Years Ended June 30,
		2004			2005			2006			2007
Number of new contracts won during the year			599			702			927			1161
Total amount of new contracts (mm)		$	88.29		$	90.06		$	117.17		$	138.77
Average price per contract		$	147,398		$	128,286		$	126,397		$	119,526

		As of June 30,
Backlog Situation:		2004			2005			2006			2007
Contracts newly entered and unfinished (mm)		$	56.92		$	46.95		$	54.95		$	67.60
Contracts started in the prior year and unfinished (mm)		$	15.43		$	23.98		$	31.80		$	34.32
Total amount of backlog (mm)		$	72.35		$	70.93		$	86.75		$	101.92

 

As a growing company, HollySys and its subsidiaries have achieved significant progress in the past three years. HollySys has been able to convert its increased revenues into higher profits. The Company generated net income of $13.08 million, $18.05 million and $13.70 million for the fiscal year ended June 30, 2007, 2006, and 2005, respectively.

 

Regarding the total consolidated revenues, the Company achieved $101.89 million for the fiscal year ended June 30, 2007, compared to $89.92 million for the prior fiscal year, representing an increase of 13.3%, followed by a growth of 13.0 % from $79.57 million in fiscal 2005.

HollySys’ philosophy emphasizes operating a highly efficient and profitable business enterprise that generates value for its customers, employees, and shareholders.

RECENT SIGNIFICANT TRANSACTIONS

In November 2006, the parties to the stock purchase agreement recognized that the closing of the stock purchase was going to be delayed beyond what had been expected when the stock purchase agreement was originally signed in early February 2006. The shareholders of Gifted Time Holdings had obligations that needed to be satisfied by the end of 2006, and they had intended to apply the cash proceeds from the stock purchase transaction to those obligations, circumstances they had made known to Chardan in the course of negotiations. The stock purchase agreement had a termination date of December 31, 2006, and it was not feasible to close the transaction by that date. In order to retain the opportunity to acquire Gifted Time, which the management and directors of Chardan continued to feel was a highly desirable opportunity and in the best interests of Chardan’s shareholders to pursue, Chardan and Advance Pacific Holdings, Limited (which became the sole holder of all the issued and outstanding ordinary shares of Gifted Time Holdings as a result of these transactions) agreed to amend the stock purchase agreement in certain respects that would enable the Gifted Time shareholders to receive the cash consideration that they anticipated receiving by the end of 2006 in a timely way.

To accomplish those purposes, during the period from December 18 to 20, 2006 Gifted Time , the owners (seven BVI companies) of Gifted Time Holdings and certain third parties completed a series of transactions described below to change the ownership of Gifted Time Holdings and to provide the former stockholders of Gifted Time Holdings with needed capital.

A-4

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Reorganizing the Ownership of Gifted Time Holdings

As a way of providing the needed capital to the Gifted Time Holdings shareholders, the ownership of Gifted Time Holdings was reorganized in two steps. In the first transaction, the seven BVI companies (the shareholders of Gifted Time Holdings) transferred their ownership interests in Gifted Time Holdings to OSCAF, a related party owned by Madame Qiao Li. In the second transaction, OSCAF transferred the ownership interests it had acquired in Gifted Time Holdings to Advance Pacific Holdings Limited (“Advance Pacific”) in exchange for a note for $30 million and a note for $200 million (the “$200 Million Note”). The $30 million note called for interest payable at the rate of 10% per annum, provided that if it was paid in full by December 31, 2006 (which occurred, leaving only the $200 Million Note outstanding), no interest would be due or payable. It also contained typical default provisions. The $200 Million Note calls for payment of interest at the rate of 10% and is due and payable in full on September 15, 2007. It also contains typical provisions regarding default and other matters. (As discussed more fully below, the $30 million in cash used to pay the $30 million note to OSCAF was borrowed from Gifted Time Holdings, which in turn had obtained these funds from the combination of a bridge loan (the “Bridge Loan”) made by and the sale of Gifted Time Holdings