stanley and, in September 2002, was named Chief Administrative Officer of Morgan Stanley's Client Solutions Division. Mr. Zafran joined the firm in 1979 and has held various positions in Corporate Accounting and the Insurance Department, including Senior Operations Officer - Insurance Division, until his appointment in 2000 as Director of 401(k) Plan Services, responsible for all aspects of 401(k) Plan Services including marketing, sales and operations. Mr. Zafran received a B.S. degree in Accounting from Brooklyn College, New York. Douglas J. Ketterer, age 38, was named a Director of Demeter, and confirmed by the National Futures Association as a principal of Demeter on October 27, 2003. Mr. Ketterer is a Managing Director and head of the Investment Solutions Group, which is comprised of a number of departments which offer products and services through Morgan Stanley's Individual Investor Group (including Managed Futures, Alternative Investments, Insurance Services, Personal Trust, Corporate Services, and others). Mr. Ketterer joined the firm in 1990 in the Corporate Finance Division as a part of the Retail Products Group. He later moved to the origination side of Investment Banking, and then, after the merger between Morgan Stanley and Dean Witter, served in the Product Development Group at Morgan Stanley Dean Witter Advisors (now known as Morgan Stanley Funds). From the summer of 2000 to the summer of 2002, Mr. Ketterer served as the Chief Administrative Officer for Morgan Stanley Investment Management, where he headed the Strategic Planning & Administrative Group. Mr. Ketterer received his M.B.A. from New York University's Leonard N. Stern School of Business and his B.S. in Finance from the University at Albany's School of Business. Jeffrey S. Swartz, age 36, was named a Director of Demeter, and confirmed by the National Futures Association as a principal of Demeter on October 23, 2003. Mr. Swartz is a Managing Director and Director of the Mass Affluent Segment of Morgan Stanley's Individual Investor Group. Mr. Swartz began his career with Morgan Stanley in 1990, working as a Financial Advisor in Boston. He was appointed Sales Manager of the Boston office in 1994, and served in that role for two years. In 1996, he was named Branch Manager of the Cincinnati office. In 1999, Mr. Swartz was named Associate Director of the Midwest Region, which consisted of 10 states and approximately 90 offices. Mr. Swartz served in this capacity until October of 2001, when he was named Director of Investor Advisory Services ("IAS") Strategy and relocated to IAS headquarters in New York. In December of 2002, Mr. Swartz was promoted to Managing Director and Chief Operating Officer of IAS and has recently assumed the responsibility for managing the Mass Affluent Client Segment. Mr. Swartz received his degree in Business Administration from the University of New Hampshire. Jeffrey D. Hahn, age 46, is the Chief Financial Officer of Demeter. Mr. Hahn began his career at Morgan Stanley in 1992 and is currently an Executive Director responsible for the management and supervision of the accounting, reporting, tax and finance functions for the firm's private equity, managed futures, and certain legacy real estate investing activities. He is also the Chief Financial Officer of Morgan Stanley Futures & Currency Management Inc. From August 1984 through May 1992, Mr. Hahn held various positions as an auditor at Coopers & Lybrand, specializing in manufacturing businesses and venture capital organizations. Mr. Hahn received his B.A. in Economics from St. Lawrence University in 1979, an M.B.A. from Pace University in 1984, and is a Certified Public Accountant. All of the foregoing directors have indefinite terms. The Audit Committee The Partnership is operated by its general partner, Demeter, and does not have an audit committee. As such, the entire Board of Directors of Demeter serves as the audit committee. None of the directors are considered to be "independent" as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934, as amended. The Board of Directors of Demeter has determined that Mr. Jeffrey D. Hahn is the audit committee financial expert. Section 16(a) Beneficial Ownership Reporting Compliance The Partnership has no directors, executive officers or greater than 10 percent beneficial owners and none of the directors or executive officers of Demeter, the general partner of the Partnership, own Units of the Partnership. As such, no Forms 3, 4, or 5 have been filed. Code of Ethics The Partnership has not adopted a code of ethics that applies to the Partnership's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The Partnership is operated by its general partner, Demeter. The President, Chief Financial Officer and each member of the Board of Directors of Demeter are employees of Morgan Stanley and are subject to the code of ethics adopted by Morgan Stanley, the text of which can be viewed on Morgan Stanley's website at www.morganstanley.com/ourcommitment/codeofcon duct.html. Item 11. EXECUTIVE COMPENSATION The Partnership has no directors and executive officers. As a limited partnership, the business of the Partnership is managed by Demeter, which is responsible for the administration of the business affairs of the Partnership but receives no compensation for such services. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security Ownership of Certain Beneficial Owners - At December 31, 2003, there were no persons known to be beneficial owners of more than 5 percent of the Units. (b) Security Ownership of Management - At December 31, 2003, Demeter owned 100.567 Units of general partnership interest, representing a 2.27 percent interest in the Partnership. (c) Changes in Control - None. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Refer to Note 2 - "Related Party Transactions" of "Notes to Financial Statements", in the accompanying Annual Report to Limited Partners for the year ended December 31, 2003, which is incorporated by reference to Exhibit 13.01 of this Form 10-K. In its capacity as the Partnership's retail commodity broker, Morgan Stanley DW received commodity brokerage commissions (paid and accrued by the Partnership) of $1,373,338 for the year ended December 31, 2003. Item 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The Partnership pays accounting fees as discussed in Note 1 to the Financial Statements, "Operating Expenses", in the Annual Report to the Limited Partners for the year ended December 31, 2003. (1) Audit Fees. The aggregate fees for professional services rendered by Deloitte & Touche LLP in connection with their audit of the Partnership's financial statements and reviews of the financial statements included in the Quarterly Reports on Form 10-Q and in connection with statutory and regulatory filings for the years ended December 31, 2003 and 2002 were approximately $31,300 and $31,201, respectively. (2) Audit-Related Fees. There were no fees for assurance and related services rendered by Deloitte & Touche LLP for the years ended December 31, 2003 and 2002. (3) Tax Fees. The aggregate fees for tax compliance services rendered by Deloitte & Touche LLP for the years ended December 31, 2003 and 2002 were approximately $29,914 and $29,066, respectively. (4) All Other Fees. None. As of the date of this Report, the Board of Directors of Demeter has not adopted pre-approval policies and procedures. As a result, all services provided by Deloitte & Touche LLP must be directly pre-approved by the Board of Directors of Demeter. PART IV Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Listing of Financial Statements The following financial statements and report of independent auditors, all appearing in the accompanying Annual Report to Limited Partners for the year ended December 31, 2003, are incorporated by reference to Exhibit 13.01 of this Form 10-K: - Report of Deloitte & Touche LLP, independent auditors, for the years ended December 31, 2003, 2002, and 2001. - Statements of Financial Condition, including the Schedules of Investments, as of December 31, 2003 and 2002. - Statements of Operations, Changes in Partners' Capital, and Cash Flows for the years ended December 31, 2003, 2002, and 2001. - Notes to Financial Statements. With the exception of the aforementioned information and the information incorporated in Items 7, 8, and 13, the Annual Report to Limited Partners for the year ended December 31, 2003 is not deemed to be filed with this report. 2. Listing of Financial Statement Schedules No financial statement schedules are required to be filed with this report. (b) Reports on Form 8-K No reports on Form 8-K have been filed by the Partnership during the last quarter of the period covered by this report. (c) Exhibits Refer to Exhibit Index on Pages E-1 to E-2. SIGNATURES Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DEAN WITTER CORNERSTONE FUND II (Registrant) BY: Demeter Management Corporation, General Partner March 30, 2004 BY: /s/Jeffrey A. Rothman Jeffrey A. Rothman, President 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 and on the dates indicated. Demeter Management Corporation. BY: /s/ Jeffrey A. Rothman March 30, 2004 Jeffrey A. Rothman, President /s/ Douglas J. Ketterer March 30, 2004 Douglas J. Ketterer, Director /s/ Jeffrey S. Swartz March 30, 2004 Jeffrey S. Swartz, Director /s/ Richard A. Beech March 30, 2004 Richard A. Beech, Director /s/ Raymond A. Harris March 30, 2004 Raymond A. Harris, Director /s/ Frank Zafran March 30, 2004 Frank Zafran, Director /s/ Jeffrey D. Hahn March 30, 2004 Jeffrey D. Hahn, Chief Financial Officer EXHIBIT INDEX ITEM 3.01 Limited Partnership Agreement of the Partnership, dated as of December 7, 1983, as amended as of May 11, 1984, is incorporated by reference to Exhibit 3.01 of the Partnership's Annual Report on Form 10-K for the fiscal year ended September 30, 1984 (File No. 0-13298). 10.01 Management Agreement among the Partnership, Demeter and John W. Henry & Company, Inc. dated November 15, 1983, is incorporated by reference to Exhibit 10.03 of the Partnership's Annual Report on Form 10-K for the fiscal year ended September 30, 1984 (File No. 0-13298). 10.02 Dean Witter Cornerstone Funds Exchange Agreement, dated as of May 31, 1984, is incorporated by reference to Exhibit 10.04 of the Partnership's Annual Report on Form 10-K for the fiscal year ended September 30, 1984 (File No. 0- 13298). 10.03 Management Agreement among the Partnership, Demeter and Northfield Trading L.P., dated as of April 16, 1997, is incorporated by reference to Exhibit 10.03 of the Partnership's Annual Report on Form 10-K for the fiscal year ended December 31, 1997 (File No. 0-13298). 10.04 Amended and Restated Customer Agreement between the Partnership and Morgan Stanley DW Inc., dated as of June 22, 2000, is incorporated by reference to Exhibit 10.01 of the Partnership's Form 8-K (File No. 0-13298) filed with the Securities and Exchange Commission on November 13, 2001. 10.05 Commodity Futures Customer Agreement between Morgan Stanley & Co. Incorporated and the Partnership, and acknowledged and agreed to by Morgan Stanley DW Inc., dated as of May 1, 2000, is incorporated by reference to Exhibit 10.02 of the Partnership's Form 8-K (File No. 0- 13298) filed with the Securities and Exchange Commission on November 13, 2001. 10.06 Customer Agreement between the Partnership and Morgan Stanley & Co. International Limited, dated as of May 1, 2000, is incorporated by reference to Exhibit 10.04 of the Partnership's Form 8-K (File No. 0-13298) filed with the Securities and Exchange Commission on November 13, 2001. E-1 10.07 Foreign Exchange and Options Master Agreement between Morgan Stanley & Co. Incorporated and the Partnership, dated as of April 30, 2000, is incorporated by reference to Exhibit 10.05 of the Partnership's Form 8- K (File No. 0-13298) filed with the Securities and Exchange Commission on November 13, 2001. 10.08 Amendment to Management Agreement between the Partnership and John W. Henry & Company, Inc., dated as of November 30, 2000, is incorporated by reference to Exhibit 10.1 of the Partnership's Form 8-K (File No. 0-13298) filed with the Securities and Exchange Commission on January 3, 2001. 10.09 Amendment to Management Agreement between the Partnership and Northfield Trading L.P., dated as of November 30, 2000, is incorporated by reference to Exhibit 10.2 of the Partnership's Form 8-K (File No. 0-13298) filed with the Securities and Exchange Commission on January 3, 2001. 10.10 Securities Account Control Agreement among the Partnership, Morgan Stanley & Co. Incorporated, and Morgan Stanley DW Inc., dated as of May 1, 2000, is incorporated by reference to Exhibit 10.03 of the Partnership's Form 8-K (File No. 0- 13298) filed with the Securities and Exchange Commission on November 13, 2001. 13.01 December 31, 2003 Annual Report to Limited Partners is filed herewith. 31.01 Certification of President of Demeter Management Corporation, the general partner of the Partnership, pursuant to rules 13a-15(e) and 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.02 Certification of Chief Financial Officer of Demeter Management Corporation, the general partner of the Partnership, pursuant to rules 13a-15(e) and 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.01 Certification of President of Demeter Management Corporation, the general partner of the Partnership, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.02 Certification of Chief Financial Officer of Demeter Management Corporation, the general partner of the Partnership, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. E-2 Cornerstone Funds December 31, 2003 Annual Report [LOGO] Morgan Stanley DEAN WITTER CORNERSTONE FUNDS HISTORICAL FUND PERFORMANCE Presented below is the percentage change in Net Asset Value per Unit from the start of each calendar year each Fund has traded. Also provided is the inception-to-date return and the compound annualized return since inception for each Fund. Past performance is not necessarily indicative of future results. 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 FUND % % % % % % % % % % % % % % % % % % % --------------------------------------------------------------------------------------------------------------------------- Cornerstone Fund II... 20.1 (17.6) 71.6 0.1 (15.1) 47.9 11.0 (1.3) 7.8 (8.9) 26.5 11.5 18.1 12.5 (5.4) 11.5 (1.3) 13.8 0.4 --------------------------------------------------------------------------------------------------------------------------- Cornerstone Fund III.. 54.6 (8.0) 32.5 19.4 (11.4) 18.7 12.0 (11.1) (4.8) (10.0) 27.5 8.2 10.2 9.1 (6.8) (0.3) 0.3 17.9 8.8 --------------------------------------------------------------------------------------------------------------------------- Cornerstone Fund IV... -- -- 10.6 37.5 (14.1) 57.8 33.5 10.4 (9.1) (14.3) 23.0 13.0 38.4 6.8 (1.1) 14.7 15.9 12.3 13.6 (8 mos.) --------------------------------------------------------------------------------------------------------------------------- INCEPTION- COMPOUND TO-DATE ANNUALIZED RETURN RETURN FUND % % --------------------------------- Cornerstone Fund II... 410.9 9.0 --------------------------------- Cornerstone Fund III.. 301.0 7.6 --------------------------------- Cornerstone Fund IV... 714.7 13.4 --------------------------------- DEMETER MANAGEMENT CORPORATION 825 Third Avenue, 9th Floor New York, NY 10022 Telephone (212) 310-6444 DEAN WITTER CORNERSTONE FUNDS ANNUAL REPORT 2003 Dear Limited Partner: This marks the nineteenth annual report for Cornerstone Funds II and III and the seventeenth annual report for Cornerstone Fund IV. The Net Asset Value per Unit for each of the three Cornerstone Funds ("Fund(s)") as of December 31, 2003 was as follows: % CHANGE FUNDS N.A.V. FOR 2003 ------------------------------------------------------------------------------- Cornerstone Fund II $4,981.39 0.4% ------------------------------------------------------------------------------- Cornerstone Fund III $3,909.31 8.8% ------------------------------------------------------------------------------- Cornerstone Fund IV $7,943.73 13.6% ------------------------------------------------------------------------------- Since their inception in 1985, Cornerstone Funds II and III have increased by 410.9% (a compound annualized return of 9.0%) and 301.0% (a compound annualized return of 7.6%), respectively. Since its inception in 1987, Cornerstone Fund IV has increased by 714.7% (a compound annualized return of 13.4%). Detailed performance information for each Fund is located in the body of the financial report. For each Fund, we provide a trading results by sector chart that portrays trading gains and trading losses for the year in each sector in which the Fund participates. In the case of Cornerstone Fund IV, we provide the trading gains and trading losses for the five major currencies in which the Fund participates, and composite information for all other "minor" currencies traded within the Fund. The trading results by sector charts indicate the year's composite percentage returns generated by the specific assets dedicated to trading within each market sector in which each Fund participates. Please note that there is not an equal amount of assets in each market sector, and the specific allocations of assets by a Fund to each sector will vary over time within a predetermined range. Below each chart is a description of the factors that influenced trading gains and trading losses within each Fund during the year. Should you have any questions concerning this report, please feel free to contact Demeter Management Corporation, 825 Third Avenue, 9th Floor, New York, NY 10022 or your Morgan Stanley Financial Advisor. I hereby affirm, that to the best of my knowledge and belief, the information contained in this report is accurate and complete. Past performance is no guarantee of future results. Sincerely, /s/ Jeffrey A. Rothman Jeffrey A. Rothman Chairman and President Demeter Management Corporation General Partner for Dean Witter Cornerstone Fund II Dean Witter Cornerstone Fund III Dean Witter Cornerstone Fund IV CORNERSTONE FUND II [CHART] Year ended December 31, 2003 ---------------------------- Currencies 12.13% Interest Rates -2.19% Stock Indices 1.27% Energies -4.37% Metals 2.49% Agriculturals -7.17% Note:Includes trading results and commissions but does not include other fees or interest income. FACTORS INFLUENCING ANNUAL TRADING GAINS: . In the currency markets, gains were recorded, mainly throughout the fourth quarter, from long positions in a variety of major and minor currencies versus the U.S. dollar. A confluence of factors including concerns regarding U.S. budget and trade deficits, a dip in consumer confidence, an outbreak of Mad Cow Disease in the U.S., and fears of a potential terrorist attack forced the U.S. dollar to retreat. The Fund's largest gains were achieved during December from long positions in the euro, British pound, and Australian and New Zealand dollars versus the U.S. dollar. Weakness in the U.S. dollar during the first quarter also contributed to currency gains for the year. . In the metals markets, gains were supplied by long futures positions in base and precious metals. During December, profits were made on long futures positions in base metals, such as copper, aluminum and nickel, as well as from long futures positions in precious metals, such as gold and silver. Copper and nickel prices rose to six and fourteen year highs respectively, benefiting from increased demand from China and the strengthening of the global economy. Meanwhile, gold and silver prices continued to soar as investors sought a safe haven from the falling U.S. dollar and an increased risk of terrorism. . Profits were also recorded in the global stock index markets. During June, long positions in European stock index futures resulted in profits as prices strengthened amid the release of positive economic data and expectations of a U.S. interest rate cut. Long positions in Japanese stock index futures also produced gains as prices rallied amid increased foreign demand for Japanese equities. Long positions in Asian stock index futures resulted in further gains during August as Asian equity prices drew strength from robust Japanese economic data and gains in the U.S. equity markets. CORNERSTONE FUND II (continued) FACTORS INFLUENCING ANNUAL TRADING LOSSES: . In the agricultural markets, positions in cotton futures returned losses during August as prices moved without consistent direction. Additional losses were recorded from positions in corn futures during August and September as volatile prices resulted from supply data and weather related concerns. Long positions in coffee futures during September and sugar positions during December compounded sector losses. . In the energy markets, the greatest losses were incurred during October. The Fund entered the month with short natural gas positions, but these positions proved unprofitable as prices rallied during the first part of the month. In response to rising natural gas prices, the Fund reversed its position from short to long, only to see prices decline in the latter part of the month. December also added to losses from short natural gas futures positions. Additional losses were incurred from short crude oil positions during September and October as prices moved higher in response to supply fears resulting primarily from geopolitical tensions. . Losses were also incurred in the global interest rate markets, primarily during the fourth quarter. Long positions in European interest rate futures recorded losses during October as bond prices were negatively impacted by the release of positive U.S. economic data and inflation concerns. During December, short European interest rate futures positions suffered losses as economic data released throughout the month indicated that inflation in the U.S. remained under control, despite the strengthening of the U.S. economy, and reinforcing the belief that the U.S. Federal Reserve would remain committed to keeping U.S. rates at their current low levels. CORNERSTONE FUND III [CHART] Year ended December 31, 2003 ---------------------------- Currencies 7.16% Interest Rates -2.96% Stock Indices 4.61% Energies -2.10% Metals 5.42% Agriculturals 0.62% Note: Includes trading results and commissions but does not include other fees or interest income. FACTORS INFLUENCING ANNUAL TRADING GAINS: . Gains were produced in the currency markets, mainly throughout the fourth quarter, from long positions in a variety of major and minor currencies versus the U.S. dollar. A confluence of factors including concerns regarding U.S. budget and trade deficits, a dip in consumer confidence, an outbreak of Mad Cow Disease in the U.S., and fears of a potential terrorist attack forced the U.S. dollar to retreat. The Fund's largest currency sector gains were achieved during January, May and December from long positions in the euro, British pound, Australian dollar, South African rand and New Zealand dollar versus the U.S. dollar. . Additional gains were recorded in the metals markets primarily during the fourth quarter from long futures positions in base metals, such as copper and nickel, as well as from long futures positions in precious metals, such as gold. During October and December, industrial metals prices rallied in response to growing investor sentiment that the global economy was on the path to recovery and amid increased demand, especially from China. Meanwhile, gold soared as investors sought a safe haven from the falling U.S. dollar and an increased risk of terrorism. . Gains were also achieved in the global equity markets, again primarily during the fourth quarter of the year. During October and December, long U.S. equity index futures positions profited amid the release of favorable economic data and increased confidence that the global economic recovery was materializing. CORNERSTONE FUND III (continued) FACTORS INFLUENCING ANNUAL TRADING LOSSES: . In the global interest rate markets, losses stemmed from positions in European and U.S. interest rate futures. Long positions suffered losses during July as prices declined amid rising interest rates and a rally in global equity prices prompted by renewed hope for a global economic recovery. During September, short positions in the same markets recorded losses as bond prices reversed higher due to renewed skepticism regarding a global economic recovery and lower equity prices. . Further losses were experienced in the energy markets. During October, the Fund entered the month with short natural gas positions, but these positions proved unprofitable as prices rallied during the first part of the month. In response to rising natural gas prices, the Fund reversed its position from short to long, only to see prices decline in the latter part of the month. December also added to losses from short natural gas futures positions. Additional losses were incurred from short crude oil positions during September and October as prices moved higher in response to supply fears primarily caused by geopolitical tensions. Crude oil prices continued to trade in a volatile fashion during November, moving in one direction for a few days and then sharply reversing, resulting in additional losses. CORNERSTONE FUND IV [CHART] Year ended December 31, 2003 ---------------------------- Australian dollar 8.92% British pound -3.18% Euro 12.10% Japanese yen -0.53% Swiss franc -2.43% Minor Currencies 3.97% Note: Includes trading results and commissions but does not include other fees or interest income. Minor currencies may include, but are not limited to, the South African rand, Thai baht, Greek drachma, Singapore dollar, Mexican peso, New Zealand dollar and Norwegian krone. FACTORS INFLUENCING ANNUAL TRADING GAINS: . The most significant gains were recorded from long positions in the euro versus the U.S. dollar as the dollar's value weakened throughout a majority of the year. Fears of a military conflict with Iraq, skepticism regarding the likelihood of a U.S. economic recovery and fears of a potential terrorist attack resulted in gains from long euro positions during January, April and May. A confluence of factors during December including concerns regarding U.S. budget and trade deficits, a dip in consumer confidence, an outbreak of Mad Cow Disease in the U.S., and continued fears of a potential terrorist attack forced the U.S. dollar to retreat further and the euro to climb. . Long positions in the Australian dollar versus the U.S. dollar supplied additional gains as the Australian currency strengthened during April, May and June and again during November and December in response to continued weakness in the U.S. dollar, higher interest rates in Australia relative to those in the U.S. and higher gold prices. . Gains were also provided by long positions in the South African rand versus the U.S. dollar during April and December due to significant interest rate differentials between the two countries, economic concerns regarding U.S. budget and trade deficits and fears of a potential terrorist attack. . Finally, smaller profits were experienced from long positions in the New Zealand dollar versus the U.S. dollar primarily during November as the U.S. dollar's value tumbled to a six-year low versus the New Zealand currency. CORNERSTONE FUND IV (continued) FACTORS INFLUENCING ANNUAL TRADING LOSSES: . Positions in the British pound versus the U.S. dollar resulted in losses as the value of the pound strengthened during April and May amid expectations that the Bank of England would likely leave interest rates unchanged and the release of lower-than-expected unemployment data from Great Britain. During June, losses stemmed from positions in the pound versus the U.S. dollar as the pound's value increased early in the month, amid expectations that the Bank of England would likely leave interest rates unchanged again, and then reversed lower, after the British Finance Minister released positive comments regarding the U.K.'s entry prospects into the European Union. . Additional losses stemmed from short positions in the Swiss franc versus the U.S. dollar as the dollar's value declined during September amid concerns for the strength of the U.S. economy and the potential impact of a statement by the G-7 nations supporting "more flexible exchange rates." DEAN WITTER CORNERSTONE FUNDS INDEPENDENT AUDITORS' REPORT To the Limited Partners and the General Partner of Dean Witter Cornerstone Fund II Dean Witter Cornerstone Fund III Dean Witter Cornerstone Fund IV: We have audited the accompanying statements of financial condition of Dean Witter Cornerstone Fund II, Dean Witter Cornerstone Fund III and Dean Witter Cornerstone Fund IV (collectively, the "Partnerships"), including the schedules of investments, as of December 31, 2003 and 2002, and the related statements of operations, changes in partners' capital, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Partnerships' management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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, such financial statements present fairly, in all material respects, the financial position of Dean Witter Cornerstone Fund II, Dean Witter Cornerstone Fund III and Dean Witter Cornerstone Fund IV at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. /s/ Deloitte & Touche LLP New York, New York March 2, 2004 DEAN WITTER CORNERSTONE FUND II STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, --------------------- 2003 2002 ---------- ---------- $ $ ASSETS Equity in futures interests trading accounts: Cash 20,927,464 21,702,438 Net unrealized gain on open contracts (MS&Co.) 796,998 1,627,315 Net unrealized gain on open contracts (MSIL) 501,462 423,825 ---------- ---------- Total net unrealized gain on open contracts 1,298,460 2,051,140 ---------- ---------- Total Trading Equity 22,225,924 23,753,578 Due from Morgan Stanley DW 62,699 107,236 Interest receivable (Morgan Stanley DW) 13,072 18,316 ---------- ---------- Total Assets 22,301,695 23,879,130 ========== ========== LIABILITIES AND PARTNERS' CAPITAL LIABILITIES Redemptions payable 141,402 236,692 Accrued management fees 64,913 69,501 Accrued administrative expenses 45,971 50,546 Accrued incentive fee -- 40,483 ---------- ---------- Total Liabilities 252,286 397,222 ---------- ---------- PARTNERS' CAPITAL Limited Partners (4,325.789 and 4,613.758 Units, respectively) 21,548,446 22,899,223 General Partner (100.567 and 117.400 Units, respectively) 500,963 582,685 ---------- ---------- Total Partners' Capital 22,049,409 23,481,908 ---------- ---------- Total Liabilities and Partners' Capital 22,301,695 23,879,130 ========== ========== NET ASSET VALUE PER UNIT 4,981.39 4,963.25 ========== ========== STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, ------------------------------- 2003 2002 2001 --------- --------- ---------- $ $ $ REVENUES Trading profit (loss): Realized 3,071,019 4,300,258 2,978,000 Net change in unrealized (752,680) 511,624 (1,728,062) --------- --------- ---------- 2,318,339 4,811,882 1,249,938 Proceeds from Litigation Settlement -- 76,613 -- --------- --------- ---------- Total Trading Results 2,318,339 4,888,495 1,249,938 Interest income (Morgan Stanley DW) 197,038 292,709 648,456 --------- --------- ---------- Total 2,515,377 5,181,204 1,898,394 --------- --------- ---------- EXPENSES Brokerage commissions (Morgan Stanley DW) 1,373,338 1,196,563 1,279,146 Management fees 843,500 798,116 816,137 Transaction fees and costs 106,566 133,591 115,808 Common administrative expenses 48,477 59,809 46,155 Incentive fees 9,461 41,877 -- --------- --------- ---------- Total 2,381,342 2,229,956 2,257,246 --------- --------- ---------- NET INCOME (LOSS) 134,035 2,951,248 (358,852) ========= ========= ========== NET INCOME (LOSS) ALLOCATION: Limited Partners 125,757 2,880,472 (351,955) General Partner 8,278 70,776 (6,897) NET INCOME (LOSS) PER UNIT: Limited Partners 18.14 602.86 (58.74) General Partner 18.14 602.86 (58.74) The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND III STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, --------------------- 2003 2002 ---------- ---------- $ $ ASSETS Equity in futures interests trading accounts: Cash 25,869,355 26,372,589 Net unrealized gain on open contracts (MS&Co.) 1,572,599 1,996,397 Net unrealized gain (loss) on open contracts (MSIL) 889,391 (443,790) ---------- ---------- Total net unrealized gain on open contracts 2,461,990 1,552,607 ---------- ---------- Total Trading Equity 28,331,345 27,925,196 Interest receivable (Morgan Stanley DW) 16,293 21,594 Due from Morgan Stanley DW -- 264,529 ---------- ---------- Total Assets 28,347,638 28,211,319 ========== ========== LIABILITIES AND PARTNERS' CAPITAL LIABILITIES Accrued administrative expenses 149,518 145,017 Redemptions payable 119,105 144,217 Accrued management fees 82,245 81,861 ---------- ---------- Total Liabilities 350,868 371,095 ---------- ---------- PARTNERS' CAPITAL Limited Partners (7,059.053 and 7,608.072 Units, respectively) 27,596,004 27,329,760 General Partner (102.516 and 142.103 Units, respectively) 400,766 510,464 ---------- ---------- Total Partners' Capital 27,996,770 27,840,224 ---------- ---------- Total Liabilities and Partners' Capital 28,347,638 28,211,319 ========== ========== NET ASSET VALUE PER UNIT 3,909.31 3,592.21 ========== ========== STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, ------------------------------ 2003 2002 2001 --------- --------- ---------- $ $ $ REVENUES Trading profit (loss): Realized 3,641,193 2,266,403 5,761,442 Net change in unrealized 909,383 1,480,039 (3,780,263) --------- --------- ---------- 4,550,576 3,746,442 1,981,179 Proceeds from Litigation Settlement -- 2,842,492 -- --------- --------- ---------- Total Trading Results 4,550,576 6,588,934 1,981,179 Interest income (Morgan Stanley DW) 233,160 337,401 773,760 --------- --------- ---------- Total 4,783,736 6,926,335 2,754,939 --------- --------- ---------- EXPENSES Brokerage commissions (Morgan Stanley DW) 1,257,269 1,386,685 1,453,337 Management fees 998,731 903,361 978,766 Common administrative expenses 78,892 98,459 76,385 Transaction fees and costs 68,929 177,181 134,490 --------- --------- ---------- Total 2,403,821 2,565,686 2,642,978 --------- --------- ---------- NET INCOME 2,379,915 4,360,649 111,961 ========= ========= ========== NET INCOME ALLOCATION: Limited Partners 2,339,613 4,283,008 110,780 General Partner 40,302 77,641 1,181 NET INCOME PER UNIT: Limited Partners 317.10 546.37 8.31 General Partner 317.10 546.37 8.31 The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND IV STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, ----------------------- 2003 2002 ----------- ----------- $ $ ASSETS Equity in futures interests trading accounts: Cash 110,416,089 103,560,309 Net unrealized gain on open contracts (MS&Co.) 3,046,277 6,834,888 ----------- ----------- Total Trading Equity 113,462,366 110,395,197 Interest receivable (Morgan Stanley DW) 61,521 80,149 ----------- ----------- Total Assets 113,523,887 110,475,346 =========== =========== LIABILITIES AND PARTNERS' CAPITAL LIABILITIES Redemptions payable 567,382 642,547 Accrued management fees 330,595 321,727 Accrued administrative expenses 177,019 169,156 Accrued incentive fees 6,682 1,500,021 ----------- ----------- Total Liabilities 1,081,678 2,633,451 ----------- ----------- PARTNERS' CAPITAL Limited Partners (13,997.351 and 15,202.402 Units, respectively) 111,191,238 106,345,673 General Partner (157.479 and 213.889 Units, respectively) 1,250,971 1,496,222 ----------- ----------- Total Partners' Capital 112,442,209 107,841,895 ----------- ----------- Total Liabilities and Partners' Capital 113,523,887 110,475,346 =========== =========== NET ASSET VALUE PER UNIT 7,943.73 6,995.32 =========== =========== STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2003 2002 2001 ---------- ---------- ---------- $ $ $ REVENUES Trading profit (loss): Realized 26,693,128 20,928,554 16,761,382 Net change in unrealized (3,788,611) (948,478) 3,787,359 ---------- ---------- ---------- Total Trading Results 22,904,517 19,980,076 20,548,741 Interest income (Morgan Stanley DW) 858,078 1,290,361 2,669,364 ---------- ---------- ---------- Total 23,762,595 21,270,437 23,218,105 ---------- ---------- ---------- EXPENSES Management fees 3,904,764 3,640,869 3,482,595 Brokerage commissions (Morgan Stanley DW) 3,456,636 3,568,609 2,563,321 Incentive fees 2,307,973 1,886,229 2,152,705 Common administrative expenses 156,630 195,738 151,459 ---------- ---------- ---------- Total 9,826,003 9,291,445 8,350,080 ---------- ---------- ---------- NET INCOME 13,936,592 11,978,992 14,868,025 ========== ========== ========== NET INCOME ALLOCATION: Limited Partners 13,766,843 11,815,072 14,685,095 General Partner 169,749 163,920 182,930 NET INCOME PER UNIT: Limited Partners 948.41 766.38 855.25 General Partner 948.41 766.38 855.25 The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND II STATEMENTS OF CHANGES IN PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 UNITS OF PARTNERSHIP LIMITED GENERAL INTEREST PARTNERS PARTNER TOTAL ----------- ---------- -------- ---------- $ $ $ Partners' Capital, December 31, 2000 5,586.548 24,168,885 518,806 24,687,691 Net loss -- (351,955) (6,897) (358,852) Redemptions (381.107) (1,631,103) -- (1,631,103) --------- ---------- -------- ---------- Partners' Capital, December 31, 2001 5,205.441 22,185,827 511,909 22,697,736 Net income -- 2,880,472 70,776 2,951,248 Redemptions (474.283) (2,167,076) -- (2,167,076) --------- ---------- -------- ---------- Partners' Capital, December 31, 2002 4,731.158 22,899,223 582,685 23,481,908 Net income -- 125,757 8,278 134,035 Redemptions (304.802) (1,476,534) (90,000) (1,566,534) --------- ---------- -------- ---------- Partners' Capital, December 31, 2003 4,426.356 21,548,446 500,963 22,049,409 ========= ========== ======== ========== DEAN WITTER CORNERSTONE FUND III STATEMENTS OF CHANGES IN PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 UNITS OF PARTNERSHIP LIMITED GENERAL INTEREST PARTNERS PARTNER TOTAL ----------- ---------- -------- ---------- $ $ $ Partners' Capital, December 31, 2000 9,346.774 27,959,423 431,642 28,391,065 Net income -- 110,780 1,181 111,961 Redemptions (713.990) (2,208,965) -- (2,208,965) --------- ---------- -------- ---------- Partners' Capital, December 31, 2001 8,632.784 25,861,238 432,823 26,294,061 Net income -- 4,283,008 77,641 4,360,649 Redemptions (882.609) (2,814,486) -- (2,814,486) --------- ---------- -------- ---------- Partners' Capital, December 31, 2002 7,750.175 27,329,760 510,464 27,840,224 Net income -- 2,339,613 40,302 2,379,915 Redemptions (588.606) (2,073,369) (150,000) (2,223,369) --------- ---------- -------- ---------- Partners' Capital, December 31, 2003 7,161.569 27,596,004 400,766 27,996,770 ========= ========== ======== ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND IV STATEMENTS OF CHANGES IN PARTNERS' CAPITAL FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001 UNITS OF PARTNERSHIP LIMITED GENERAL INTEREST PARTNERS PARTNER TOTAL ----------- ----------- --------- ----------- $ $ $ Partners' Capital, December 31, 2000 18,538.214 98,469,183 1,149,372 99,618,555 Net income -- 14,685,095 182,930 14,868,025 Redemptions (1,422.938) (7,876,555) -- (7,876,555) ---------- ----------- --------- ----------- Partners' Capital, December 31, 2001 17,115.276 105,277,723 1,332,302 106,610,025 Net income -- 11,815,072 163,920 11,978,992 Redemptions (1,698.985) (10,747,122) -- (10,747,122) ---------- ----------- --------- ----------- Partners' Capital, December 31, 2002 15,416.291 106,345,673 1,496,222 107,841,895 Net income -- 13,766,843 169,749 13,936,592 Redemptions (1,261.461) (8,921,278) (415,000) (9,336,278) ---------- ----------- --------- ----------- Partners' Capital, December 31, 2003 14,154.830 111,191,238 1,250,971 112,442,209 ========== =========== ========= =========== The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND II STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2003 2002 2001 ---------- ---------- ---------- $ $ $ CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) 134,035 2,951,248 (358,852) Noncash item included in net income (loss): Net change in unrealized 752,680 (511,624) 1,728,062 (Increase) decrease in operating assets: Due from Morgan Stanley DW 44,537 (53,316) (32,602) Interest receivable (Morgan Stanley DW) 5,244 7,246 67,028 Increase (decrease) in operating liabilities: Accrued management fees (4,588) 2,750 (6,524) Accrued administrative expenses (4,575) 1,930 21,771 Accrued incentive fee (40,483) 40,483 -- ---------- ---------- ---------- Net cash provided by operating activities 886,850 2,438,717 1,418,883 ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in redemptions payable (95,290) 115,021 (240,275) Redemptions of Units (1,566,534) (2,167,076) (1,631,103) ---------- ---------- ---------- Net cash used for financing activities (1,661,824) (2,052,055) (1,871,378) ---------- ---------- ---------- Net increase (decrease) in cash (774,974) 386,662 (452,495) Balance at beginning of period 21,702,438 21,315,776 21,768,271 ---------- ---------- ---------- Balance at end of period 20,927,464 21,702,438 21,315,776 ========== ========== ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND III STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, ---------------------------------- 2003 2002 2001 ---------- ---------- ---------- $ $ $ CASH FLOWS FROM OPERATING ACTIVITIES Net income 2,379,915 4,360,649 111,961 Noncash item included in net income: Net change in unrealized (909,383) (1,480,039) 3,780,263 (Increase) decrease in operating assets: Interest receivable (Morgan Stanley DW) 5,301 8,900 75,489 Due from Morgan Stanley DW 264,529 (130,959) (94,885) Net option premiums -- (23,122) (9,300) Increase (decrease) in operating liabilities: Accrued administrative expenses 4,501 2,721 36,117 Accrued management fees 384 4,445 (6,471) ---------- ---------- ---------- Net cash provided by operating activities 1,745,247 2,742,595 3,893,174 ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES Decrease in redemptions payable (25,112) (27,034) (115,008) Redemptions of Units (2,223,369) (2,814,486) (2,208,965) ---------- ---------- ---------- Net cash used for financing activities (2,248,481) (2,841,520) (2,323,973) ---------- ---------- ---------- Net increase (decrease) in cash (503,234) (98,925) 1,569,201 Balance at beginning of period 26,372,589 26,471,514 24,902,313 ---------- ---------- ---------- Balance at end of period 25,869,355 26,372,589 26,471,514 ========== ========== ========== The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUND IV STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, ------------------------------------- 2003 2002 2001 ----------- ----------- ----------- $ $ $ CASH FLOWS FROM OPERATING ACTIVITIES Net income 13,936,592 11,978,992 14,868,025 Noncash item included in net income: Net change in unrealized 3,788,611 948,478 (3,787,359) Decrease in operating assets: Interest receivable (Morgan Stanley DW) 18,628 28,632 266,959 Increase (decrease) in operating liabilities: Accrued management fees 8,868 4,355 18,696 Accrued administrative expenses 7,863 5,357 71,662 Accrued incentive fees (1,493,339) 148,204 509,200 ----------- ----------- ----------- Net cash provided by operating activities 16,267,223 13,114,018 11,947,183 ----------- ----------- ----------- CASH FLOWS FROM FINANCING ACTIVITIES Increase (decrease) in redemptions payable (75,165) 108,571 (1,109,566) Redemptions of Units (9,336,278) (10,747,122) (7,876,555) ----------- ----------- ----------- Net cash used for financing activities (9,411,443) (10,638,551) (8,986,121) ----------- ----------- ----------- Net increase in cash 6,855,780 2,475,467 2,961,062 Balance at beginning of period 103,560,309 101,084,842 98,123,780 ----------- ----------- ----------- Balance at end of period 110,416,089 103,560,309 101,084,842 =========== =========== =========== The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE II SCHEDULES OF INVESTMENTS DECEMBER 31, 2003 AND 2002 LONG UNREALIZED PERCENTAGE SHORT UNREALIZED PERCENTAGE FUTURES AND FORWARD CONTRACTS: GAIN/(LOSS) OF NET ASSETS GAIN/(LOSS) OF NET ASSETS ------------------------------ --------------- ------------- ---------------- ------------- 2003 PARTNERSHIP NET ASSETS: $22,049,409 $ % $ % Foreign currency 605,088 2.75 (17,470) (0.08) Commodity 550,044 2.49 (80,715) (0.37) Interest rate 40,604 0.18 (26,475) (0.12) Equity 124,756 0.57 (141,055) (0.64) --------- ----- -------- ----- Grand Total: 1,320,492 5.99 (265,715) (1.21) ========= ===== ======== ===== Unrealized Currency Gain Total Net Unrealized Gain per Statement of Financial Condition 2002 PARTNERSHIP NET ASSETS: $23,481,908 Foreign currency 1,015,521 4.32 285 -- Commodity 450,244 1.92 158,752 0.68 Interest rate 344,456 1.47 (166,859) (0.71) Equity (97,829) (0.42) 80,749 0.34 --------- ----- -------- ----- Grand Total: 1,712,392 7.29 72,927 0.31 ========= ===== ======== ===== Unrealized Currency Gain Total Net Unrealized Gain per Statement of Financial Condition FUTURES AND FORWARD CONTRACTS: NET UNREALIZED GAIN/(LOSS) # OF CONTRACTS/NOTIONAL AMOUNTS ------------------------------ -------------------------- ------------------------------- 2003 PARTNERSHIP NET ASSETS: $22,049,409 $ Foreign currency 587,618 1,598,518,831 Commodity 469,329 713 Interest rate 14,129 378 Equity (16,299) 147 --------- Grand Total: 1,054,777 Unrealized Currency Gain 243,683 --------- Total Net Unrealized Gain per Statement of Financial Condition 1,298,460 ========= 2002 PARTNERSHIP NET ASSETS: $23,481,908 Foreign currency 1,015,806 504,828,717 Commodity 608,996 668 Interest rate 177,597 437 Equity (17,080) 122 --------- Grand Total: 1,785,319 Unrealized Currency Gain 265,821 --------- Total Net Unrealized Gain per Statement of Financial Condition 2,051,140 ========= The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE III SCHEDULES OF INVESTMENTS DECEMBER 31, 2003 AND 2002 LONG UNREALIZED PERCENTAGE SHORT UNREALIZED PERCENTAGE FUTURES AND FORWARD CONTACTS: GAIN/(LOSS) OF NET ASSETS GAIN/(LOSS) OF NET ASSETS ----------------------------- --------------- ------------- ---------------- ------------- 2003 PARTNERSHIP NET ASSETS: $27,996,770 $ % $ % Foreign currency 557,716 2.00 (67,418) (0.24) Commodity 1,395,548 4.98 (1,310) -- Interest rate 9,410 0.03 (11,520) (0.04) Equity 625,429 2.23 -- -- --------- ----- ---------- ----- Grand Total: 2,588,103 9.24 (80,248) (0.28) ========= ===== ========== ===== Unrealized Currency Loss Total Net Unrealized Gain per Statement of Financial Condition 2002 PARTNERSHIP NET ASSETS: $27,840,224 Foreign currency 1,927,510 6.92* (1,063,204) (3.82) Interest rate 1,071,951 3.85 (8,694) (0.03) Commodity (305,430) (1.09) (4,875) (0.02) Equity -- -- 27,282 0.10 --------- ----- ---------- ----- Grand Total: 2,694,031 9.68 (1,049,491) (3.77) ========= ===== ========== ===== Unrealized Currency Loss Total Net Unrealized Gain per Statement of Financial Condition NET UNREALIZED # OF CONTRACTS/NOTIONAL FUTURES AND FORWARD CONTACTS: GAIN/(LOSS) AMOUNTS ----------------------------- -------------- ----------------------- 2003 PARTNERSHIP NET ASSETS: $27,996,770 $ Foreign currency 490,298 655,430,138 Commodity 1,394,238 695 Interest rate (2,110) 285 Equity 625,429 220 --------- Grand Total: 2,507,855 Unrealized Currency Loss (45,865) --------- Total Net Unrealized Gain per Statement of Financial Condition 2,461,990 ========= 2002 PARTNERSHIP NET ASSETS: $27,840,224 Foreign currency 864,306 2,056,042,500 Interest rate 1,063,257 626 Commodity (310,305) 431 Equity 27,282 16 --------- Grand Total: 1,644,540 Unrealized Currency Loss (91,933) --------- Total Net Unrealized Gain per Statement of Financial Condition 1,552,607 ========= *No single contract's value exceeds 5% of Net Assets. The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE IV SCHEDULES OF INVESTMENTS DECEMBER 31, 2003 AND 2002 LONG UNREALIZED PERCENTAGE OF SHORT UNREALIZED PERCENTAGE OF FUTURES AND FORWARD CONTRACTS: GAIN/(LOSS) NET ASSETS GAIN/(LOSS) NET ASSETS ------------------------------ --------------- ------------- ---------------- ------------- 2003 PARTNERSHIP NET ASSETS: $112,442,209 $ % $ % Foreign currency 3,142,423 2.80 (96,146) (0.08) ---------- ----- ---------- ----- Grand Total: 3,142,423 2.80 (96,146) (0.08) ========== ===== ========== ===== Unrealized Currency Gain/(Loss) Total Net Unrealized Gain per Statement of Financial Condition 2002 PARTNERSHIP NET ASSETS: $107,841,895 Foreign currency: Other 5,698,117 5.28* (4,784,058) (4.43) Euro/US dollar Mar. 03 5,843,488 5.42 -- -- ---------- ----- ---------- ----- Grand Total: 11,541,605 10.70 (4,784,058) (4.43) ========== ===== ========== ===== Unrealized Currency Gain Total Net Unrealized Gain per Statement of Financial Condition FUTURES AND FORWARD CONTRACTS: NET UNREALIZED GAIN/(LOSS) NOTIONAL AMOUNTS ------------------------------ -------------------------- ---------------- 2003 PARTNERSHIP NET ASSETS: $112,442,209 $ Foreign currency 3,046,277 6,364,827,569 --------- Grand Total: 3,046,277 Unrealized Currency Gain/(Loss) -- --------- Total Net Unrealized Gain per Statement of Financial Condition 3,046,277 ========= 2002 PARTNERSHIP NET ASSETS: $107,841,895 Foreign currency: Other 914,059 11,897,260,598 Euro/US dollar Mar. 03 5,843,488 172,375,000 --------- Grand Total: 6,757,547 Unrealized Currency Gain 77,341 --------- Total Net Unrealized Gain per Statement of Financial Condition 6,834,888 ========= * No single contract's value exceeds 5% of Net Assets. The accompanying notes are an integral part of these financial statements. DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS -------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION. Dean Witter Cornerstone Fund II ("Cornerstone II"), Dean Witter Cornerstone Fund III ("Cornerstone III"), and Dean Witter Cornerstone Fund IV ("Cornerstone IV") (individually, a "Partnership", or collectively, the "Partnerships"), are limited partnerships organized to engage in the speculative trading of futures contracts, options on futures contracts, and forward contracts on foreign currencies and other commodity interests (collectively, "futures interests"). The Partnership's general partner is Demeter Management Corporation ("Demeter"). The non-clearing commodity broker is Morgan Stanley DW Inc. ("Morgan Stanley DW"). The clearing commodity brokers for Cornerstone II and Cornerstone III are Morgan Stanley & Co. Incorporated ("MS&Co.") and Morgan Stanley & Co. International Limited ("MSIL"). Cornerstone IV's sole clearing commodity broker is MS&Co. Demeter, Morgan Stanley DW, MS&Co. and MSIL are wholly-owned subsidiaries of Morgan Stanley. Effective June 20, 2002, Morgan Stanley Dean Witter & Co. changed its name to Morgan Stanley. Demeter is required to maintain a 1% minimum interest in the equity of each Partnership and income (losses) are shared by Demeter and the limited partners based upon their proportional ownership interests. Effective December 31, 2002, Welton Investment Corporation was terminated as a trading manager of Cornerstone III and was replaced by Graham Capital Management, L.P. on January 1, 2003. USE OF ESTIMATES. The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the reported amounts in the financial statements and related disclosures. Management believes that the estimates utilized in the preparation of the financial statements are prudent and reasonable. Actual results could differ from those estimates. DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) REVENUE RECOGNITION. Futures interests are open commitments until settlement date. They are valued at market on a daily basis and the resulting net change in unrealized gains and losses is reflected in the change in unrealized profit (loss) on open contracts from one period to the next in the statements of operations. Monthly, Morgan Stanley DW pays each Partnership interest income based upon 80% of its average daily Net Assets at a rate equal to the average yield on 13-week U.S. Treasury bills. For purposes of such interest payments to Cornerstone IV, Net Assets do not include monies owed to the Partnership on futures interests. NET INCOME (LOSS) PER UNIT. Net income (loss) per unit of limited partnership interest ("Unit(s)") is computed using the weighted average number of Units outstanding during the period. CONDENSED SCHEDULES OF INVESTMENTS. In March 2001, the American Institute of Certified Public Accountants' Accounting Standards Executive Committee ("AICPA Executive Committee") issued Statement of Position 01-1 ("SOP 01-1") "Amendment to the Scope of Statement of Position 95-2, Financial Reporting By Nonpublic Investment Partnerships, to Include Commodity Pools". SOP 01-1 required commodity pools to include a condensed schedule of investments identifying those investments which constitute more than 5% of Net Assets, taking long and short positions into account separately, beginning in fiscal years ending after December 15, 2001. In December 2003, the AICPA Executive Committee issued Statement of Position 03-4 ("SOP 03-4") "Reporting Financial Highlights and Schedule of Investments by Nonregistered Investment Partnerships: An Amendment to the Audit and Accounting Guide Audits Of Investment Companies and AICPA Statement of Position 95-2, Financial Reporting By Nonpublic Investment Partnerships". SOP 03-4 requires commodity pools to disclose on the Schedule of Investments the number of contracts, the contracts' expiration dates and the cumulative unrealized gains/(losses) on open futures contracts, when the cumulative DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) unrealized gains/(losses) on an open futures contract exceeds 5% of Net Assets, taking long and short positions into account separately. SOP 03-4 also requires ratios for expenses and net income/(losses) based on average net assets to be disclosed in Financial Highlights. SOP 03-4 is effective for fiscal years ending after December 15, 2003. EQUITY IN FUTURES INTERESTS TRADING ACCOUNTS. The Partnerships' asset "Equity in futures interests trading accounts", reflected on the statements of financial condition, consists of (A) cash on deposit with Morgan Stanley DW, MS&Co. and MSIL for Cornerstone II and Cornerstone III, and Morgan Stanley DW and MS&Co. for Cornerstone IV, to be used as margin for trading; (B) net unrealized gains or losses on open contracts, which are valued at market and calculated as the difference between original contract value and market value; and (C) net option premiums, which represent the net of all monies paid and/or received for such option premiums. The Partnerships, in their normal course of business, enter into various contracts with MS&Co. and/or MSIL acting as their commodity brokers. Pursuant to brokerage agreements with MS&Co. and/or MSIL, to the extent that such trading results in unrealized gains or losses, these amounts are offset and reported on a net basis on the Partnerships' statements of financial condition. The Partnerships have offset the fair value amounts recognized for forward contracts executed with the same counterparty as allowable under the terms of their master netting agreements with MS&Co., the sole counterparty on such contracts. The Partnerships have consistently applied their right to offset. BROKERAGE COMMISSIONS AND RELATED TRANSACTION FEES AND COSTS. Brokerage commissions and related transaction fees and costs for each Partnership are accrued on a half-turn basis at 80% and 100%, respectively, of the rates Morgan Stanley DW charges parties that are not clearinghouse members. Brokerage commissions and transaction fees and costs combined for each Partnership are capped at 13/20 of 1% per DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) month (a 7.8% maximum annual rate) of the adjusted Net Assets allocated to each trading program employed by the Partnerships' trading managers. OPERATING EXPENSES. Each Partnership has entered into an exchange agreement pursuant to which certain common administrative expenses (i.e., legal, auditing, accounting, filing fees and other related expenses) are shared by each of the Partnerships based upon the number of outstanding Units of each Partnership during the month in which such expenses are incurred. In addition, the Partnerships incur monthly management fees and may incur incentive fees. Demeter bears all other operating expenses. INCOME TAXES. No provision for income taxes has been made in the accompanying financial statements, as partners are individually responsible for reporting income or loss based upon their respective share of each Partnership's revenues and expenses for income tax purposes. DISTRIBUTIONS. Distributions, other than redemptions of Units, are made on a pro-rata basis at the sole discretion of Demeter. No distributions have been made to date. REDEMPTIONS. Limited partners may redeem some or all of their Units at 100% of the Net Asset Value per Unit as of the last day of any month upon fifteen days advance notice by redemption form to Demeter. DISSOLUTION OF THE PARTNERSHIPS. Each Partnership will terminate on September 30, 2025 regardless of its financial condition at such time, upon a decline in Net Assets to less than $250,000, a decline in the Net Asset Value per Unit to less than $250, or under certain other circumstances defined in each Limited Partnership Agreement. LITIGATION SETTLEMENT. On February 27, 2002, Cornerstone II and Cornerstone III received notification of a preliminary entitlement to payment from the Sumitomo Copper Litigation Settlement Administrator and received payment of these settlement awards in the amount of $76,613 and $2,842,492, respectively, on August 30, 2002. DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) -------------------------------------------------------------------------------- 2. RELATED PARTY TRANSACTIONS Each Partnership pays brokerage commissions to Morgan Stanley DW as described in Note 1. Cornerstone II and Cornerstone III's cash is on deposit with Morgan Stanley DW, MS&Co. and MSIL, and Cornerstone IV's cash is on deposit with Morgan Stanley DW and MS&Co., in futures interests trading accounts to meet margin requirements as needed. Morgan Stanley DW pays interest on these funds as described in Note 1. -------------------------------------------------------------------------------- 3. TRADING MANAGERS Demeter, on behalf of each Partnership, retains certain commodity trading managers to make all trading decisions for the Partnerships. The trading managers for each Partnership at December 31, 2003 were as follows: Dean Witter Cornerstone Fund II John W. Henry & Company, Inc. Northfield Trading L.P. Dean Witter Cornerstone Fund III Graham Capital Management, L.P. Sunrise Capital Management, Inc. Dean Witter Cornerstone Fund IV John W. Henry & Company, Inc. Sunrise Capital Management, Inc. Compensation to the trading managers by the Partnerships consists of a management fee and an incentive fee as follows: MANAGEMENT FEE. Each Partnership's management fee is accrued at the rate of 1/12 of 3.5% per month (a 3.5% annual rate) of the Net Assets under management by each trading manager at each month end. INCENTIVE FEE. Each Partnership pays an annual incentive fee equal to 15% of the new appreciation in Net Assets, as defined in the Limited Partnership Agreements, as of the end of each annual incentive period ending December 31, except for Cornerstone DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) IV, which pays incentive fees at the end of each annual incentive period ending May 31. New appreciation represents the amount by which Net Assets are increased by profits from futures, forwards and options trading that exceed losses after brokerage commissions, management fees, transaction fees and costs and common administrative expenses are deducted. Such incentive fee is accrued in each month in which new appreciation occurs. In those months in which new appreciation is negative, previous accruals, if any, during the incentive period are reduced. In those instances in which a Limited Partner redeems an investment, the incentive fee (if earned through a redemption date) is paid on that redemption to the trading manager in the month of such redemption. -------------------------------------------------------------------------------- 4. FINANCIAL INSTRUMENTS The Partnerships trade futures contracts, options on futures contracts, and forward contracts on foreign currencies and other commodity interests. Futures and forwards represent contracts for delayed delivery of an instrument at a specified date and price. Risk arises from changes in the value of these contracts and the potential inability of counterparties to perform under the terms of the contracts. There are numerous factors which may significantly influence the market value of these contracts, including interest rate volatility. The market value of contracts is based on closing prices quoted by the exchange, bank or clearing firm through which the contracts are traded. The Partnerships' contracts are accounted for on a trade-date basis and market to market on a daily basis. Each Partnership accounts for its derivative investments in accordance with the provisions of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (''SFAS No. 133"). SFAS No. 133 defines a derivative as a financial instrument or other contract that has all three of the following characteristics: (1)One or more underlying notional amounts or payment provisions; DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) (2)Requires no initial net investment or a smaller initial net investment than would be required relative to changes in market factors; (3)Terms require or permit net settlement. Generally, derivatives include futures, forward, swaps or options contracts, and other financial instruments with similar characteristics such as caps, floors and collars. The net unrealized gains (losses) on open contracts at December 31, reported as a component of "Equity in futures interests trading accounts" on the statements of financial condition, and their longest contract maturities are as follows: CORNERSTONE II NET UNREALIZED GAINS ON OPEN CONTRACTS LONGEST MATURITIES ----------------------------- ------------------------ OFF- OFF- EXCHANGE- EXCHANGE- EXCHANGE- EXCHANGE- YEAR TRADED TRADED TOTAL TRADED TRADED ---- --------- --------- --------- ------------- ---------- $ $ $ 2003 748,037 550,423 1,298,460 December 2004 March 2004 2002 1,077,589 973,551 2,051,140 December 2003 March 2003 CORNERSTONE III NET UNREALIZED GAINS ON OPEN CONTRACTS LONGEST MATURITIES ----------------------------- ------------------------ OFF- OFF- EXCHANGE- EXCHANGE- EXCHANGE- EXCHANGE- YEAR TRADED TRADED TOTAL TRADED TRADED ---- --------- --------- --------- ------------- ---------- $ $ $ 2003 2,061,496 400,494 2,461,990 June 2005 March 2004 2002 688,301 864,306 1,552,607 December 2003 March 2003 CORNERSTONE IV NET UNREALIZED GAINS ON OPEN CONTRACTS LONGEST MATURITIES ----------------------------- -------------------- OFF- OFF- EXCHANGE- EXCHANGE- EXCHANGE- EXCHANGE- YEAR TRADED TRADED TOTAL TRADED TRADED ---- --------- --------- --------- --------- ---------- $ $ $ 2003 -- 3,046,277 3,046,277 -- March 2004 2002 -- 6,834,888 6,834,888 -- March 2003 The Partnerships have credit risk associated with counterparty nonperformance. The credit risk asso- DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) ciated with the instruments in which the Partnerships are involved is limited to the amounts reflected in the Partnerships' statements of financial condition. The Partnerships also have credit risk because Morgan Stanley DW, MS&Co., and/or MSIL act as the futures commission merchants or the counterparties, with respect to most of the Partnerships' assets. Exchange-traded futures and futures-styled options contracts are marked to market on a daily basis, with variations in value settled on a daily basis. Morgan Stanley DW, MS&Co. and/or MSIL, each as a futures commission merchant for each Partnership's exchange-traded futures and futures-styled options contracts, are required, pursuant to regulations of the Commodity Futures Trading Commission, to segregate from their own assets, and for the sole benefit of their commodity customers, all funds held by them with respect to exchange-traded futures and futures-styled options contracts, including an amount equal to the net unrealized gains (losses) on all open futures and futures-styled options contracts, which funds, in the aggregate, totaled at December 31, 2003 and 2002 respectively, $21,675,501 and $22,780,027 for Cornerstone II and $27,930,851 and $27,060,890 for Cornerstone III. With respect to each Partnership's off-exchange-traded forward currency contracts, there are no daily exchange-required settlements of variations in value nor is there any requirement that an amount equal to the net unrealized gains (losses) on open forward contracts be segregated, however, MS&Co. and Morgan Stanley DW will make daily settlements of losses as needed. With respect to those off-exchange-traded forward currency contracts, the Partnerships are at risk to the ability of MS&Co., the sole counterparty on all such contracts, to perform. Each Partnership has a netting agreement with MS&Co. These agreements, which seek to reduce both the Partnerships' and MS&Co.'s exposure on off-exchange-traded forward currency contracts, should materially decrease the Partnerships' credit risk in the event of MS&Co.'s bankruptcy or insolvency. DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (continued) -------------------------------------------------------------------------------- 5. FINANCIAL HIGHLIGHTS CORNERSTONE II PER UNIT: --------- NET ASSET VALUE, JANUARY 1, 2003: $4,963.25 --------- NET OPERATING RESULTS: Realized Profit 659.01 Unrealized Loss (164.24) Interest Income 43.00 Expenses (519.63) --------- Net Income 18.14 --------- NET ASSET VALUE, DECEMBER 31, 2003: $4,981.39 ========= Expense Ratio 10.0% Net Income Ratio 0.6% TOTAL RETURN 2003 0.4% INCEPTION-TO-DATE RETURN 410.9% COMPOUND ANNUALIZED RETURN 9.0% CORNERSTONE III PER UNIT: --------- NET ASSET VALUE, JANUARY 1, 2003: $3,592.21 --------- NET OPERATING RESULTS: Realized Profit 486.69 Unrealized Profit 122.28 Interest Income 31.35 Expenses (323.22) --------- Net Income 317.10 --------- NET ASSET VALUE, DECEMBER 31, 2003: $3,909.31 ========= Expense Ratio 8.5% Net Income Ratio 8.4% TOTAL RETURN 2003 8.8% INCEPTION-TO-DATE RETURN 301.0% COMPOUND ANNUALIZED RETURN 7.6% DEAN WITTER CORNERSTONE FUNDS NOTES TO FINANCIAL STATEMENTS (concluded) CORNERSTONE IV PER UNIT: --------- NET ASSET VALUE, JANUARY 1, 2003: $6,995.32 --------- NET OPERATING RESULTS: Realized Profit 1,813.28 Unrealized Loss (256.86) Interest Income 58.18 Expenses (666.19) --------- Net Income 948.41 --------- NET ASSET VALUE, DECEMBER 31, 2003: $7,943.73 ========= Expense Ratio 9.0% Net Income Ratio 12.8% TOTAL RETURN 2003 13.6% INCEPTION-TO-DATE RETURN 714.7% COMPOUND ANNUALIZED RETURN 13.4% PRESORTED FIRST CLASS MAIL U.S. POSTAGE PAID PERMIT #374 LANCASTER, PA Demeter Management Corporation 825 Third Avenue, 9th Floor New York, NY 10022 [LOGO] Morgan Stanley ADDRESS SERVICE REQUESTED [LOGO] printed on recycled paper - 50 -

HUTTON GSH COMMERCIAL PROPERTIES 3

10-K

https://www.sec.gov/Archives/edgar/data/725767/0001073339-00-000041.txt

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF - ----- THE SECURITIES EXCHANGE ACT OF 1934. For the fiscal year ended December 31, 1999 ----------------- OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF - ----- THE SECURITIES EXCHANGE ACT OF 1934. Commission file number: 0-13341 ------- COMMERCIAL PROPERTIES 3, L.P. (formerly Hutton/GSH Commercial Properties 3) --------------------------------------------- Exact name of registrant as specified in its charter Virginia 11-2680561 -------- ---------- State or other jurisdiction of I.R.S. Employer Identification No. incorporation or organization 3 World Financial Center, 29th Floor New York, NY Attn.: Andre Anderson 10285 - -------------------------------------- ----- Address of principal executive offices Zip code Registrant's telephone number, including area code: (212) 526-3183 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: UNITS OF LIMITED PARTNERSHIP INTEREST ------------------------------------- Title of Class Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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 ----- ----- 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 the 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 ----- DOCUMENTS INCORPORATED BY REFERENCE: Portions of Prospectus of Registrant dated December 13, 1983 (included in Amendment No. 1 to Registration Statement No. 2-85936, of Registrant filed December 13, 1983) are incorporated by reference to Part III. Portions of Parts I, II and IV are incorporated by reference to the Partnership's Annual Report to Unitholders for the year ended December 31, 1999 filed as an exhibit under Item 14. 1 PART I Item 1. Business (a) General Development of Business ------------------------------- Commercial Properties 3, L.P. (the "Registrant" or the "Partnership") (formerly Hutton/GSH Commercial Properties 3), is a Virginia limited partnership formed on April 19, 1984, of which Real Estate Services VII, Inc. ("RE Services"), formerly Hutton Real Estate Services VII, Inc. (See Item 10. "Certain Matters Involving Affiliates"), and HS Advisors III, Ltd. ("HS Advisors"), are the general partners (the "General Partners"). Commencing December 13, 1983, the Registrant began offering through E.F. Hutton & Company Inc., a former affiliate of the Registrant, up to a maximum of 120,000 units of limited partnership interest (the "Units") at $500 per Unit. The Units were registered under the Securities Act of 1933, as amended (the "Act"), under Registration Statement No. 2-85936, which Registration Statement was declared effective on December 13, 1983. The offering of Units was terminated on August 9, 1984. Upon termination of the offering, the Registrant had accepted subscriptions for 109,378 Units for an aggregate of $54,689,000. After deducting offering costs and initial working capital reserves, approximately $46,000,000 was available for investment in real estate. Of such proceeds, $44,995,452 was invested in an office and light industrial complex, one limited partnership and two joint ventures, each of which owned a specific office building (the "Properties"), and $1,093,780 of uncommitted funds were distributed to the Limited Partners as a return of capital on May 15, 1986. The Registrant also distributed $437,512 in 1986 and $218,756 in 1985 to the Limited Partners as returns of capital, which sums represented the excess of the initial working capital reserves set aside for present and future operating requirements. To the extent that funds committed for investment or held as a working capital reserve have not been expended (and have not otherwise been distributed to the Limited Partners as a return of capital), the Registrant has invested such funds in bank certificates of deposit, unaffiliated money market funds or other highly liquid short-term investments where there is appropriate safety of principal, in accordance with the Registrant's investment objectives and policies. (b) Financial Information About Industry Segment -------------------------------------------- The Registrant's sole business is the ownership and operation of the Properties. All of the Registrant's revenues, operating profit or losses and assets relate solely to such industry segment. (c) Narrative Description of Business --------------------------------- Incorporated by reference to Note 1 "Organization" of the Notes to the Consolidated Financial Statements in the Partnership's Annual Report to Unitholders for the year ended December 31, 1999 filed as an exhibit under Item 14. The Registrant's principal investment objectives with respect to the Properties (in no particular order of priority) are: 1) Capital appreciation. 2) Distributions of net cash from operations attributable to rental income. 3) Preservation and protection of capital. 4) Equity build-up through principal reduction of mortgage loans, if any, on the Properties. Distribution of net cash from operations is the Registrant's objective during its operational phase, while the preservation and appreciation of capital is the Registrant's long-term objective. The attainment of the Registrant's investment objectives will depend on many factors, including future economic conditions in the United States as a whole and, in particular, in the localities in which the Registrant's Properties are located, especially with regard to achievement of capital appreciation. The Registrant sold three of its Properties as of December 31, 1999, and the fourth Property was sold on January 31, 2000 (see Item 7). 2 (d) Employees --------- The Registrant has no employees. Item 2. Properties As of the filing date of this report, all of the Partnership's Properties had been sold. On January 12, 1999, the Partnership closed on the sale of Quorum II Office Building. On February 9, 1999, the Partnership closed on the sale of Metro Park Executive Center. On April 14, 1999, the Partnership closed on the sale of Ft. Lauderdale Commerce Center, and on January 31, 2000, the Partnership sold its remaining Property, Three Financial Centre. See Item 7 for a discussion of the sales. Item 3. Legal Proceedings The Registrant recently settled a legal dispute with a former tenant at the Quorum II Office Building in Dallas for $70,000. The Registrant will be paying such an amount in the first half of 2000. This settlement has been accepted by the former tenant in full compromise and settlement of all causes of action. Accordingly, the Registrant will have no additional liability. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of Unitholders during the fourth quarter of 1999. PART II Item 5. Market for Registrant's Limited Partnership Units and Related Unitholder Matters (a) Market Information ------------------ No established public trading market has developed for the Units, and it is not anticipated that such a market will develop in the future. (b) Holders ------- As of December 31, 1999, the number of holders of Units was 4,761. (c) Distributions ------------- In consideration of the Partnership's marketing efforts and the need to fund several capital improvements at the properties to better position them for sale, cash distributions were suspended commencing with the 1998 third quarter distribution which would have been paid in November 1998. The General Partners distributed the net proceeds from the sales of Quorum II Office Building, Metro Park Business Center and Ft. Lauderdale Commerce Center in September 1999. The General Partners plan to distribute the net proceeds from the sale of Three Financial Centre, which was completed on January 31, 2000, together with the Partnership's remaining cash reserves (after payment of or provision for the Partnership's liabilities and expenses), and terminate the Partnership during the second quarter of 2000. The following distributions were paid to the Limited Partners for the two years ended December 31, 1999 and December 31, 1998. 3 Cash Distributions Per Limited Partnership Unit First Second Third Fourth Quarter Quarter Quarter Quarter Total ------- ------- ------- ------- ------- 1998 $ 5.00 $ 5.00 $ -- $ -- $ 10.00 1999 $ -- $ -- $200.56 $ -- $200.56 Item 6. Selected Financial Data For The Years Ended December 31, (dollars in thousands except per Unit data) 1999 1998 1997 1996 1995 - ---------------------------------------------------------------------------------------------- Total income $ 3,313 $ 5,788 $ 5,109 $ 5,279 $ 5,158 Operating income (loss) 1,572 1,747 43 568 (3,631) Gain on sale of real estate assets 6,831 -- -- -- -- Net income (loss) 8,403 1,747 43 568 (3,631) Total assets at year end 10,924 25,007 24,464 25,364 27,842 Net cash from operations 1,515 2,951 2,194 2,560 2,168 Net income (loss) per Unit 76.06 14.89 (.23) 4.09 (32.87) Cash distributions per Limited Partnership Unit 200.56(2) 10.00 12.00 25.30(1) 13.25 - ---------------------------------------------------------------------------------------------- (1) Includes a special cash distribution of $13.30 per Unit paid on March 29, 1996. (2) Represents a special cash distribution of the net sale proceeds from Quorum II Office Building, Metro Park Business Center and Ft. Lauderdale Commerce Center paid on September 22, 1999. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources - ------------------------------- On January 12, 1999, the Partnership completed the sale of Quorum to an unaffiliated partnership for a selling price of $7,612,065, net of closing adjustments and selling costs, resulting in a gain of $2,894,064, which is reflected in the Partnership's consolidated statement of operations for the year ended December 31, 1999. On February 9, 1999, the Partnership completed the sale of Metro Park to an unaffiliated partnership for a selling price of $3,797,438, net of closing adjustments and selling costs, resulting in a gain of $565,698, which is reflected in the Partnership's consolidated statement of operations for the year ended December 31, 1999. On April 14, 1999, the Partnership sold Ft. Lauderdale to an unaffiliated partnership for a selling price of $12,465,291, net of closing adjustments and selling costs, resulting in a gain of $3,371,728 which is reflected in the Partnership's consolidated operations for the year ended December 31, 1999. The selling prices were determined by arm's length negotiations between the Partnership and the buyers. As a result of these sales, on September 22, 1999 the Partnership paid a special cash distribution to the Limited Partners in the amount of $21,936,419, or $200.56 per Unit and $221,580 to the General Partners. 4 On January 31, 2000, the Partnership sold its remaining Property, Three Financial Centre, to an affiliate of the Joint Venture Partner, Three Financial Centre LLC ("3FCLLC"), for a selling price of approximately $10,130,000, net of closing adjustments and selling costs. The sale is expected to result in a gain of approximately $4,100,000 which will be reflected in the Partnership's consolidated operations for the three months ended March 31, 2000. The selection of the buyer was a result of a competitive bidding process organized by the real estate broker engaged to assist in selling the Property. The General Partners plan to distribute the net proceeds from the sale, together with the Partnership's remaining cash reserves (after payment of or provision for the Partnership's liabilities and expenses), and terminate the Partnership during the second quarter 2000. In anticipation of the Partnership being dissolved, the minority interest allocation has been conformed to the tax basis. The Partnership's real estate has been recorded on the Partnership's December 31, 1999 balance sheet as "Real estate assets held for disposition." Real estate assets held for disposition at December 31, 1999 totaled $5,974,046. The Partnership had cash and cash equivalents totaling $4,785,516 at December 31, 1999, compared to $2,246,926 at December 31, 1998. The increase is primarily due to the proceeds from the sale of three properties during 1999. The Partnership also had restricted cash, which consists of security deposits of $78,031 at December 31, 1999, compared to $143,536 at December 31, 1998. This decrease resulted from the sale of Quorum, Metro Park and Ft. Lauderdale. Accounts and rent receivable, net of allowance for doubtful accounts, totaled $65,401 at December 31, 1999, compared to $136,156 at December 31, 1998. The decrease is mainly due to the sale of three properties in 1999. Prepaid expenses and other assets totaled $21,282 at December 31, 1999, compared to $51,093 at December 31, 1998. The decrease is due to the sale of three properties during 1999. Accounts payable and accrued expenses totaled $233,207 at December 31, 1999, compared to $512,546 at December 31, 1998. The decrease is largely due to a decrease in real estate taxes payable resulting from the sale of Quorum, Metro Park and Ft. Lauderdale and the timing of invoices and payments. Security deposits totaled $78,031 at December 31, 1999, compared to $240,423 at December 31, 1998. The decrease is due to the sale of Quorum, Metro Park and Ft. Lauderdale. Market Risk - ----------- The Partnership's principal market risk exposure is interest rate risk. The Partnership has no long-term debt and its remaining Property has no mortgage debt. Accordingly, the Partnership's interest risk exposure is primarily limited to interest earned on the Partnership's cash and cash equivalents which are invested at short-term rates. Such risk is not considered material to the Partnership's operations. Results of Operations - --------------------- 1999 vs 1998 - ------------ The Partnership's operations resulted in net income of $8,403,060 for the year ended December 31, 1999, compared to a net income of $1,747,214 in fiscal 1998. The increase is primarily attributable to the gain recognized on the sale of Quorum, Metro Park and Ft. Lauderdale. Rental income totaled $2,530,185 for the year ended December 31, 1999, compared to $5,719,841 for the year ended December 31, 1998. The decrease is largely attributable to the sale of Quorum, Metro Park and Ft. Lauderdale. Interest income totaled $783,312 for the year ended December 31, 1999, compared to $68,146 in fiscal 1998. The increase is primarily attributable to the proceeds received from the sale of Quorum, Metro Park and Ft. Lauderdale. Property operating expenses totaled $1,142,270 for the year ended December 31, 1999, compared to $2,323,191 in fiscal 1998. The decrease is primarily due to the sale of Quorum, Metro Park and Ft. Lauderdale. 5 Depreciation and amortization expense totaled $28,522 for the year ended December 31, 1999, compared with $1,077,837 for the year ended December 31, 1998. For the year ended December 31, 1999, depreciation and amortization represent the write-off of tenant improvements and leasing commissions related to tenants who have vacated the Property. The Partnership suspended depreciation and amortization on July 1, 1998, in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." General and administrative expenses totaled $454,088 for the year ended December 31, compared to $404,990 in fiscal 1998. The increase is primarily due to higher administrative and marketing fees on the sale of Quorum, Metro Park and Ft. Lauderdale. As of December 31, 1999, Three Financial Centre was 85% leased. 1998 vs 1997 - ------------ Partnership operations resulted in net income of $1,747,214 for the year ended December 31, 1998, compared to $42,860 in 1997. The increase in net income is primarily attributable to higher rental income and a decrease in depreciation expense due to the reclassification of the properties as "Real estate assets held for disposition." Rental income totaled $5,719,841 for the year ended December 31, 1998, compared to $5,031,723 for the year ended December 31, 1997. The increase is attributable to higher rental income at all four properties, particularly at Metro Park Business Center and Quorum II Office Building, and an increase in average occupancy at Three Financial Centre. Interest income totaled $68,146 for the year ended December 31, 1998, compared to $77,701 in 1997. The slight decrease is primarily attributable to the Partnership's lower average cash balances in 1998. Property operating expenses totaled $2,323,191 for the year ended December 31, 1998, largely unchanged from $2,392,473 in 1997, as reductions in operating expenses at three of the properties were largely offset by an increase in property tax expense at the Quorum property. Depreciation and amortization expense totaled $1,077,837 for the year ended December 31, 1998, compared with $2,089,050 in 1997. The Partnership suspended depreciation and amortization on July 1, 1998, in accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." General and administrative expenses for the year ended December 31, 1998 totaled $404,990, compared to $477,582 in 1997. The decrease is primarily due to lower management and appraisal expenses. As of December 31, 1998, lease levels at each of the Properties were as follows: Metro Park Executive Center - 86%; Fort Lauderdale Commerce Center - 85%; Three Financial Centre - 96%; and Quorum II Office Building - 83%. Item 8. Financial Statements and Supplementary Data Incorporated by reference to the Partnership's Annual Report to Unitholders for the year ended December 31, 1999, which is filed as an exhibit under Item 14. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. 6 PART III Item 10. Directors and Executive Officers of the Registrant The Registrant has no officers and directors. RE Services and HS Advisors, the General Partners of the Registrant, jointly manage and control the affairs of the Registrant and have general responsibility and authority in all matters affecting its business. Real Estate Services VII, Inc. - ------------------------------ Real Estate Services VII, Inc., is a Delaware corporation formed on August 2, 1982 and is an affiliate of Lehman Brothers Inc. ("Lehman"). See the section captioned "Certain Matters Involving Hutton Affiliates" below for a description of the Hutton Group's acquisition by Shearson Lehman Brothers, Inc. ("Shearson") and the subsequent sale of certain of Shearson's domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated, which resulted in a change in the general partner's name. The names and ages of, as well as the positions held by, the directors and executive officers of RE Services are set forth below. There are no family relationships between any officer or director and any other officer or director. Certain officers and directors of RE Services are now serving (or in the past have served) as officers and directors of entities which act as general partners of a number of real estate limited partnerships which have sought protection under the provisions of the Federal Bankruptcy Code. The partnerships which have filed bankruptcy petitions own real estate which has been adversely affected by the economic conditions in the markets in which that real estate is located and, consequently, the partnerships sought the protection of the bankruptcy laws to protect the Partnership's assets from loss through foreclosure. Name Office ---- ------ Michael T. Marron Director, President and Chief Financial Officer Rocco F. Andriola Director, Vice President Michael T. Marron, 36, is a Vice President of Lehman Brothers and has been a member of the Diversified Asset Group since 1990 where he has actively managed and restructured a diverse portfolio of syndicated limited partnerships. Prior to joining Lehman Brothers, Mr. Marron was associated with Peat Marwick Mitchell & Co. serving in both its audit and tax divisions from 1985 to 1989. Mr. Marron received a B.S. degree from the State University of New York at Albany and an M.B.A. degree from Columbia University and is a Certified Public Accountant. Rocco F. Andriola, 41, is a Managing Director of Lehman Brothers in its Diversified Asset Group and has held such position since October 1996. Mr. Andriola also serves as the Director of Global Corporate Services for Lehman. Since joining Lehman in 1986, Mr. Andriola has been involved in a wide range of restructuring and asset management activities involving real estate and other direct investment transactions. From June 1991 through September 1996, Mr. Andriola held the position of Senior Vice President in Lehman's Diversified Asset Group. From June 1989 through May 1991, Mr. Andriola held the position of First Vice President in Lehman's Capital Preservation and Restructuring Group. From 1986 to 1989, Mr. Andriola served as a Vice President in the Corporate Transactions Group of Shearson Lehman Brothers' office of the general counsel. Prior to joining Lehman, Mr. Andriola practiced corporate and securities law at Donovan Leisure Newton & Irvine in New York. Mr. Andriola received a B.A. from Fordham University, a J.D. from New York University School of Law, and an LL.M in Corporate Law from New York University's Graduate School of Law. HS Advisors III, Ltd. - --------------------- HS Advisors III, Ltd., a California limited partnership, was formed on August 11, 1982, the sole general partner of which is Hogan Stanton Investment, Inc. ("HS Inc."), a wholly-owned subsidiary of Goodman Segar Hogan, Inc. The names and ages of, as well as the positions held by, the directors and executive officers of HS Inc. are as set forth below. There are no family relationships between or among any officer and any other officer or director. Name Office ---- ------ Mark P. Mikuta President Julie R. Adie Vice President, Treasurer and Secretary 7 Mark P. Mikuta, 46, is Senior Vice President of Goodman Segar Hogan, Inc. and is Vice President and Controller of Dominion Capital, Inc., a wholly-owned subsidiary of Dominion Resources. Mr. Mikuta joined Dominion Resources in 1987. Prior to joining Dominion Resources, he was an internal auditor with Virginia Commonwealth University in Richmond, Virginia from 1980 - 1987 and an accountant with Coopers & Lybrand from 1977 - 1980. Mr. Mikuta earned a Bachelor of Science degree in accounting from the University of Richmond in 1977. He is a Certified Public Accountant (CPA) and Certified Financial Planner (CFP) in the state of Virginia and a member of the American Institute of Certified Public Accountants. Julie R. Adie, 45, is a Vice President of Goodman Segar Hogan, Inc. and Senior Vice President of Goodman Segar Hogan Hoffler, L.P. ("GSHH"). She is responsible for investment management of a commercial real estate portfolio for the company's Asset Management Division. Prior to GSHH, Ms. Adie was an asset manager with Aetna Real Estate Investors from 1986 to 1988. Ms. Adie practiced as an attorney from 1978 through 1984 and is currently a member of the Virginia Bar Association. She holds a B.A. degree from Duke University, a Juris Doctor from University of Virginia and an M.B.A. from Dartmouth College. Certain Matters Involving Affiliates - ------------------------------------ On July 31, 1993, Shearson Lehman Brothers Inc. sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to the sale, Shearson Lehman Brothers Inc. changed its name to Lehman Brothers Inc. The transaction did not affect the ownership of the General Partners. However, the assets acquired by Smith Barney included the name "Hutton." Consequently, Hutton Real Estate Services VII, Inc., a General Partner, changed its name to Real Estate Services VII, Inc. Additionally, effective August 3, 1995, the Partnership changed its name to Commercial Properties 3, L.P., to delete any reference to "Hutton." On August 1, 1993, Goodman Segar Hogan ("GSH") transferred all of its leasing, management and sales operations to Goodman Segar Hogan Hoffler, L.P., a Virginia limited partnership ("GSHH"). On that date, the leasing, management and sales operations of a portfolio of properties owned by the principals of Armada/Hoffler ("HK") were also obtained by GSHH. The General Partner of GSHH is Goodman Segar Hogan Hoffler, Inc., a Virginia corporation ("GSHH Inc."), which has a one percent interest in GSHH. The stockholders of GSHH Inc. are GSH with a sixty-two percent stock interest and H.K. Associates, L.P., an affiliate of HK, with a thirty-eight percent stock interest. The remaining interests in GSHH are limited partnership interests owned by GSH, HK and 23 employees of GSHH. On September 28, 1998, GSH sold its general partner and limited partner interests in GSHH to The St. Joe Company, an unaffiliated company. The transactions did not affect the ownership of the General Partners. Item 11. Executive Compensation Neither of the General Partners nor any of their directors and officers received any compensation from the Registrant. See Item 13 below with respect to a description of certain transactions of the General Partners and their affiliates with the Registrant. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners ----------------------------------------------- No person (including any "group" as that term is used in Section 13(d)(3) of the Securities Exchange Act of 1934) is known to the Registrant to be the beneficial owner of more than five percent of the outstanding Units as of December 31, 1999. (b) Security Ownership of Management -------------------------------- No officer or director of the General Partners beneficially owned or owned of record directly or indirectly any Units of the Registrant as of December 31, 1999. 8 (c) Changes In Control ------------------ None. Item 13. Certain Relationships and Related Transactions Pursuant to the Certificate and Agreement of Limited Partnership of the Registrant, for the year ended December 31, 1999, $84,030 of the Registrant's income was allocated to the General Partners ($42,015 to RE Services and $42,015 to HS Advisors). For a description of the allocation of net cash from operations and the allocation of income and loss to which the General Partners are entitled, reference is made to the material contained on pages 45 through 48 of the Prospectus of Registrant dated December 13, 1983 (the "Prospectus"), contained in Amendment No. 1 to Registrant's Registration Statement No. 2-85936, under the section captioned "Distributions and Allocations," which section is incorporated herein by reference thereto. On January 31, 2000, the Partnership sold its remaining Property, Three Financial Centre, to an affiliate of the Joint Venture Partner, 3FCLLC, for a selling price of approximately $10,130,000, net of closing adjustments and selling costs. The selection of 3FCLLC was a result of a competitive bidding process organized by the real estate broker engaged to assist in selling the Property. Pursuant to Section 12(g) of the Registrant's Certificate and Agreement of Limited Partnership, the General Partners and certain affiliates may be reimbursed by the Registrant for certain costs as described on page 16 of the Prospectus, which description is incorporated herein by reference thereto. Commencing January 1, 1997, the Partnership began reimbursing certain expenses incurred by RE Services and its affiliates in servicing the Partnership to the extent permitted by the Partnership Agreement. In prior years, affiliates of RE Services had voluntarily absorbed these expenses. Disclosure relating to amounts paid to the General Partners or their affiliates during the past three years is incorporated by reference to Note 6 "Transactions With the General Partners and Affiliates" of Notes to the Consolidated Financial Statements contained in the Partnership's Annual Report to Unitholders for the year ended December 31, 1999 filed as an exhibit under Item 14. 9 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: Page Number ------ (1) Financial Statements: Consolidated Balance Sheets - At December 31, 1999 and 1998..... (4) Consolidated Statements of Partners' Capital (Deficit) - For the years ended December 31, 1999, 1998 and 1997.......... (4) Consolidated Statements of Operations - For the years ended December 31, 1999, 1998 and 1997.......... (5) Consolidated Statements of Cash Flows - For the years ended December 31, 1999, 1998 and 1997.......... (6) Notes to the Consolidated Financial Statements.................. (7) (2) Financial Statement Schedule: Schedule III - Real Estate and Accumulated Depreciation ........ F-1 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (1) Incorporated by reference to the Partnership's Annual Report to Unitholders for the year ended December 31, 1999, which is filed as Exhibit 13. (b) Reports on Form 8-K: No Reports on Form 8-K were filed during the three months ended December 31, 1999. On February 14, 2000, the Partnership filed a Report on Form 8-K reporting the sale of Three Financial Centre on January 31, 2000. (c) See Exhibit Index contained herein. 10 EXHIBIT INDEX Exhibit No. - ---------- (4) (A) Certificate and Agreement of Limited Partnership (included as, and incorporated herein by reference to, Exhibit A to the Prospectus of Registrant dated December 13, 1983 (the "Prospectus"), contained in Amendment No. 1 to Registration Statement, No. 2-85936, of the Registrant filed December 13, 1983 (the "Registration Statement")). (B) First Amendment to Certificate and Agreement of Limited Partnership (included as, and incorporated herein by reference to, Exhibit 4(B) of the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1984 (the "1984 Annual Report")). (C) Subscription Agreement and Signature Page (included as, and incorporated herein by reference to, Exhibit 3.1 to the 1983 Registration Statement). (10) (A) Agreements relating to Quorum II Office Building (included as, and incorporated herein by reference to, Exhibit (10)(A) to the 1984 Annual Report). (B) Agreements relating to Three Financial Centre Office Building (included as, and incorporated herein by reference to, Exhibit (10)(B) to the 1984 Annual Report). (C) Agreements relating to Fort Lauderdale Commerce Center (included as, and incorporated herein by reference to, Exhibit (10)(C) to the 1984 Annual Report). (D) Agreements relating to Metro Park Executive Center (included as, and incorporated herein by reference to, Exhibit (10)(D) to the 1984 Annual Report). (13) Annual report to the Unitholders for the year ended December 31, 1999. (23) Consent of Independent Auditors. (27) Financial Data Schedule. (28) Portions of Prospectus of Registrant dated December 13, 1983. 11 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COMMERCIAL PROPERTIES 3, L.P. BY: HS Advisors III, Ltd. General Partner Hogan Stanton Investment, Inc. General Partner Date: March 30, 2000 BY: /s/Mark P. Mikuta ----------------- Name: Mark P. Mikuta Title: President BY: Real Estate Services VII, Inc. General Partner Date: March 30, 2000 BY: /s/Michael T. Marron -------------------- Name: Michael T. Marron Title: Director, President and Chief Financial Officer 12 SIGNATURES 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 in the capabilities and on the dates indicated. REAL ESTATE SERVICES VII, INC. A General Partner Date: March 30, 2000 BY: /s/Michael T. Marron -------------------- Name: Michael T. Marron Title: Director, President and Chief Financial Officer Date: March 30, 2000 BY: /s/Rocco F. Andriola -------------------- Name: Rocco F. Andriola Title: Director, Vice President 13 SIGNATURES 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 in the capabilities and on the dates indicated. HS ADVISORS III, LTD. A General Partner Date: March 30, 2000 BY: /s/Mark P. Mikuta ----------------- Name: Mark P. Mikuta Title: President of Hogan Stanton Investment, Inc., as general partner of HS Advisors III, Ltd. Date: March 30, 2000 BY: /s/Julie R. Adie ---------------- Name: Julie R. Adie Title: Vice President, Secretary and Treasurer of Hogan Stanton Investment, Inc. as general partner of HS Advisors III, Ltd. 14 EX-13 2 ANNUAL REPORT EXHIBIT 13 Commercial Properties 3, L.P. 1999 Annual Report to Unitholders - -------------------------------------------------------------------------------- MESSAGE TO INVESTORS - -------------------------------------------------------------------------------- Presented for your review is the 1999 Annual Report for Commercial Properties 3, L.P. (the "Partnership"). As discussed in previous reports, the Partnership sold three properties during 1999, Quorum II Office Building, Metro Park Executive Center and Ft. Lauderdale Commerce Center. In addition, the Partnership's final property, Three Financial Centre, was sold in January of this year. This report includes an overview on the sale of this property and the Partnership's audited financial statements for the year ended December 31, 1999. Sale Update We are pleased to report that Three Financial Centre was sold on January 31, 2000 for net sales proceeds of approximately $10,130,000. The buyer, an affiliate of the joint venture partner, was selected following a competitive bidding process organized by the real estate brokerage firm engaged to assist in the sale of the property. A special cash distribution representing a majority of the sales proceeds is expected to be paid to the Limited Partners in April. In addition, the Partnership is expected to terminate during the second quarter of this year following the expiration of the representations and warranties associated with the sale. The Partnership's remaining cash reserves (after payment of, or provision for, the Partnership's liabilities and expenses) will be distributed to the Limited Partners following termination. Cash Distributions The Partnership paid a special cash distribution in the amount of $200.56 per Unit in September 1999, resulting from the sale of three properties during the first half of 1999. As discussed above, Limited Partners will receive a special cash distribution resulting from the sale of the Partnership's final property in the near future. General Information Additional information regarding the payment of your final cash distributions and the termination of the Partnership will be included in future correspondence. In the interim, questions regarding the Partnership should be directed to your Financial Consultant or Partnership Investor Services. All requests for a change of address or transfer should be submitted in writing to the Partnership's administrative agent at P.O. Box 7090, Troy, MI 48007-7090. Partnership Investor Services can be reached at (617) 342-4225, and the Partnership's administrative agent can be reached at (248) 637-7900. Very truly yours, Real Estate Services VII, Inc. Hogan Stanton Investment, Inc. General Partner General Partner of HS Advisors III, Ltd. Michael T. Marron Mark P. Mikuta President President March 30, 2000 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES - ------------------------------------------------------------------------------------------ CONSOLIDATED BALANCE SHEETS At December 31, At December 31, 1999 1998 - ------------------------------------------------------------------------------------------ Assets Real estate assets held for disposition $ 5,974,046 $ 22,429,538 Cash and cash equivalents 4,785,516 2,246,926 Restricted cash 78,031 143,536 Accounts and rent receivable, net of allowance for doubtful accounts of $96,362 in 1999 and $5,444 in 1998 65,401 136,156 Prepaid expenses and other assets 21,282 51,093 - ------------------------------------------------------------------------------------------ Total Assets $ 10,924,276 $ 25,007,249 ========================================================================================== Liabilities and Partners' Capital (Deficit) Liabilities: Accounts payable and accrued expenses $ 233,207 $ 512,546 Due to affiliates 48,376 47,930 Prepaid rent 17,581 -- Security deposits payable 78,031 240,423 ------------------------------ Total Liabilities 377,195 800,899 ------------------------------ Minority Interest 701,361 605,691 ------------------------------ Partners' Capital (Deficit): General Partners (393,353) (255,803) Limited Partners (109,378 units outstanding) 10,239,073 23,856,462 ------------------------------ Total Partners' Capital 9,845,720 23,600,659 - ------------------------------------------------------------------------------------------ Total Liabilities and Partners' Capital $ 10,924,276 $ 25,007,249 ========================================================================================== - ------------------------------------------------------------------------------------------ CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) For the years ended December 31, 1999, 1998 and 1997 General Limited Partners Partners Total - ------------------------------------------------------------------------------------------ Balance at December 31, 1996 $ (368,069) $ 24,659,390 $ 24,291,321 Net Income (Loss) 67,729 (24,869) 42,860 Distributions (40,592) (1,312,536) (1,353,128) - ------------------------------------------------------------------------------------------ Balance at December 31, 1997 (340,932) 23,321,985 22,981,053 Net Income 118,957 1,628,257 1,747,214 Distributions (33,828) (1,093,780) (1,127,608) - ------------------------------------------------------------------------------------------ Balance at December 31, 1998 (255,803) 23,856,462 23,600,659 Net Income 84,030 8,319,030 8,403,060 Distributions (221,580) (21,936,419) (22,157,999) - ------------------------------------------------------------------------------------------ Balance at December 31, 1999 $ (393,353) $ 10,239,073 $ 9,845,720 ========================================================================================== See accompanying notes to the consolidated financial statements. 2 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES - -------------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS For the years ended December 31, 1999 1998 1997 - -------------------------------------------------------------------------------------- Income Rental $ 2,530,185 $ 5,719,841 $ 5,031,723 Interest 783,312 68,146 77,701 ----------------------------------------- Total Income 3,313,497 5,787,987 5,109,424 - -------------------------------------------------------------------------------------- Expenses Property operating 1,142,270 2,323,191 2,392,473 Depreciation and amortization 28,522 1,077,837 2,089,050 General and administrative 454,088 404,990 477,582 ----------------------------------------- Total Expenses 1,624,880 3,806,018 4,959,105 ----------------------------------------- Net income before minority interest 1,688,617 1,981,969 150,319 Minority interest (117,047) (234,755) (107,459) ----------------------------------------- Income before gain on sale of real estate 1,571,570 1,747,214 42,860 Gain on sale of real estate 6,831,490 -- -- ----------------------------------------- Net Income $ 8,403,060 $ 1,747,214 $ 42,860 ====================================================================================== Net Income (Loss) Allocated: To the General Partners $ 84,030 $ 118,957 $ 67,729 To the Limited Partners 8,319,030 1,628,257 (24,869) - -------------------------------------------------------------------------------------- $ 8,403,060 $1,747,214 $ 42,860 ====================================================================================== Per limited partnership unit (109,378 outstanding) $ 76.06 $ 14.89 $ (.23) - -------------------------------------------------------------------------------------- See accompanying notes to the consolidated financial statements. 3 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES - --------------------------------------------------------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 1999 1998 1997 - --------------------------------------------------------------------------------------------------- Cash Flows From Operating Activities Net Income $ 8,403,060 $ 1,747,214 $ 42,860 Adjustments to reconcile net income to net cash provided by operating activities: Minority interest 117,047 234,755 107,459 Depreciation 15,460 954,030 1,858,297 Amortization 13,062 123,807 230,753 Bad debt 90,918 -- -- Gain on sale of real estate (6,831,490) -- -- Increase (decrease) in cash arising from changes in operating assets and liabilities: Restricted cash 65,505 79,347 9,447 Accounts and rent receivable (20,163) (55,555) (40,511) Deferred rent receivable 55,576 50,521 53,688 Prepaid expenses and other assets 29,811 (209,810) (371,185) Accounts payable and accrued expenses (279,339) 75,519 187,510 Due to affiliates 446 (7,340) 49,329 Prepaid rent 17,581 (58,937) 58,937 Security deposits payable (162,392) 17,540 7,857 ------------------------------------------ Net cash provided by operating activities 1,515,082 2,951,091 2,194,441 - --------------------------------------------------------------------------------------------------- Cash Flows From Investing Activities Proceeds from sale of real estate 23,874,794 -- -- Additions to real estate -- (511,289) (796,801) Additions to real estate held for disposition (671,910) -- -- ------------------------------------------ Net cash provided by (used for) investing activities 23,202,884 (511,289) (796,801) - --------------------------------------------------------------------------------------------------- Cash Flows From Financing Activities Cash distributions (22,157,999) (1,465,890) (1,353,128) Cash distributions to minority interest joint venture (21,377) -- -- ------------------------------------------ Net cash used for financing activities (22,179,376) (1,465,890) (1,353,128) - --------------------------------------------------------------------------------------------------- Net increase in cash and cash equivalents 2,538,590 973,912 44,512 Cash and cash equivalents, beginning of period 2,246,926 1,273,014 1,228,502 ------------------------------------------ Cash and cash equivalents, end of period $ 4,785,516 $ 2,246,926 $ 1,273,014 =================================================================================================== Supplemental Disclosure of Non-Cash Operating Activities: In connection with the General Partners' intent to sell the Property, real estate held for investment, deferred rent receivable and prepaid leasing commissions in the amount of $21,403,550, $101,362, and $628,865, respectively, were reclassified to "Real estate assets held for disposition" in June of 1998. - --------------------------------------------------------------------------------------------------- Supplemental Disclosure of Non-Cash Investing Activities: Write-off of leasing commissions on vacated tenants $ 209,345 $ -- $ -- Write-off of tenant improvements on vacated tenants 56,014 -- -- - --------------------------------------------------------------------------------------------------- See accompanying notes to the consolidated financial statements. 4 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS December 31, 1999, 1998 and 1997 1. Organization Commercial Properties 3, L.P. (the "Partnership") was organized as a limited partnership under the laws of the Commonwealth of Virginia pursuant to a Certificate and Agreement of Limited Partnership dated and filed April 19, 1984 (the "Partnership Agreement"). The Partnership was formed for the purpose of acquiring and operating certain types of commercial real estate. The General Partners of the Partnership are Real Estate Services VII, Inc. ("Real Estate Services"), formerly Hutton Real Estate Services VII, Inc., which is an affiliate of Lehman Brothers Inc. ("Lehman Brothers") and HS Advisors III, Ltd. ("HS Advisors"), which is an affiliate of Goodman Segar Hogan, Inc. The General Partners expect to liquidate the Partnership in 2000. On July 31, 1993, Shearson Lehman Brothers Inc. sold certain of its domestic retail brokerage and asset management businesses to Smith Barney, Harris Upham & Co. Incorporated ("Smith Barney"). Subsequent to the sale, Shearson Lehman Brothers Inc. changed its name to Lehman Brothers Inc. The transaction did not affect the ownership of the General Partners. However, the assets acquired by Smith Barney included the name "Hutton." Consequently, effective October 22, 1993, the Hutton Real Estate Services VII, Inc. General Partner changed its name to delete any reference to Hutton. Additionally, effective August 3, 1995, the Partnership changed its name to Commercial Properties 3, L.P., to delete any reference to "Hutton." 2. Significant Accounting Policies Basis of Accounting - The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Revenues are recognized as earned and expenses are recorded as obligations are incurred. Consolidation - The consolidated financial statements include the accounts of the Partnership and its ventures, Metro Park Associates Joint Venture ("Metro Park"), Three Financial Centre Joint Venture ("Three Financial Centre"), and 14850 Quorum Associates, Ltd. ("Quorum"). Intercompany accounts and transactions between the Partnership and the ventures are eliminated in consolidation. Real Estate Investments - Real estate investments, which consist of commercial buildings and capital improvements (the "Properties"), are recorded at cost, which includes the initial purchase price of the property plus closing costs, acquisition and legal fees and other miscellaneous acquisition costs. Depreciation was computed using the straight-line method based upon the estimated useful lives of 3 to 25 years except for tenant improvements which are depreciated over the terms of the respective leases. Real Estate Held for Disposition - During 1998, the Partnership engaged brokers to market the Partnership's remaining Property for sale. In view of the anticipated sale of the Property, the Partnership's real estate assets, deferred rent receivable and prepaid leasing costs, which had a carrying value of $22,429,538 at December 31, 1998, were reclassified as Real Estate Assets Held for Disposition and were no longer depreciated or amortized. Cash Equivalents - Cash equivalents consist of short-term highly liquid investments which have maturities of three months or less from the date of purchase. The carrying amount approximates fair value because of the short maturity of these instruments. Restricted Cash - Restricted cash consists of amounts held for tenant security deposits. 5 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES Concentration of Credit Risk - Financial instruments which potentially subject the Partnership to a concentration of credit risk principally consist of cash in excess of the financial institution's insurance limits. The Partnership invests available cash with high credit quality financial institutions. Deferred Rent Receivable - Deferred rent receivable consists of rental income which is recognized on a straight-line basis over the terms of the respective leases even though rent is not received until later periods as a result of rental escalations. During 1998 deferred rent receivable was reclassified as real estate assets held for disposition and was no longer amortized. Prepaid Leasing Costs - Leases are accounted for as operating leases. Leasing commissions are amortized over the terms of the respective leases. During 1998 leasing commissions were reclassified as real estate assets held for disposition and were no longer amortized. Income Taxes - No provision for income taxes has been made in the financial statements of the Partnership since such taxes are the responsibility of the individual partners rather than of the Partnership. Fair Value of Financial Instruments - Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("FAS 107"), requires that the Partnership disclose the estimated fair values of its financial instruments. Fair values generally represent estimates of amounts at which a financial instrument could be exchanged between willing parties in a current transaction other than in forced liquidation. Fair value estimates are subjective and are dependent on a number of significant assumptions based on management's judgment regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. In addition, FAS 107 allows a wide range of valuation techniques, therefore, comparisons between entities, however similar, may be difficult. Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications - Certain prior year amounts have been reclassified in order to conform to the current year's presentation. 3. Partnership Agreement The Partnership agreement provides that net cash from operations, as defined, will be distributed on a quarterly basis as follows: 97% to the Limited Partners and 3% to the General Partners until each Limited Partner has received a 9% annual noncumulative return on his adjusted capital investment, as defined. The net cash from operations will then be distributed to the General Partners until the General Partners have received 10% of the aggregate net cash from operations distributed to all partners. The balance of net cash from operations, if any, will then be distributed 90% to the Limited Partners and 10% to the General Partners. Net proceeds from sales or refinancings shall be distributed as follows: 99% to the Limited Partners and 1% to the General Partners until each Limited Partner has received an amount equal to his adjusted capital investment, as defined, and a 10% cumulative annual return thereon, reduced by any net cash from operations actually distributed to such Limited Partner. The balance of net proceeds, if any, will then be distributed 85% to the Limited Partners and 15% to the General Partners. 6 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES Losses and all depreciation for any fiscal year shall be allocated 99% to the Limited Partners and 1% to the General Partners, provided, however, that the deficit balance of the General Partners' capital account does not exceed the amount they are required to contribute upon dissolution of the Partnership, as discussed below. If income exceeds the amount of net cash from operations distributable to the Partners for any fiscal year, the excess will be allocated (1) 100% to the General Partners in an amount equal to the excess, if any, of General Partners' deficit in their capital accounts, over an amount equal to 1% of the total capital contributions to the Partnership as reduced by the amount of the General Partners' capital contributions and (2) 99% to the Limited Partners and 1% to the General Partners. If income does not exceed the amount of net cash from operations distributable to the Partners for any fiscal year, income will be allocated 90% to the Limited Partners and 10% to the General Partners. In 1999, income was allocated to the General Partners such that their deficit did not increase beyond their obligations required by the Partnership Agreement, as discussed below. Upon the dissolution of the Partnership, the General Partners shall contribute to the capital of the Partnership, an amount not to exceed 1% of the total capital contributions made by all the Partners, less any prior capital contributions made by the General Partners. In no event shall the General Partners be obligated to contribute an amount in excess of any negative balance in their respective capital accounts. If as a result of the dissolution of the Partnership, the sum of the Limited Partners' capital contribution plus an amount equal to a 6% cumulative annual return on each Limited Partner's adjusted capital value less any distributions made to each Limited Partner from net cash flow from operations, exceeds total distributions to the Limited Partners of net proceeds from a sale or refinancing, the General Partners will contribute to the Partnership for distribution to the Limited Partners an amount equal to the lesser of such excess or the aggregate distribution of net proceeds from a sale or refinancing distributed to the General Partners. 4. Real Estate Investments Since inception, the Partnership acquired, directly or indirectly, the following three commercial office buildings and an office and light industrial complex. The purchase price amounts exclude acquisition fees and other closing costs. Net Leasable Square Date Type of Purchase Property Name Feet Location Acquired Ownership Price - --------------------------------------------------------------------------------------- Metro Park Fort Myers, Joint Executive Center 60,597 Florida 1/17/85 Venture $ 5,136,504 Three Financial Little Rock, Joint Centre 123,833 Arkansas 1/22/85 Venture $10,452,005 Fort Lauderdale Fort Lauderdale, Fee Commerce Center 186,884 Florida 4/18/85 Simple $12,843,569 Quorum II Dallas, Office Building 84,094 Texas 6/12/85 (A) $12,995,384 - --------------------------------------------------------------------------------------- (A) The Partnership is the General Partner in a Limited Partnership. 7 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES The Joint Venture and Limited Partnership agreements substantially provide or provided that: i. Net cash from operations will be distributed 100% to the Partnership until it has received an annual, noncumulative return on its adjusted capital balance, as defined, of 10.5% for Three Financial Centre, 12% for Metro Park, and 10% for Quorum. With regard to Three Financial Centre, net cash from operations will then be distributed 100% to the co-venturer until it has received an annual amount of $115,000. Thereafter, any remaining net cash from operations will be distributed 80% to the Partnership and 20% to the respective co-venturers. ii. Net proceeds from a refinancing or other interim capital transaction of the properties will be distributed 100% to the Partnership until it has received 115% of its capital contribution and a cumulative return of 12% for Metro Park, and 10% for Quorum on its adjusted capital investment, as defined. With regard to Three Financial Centre, net proceeds will be distributed 93% to the Partnership and 7% to the respective co-venturers. iii. Net proceeds from a sale of the properties will generally be distributed to the venturers, pro rata in accordance with each venturer's capital account balance. iv. Income will be allocated in substantially the same manner as net cash from operations. For Three Financial Centre and Metro Park, net income in excess of net cash from operations distributed in such year shall be allocated 80% to the Partnership and 20% to the co-venturers. Losses and all depreciation will generally be allocated 100% to the Partnership. On January 12, 1999, the Partnership completed the sale of Quorum II Office Building to an unaffiliated partnership, for a selling price of $7,612,065, net of closing adjustments and selling costs. The selling price was determined by arm's length negotiations between the Partnership and the buyer. The sale resulted in a gain on sale of real estate in the amount of $2,894,064, which has been reflected in the Partnership's consolidated statement of operations for the year ended December 31, 1999. On February 9, 1999, the Partnership completed the sale of Metro Park Business Center to an unaffiliated partnership, for a selling price of $3,797,438, net of closing adjustments and selling costs. The selling price was determined by arm's length negotiations between the Partnership and the buyer. The sale resulted in a gain on sale of real estate in the amount of $565,698, which has been reflected in the Partnership's consolidated statement of operations for the year ended December 31, 1999. On April 14, 1999, the Partnership completed the sale of Ft. Lauderdale Commerce Center to an unaffiliated partnership, for a selling price of $12,465,291, net of closing adjustments and selling costs. The sale resulted in a gain of $3,371,728, which has been reflected in the Partnership's consolidated statement of operations for the year ended December 31, 1999. On January 31, 2000, the Partnership sold its remaining Property, Three Financial Centre. See Note 8 "Subsequent Event." 5. Rental Income Under Operating Leases Future minimum rental income to be received on noncancelable operating leases as of December 31, 1999 on the remaining property is as follows: 8 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES -------------------------------------- 2000 $1,560,630 2001 1,002,290 2002 704,109 2003 539,718 2004 372,936 Thereafter 1,426,567 -------------------------------------- $5,606,250 ========== Generally, leases are for terms of 2 to 10 years and contain renewal options. The leases allow for increases in certain property operating costs to be passed on to the tenants. 6. Transactions with General Partners and Affiliates The following is a summary of amounts earned by, or reimbursed to, the General Partners and their affiliates for property management fees and out-of-pocket expenses during the years ended December 31, 1999, 1998 and 1997: Unpaid at Earned December 31, ----------------------------------------- 1999 1999 1998 1997 - ------------------------------------------------------------------------------------------ Real Estate Services and affiliates Salary reimbursement $ 40,000 $ 59,876 $ 59,283 $ 111,862 HS Advisors and affiliates Out of pocket expenses -- 524 1,504 3,196 Property management fees (GSH) 8,376 33,192 33,192 37,995 - ------------------------------------------------------------------------------------------ $ 48,376 $ 93,592 $ 93,979 $ 153,053 ----------------------------------------------------- Commencing January 1, 1997, the Partnership began reimbursing certain expenses incurred by Real Estate Services VII, Inc. and its affiliates in servicing the Partnership to the extent permitted by the partnership agreement. In prior years, affiliates of the Real Estate Services VII, Inc., general partner, had voluntarily absorbed these expenses. 7. Reconciliation of Financial Statement Net Income to Federal Income Tax Basis Net Income Years Ended December 31, ----------------------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------------------ Financial statement net income $ 8,403,060 $ 1,747,214 $ 42,860 Tax basis depreciation and amortization over financial statement depreciation and amortization (796,012) (1,155,094) (203,613) Deferred rent 17,581 50,521 53,688 Minority interest 117,047 234,755 107,459 Gain on sale 1,581,996 -- -- Adjustment for minority interest (302,897) -- -- Bad debt expense 90,918 -- -- - ------------------------------------------------------------------------------------------ Federal income tax basis net income $ 9,111,693 $ 877,396 $ 394 ========================================= 9 COMMERCIAL PROPERTIES 3, L.P. AND CONSOLIDATED VENTURES 8. Subsequent Event On January 31, 2000, the Partnership sold its remaining Property, Three Financial Centre, to an affiliate of the Joint Venture Partner, Three Financial Centre LLC ("3FCLLC"), for a selling price of approximately $10,130,000, net of closing adjustments and selling costs. The sale is expected to result in a gain of approximately $4,100,000 which will be reflected in the Partnership's consolidated operations for the three months ended March 31, 2000. The selection of the buyer was a result of a competitive bidding process organized by the real estate broker engaged to assist in selling the Property. The General Partners plan to distribute the net proceeds from the sale, together with the Partnership's remaining cash reserves (after payment of or provision for the Partnership's liabilities and expenses), and terminate the Partnership during the second quarter 2000. 10 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT AUDITORS - -------------------------------------------------------------------------------- General and Limited Partners Commercial Properties 3, L.P. and Consolidated Ventures We have audited the accompanying consolidated balance sheets of Commercial Properties 3, L.P. and Consolidated Ventures as of December 31, 1999 and 1998, and the related consolidated statements of operations, partners' capital (deficit) and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the 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 financial statements referred to above represent fairly, in all material respects, the consolidated financial position of Commercial Properties 3, L.P. and Consolidated Ventures at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ERNST & YOUNG LLP New York, New York February 2, 2000 11 - -------------------------------------------------------------------------------- NET ASSET VALUATION - -------------------------------------------------------------------------------- Comparison of Acquisition Costs to Estimated Value and Determination of Net Asset Value Per $283.44 Unit at December 31, 1999 (Unaudited) Acquisition 1999 Estimated Property Date of Acquisition Cost(1) Value - -------------------------------------------------------------------------------------- Three Financial Centre (2)(3) 01-22-85 $11,378,512 $ 10,130,000 ------------ Cash and cash equivalents 4,785,516 Accounts and rent receivable, net 65,401 Prepaid expense and other assets 21,282 ------------ 15,002,199 Less: Accounts payable and accrued expenses 233,207 Prepaid rent 17,581 Due to affiliates 48,376 Minority Interest 701,361 ------------ Partnership Net Asset Value(4) $ 14,001,674 ============ Net Asset Value Allocated: General Partners $ 140,017 Limited Partners 13,861,657 ------------ $ 14,001,674 ============ Net Asset Value Per Unit (109,378 units outstanding) $ 126.73 - -------------------------------------------------------------------------------------- (1) The acquisition cost of each property is comprised of fundings made through December 31, 1999, the acquisition fee paid to the General Partners and an amount estimated to fund the completion of tenant improvements. (2) This represents the Partnership's share of the December 31, 1999 estimated values which were determined by the General Partners, with the assistance of the broker engaged to market the properties. The Partnership's share of the December 31, 1999 estimated value takes into account the allocation provisions of the joint venture and limited partnership agreements governing the distribution of sales proceeds for each of the above properties. (3) Estimated value is based on the actual net sales price of the property. (4) The Net Asset Value assumes a hypothetical sale on December 31, 1999 of the Partnership's property at its estimated value and the distribution of the net proceeds to Limited Partners in the liquidation of the Partnership. However, the Net Asset Value does not reflect the expenses to be incurred with the wind-down and termination of the Partnership. Therefore, the cash available for distribution to the limited partners may be less than the Net Asset Value. Limited Partners should note that as a result of the illiquid nature of an investment in Units of the Partnership, the variation between the estimated value of the Partnership's property and the price at which Units of the Partnership could be sold may be significant. Fiduciaries of Limited Partners which are subject to ERISA or other provisions of law requiring valuations of Units should consider all relevant factors, including, but not limited to Net Asset Value per Unit, in determining the fair market value of the investment in the Partnership for such purposes. 12 Schedule III - Real Estate and Accumulated Depreciation December 31, 1999 Three Consolidated Ventures: Financial Centre - ------------------------------------------------------------------------------- Location Little Rock, AR Construction date 1984 Acquisition date 01-22-85 Life on which depreciation in latest income statements is computed 1-25 yrs Encumbrances -- Initial cost to Partnership: Land $ 1,018,332 Buildings and improvements 10,419,160 Costs capitalized subsequent to acquisition: Land, buildings and improvements 12,789 Deferred rent (207,025) Leasing commissions 376,489 Gross amount at which carried at close of period(1): Land $ 1,018,332 Buildings and improvements 10,431,949 Deferred rent (207,025) Leasing commissions 376,489 ------------ 11,619,745 ------------ Accumulated depreciation (2) $ 5,645,699 - ------------------------------------------------------------------------------- (1) For Federal income tax purposes, the basis of land, building and improvements is $11,425,926. (2) For Federal income tax purposes, the amount of accumulated depreciation is $8,540,334. A reconciliation of the carrying amount of real estate and accumulated depreciation for the years ended December 31, 1999, 1998 and 1997 follows: 1999 1998 1997 - ------------------------------------------------------------------------------- Real estate investments: Beginning of year $ 38,294,245 $ 36,942,494 $ 36,640,226 Additions 671,910 1,351,751 796,801 Deletions (27,221,757) -- (494,533) Write offs (124,653) -- -- -------------------------------------------- End of year $ 11,619,745 $ 38,294,245 $ 36,942,494 -------------------------------------------- Accumulated depreciation: Beginning of year $ 15,864,707 $ 14,910,677 $ 13,546,913 Depreciation expense 15,460 954,030 1,858,297 Deletions (10,234,468) -- (494,533) -------------------------------------------- End of year $ 5,645,699 $ 15,864,707 $ 14,910,677 - ------------------------------------------------------------------------------- F-1 EX-23 3 CONSENT OF INDEPENDENT AUDITORS EXHIBIT 23 Consent of Independent Auditors Consent of Independent Auditors We consent to the incorporation by reference in this Annual Report (Form 10-K) of Commercial Properties 3, L.P. of our report dated February 2, 1999, included in the 1999 Annual Report to Shareholders of Commercial Properties 3, L.P. and Consolidated Ventures. Our audit also included the financial statement schedule of Commercial Properties 3, L.P. and Consolidated Ventures listed in Item 14(a)(2). This schedule is the responsibility of the Partnership's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ERNST & YOUNG LLP New York, New York February 2, 2000 EX-27 4 FDS -- FOR 1999 FORM 10-K 5 12-mos Dec-31-1999 Dec-31-1999 4,785,516 000 161,763 96,362 000 4,928,948 5,974,046 000 10,924,276 377,195 000 000 000 000 9,845,720 10,924,276 000 3,313,497 000 000 1,624,880 000 000 1,571,570 000 1,571,570 000 6,831,490 000 8,403,060 76.06 76.06 -----END PRIVACY-ENHANCED MESSAGE-----

HIGHLANDS BANKSHARES INC /VA/

10-K

https://www.sec.gov/Archives/edgar/data/1008579/0001002105-03-000077.txt

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2002 Commission File Number 430893107 HIGHLANDS BANKSHARES, INC. (Exact name of registrant as specified in its charter) Virginia 54-1796693 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification No.) 340 West Main Street Abingdon, Virginia 24210-1128 (Address of Principal Executive Offices) (Zip Code) (276) 628-9181 Registrant's telephone number, including area code Securities registered pursuant to Section 12(b) of the Act: Name of Each Exchange Title of Each Class on Which Registered ------------------- ------------------- None n/a Securities registered pursuant to Section 12(g) of the Act: Common Stock, $1.25 par value (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods 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___ 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 an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ___ No _X_ State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity as of the last business day of the registrant's most recently completed second fiscal quarter. $53,341,288 Indicate the number of shares outstanding of each of the registrant's classes of common stock as of the latest practicable date. As of March 13, 2002, there were 2,650,729 shares of Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Annual Report to Shareholders for the fiscal year ended December 31, 2002 --Parts I and II Proxy Statement for the 2003 Annual Meeting of Shareholders--Part III Table of Contents Page Number ----------- Part I Item 1. Business 3-26 Item 2. Properties 27-28 Item 3. Legal Proceedings 28 Item 4. Submission of Matters to a Vote of Security Holders 28 Part II Item 5. Market for Registrant's Common Equity And Related Stockholder Matters 29-30 Item 6. Selected Financial Data 30 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation 31 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 31 Item 8. Financial Statements and Supplemental Data 31 Item 9. Changes in and Disagreements With Accountants With Accountants on Accounting and Financial Disclosure 31 Part III Item 10. Directors and Executive Officers of the Registrant 31 Item 11. Executive Compensation 31 Item 12. Security Ownership of Certain Beneficial Owners and Management And Related Stockholder Matters 32 Item 13. Certain Relationships and Related Transactions 32 Item 14. Controls and Procedures 32 Part IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 32-33 2 Forward-Looking Information This report contains forward-looking statements with respect to the financial condition, results of operations and business of Highlands Bankshares, Inc. (the "Corporation"). These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of the management of the Corporation, and on the information available to management at the time that these disclosures were prepared. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and / or a reduced demand for credit; (4) legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses in which the Corporation and its subsidiaries are engaged; (5) costs or difficulties related to the integration of the businesses of the Corporation and its merger partners may be greater than expected; (6) expected cost savings associated with pending mergers may not be fully realized or realized within the expected time frame; (7) deposit attrition, customer loss or revenue loss following pending mergers may be greater than expected; (8) competitors may have greater financial resources and develop products that enable such competitors to compete more successfully than the Corporation and its subsidiaries; and (9) adverse changes may occur in the securities markets. Part I. Item I. Business General The Corporation was incorporated in Virginia in 1995 to serve as the holding company for Highlands Union Bank, (the "Bank"). The shareholders of the Bank approved the Plan of Reorganization at the Annual Meeting on December 13, 1995, and the reorganization was consummated on December 29, 1995 with the Bank becoming a wholly-owned subsidiary of the Corporation. The Bank is a state charted bank with principal offices in Abingdon, Virginia. The Bank was incorporated in 1985. At December 31, 2002, the Corporation had total assets of $485,603,000 deposits of $410,301,000 and net worth of $32,199,000. The Corporation's principal business activities, which are conducted through the Bank, are attracting checking and savings deposits from the general public through its retail banking offices and originating and servicing loans secured by first mortgage liens on single-family dwellings, including condominium units. All of the retail banking offices are located in Virginia, North Carolina and Tennessee. The Corporation also lends funds to retail banking customers by means of home equity and installment loans, and originates construction loans and loans secured by commercial property, multi-family dwellings and manufactured housing units. The Corporation opened an indirect lending department in 1997. The majority of indirect lending originates through new and used car dealerships. The indirect lending portfolio comprises a significant portion of the total consumer loan portfolio. The Corporation invests in certain U.S. Government and agency obligations and other investments permitted by applicable laws and regulations. The operating results of the Corporation are highly dependent on net interest income, 3 the difference between interest income earned on loans and investments and the cost of checking and savings deposits and borrowed funds. The Bank is a member of the Federal Deposit Insurance Corporation ("FDIC"), and its deposit accounts are insured up to $100,000 as required by FDIC guidelines. The Bank is also a member of the Federal Reserve System, as such, the Bank and the Corporation are subject to the supervision, regulation and examination of the Federal Reserve. As a Virginia state chartered bank, the Bank is also subject to supervision, regulation and examination by the Virginia State Corporation Commission. The Corporation has two direct subsidiaries as of December 31, 2002: the Bank, which was formed in 1985, and Highlands Capital Trust I, a statutory business trust (the "Trust") which was formed in 1998. The Corporation's material assets as of December 31, 2002 include: cash in bank of approximately $1.1 million; building, land, and equipment with a net book value of approximately $1.47 million; approximately $3.9 million in loan participations from the Bank; approximately $345 thousand in other assets; and its investment in subsidiaries, approximately $33.06 million. The Corporation's only material liability is the note payable on the trust preferred debentures issued in January of 1998, $7.5 million. The Bank has two wholly-owned subsidiaries, Highlands Union Insurance Services, Inc., which was formed in 1999 and Highlands Union Financial Services, Inc. which was formed in 2001. The Bank, through Highlands Union Insurance Services, Inc., joined a consortium of approximately sixty other financial institutions to form Bankers' Insurance, LLC. Bankers' Insurance, LLC, as of December 31, 2002, had purchased seven full service insurance agencies across the state of Virginia. Highlands Union Insurance Services, Inc. will be used to sell insurance services through the Bankers' Insurance, LLC. Highlands Union Financial Services, Inc. was formed in order for the Bank to continue to offer third-party mutual funds, annuities and other financial services to its customers in all market areas served. Also during 2002, the Bank became an equity owner in the Virginia Title Center, LLC. This entity is owned by approximately 16 member banks located in Southwest Virginia.. The organization is involved in the underwriting and issuance of title insurance on real estate closings, primarily as a result of referrals from the member banks. As of December 31, 2002, the Corporation operates one express and eight full-service banking facilities throughout Washington County, Virginia, the City of Bristol, Virginia, Marion, Virginia, Glade Spring, Virginia, Rogersville, Tennessee and Boone, North Carolina. The Corporation also opened a loan production office in the fourth quarter of 2001. This office is located in Kingsport, Tennessee and offers a full range of loan products to customers in the Northeast Tennessee area. The Corporation also operates twenty-eight off-site ATM's throughout the service areas listed above as well as Russell County, Virginia, Wythe County, Virginia, Bristol, Tennessee and Banner Elk, North Carolina. The results of operations for the fiscal years ended December 31, 2002, 2001, and 2000 ("fiscal year 2002", "fiscal year 2001" and "fiscal year 2000", respectively) reflect the Corporation's strategies of expanding its community banking operations. See "Management's Discussion and Analysis" of operations and financial condition, included as part of the Annual Report to Shareholders, for a detailed discussion of certain aspects of the Corporation's business. 4 During the second quarter of 2002, the Bank purchased approximately $7.38 million in bank owned life insurance. The policies were issued to insure the lives of a selected number of officers and directors of the Bank. The Bank is the named beneficiary, and the premiums were allocated among four separate highly rated carriers. The earnings related to the policies will be used to offset future employee benefit costs. The life insurance purchased by the Bank will remain a corporate asset even after the employer / employee relationship is terminated. The Bank has also entered into a separate agreement with each of the insureds to provide their named beneficiary(s) a separate death benefit. This amount is approximately 20% of the proceeds received by the Bank from the various carriers and requires that the named insureds are actively employed or still serving as a director upon death. This death benefit amount will be fully taxable to the recipient(s) and tax deductible to the Bank. Lending Activities Residential Mortgage Lending The Bank's lending policy is generally to lend up to 80% of the appraised value of residential property. The Bank lends up to 95% of the appraised value with the normal requirement of insurance from private mortgage insurance companies. This insurance normally covers amounts in excess of 80% loan to value up to 95%. The in-house residential mortgages are comprised of primarily one, three and five year adjustable rate mortgages and 15 year fixed rate mortgages as well as three and five year balloon mortgages. Adjustable rate mortgages are indexed to 275 basis points over the average yield on United States Treasury securities adjusted to a constant maturity of one, three or five years. An adjustment limitation (increase or decrease) of 2% per annum applies to the one year adjustable product. A 4% lifetime cap over the initial rate of the loan is included in the one, three and five year adjustable rate mortgages. The Bank's existing loan contracts generally provide for repayment of residential mortgage loans over periods ranging from 15 to 30 years. However, such loans normally have remained outstanding for much shorter periods of time as borrowers refinance or prepay their loans through the sale of their homes. Most of the Bank's residential mortgage loans have "due on sale" clauses which allows the creditor the right to declare a loan immediately due and payable in the event the borrower sells or otherwise disposes of the real property. Most of the Bank's residential mortgage loans are not assumable. Aggregate debt to any one borrower exceeding $850,000 but less than $2,000,000 must be approved by the loan committee of the Board of Directors. Loan requests in excess of the customer's aggregate debt of $2,000,000 must be approved by the Board of Directors. All of the Bank's mortgage lending is subject to loan origination procedures established by the Board of Directors. Most originations require a property valuation by state licensed appraisers, for a fee, approved by the Board of Directors. Loan applications are obtained to determine the borrowers ability to repay. Significant items are verified through the use of credit reports, financial statements, etc. It is generally the Bank's policy to require title insurance on first mortgage loans in excess of $50,000 (lower where deemed necessary). It is also the Bank's general policy to require 5 an attorney's opinion statement on all first mortgage deeds of trust. Fire and casualty insurance (extended coverage) is required on all property serving as security for these loans. Hazard insurance and flood insurance (where required) is provided by the customer prior to closing of the loan. The borrower is responsible for paying insurance premiums and real estate taxes. Federal regulations allow the Bank to originate loans on real estate within its designated market area, and within limits, to originate and purchase loans or loan participations secured by real estate located in any part of the United States. During fiscal year 2002 the Bank's primary lending area was Washington County, Virginia , the City of Bristol, Virginia, Smyth County, Virginia, Hawkins County, Tennessee, Sullivan County, Tennessee and Watauga County, North Carolina. Residential loan originations come from many sources. Some of these sources include existing customers, walk-in applications, referrals from real estate brokers and others. Federal regulation limits loans to one borrower to a maximum of 15% of unimpaired capital and unimpaired surplus of the Bank. The Bank receives fees in addition to interest in connection with real estate loan originations, loan modifications, late payments, etc. Income from these activities varies from period to period depending on the volume and type of loan made. Although not a significant portion of the Bank's income, late charges are received when monthly payments are delinquent but are later paid. The Bank also offers secondary market fixed rate mortgages with terms up to 30 years and up to 95% loan to value. These loans and servicing rights are generally sold immediately into the secondary market and fees received are booked into income. These loans must meet certain criteria generally set by the secondary market. Residential mortgages, including equity lines of credit, made up approximately 41.38% of the loan portfolio as of December 31, 2002. Construction and Commercial Real Estate Lending The Bank generally makes construction loans for periods up to one year on residential and commercial real estate property. These loans are for interim financing and are either paid off or converted to permanent financing when completed. At December 31, 2002, outstanding construction loans (net of undisbursed funds) totaled $8,359,000. These loans are generally made at 80% or less of appraised value at completion. Funds are advanced as the project is completed after an inspection by a staff inspector or the appraiser as deemed appropriate. These loans are made based on established corporate underwriting standards. Most of these construction loans are one to four family dwellings. The Bank generally charges a 1% origination fee on these construction loans in addition to applicable interest. Loans on commercial properties, multi-family dwellings, and apartment buildings are typically made at 75% to 80% of the appraised value. These loans totaled $78,578,000 or 23.13% of total loans held for investment at December 31, 2002. Commercial and construction loans, by nature, entail additional risk as compared to residential mortgage lending. They are generally more complex and involve larger balances than typical residential mortgages. Payments are typically dependent upon successful operation of a 6 related real estate project or business as compared to individual earnings on most residential mortgages. Therefore, the market risk is somewhat greater. Construction delays, cost overruns or the inability of the contractor to sell the finished product add an element of risk to such lending. Consumer lending The Bank offers other types of loans in addition to real estate mortgage and construction loans. Consumer loans of many types are offered by the Bank. Some of these loans are loans to purchase automobiles, boats, recreational vehicles and manufactured housing, as well as other secured and unsecured consumer loans, including credit cards. The Bank further makes loans secured by savings accounts at 5% above the rate of the savings instrument. The Bank also makes loans secured by certificates of deposit issued internally. The terms generally do not exceed ten years for manufactured housing loans and five years on other consumer loans. Outstanding consumer loans at December 31, 2002 were $57,628,000. The Bank maintains a significant portfolio of dealer paper originated through its indirect lending department. As of December 31, 2002 this portfolio had a balance of $23,280,000 included in the $57 million above. Commercial and agriculture non-real estate loans The Bank also makes commercial (including agriculture) non-real estate loans. These loans in general have higher risks associated with them than real estate loans. They are generally secured by inventory, equipment, accounts receivable, etc., or unsecured in some cases backed by appropriate financial condition as per the underwriting standards of the Bank. Agriculture loans are generally secured by machinery, equipment, other miscellaneous assets or unsecured in keeping with the underwriting standards of the Bank. The timely pay back is dependent upon the successful operation of the business or farm. The outstanding balance of non-real estate commercial loans was $37,371,000 at December 31, 2002, and the outstanding balance of non-real estate agriculture loans was $4,871,000 at December 31, 2002. Investments Investment Securities The Corporation invests in mortgage-backed securities, agency notes and bonds, collateralized mortgage obligations (CMO's), municipal bonds, agency equity securities, asset-backed securities, equity securities and trust preferred securities. A substantial portion of the mortgage-backed security portfolio consists of securities that are either insured or guaranteed by FHLMC, FNMA or GNMA. Guaranteed securities are more liquid than individual mortgage loans. At December 31, 2002, the Corporation's mortgage-backed securities portfolio had a carrying value of $57,729,952 or 11.89% of total assets compared to $53,957,000 or 11.89% of total assets at December 31, 2001. Amortized costs of mortgage-backed securities were $53,483,000 at December 31, 2001 and $57,051,975 for the comparable 2002 period. Due to repayments and prepayments of the underlying loans, the actual maturities of mortgage-backed securities are expected to be substantially less than the scheduled maturities. The Corporation held investments in CMO's for the years ended December 31, 2002 and 2001. At December 31, 2002 and 2001, the Corporation had carrying value of CMO's of 7 $2,305,000 and $8,885,000, respectively. These carrying values represent .47% and 1.96% of total assets for the respective year-ends. Amortized cost of CMO's were $2,292,000 and $8,901,000 as of December 31, 2002 and 2001. The Corporation invests in municipal securities that are bank-qualified. As of December 31, 2002 and 2001, the Corporation had carrying values of $30,719,000 and $24,305,000 respectively. These investments represent 6.33% and 5.36% of total assets as of December 31, 2002 and 2001. The Corporation also invests in agency equity securities. As of December 31, 2002 and 2001 the Corporation had carrying values of $8,278,000 and $5,723,000, respectively. The Corporation holds the following equity investments: Federal Reserve Bank Stock of $295,000 for the periods ending December 31, 2002 and 2001 respectively; Federal Home Loan Bank Stock of $1,832,000 and $1,621,000 for the same dates as above; and Community Bankers' Bank Stock of $54,750 and $54,750 for the same dates as above. The Corporation also holds investments in corporate bonds of $2,201,000 and $2,229,000 as of December 31, 2002 and 2001 respectively. These investments represented approximately 0.47% and 0.49% of total assets at those dates. The Corporation holds investments in SLMA and SBA issued securities. At December 31, 2002 the Corporation had $1,413,000 in carrying value in these investments. Investment Activities Under Federal Reserve regulations, the Bank is required to maintain certain liquidity ratios and does so by investing in certain obligations and other securities that qualify as liquid assets. See "Regulation". As a state chartered bank, the Bank's investment authority is limited by federal and state law which permits investment in, among other things, certain certificates of deposit issued by commercial banks, banker's acceptances, loans to commercial banks for Federal Funds, United States government and agency obligations of state governments, and corporate bonds. The Corporation's internal investment committee, made up of the CEO, Cashier, CFO and V.P. of Accounting, meets routinely to determine portfolio strategies following Federal Reserve guidelines with respect to portfolio investment and accounting. The Committee performs pre-purchase and pre-sale analysis on all individual securities and presents this information to the full board of directors monthly. Such Federal Reserve guidelines state that insured institutions must account for securities held for investment, sale and/or trading in accordance with generally accepted accounting principles. The Corporation maintains a written investment policy to set forth investment portfolio composition and investment strategy. The investment portfolio composition policy considers, among other factors, the financial condition of the institution, the types of securities, amounts of investments in those securities and safety and soundness considerations pertaining to the institution. The investment strategy considers, among other factors, interest rate risk, anticipated maturity of each type of investment and the intent of the institution with respect to each investment. 8 Sources of Funds General Deposit accounts have traditionally been the principal source of the Corporation's funds for use in lending and for other general business purposes. In addition to deposits, the Corporation derives funds from loan repayments, repayments from securities, Federal Home Loan Bank System ("FHLB") advances, the national certificate of deposit market and loan participation sales. Borrowings and the national certificate of deposit market may be used on a short-term basis to compensate for seasonal or other reductions in deposits or inflows at less than projected levels, as well as on a long-term basis to support expanded lending activities. Deposit Activities The Corporation, in its continuing effort to remain a competitive force in its markets, offers a wide variety of deposit services, with varied maturities, minimum-balance requirements and market-sensitive interest rates that are attractive to all types of depositors. The Corporation's deposit products include checking accounts, statement savings accounts, money market deposit accounts, negotiable orders of withdrawal accounts, individual retirement accounts and certificates of deposit accounts. The Corporation is able to offer a broad array of products that are consistent with current Federal Reserve regulations, and as a major result, the Corporation's deposit portfolio is, for the most part, sensitive to general market fluctuations. The following table sets forth the deposit liabilities of the Corporation for the year ended December 31, 2002. 2002 Weighted Minimum Amount Average Balance in % of Type of Account Rate Term Deposit Thousands Total --------------- ---- ---- ------- --------- ----- Checking Account 0.00% none $ 100.00 $55,597 13.55% Interest Checking 1.35 none 100.00 26,028 6.34 Statement Savings 2.07 none 25.00 70,258 17.12 Money Market Deposit Accounts 2.24 none 500.00 23,491 5.73 Christmas Club Accts. 2.26 none 5.00 70 0.02 Individual Retirement Accounts 5.53 various 500.00 44,030 10.73 Certificates of Deposit Accounts 3.81 various 500.00 190,827 46.51 ------- ----- Totals $410,301 100.00% -------- ------- The variety of deposit accounts offered by the Corporation and the competitive rates paid on these deposit accounts have increased the Corporation's ability to retain deposits and has allowed it to be more competitive in obtaining new funds, reducing the threat of disintermediation (the flow of funds away from deposit institutions into direct investment vehicles such as government and corporate securities). As customers have become more rate conscious and willing to move funds to higher yielding accounts, the ability of the Corporation to attract and maintain deposits and the Corporation's cost of funds have been, and will continue to be, significantly affected by money market conditions. The following table sets forth information relating to the Corporation's deposit flows during the years indicated. 9 Years Ended December 31, (In Thousands) 2002 2001 2000 -------------- ---- ---- ---- Increase (decrease) in deposits before interest credited back to accounts $ 5,452 $ 28,516 $ 25,586 Interest credited back to accounts 12,756 17,262 14,536 -------- -------- -------- Net increase in deposits 18,208 45,778 40,122 -------- -------- -------- Total deposits at year end $410,301 $392,093 $346,315 -------- -------- -------- Borrowings The Corporation may obtain advances from the FHLB upon the security of the capital stock it owns in the bank and certain of its home mortgage loans, provided certain standards related to creditworthiness have been met. Such advances may be made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities, and the FHLB prescribes the acceptable uses to which the advances pursuant to each program may be used, as well as limitations on the size of such advances. Depending on the program, such limitations are based either on a fixed percentage of the Corporation's net worth or on the FHLB's assessment of the Corporation's creditworthiness. The FHLB is required to review its credit limitations and standards at least once every six months. FHLB advances have from time to time been available to meet seasonal and other withdrawals of savings accounts and to expand lending. The Bank also has established credit arrangements with several of its correspondent banks. At December 31, 2002, the Bank had approximately $95,228,000 of unused lines of credit, including FHLB unused lines of credit, to fund any necessary cash requirements. The following table sets forth certain information as to the Corporation's advances and other borrowings at the dates indicated. See Notes 9, 10, and 11 to the Consolidated Financial Statements, included as part of the Annual Report to Shareholders, for information as to rates, maturities, average balances and maximum amounts outstanding. Years Ended December 31, (In Thousands) 2002 2001 2000 -------------- ---- ---- ---- Advances from FHLB $ 33,072 $ 23,214 $ 23,357 Guaranteed preferred beneficial interests in corporation's junior subordinated debt securities 7,500 7,500 7,500 Other borrowings 222 269 312 -------- -------- --------- Total Borrowings $ 40,794 $ 30,983 $ 31,169 In January 1998, the Corporation issued $7,500,000 of trust-preferred securities through its subsidiary Highlands Capital Trust I. The proceeds from this issue are included in the Corporations' Tier 1 and Tier 2 capital up to specified levels according to federal regulations. The subordinated notes were issued with a final maturity of 30 years and a ten-year call option at the discretion of the Corporation. The issuance of these trust-preferred securities has enabled the 10 Corporation to continue expansion while maintaining a well-capitalized position according to regulatory standards. Competition The Corporation encounters competition for both deposits and loans. For deposits, competition comes from other commercial banks, savings and loan associations and/or savings banks, mutual money market funds, credit unions and various other corporate and financial institutions. Competition also comes from interest paying obligations issued by various levels of government and from a variety of securities paying dividends or interest. Competition for loans comes primarily from other commercial banks, savings and loan associations and/or savings banks, insurance companies, mortgage companies and other lending institutions. Employees The Corporation, at December 31, 2002, had 202 full time employees. None of these employees are represented by a collective agent, and the Corporation believes its employee relations are excellent. Subsidiaries The Corporation was incorporated in Virginia in 1995 to serve as the holding company for the Bank. The Bank is a state chartered bank with its principal offices in Abingdon, Virginia. The Bank was incorporated in 1985 under the laws of the Commonwealth of Virginia. The Corporation formed a statutory business trust, Highlands Capital Trust I, in January 1998 to issue trust preferred securities in order to raise additional capital. The Bank formed a wholly-owned subsidiary, Highlands Union Insurance Services, Inc., in 1999 for the purpose of selling insurance services through Bankers' Insurance, LLC. The Bank, through Highlands Union Insurance Services, Inc. joined a consortium of approximately sixty other financial institutions to form Bankers' Insurance, LLC. Bankers' Insurance LLC, as of December 31, 2002, had purchased seven full service insurance agencies across the state of Virginia. The Bank also formed a wholly-owned subsidiary, Highlands Union Financial Services, Inc., in 2001 for the purpose of selling non-banking financial products through Independent Community Bankers' Association Financial Services. Federal Home Loan Bank System The Bank is a member of the FHLB, which consists of 12 regional FHLB banks. The FHLB is regulated by the Federal Housing Finance Board ("FHFB"). The FHFB is composed of five members, including the Secretary of Housing and Urban Development and four private citizens appointed by the President with the advice and consent of the Senate for terms of seven years. At least one director must be chosen from organizations with more than a two-year history of representing consumer or community interests on banking services, credit needs, housing or financial consumer protections. The Bank, as a member of the FHLB of Atlanta, is required to purchase and maintain stock in its bank in an amount as if 30 percent of the member's assets were home mortgage loans. 11 The FHFB is required to adopt regulations establishing standards of community investment or service for members of the FHLB as a condition for continued access to advances. The regulations are to take into account the record of performance of the institution under the Community Reinvestment Act of 1977 and its record of lending to first time homebuyers. In addition, new collateral requirements for advances are to be established which will be designed to insure credit quality and marketability of the collateral. Regulation General The Corporation and its subsidiaries are subject to the supervision, regulation and examination of the Federal Reserve Board, the Federal Deposit Insurance Corporation and the state regulators of the Commonwealth of Virginia which has jurisdiction over financial institutions. The Corporation and its subsidiaries has obtained regulatory approval for its various activities to the extent required. Federal and State Laws and Regulations Bank holding companies and banks are extensively regulated under federal and state law. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to such statutes and regulations. Any change in applicable law or regulation may have a material effect on the business of the Corporation and its subsidiaries. Bank Holding Company Regulation The Corporation is registered as a "bank holding company" with the Board of Governors of the Federal Reserve System ("Federal Reserve"), and is subject to supervision by the Federal Reserve under the Bank Holding Corporation Act of 1956 ("BHC Act"). The Corporation is required to file with the Federal Reserve periodic reports and such additional information as the Federal Reserve may require pursuant to the BHC Act. The Federal Reserve examines the Corporation and the Bank. The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for it's authorized subsidiaries. A bank holding company may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. 12 Bank Regulation The Bank, as a state chartered member of the Federal Reserve, is subject to regulation and examination by the Virginia State Corporation Commission and the Federal Reserve Board. In addition, the Bank is subject to the rules and regulations of the Federal Deposit Insurance Corporation, which currently insures the deposits of each member bank to a maximum of $100,000 per depositor. The commercial banking business is affected by the monetary policies adopted by the Federal Reserve Board. Changes in the discount rate on member bank borrowings, availability of borrowing at the "discount window", open market operations, the imposition of any changes in reserve requirements against member banks' deposits and certain borrowings by banks and their affiliates, and the limitation of interest rates which member banks may pay on deposits, are some of the instruments of monetary policy available to the Federal Reserve Board. Taken together, these controls give the Federal Reserve Board a significant influence over the growth and profitability of all banks. Management of the Bank is unable to predict how the Federal Reserve Board's monetary policies (or the fiscal policies or economic controls imposed by Federal or state governments) will affect the business and earnings of the Bank or the Corporation, or what those policies or controls will be. The references in this section to various aspects of supervision and regulation are brief summaries which do not purport to be complete and which are qualified in their entirety by reference to applicable laws, rules and regulations. Federal Deposit Insurance Corporation Improvement Act The difficulties encountered nationwide by financial institutions during 1990 and 1991 prompted federal legislation designed to reform the banking industry and to promote the viability of the industry and of the deposit insurance system. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which became effective on December 19, 1991, bolsters the deposit insurance fund, tightens bank and thrift regulation and trims the scope of federal deposit insurance as summarized below. FDICIA requires each federal banking regulatory agency to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; (vi) compensation, fees and benefits; and (vii) such other operational and managerial standards as the agency determines to be appropriate. The compensation standards would prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that provide excessive compensation, fees or benefits or could lead to material financial loss. In addition, each federal banking regulatory agency must prescribe by regulation standards specifying (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies; and (iv) such other standards relating to asset quality, earnings and valuation as the agency determines to be appropriate. If an insured institution fails to meet any of the standards promulgated by regulation, then such institution will be required to submit a plan to its federal regulatory agency specifying the steps it will take to correct the deficiency. 13 Prompt corrective action measures adopted in FDICIA and which became effective on December 19,1992, impose significant new restrictions and requirements on depository institutions that fail to meet their minimum capital requirements. Under Section 38 of the Federal Deposit Insurance Act ("FDI Act"), the federal banking regulatory agencies have developed a classification system pursuant to which all depository institutions are placed into one of five categories based on their capital levels and other supervisory criteria: well capitalized, adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized. The Bank met the requirements at December 31, 2002 to be classified as "well capitalized." This classification is determined solely for the purposes of applying the prompt corrective action regulations and may not constitute an accurate representation of the Corporation's overall financial condition. An undercapitalized depository institution is required to submit a capital restoration plan to its principal federal regulator. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital and is guaranteed by the parent holding company. If a depository institution fails to submit an acceptable plan, it will be treated as if it were significantly undercapitalized. Unless its principal federal regulator has accepted its capital plan, an undercapitalized bank may not increase its average total assets in any calendar quarter. If an undercapitalized institution's capital plan has been accepted, asset growth will be permissible only if the growth is consistent with the plan and the institution's ratio of tangible equity to assets increases during the quarter at a rate sufficient to enable the institutions to become adequately capitalized within a reasonable time. An institution that is undercapitalized depository institution may not solicit deposits by offering rates of interest that are significantly higher than the prevailing rates on insured deposits in the institution's normal market areas or in the market area in which the deposits would otherwise be accepted. An undercapitalized depository institution may not branch, acquire an interest in another business or institution or enter a new line of business unless its capital plan has been accepted and its principal federal regulator approves the proposed action. An insured depository institution may not pay management fees to any person having control of the institution nor may an institution, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after making such payment or distribution, the institution would be undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions are subject to appointment of a receiver or conservator. If its principal federal regulator determines that an adequately capitalized institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice, it may require the institution to submit a corrective action plan, restrict its asset growth and prohibit branching, new 14 acquisitions and new lines of business. An institution's principal federal regulator may deem it to be engaging in unsafe or unsound practices if it receives a less than satisfactory rating for asset quality, management, earnings or liquidity in its most recent examination. In addition, regulators were required to draft a new set of non-capital measures of bank safety, such as loan underwriting standards and minimum earnings levels, effective December 1, 1993. The legislation also requires regulators to perform annual on-site bank examinations, place limits on real estate lending by banks and tightens auditing requirements. Federal and State Taxation General The following discussion of federal taxation is a summary of certain pertinent federal income tax matters as they pertain to the Corporation. With some exceptions, including particularly the reserve for bad debts discussed below, the Corporation is subject to federal income tax under the Internal Revenue Code of 1986 (the "Code") in the same general manner as other corporations. Bad Debt Reserves Commercial banks such as the Bank, which meet certain definitional tests primarily relating to their assets and the nature of their businesses, are permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions, may within specified formula limits, be deducted in arriving at the Bank's taxable income. For purposes of computing the deductible addition to its bad debt reserve, the Bank utilizes the experience method. Under the experience method, the deductible annual addition is the amount necessary to increase the balance of the reserve at the close of the taxable year to the greater of (1) the amount which bears the same ratio to loans outstanding at the close of the taxable year as the total net bad debts sustained during the current and five preceding taxable years bears to the sum of the loans outstanding at the close of those six years or (2) the lower of (a) the balance in the reserve account at the close of the last taxable year prior to the most recent adoption of the experience method (the base year is the last taxable year beginning before 1988), or (b) if the amount of loans outstanding at the close of the taxable year is less than the amount of loans outstanding at the close of the base year, the amount which bears the same ratio to loans outstanding at the close of the taxable year as the balance of the reserve at the close of the base year bears to the amount of loans outstanding at the close of the base year. The Bank will be subject to the direct charge-off method of writing off bad debts once it reaches $500 million. Once the Bank is subject to this method it will not be allowed to carry a tax reserve that was allowed under the experience method. Management predicts that this change will occur in 2003 due to growth projections. Minimum Tax A 20% corporate alternative minimum tax generally will apply to a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI") and will be payable to the extent such AMTI is in excess of an exemption amount. The Code provides that an item of tax preference is the excess of the bad debt deduction over the amount allowable under the experience method. The other items of tax preference that constitute AMTI 15 include (a) tax-exempt interest on newly-issued (generally, issued on or after August 8, 1986) private activity bonds other than certain qualified bonds and (b) 75% of the excess (if any) of (i) 75% of adjusted current earnings as defined in the Code, over (ii) AMTI (determined without regard to this preference and prior to reduction by net operating losses). Other For federal income tax purposes, the Corporation reports its income and expenses on the accrual basis method of accounting and uses a year ending December 31 for filing its income tax returns. The Corporation may carry back net operating losses to the preceding two taxable years and forward to the succeeding twenty taxable years. The Commonwealth of Virginia imposes an income tax on corporations domiciled in the state. The Virginia taxable income is based on the federal taxable income with certain adjustments for interest and dividend income on obligations of securities of the United States and states other than Virginia. The tax rate is 6% of taxable income of the Corporation, exclusive of the Bank and its subsidiaries. The State of Virginia assesses a Bank Franchise Tax for Banks located in the Commonwealth. The rate is 1% of capital subject to certain deductions and additions. The majority of the tax is paid back to the Virginia localities in which the Bank operates. The State of North Carolina imposes a state income tax while Tennessee assesses a combined Franchise / Excise Tax. See Note 7 to the Consolidated Financial Statements, included as part of the Annual Report to Shareholders, for additional information regarding the income taxes of the Company. 16 Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential Year Ended December 31, 2002 2001 2000 (Dollars in Thousands) Interest Interest Interest Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate ------- ------- ---- ------- ------- ---- ------- ------- ---- ASSETS Interest earning assets (taxable-equivalent basis) Loans (net of unearned discount (2) $335,823 $ 26,095 7.77% $309,753 $27,574 8.90% $277,115 $25,077 9.05% Securities (1)(3) 99,768 4,758 5.52 87,254 5,107 6.40 80,315 5,218 6.69 Federal funds sold 5,544 91 1.64 9,133 317 3.47 1,834 123 6.68 -------- ------- ---- -------- ------- ---- -------- ------- ---- Total interest-earning assets $441,134 $30,944 7.18% $406,140 $32,998 8.42% $359,264 $30,418 8.51% -------- ------- ---- -------- ------- ---- -------- ------- ---- LIABILITIES Interest bearing liabilities Interest bearing dep. $343,900 $ 11,768 3.42% $322,847 $16,740 5.19% $283,484 $15,610 5.51% Other interest bearing liabilities 38,783 2,498 6.44 31,117 2,146 6.90 31,169 2,090 6.71 -------- ------- ---- -------- ------- ---- -------- ------- ---- Total interest-bearing liabilities $382,683 $14,266 3.73% $353,964 $18,886 5.34% $314,653 $17,700 5.63% -------- ------- ---- -------- ------- ---- -------- ------- ---- Net interest income. $16,678 $14,112 $12,718 Net margin on int. earning assets on a tax equivalent basis 3.95% 3.59% 3.59% Average interest spread 3.45% 2.90% 2.88% (1) Tax equivalent adjustments (using 34% federal tax rates) have been made in calculating yields on tax-free investments. Virginia banks are exempt from state income tax. (2) For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding. (3) The yield on securities classified as available for sale is computed based on the average balance of the historical amortized cost balance without the effects of the fair value adjustment required by FAS 115. 17 As the largest component of income, net interest income represents the amount that interest and fees earned on loans and investments exceed the interest costs of funds used to support these earning assets. Net interest income is determined by the relative levels, rates and mix of earning assets and interest-bearing liabilities. The following table attributes changes in net interest income either to changes in average volume or to changes in interest rates. Dollar changes have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Increase/(Decrease) Due to Volume and Rate 2002 Compared to 2001 2001 Compared to 2000 Increase Increase Increase Increase (decrease) (decrease) (decrease) (decrease) due to due to due to due to change in change in Net increase change in change in Net increase Increase (Decrease) in volume rate (decrease) volume rate (decrease) ---------------------- ------ ---- ---------- ------ ---- ---------- (Dollars in Thousands) INTEREST INCOME Securities $ 800 $ (1,149) $ (349) $ 464 $ (576) $ (112) Federal funds sold (125) (101) (226) 488 (293) 195 Loans 2,000 (3,479) (3,479) 2,955 (458) 2,497 ------- -------- -------- ------- ------- ------- Total Income Change $ 2,675 $ (4,729) $ (2,054) $ 3,907 $(1,327) $ 2,580 ------- -------- -------- ------- ------- ------- INTEREST EXPENSE Savings and time deposits $ 1,091 $ (6,063) $ (4,972) $ 2,168 $ (1,038) $ 1,129 Other interest-bearing liabilities 528 (177) 351 (4) 60 57 ------- -------- -------- ------- ------- ------- Total Expense Change $ 1,619 $ (6,240) $ (4,621) $ 2,164 $ (978) $ 1,186 ------- -------- -------- ------- ------- ------- Increase (Decrease) in Net Interest Income $ 1,056 $ 1,511 $ 2,567 $ 1,743 $ (349) $ 1,394 ------- -------- -------- ------- ------- ------- Investment Portfolio The following table presents the maturity distribution, market value, amortized cost and approximate tax equivalent yield (assuming a 34% federal income tax rate) of the investment portfolio at December 31, 2002. (Dollars in Thousands) One Year Five Years Within One Through Through After Ten Market Amortized Year Five Years Ten Years Years Yield Value Cost State & Muni's $ 0 $1,437 $ 986 28,296 7.09 30,719 29,824 Mtg.-backed Sec 133 216 528 56,853 4.25 57,730 57,052 Other 750 0 986 12,558 3.57 14,294 14,335 ----- ------ ------ ------- ---- -------- -------- TOTAL $ 883 $1,653 $2,500 $97,707 5.02 $102,743 $101,211 ----- ------ ------ ------- ---- -------- -------- 18 Loan Portfolio The table below classifies gross loans by major category and percentage distribution at December 31, 2002 for each of the past five years: December 31, (Dollars in thousands) 2002 2001 2000 Amount Percentage Amount Percentage Amount Percentage ------ ---------- ------ ---------- ------ ---------- Real Estate Secured: Residential 1-4 family $128,462 37.82% $114,556 35.18% $102,631 35.14% Multi-family 3,383 1.00 3,011 0.92 3,909 1.34 Commercial, Construction Construction and Land Development 85,468 25.16 80,673 24.77 61,666 21.11 Second Mortgages 11,676 3.43 7,737 2.38 5,342 1.83 Equity Line of Credit 5,253 1.54 4,166 1.28 3,455 1.18 Farmland 5,589 1.65 5,055 1.56 4,928 1.69 --------- ------ -------- ------ -------- ------ $ 239,831 70.60% $215,208 66.09% $181,931 62.29% Secured, Other: Personal $ 49,483 14.57% $60,532 18.59% $63,137 21.62% Commercial 26,043 7.67 26,002 7.98 26,463 9.05 Agricultural 4,209 1.23 3,274 1.01 4,498 0.86 --------- ------ -------- ----- -------- ------ $ 79,735 23.47% $89,808 27.58% $92,098 31.53% Unsecured: $ 20,135 5.93% $20,614 6.33% $18,059 6.18% --------- ------ -------- ------ -------- ------ Loans, gross $ 339,701 100.00% $325,630 100.00% $292,088 100.00% --------- ------ -------- ------ -------- ------ December 31, (Dollars in thousands) 1999 1998 Amount Percentage Amount Percentage ------ ---------- ------ ---------- Real Estate Secured: Residential 1-4 family $ 94,356 36.04% $ 81,181 34.76% Multi-family 3,072 1.17 1,888 0.81 Commercial, Construction Construction and Land Development 53,893 20.58 45,832 19.63 Second Mortgages 4,199 1.60 2,606 1.12 Equity Line of Credit 3,536 1.35 3,064 1.31 Farmland 4,403 1.68 1,768 0.76 -------- ------ -------- ------ $163,459 62.42% $136,339 58.38% Secured, Other: Personal $60,492 23.10% $62,366 26.70% Commercial 18,226 6.97 14,293 6.12 Agricultural 2,408 0.92 2,133 0.91 -------- ------ -------- ------ $81,126 30.99% $78,792 33.74% Unsecured: $17,258 6.59% $18,406 7.88% -------- ------ -------- ------ Loans, gross $261,843 100.00% $233,537 100.00% -------- ------ -------- ------ 19 The following table shows the maturity of loans outstanding, inclusive of contractual amortization as of December 31, 2002. December 31, 2002 (Dollars in Thousands) Within One After One But After Five Year Within Five Years Years Fixed Floating Fixed Floating Fixed Floating Rate Rate Rate Rate Rate Rate Total ---- ---- ---- ---- ---- ---- ----- Real Estate Secured: Residential 1-4 family $ 6,973 $ 4,119 $ 19,610 $ 9,378 $ 20,964 $ 67,418 $128,462 Multi-family 233 0 2,431 0 719 0 3,383 Commercial, Construction & Land Development 21,195 7,088 45,859 841 6,679 3,806 85,468 Second Mortgages 1,455 3,542 3,858 93 2,283 445 11,676 Equity Line of Credit 0 407 0 1,867 0 2,979 5,253 Farmland 893 844 3,016 81 755 0 5,589 Secured, Other: Personal 15,720 44 32,348 0 1,371 0 49,483 Commercial 8,206 5,862 9,663 1,392 920 0 26,043 Agricultural 797 1,835 1,142 47 388 0 4,209 Unsecured 8,588 7,635 2,709 939 264 0 20,135 -------- -------- -------- -------- -------- -------- -------- Loans, Gross $ 64,060 $ 31,376 $120,636 $ 14,638 $ 34,343 $ 74,648 $339,701 -------- -------- -------- -------- -------- -------- -------- Non-performing loans The loan portfolio of the Bank is reviewed regularly by senior officers to evaluate loan performance. The frequency of the review is based on a rating of credit worthiness of the borrower utilizing various factors such as net worth, credit history, customer relationship, etc. The evaluations emphasize different factors depending upon the type of loan involved. Commercial and real estate loans are reviewed on the basis of estimated net realizable value through an evaluation of collateral and the financial strength of the borrower. Installment loans are evaluated largely on the basis of delinquency data because of the large number of such loans and relatively small size of each individual loan. Management's review of commercial and other loans may result in a determination that a loan should be placed on a non-accrual of interest basis. It is the policy of the Bank to discontinue the accrual of interest on any loan on which full collectability of principal and / or interest is doubtful. Subsequent collection of interest is recognized as income on a cash basis upon receipt. Placing a loan on non-accrual status for the purpose of income recognition is not in itself a reliable indication of potential loss of principal. Other factors, such as the value of the collateral securing the loan and the financial condition of the borrower, serve as more reliable indications of potential loss of principal. The policy of the Bank is that non-performing loans consist of loans accounted for on a non-accrual basis and loans which are contractually past due 90 days or more in regards to interest and/ or principal payments. As of the five periods ended December 31, 2002, 2001, 2000, 1999 and 1998 non-performing loans amounted to $2,606,000, $2,063,000, $1,502,000, $1,641,000 and $2,033,000 respectively. As of the five periods ended December 31, 2002, 2001, 2000, 1999 and 1998 non-accrual loans and more and still accruing amounted to $1,657,000, $950,000, $586,000, $559,000 and $1,380,000 respectively. As of the five periods ended December 31, 2002, 2001, 2000, 1999 and 1998 loans past-due 90 days and more amounted to $949,000, $1,113,000, $916,000, $1,082,000 and $653,000 respectively. 20 Interest income lost on non-accruing loans was approximately $104,000, $73,000, $121,000, $136,000 and $86,000 for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 respectively. Interest income realized on loans past-due 90 days and more and still accruing was approximately $15,000, $18,000, $15,000, $17,000 and $10,000 for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 respectively. Summary of Loan Loss Experience The allowance for loan losses is increased by the provision for loan losses and reduced by loans charged off net of recoveries. The allowance for loan losses is established and maintained at a level judged by management to be adequate to cover any anticipated loan losses to be incurred in the collection of outstanding loans. In determining the adequate level of the allowance for loan losses, management considers the following factors: (a) loan loss experience; (b) problem loans, including loans judged to exhibit potential charge-off characteristics, loans on which interest is no longer being accrued, loans which are past due and loans which have been classified in the most recent regulatory examination; and (c) anticipated economic conditions and the potential impact these conditions may have on individual classifications of borrowers. The following table presents the Corporation's loan loss experience for the past five years: Years Ended December 31, (Dollars in Thousands) 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Allowance for loan losses at beginning of year $ 3,418 $ 2,950 $ 2,494 $ 2,008 $ 1,636 Loans charged off: Commercial 389 107 69 357 270 Real Estate - mortgage 94 10 0 27 0 Consumer 1,043 1,087 925 710 786 Other 0 0 0 0 0 -------- -------- ------ -------- -------- Total $ 1,526 $ 1,204 $ 994 $ 1,094 $ 1,056 -------- -------- ------ -------- -------- Recoveries of loans previously charged off: Commercial $ 5 $ 3 $ 6 $ 97 $ 41 Real Estate - mortgage 0 0 0 0 0 Consumer 155 221 167 65 157 Other 0 0 0 0 0 -------- -------- ------ -------- -------- Total $ 160 $ 224 $ 173 $ 162 $ 198 -------- -------- ------ -------- -------- Net loans charged off $ 1,366 $ 980 $ 821 $ 932 $ 858 -------- -------- ------ -------- -------- Provision for loan losses 1,825 1,448 1,277 1,418 1,230 -------- -------- ------ -------- -------- Allowance for loan losses end of year $ 3,877 $ 3,418 $ 2,950 $ 2,494 $ 2,008 -------- -------- ------ -------- -------- Average total loans (net of unearned income) $335,823 $309,753 $ 277,115 $246,687 $213,069 Total loans (net of unearned income) at year-end $339,521 $325,460 $ 291,897 $261,678 $233,372 Ratio of net charge-offs to average loans 0.407% 0.316% 0.296% 0.378% 0.403% Ratio of provision for loan losses to average loan 0.543% 0.467% 0.461% 0.575% 0.577% Ratio of provision for loan losses to net charge-off 133.602% 147.755% 155.542% 152.146% 143.357% Allowance for loan losses to year-end loans 1.142% 1.050% 1.011% 0.953% 0.860% 21 Allocation of the allowance for loan losses The following table provides an allocation of the allowance for loan losses as of December 31, 2002, 2001, 2000, 1999 and 1998. Year Ended December 31, Percent of Loans on each Category (Dollars in Thousands) 2002 2001 Allowance for Percentage of Percentage of Allowance for Percentage of Percentage of Loan Loss Total Loan Loss Total Loans Loan Loss Total Loan Loss Total Loans --------- --------------- ----------- --------- --------------- ----------- Commercial $ 972 25.06% 10.87% $ 857 25.06% 7.98% Real Estate 228 5.89 70.60 201 5.89 66.09 Consumer 2,672 68.93 17.05 2,356 68.93 24.92 Other 5 0.12 1.48 4 0.12 1.01 ------- ------ ------ ------- ------ ------ Total $ 3,877 100.00% 100.00% $ 3,418 100.00% 100.00% ------- ------ ------ ------- ------ ------ Year Ended December 31, Percent of Loans on each Category (Dollars in Thousands) 2000 Allowance for Percentage of Percentage of Loan Loss Total Loan Loss Total Loans --------- --------------- ----------- Commercial $ 739 25.06% 12.52% Real Estate 174 5.89 62.29 Consumer 2,033 68.93 24.09 Other 4 0.12 -------- ------ ------ Total $ 2,950 100.00% 100.00% -------- ------ ------ 1999 1998 Allowance for Percentage of Percentage of Allowance for Percentage of Percentage of Loan Loss Total Loan Loss Total Loans Loan Loss Total Loan Loss Total Loans --------- --------------- ----------- --------- --------------- ----------- Commercial $ 625 25.06% 10.34% $ 503 25.05% 10.38% Real Estate 147 5.89 62.42 118 5.88 58.38 Consumer 1,719 68.93 26.01 1,384 68.92 30.04 Other 3 0.12 1.23 3 0.15 1.20 Unallocated 0 0 0 0 0 0 ------- ------ ------ ------- ------ ------ Total $ 2,008 100.00% 100.00% $ 2,008 100.00% 100.00% ------- ------ ------ ------- ------ ------ 22 Deposits The following table provides a breakdown of deposits at December 31 for the years indicated: December 31, (Dollars in Thousands) 2002 2001 2000 ---- ---- ---- Non-interest bearing demand deposits $ 55,597 $ 50,248 $ 45,343 Interest bearing demand deposits 49,519 37,464 25,697 Savings deposits 70,258 60,166 45,826 Time deposits 234,927 244,215 229,449 -------- -------- -------- Total Deposits $410,301 $392,093 $346,315 The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table: Year Ended December 31, (Dollars in Thousands) 2002 2001 2000 Amount Rate Amount Rate Amount Rate ------ ---- ------ ---- ------ ---- Non-interest bearing demand deposits $ 54,979 0.00% $ 47,271 0.00% $ 42,228 0.00% Interest-bearing demand deposits 43,537 1.76 29,003 2.80 25,636 3.52 Savings deposits 65,790 2.07 52,655 3.38 47,474 4.01 Time deposits 234,573 4.11 241,190 5.85 210,374 6.08 -------- -------- -------- Total $398,879 $370,119 $325,712 The remaining maturities of time deposits greater than $100,000 at December 31, 2002 are as follows (in thousands) : Maturity 3 months or less....................................$ 12,252 3 months through 6 months........................... 8,269 Over 3 through 12 months............................ 80,173 Over 12 months...................................... 28,498 ------- Total $ 61,390 ------- Interest Rate Sensitivity Analysis Interest rate risk refers to the exposure of the Corporation's earnings and market value of equity ("MVE") to changes in interest rates. The amount of change in net interest income and MVE resulting from shifts in interest rates is determined by contractual maturity of fixed rate instruments, the repricing date for variable rate instruments, competition and customer reactions. 23 The Corporation runs simulation models through a range of positive and negative interest rate movements to determine the effect these shifts in interest rates would have on the market value of the Corporation's equity. The market value is determined by applying a discount rate to the Corporations interest-earning assets and interest-bearing liabilities based on current rate levels at the time the model is run and calculating the present value of future cash flows. There are several common sources of interest rate risk that must be effectively managed to maintain minimal impact on the Corporation's earnings and capital. Repricing risk comes largely from timing differences in the pricing of interest-earning assets and interest-bearing liabilities. Reinvestment risk refers to the reinvestment of cash flows from interest and principal payments and maturing assets at lower or higher rates. Basis risk arises when different yield curves or pricing indices do not change at precisely the same moment in time or magnitude so that earning assets and interest-bearing liabilities with the same maturity are not affected equally. Yield curve risk refers to unequal movements in short-term and long-term interest rates. The following table provides the maturities of investment securities, loans, and deposits as of December 31, 2002, and measures the interest rate sensitivity gap for each range of maturity indicated: The amounts below also reflect various prepayment assumptions. December 31, 2002 (Dollars in Thousands) Maturing Within One After One But After Five Year Within Five Years Years Total ---- ----------------- ----- ----- ASSETS Interest-bearing Investment Securities $ 13,426 $ 37,232 $ 54,267 $104,925 Fed Funds Sold 5,132 0 0 5,132 Loans 142,405 173,492 23,624 339,521 Other interest-bearing 7,571 7,571 Noninterest-bearing Other Assets 0 0 28,454 28,454 -------- -------- -------- -------- Total Assets $160,963 $210,724 $113,916 $485,603 -------- -------- -------- -------- LIABILITIES AND SHARE- HOLDERS' EQUITY Interest-bearing (1) All Interest-bearing Deposits $251,222 $ 99,400 $ 4,082 $354,704 Other Interest-bearing Liab 19,072 14,110 7,612 40,794 Noninterest-bearing Demand Deposit Non-Interest 0 0 55,597 55,597 Other Liabilities 2,309 0 0 2,309 Shareholders' Equity 0 0 32,199 32,199 -------- -------- -------- -------- Total Liabilities and Shareholders' Equity $272,603 $113,510 $ 99,490 $485,603 -------- -------- -------- -------- Interest Rate Sensitivity GAP $(111,640) $ 97,214 $ 14,426 $ 0 (1) For purposes of this schedule, the Corporation includes 100% of its statement savings, NOW and MMDA's in the one year column. 24 Asset Liability Management The Corporation's primary objectives for asset and liability management are to establish internal controls and procedures that will result in managing interest rate risk, liquidity management, capital planning, asset mix and volume control, and loan and deposit pricing. The Asset and Liability Committee (ALCO) is headed by the CEO and includes management personnel from the different areas of the Bank. The Committee meets on a monthly basis. Interest rate risk refers to the exposure of the Corporation's earnings to changes in interest rates. There are several sources of interest rate risk that must be effectively managed if there is to be minimal impact on the Corporation's earnings and capital. Repricing risk arises from timing differences in the repricing of assets and liabilities. Reinvestment risk refers to the ability, or lack thereof, to reinvest cash flows of maturing assets at lower or higher rates. In determining the appropriate level of interest rate risk, the ALCO reviews the changes in projected net interest income subject to various changes in interest rates. To help effectively measure interest rate risk, the ALCO utilizes rate sensitivity and simulation analysis to determine the impact on net interest income as well as the changes in the Economic Value of Equity. Simulation analysis is used to subject or "shock" the current repricing and maturing amounts to rising and falling interest rates. Rate change increments of 1% and 2% up and down are used in the monthly simulation analysis. Loan and investment security prepayments are estimated using current market information. The following table shows the estimated cumulative impact on net interest income for the next 12 months as of December 31, 2002, subject to the specified interest rate changes. Rate change increment % change in net interest income $ change in net interest income Up 1% -3.19% $ -559,000 Up 2% -5.71% $ -1,000,000 Down 1% 3.75% $ 656,000 Down 2% 5.84% $ 1,023,000 Liquidity Liquidity is the measure of the Corporation's ability to generate sufficient funds in order to meet customers' demands for withdrawal of deposit balances and for the funding of loan requests. The Corporation maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and has sufficient flow of funds from investment security payments as well as loan payments to meet current liquidity needs. Management of the Corporation continuously monitors and plans the Corporation's liquidity position for the future. Liquidity is provided from cash and due from banks, federal funds sold, loan and investment security payments, core deposits, the national certificate of deposit market, lines of credit with 25 correspondent banks and lines of credit with the Federal Home Loan Bank, Management believes that these sources of funds provide sufficient and timely liquidity for the foreseeable future. The Corporation's major source of funding and liquidity is derived from its deposit base. The mix of the deposit base (demand deposits, statement savings, certificates of deposit, money market and interest checking) is constantly subject to change. During 2002, as reflected in the Consolidated Balance Sheets, the deposit mix changed with an increase in non-interest bearing demand deposits of $5.3 million, an increase in interest-bearing NOW and Money Market deposits of $12.1 million, an increase in statement savings deposits of $10.1 million and a decrease in total time deposits of $9.3 million. During 2002 total deposits increased $18.2 million. The Corporation had approximately $102.7 million in investment securities at December 31, 2002. The Corporation utilizes its investment portfolio as a secondary form of liquidity. Management has designated $102.7 million of the investment portfolio as available for sale under the requirements of FAS 115. Under this designation, the Corporation has the ability to sell any of these available for sale securities to meet extraordinary liquidity needs without negative impact to the financial position or results of operations. The Consolidated Statements of Cash Flows appearing in the financial statements of the Corporation reflects a net increase in cash and cash equivalents of $6.3 million over the comparable 2001 period. This increase was greatly due to the bank's increase in total deposits as well as the $10 million advances from the Federal Home Loan Bank. Liquidity strategies are implemented and monitored on a daily basis by the Corporation's Asset Liability Committee (ALCO). The Committee uses a simulation model to assess future liquidity needs of the Corporation and to manage the investment of funds. The ALCO Committee meets formally on a monthly basis. Return on Equity and Assets The following table highlights certain ratios for the periods indicated: Year Ended December 31, (Percentage) 2002 2001 2000 ---- ---- ---- Net income to: Average total assets 0.87 0.77 0.78 Average shareholders' equity 13.82 12.78 13.69 Divided payout ratio (dividends declared per share divided by net income per share) 5.81% 6.39% 6.21% Average shareholders' equity to average total assets ratio 6.32 6.00 5.71 26 Item 2. Properties The Corporation's and the Bank's main offices are located at 340 W. Main Street, Abingdon, Virginia. The main office is a two-story brick structure owned by the Bank. The Bank utilizes the entire structure for its day-to-day operations. Attached to the main office is a four-lane drive thru facility constructed in 1998. The new drive thru replaced an older unit that was detached from the main office's structure. The main office opened for operations in 1985. In addition, the Bank has three other branch locations within Washington County, Virginia. The East Abingdon branch is a one story brick facility located at 24412 Maringo Road that operates as a full service branch. The branch was completed and opened for operation in 1993. The West Abingdon location operates as an "express facility." This location contains four drive thru lanes and a walk-up window. This is a limited service facility. The West Abingdon Express branch was completed and opened for operations in 1994 and is located at Exit 14, I-81, Jonesboro Road, Abingdon, Virginia. During 1998, the Bank constructed and placed in service a two-story brick building located at 506 Maple Avenue, Glade Spring, Virginia. The Glade Spring Office is a full service location with four drive thru lanes. The Bank also has two full service branch locations within the City of Bristol, Virginia. The East Bristol office is located at 999 Old Airport Road, Bristol, Virginia. This is a two story brick building with interior customer loan and deposit areas as well as a four lane drive thru unit. The office was completed and opened for operations in 1988. The Commonwealth office is located at 821 Commonwealth Avenue, Bristol, Virginia. This is a two story block building with full service customer service areas and a four lane drive thru facility. The Bank also operates its dealer finance division out of the Commonwealth office. This office was completed and opened for operations in 1995. The Bank also has a full service branch at 1425 North Main Street, Marion, Virginia. The branch was placed in service in December of 1997. It is a two story brick building and operates as a full service branch. The Marion office has four drive thru lanes and a drive-up ATM. The Bank also owns a vacant lot, located approximately 1/2 mile from the branch on North Main Street, that originally had a drive-up ATM on location. The ATM was relocated to the Marion branch during 2001. This property is free of all liens. All of the Bank's branch locations have an on-premises ATM. All branch properties are owned by the Bank and are free of liens. In September 1998, the Bank acquired the adjacent building to its Commonwealth office to facilitate future expansion. This is a one story brick structure, located at 801-805 Commonwealth Avenue, Bristol, Virginia and is currently leased. A note payable to the sellers was executed and is secured by a first deed of trust. The balance on the note as of December 31, 2002 was approximately $22,000. Also during 1998, the Bank initiated an off premises ATM program. This program has continued to expand to include 28 offsite ATMs purchased and installed throughout the Bank's market areas. Six machines are placed in Bristol, Virginia; one is installed in Bristol, Tennessee; ten are installed in Washington County, Virginia; two in Russell County, Virginia; six in Smyth County, Virginia, one in Wythe County, Virginia, one in Banner Elk, North Carolina and one in Boone, North Carolina. All machines are free of liens. During 1999 the Bank purchased a building, across from the Main Office in Abingdon, to provide for expansion of the Bank's operations. The building is a brick and frame structure that is being used to 27 house the Bank's Financial Services Department, the Collections Department, the Bank's credit card, Human Resources department, Customer Call Center, Check Card and ATM Card Operations department, Security and Facilities department as well as the Bank's Check Printing Department. The office space not currently being used by the Bank is being leased to one other business. This property is free of any liens. On September 23, 2000, the Bank closed on the purchase of a branch office of a bank in Rogersville, Tennessee. This purchase included approximately $3.9 million of deposit accounts, $54,000 of overdraft protection accounts, $7,000 of specified furniture and equipment and approximately $639,000 for the building and real estate. The branch office is a one-story masonry and concrete structure constructed in 1985. The branch is located at 410 Highway 66 South in Rogersville, Tennessee. This building is being used as a Highlands Union Bank full service facility with two drive-thru lanes and a drive-up ATM. The Bank also purchased a tract of land located off of Highway 11W in Bristol, Tennessee, known as Bristol West Development, for future expansion. The land is approximately 1/2 acre and is currently zoned B-3. This property is free of any liens. The Bank also purchased a lot in Boone, North Carolina for a branch site. This 1.293 acre tract is located on Highway 105 in the Town of Boone. During 2000 the Bank began construction of a two-story brick building that opened as a full service branch of the Bank in January of 2001. The Seller of this property originally financed $250,000 of the purchase price of the land. The balance of this note as of December 31, 2002 was approximately $200,000. The Bank has purchased a tract of land on Highway 394, at its intersection with Blountville Boulevard, in Blountville, Tennessee for the purpose of constructing a full-service branch bank. The property was purchased for $315,000 plus the conveyance of the Bank's Volunteer Parkway property valued at $300,000. Excavation of the Highway 394 property is underway and the branch is expected to open in late summer of 2003. The Corporation acquired a commercial building during 1997 that is located at 266 West Plumb Alley, Abingdon, Virginia. The building is a two story concrete structure that was originally constructed by another bank for use as an operations center. During 1997, the Corporation entered into a leasing arrangement with its subsidiary to lease the first floor to be used for its operations center. This lease was expanded to include the second floor of the building that was renovated during 2001. During 2001, the Corporation renovated the second floor of this building and it currently houses the Bank's electronic data processing operations, bookkeeping operations, proof operations and electronic banking operations. The West Plumb Alley property is free of liens. During 1998, the Corporation purchased the adjacent property to the operations center. The property purchased is a one story brick structure that currently houses the Corporation's technology department. It is management's intention to utilize the property as growth continues. The property is owned free and clear of all liens. Item 3. Legal Proceedings The Corporation is not involved in any pending legal proceedings, other than non-material legal proceedings undertaken in the ordinary course of business. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the quarter ended December 31, 2002. 28 Part II. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters There is no established trading market for the stock of Highlands Bankshares, Inc. At December 31, 2002, the Corporation had approximately 1,247 shareholders of record. The Corporation acts as its own registered Stock Transfer Agent, without charging a transfer fee, ensuring that all applicable federal guidelines relating to stock transfers are enforced. The Corporation maintains a list of individuals who are interested in purchasing its common stock and connects these people with shareholders who are interested in selling their stock. These parties negotiate the per share price independent of the Corporation. The stock transfer agent of the Corporation attempts to keep a record of what the stock sales are trading at by asking the parties about the trade price per share. Please refer to the table below entitled Common Stock Performance for a breakdown of the trades for the four quarters of 2002 and 2001. It is the opinion of management that this range accurately reflects the market value of the Corporation's common stock for the periods presented. Common Stock Performance-December 31, 2002 Quarterly High Low Average ---- --- ------- First Quarter $25.50 $25.00 $25.47 Second Quarter $26.00 $24.00 $25.26 Third Quarter $26.00 $25.50 $25.93 Fourth Quarter $26.00 $26.00 $26.00 Common Stock Performance-December 31 2001 High Low Quarterly Average First Quarter $28.00 $25.00 $25.44 Second Quarter $25.00 $24.00 $25.00 Third Quarter $25.50 $25.00 $25.19 Fourth Quarter $25.50 $25.00 $25.15 The Corporation's Board of Directors determines whether to declare dividends and the amount of any dividends declared. Such determinations by the Board take into account the Corporation's financial condition, results of operations, and other relevant factors. The declaration, amount and timing of future dividends will be determined by the Board of Directors after a review of the Corporation's operations and will be dependent upon, among other factors, the Corporation's income, operating costs, overall financial condition, capital requirements and upon general business conditions. The Corporation declared and paid 29 annual cash dividends of $238,000 or $0.09 per share during 2002 and $211,000 in cash dividends or $0.08 per share during 2001. The Corporation's principal asset is its investment in the Bank, a wholly owned consolidated subsidiary. The primary source of income for the Corporation historically has been dividends from the Bank. Regulatory agencies limit the amount of funds that may be transferred from the Bank to the Corporation in the form of dividends, loans or advances. The Bank paid $1.5 million in dividends to the Corporation in 2002. Under applicable laws and without prior regulatory approval, the total dividend payments of the Bank in any calendar year are restricted to the net profits of that year, as defined, combined with the retained net profits for the two preceding years. The total dividends that may be declared in 2003 without regulatory approval totals $11.4 million plus year-to-date 2003 net profits as of the declaration date. At March 13, 2003, there were approximately 1,247 holders of the Corporation's common stock (based on the number of record holders as of that date). Item 6. Selected Financial Data The following table sets forth certain selected consolidated financial data for the past five years. Years Ended December 31, (Dollars in thousands, except per share data) 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- Income Statement Amounts: Gross interest income $ 30,944 $ 32,998 $ 30,418 $ 25,671 $ 22,897 Gross interest expense 14,266 18,887 17,700 14,167 13,401 Net interest income 16,678 14,111 12,718 11,504 9,496 Provision for possible loan Losses 1,825 1,448 1,277 1,418 1,230 Net interest income after provision 14,853 12,663 11,441 10,086 8,266 Other operating income 3,646 3,364 2,480 1,353 1,367 Other operating expense 13,046 11,619 9,713 8,187 6,962 Income before income taxes and other items 5,453 4,408 4,208 3,252 2,671 Income taxes 1,349 1,107 1,229 1,121 896 Income before cumulative effect of change in accounting principles 4,104 3,301 2,979 2,131 1,775 Cumulative effect of change in accounting principles 0 0 0 0 0 Net income $ 4,104 $ 3,301 $ 2,979 $ 2,131 $ 1,775 Per Share Data(1): Net income per share $ 1.55 $ 1.25 $ 1.13 $ 0.85 $ 0.72 Cash dividends per share 0.09 0.08 0.07 0.06 0.05 Book value (at year end) 12.16 10.38 9.17 7.77 7.33 Balance Sheet Amounts (at year-end): Total assets $ 485,603 $ 453,745 $ 405,212 $ 358,348 $ 307,764 Total loans (net of unearned income) 339,521 325,460 291,895 261,678 233,371 Total deposits 410,301 392,093 346,315 306,193 272,341 Long-term debt 14,200 10,483 18,669 10,599 6,763 Capital Securities 7,500 7,500 7,500 7,500 7,500 Total equity 32,199 27,452 24,183 20,408 18,279 (1) Adjusted for 1999 two-for-one stock split. 30 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required herein is incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2002. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. The information required herein is incorporated by reference to pages 23-26 above on Interest Rate Sensitivity Analysis, Asset Liability Analysis and Liquidity. Item 8. Financial Statements and Supplementary Data The following financial statements are incorporated by reference from the Annual Report to Shareholders for the fiscal year ended December 31, 2002: Independent Auditors' Report; Consolidated Statements of Financial Condition as of December 31, 2002, 2001 and 2000; Consolidated Statements of Operations for each of the years in the three year period ended December 31, 2002; Consolidated Statements of Stockholder's Equity for each of the years in the three year period ended December 31, 2002; Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 2002; and Notes to Consolidated Financial Statements for December 31, 2002, 2001 and 2000. Item 9. Changes in Accountants and Disagreements with Accountants on Accounting and Financial Disclosure None. Part III. Item 10. Directors and Executive Officers of the Registrant Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Nominees for Election," "Executive Officers Who Are Not Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. Item 11. Executive Compensation Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Director Compensation," "Executive Officer Compensation," "Stock Options" and "Option Exercises and Holdings" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. 31 Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Security Ownership of Management and Certain Beneficial Owners" and "Equity Compensation Plan Information" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading "Certain Transactions" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. Item 14. Controls and Procedures On an on-going basis, senior management monitors and reviews the internal controls established for the various operating segments of the Bank. Additionally, the Company has created a Disclosure Review Committee to review not only internal controls but the information used by Company's financial officers to prepare the Corporation's periodic SEC filings and corresponding financial statements. The Committee is comprised of the Senior Management Team of the Bank and meets at least quarterly. Internal audits conducted by the Company's internal audit department are also reviewed by senior officers to assist them in assessing the adequacy of the Company's internal control structure. These audits are also discussed in detail with the Company's Audit Committee. The Company feels that sufficient internal controls and disclosure controls have been established and have reviewed such controls within the last 90 days. Furthermore, management asserts that there have not been any significant changes in the Corporation's internal controls or in other factors that could significantly affect these controls or other factors subsequent to the date of management's most recent evaluation. Part IV. Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) The response to this portion of Item 15 is submitted as a separate section of this report. (2) All applicable financial statement schedules required by Regulation S-X are included in the Notes to the 2002 Consolidated Financial Statements. (3) Exhibits: 3.1 Articles of Incorporation of Highlands Bankshares, Inc. (restated in electronic format), filed as Exhibit 4.1 to the Registration Statement on Form S-3, Registration No. 333-83618, filed with the Commission on March 1, 2002, incorporated herein by reference. 3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference. 32 10.1 Highlands Union Bank 1995 Stock Option Plan. 11 Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2002 Annual Report to Shareholders and incorporated herein by reference). 13.1 Annual Report to Shareholders. 21 Subsidiaries of the Corporation. 23.1 Consent of Brown, Edwards & Company, L.L.P. 99.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.ss.1350. 99.2 Statement of Chief Operations Officer Pursuant to 18 U.S.C.ss.1350. 99.3 Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C.ss.1350. 99.4 Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C.ss.1350. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report. (c) Exhibits. The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted as a separate section of this report. (d) Financial Statement Schedules. The response to this portion of Item 15 is submitted as a separate section of this report. 33 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HIGHLANDS BANKSHARES, INC. Date: March 26, 2003 BY:/s/ Samuel L. Neese -------------------------------- Samuel L. Neese Executive Vice President and Chief Executive 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 March 26, 2003. Signature Title Date --------- ----- ---- /s/ James D. Morefield Chairman of the Board, and Director March 26, 2003 ----------------------------------------- James D. Morefield /s/ Dr. James D. Moore, Jr. President March 26, 2003 ----------------------------------------- Dr. James D. Moore, Jr. /s/ J. Carter Lambert Vice Chairman March 26, 2003 ----------------------------------------- J. Carter Lambert /s/ Samuel L. Neese Executive Vice President, and Chief March 26, 2003 ----------------------------------------- Executive Officer Samuel L. Neese [principal executive officer] /s/ James T. Riffe Executive Vice President and Cashier March 26, 2003 ----------------------------------------- [principal financial and James T. Riffe accounting officer] /s/ William E. Chaffin Director March 26, 2003 ----------------------------------------- William E. Chaffin /s/ E. Craig Kendrick Director March 26, 2003 ----------------------------------------- E. Craig Kendrick /s/ Clydes B. Kiser Director March 26, 2003 ----------------------------------------- Clydes B. Kiser /s/ Charles P. Olinger Director March 26, 2003 ----------------------------------------- Charles P. Olinger /s/ William J. Singleton Director March 26, 2003 ----------------------------------------- William J. Singleton /s/ Dr. H. Ramsey White, Jr. Director March 26, 2003 ----------------------------------------- Dr. H. Ramsey White, Jr. SECTION 302 CERTIFICATIONS I, Samuel L. Neese, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 /s/ Samuel L. Neese Samuel L. Neese ---------------------------------------- Executive Vice President and Chief Executive Officer I, James T. Riffe, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 /s/ James T. Riffe James T. Riffe ---------------------------------------- Executive Vice President and Chief Executive Officer I, Robert M. Little, Jr., certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 /s/ Robert M. Little, Jr. Robert M. Little, Jr. ---------------------------------------- Executive Vice President and Chief Executive Officer I, James R. Edmondson, certify that: 1. I have reviewed this annual report on Form 10-K of Highlands Bankshares, Inc. 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 26, 2003 /s/ James R. Edmondson James R. Edmondson ---------------------------------------- Executive Vice President and Chief Executive Officer EXHIBIT INDEX Exhibit No. Description ----------- ----------- 3.1 Articles of Incorporation of Highlands Bankshares, Inc. (restated in electronic format), filed as Exhibit 4.1 to the Registration Statement on Form S-3, Registration No. 333-83618, filed with the Commission on March 1, 2002, incorporated herein by reference. 3.2 Bylaws of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration Statement on Form 8-A, File No. 000-27622, filed with the Commission on January 24, 1996, incorporated herein by reference. 10.1 Highlands Union Bank 1995 Stock Option Plan. 11 Statement regarding computation of per share earnings (included as Note 1 of the Notes to Consolidated Financial Statements in the 2002 Annual Report to Shareholders and incorporated herein by reference). 13.1 Annual Report to Shareholders. 21 Subsidiaries of the Corporation. 23.1 Consent of Brown, Edwards & Company, L.L.P. 99.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.ss.1350. 99.2 Statement of Chief Operations Officer Pursuant to 18 U.S.C.ss.1350. 99.3 Statement of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C.ss.1350. 99.4 Statement of Chief Financial Officer of the Bank Pursuant to 18 U.S.C.ss.1350. 40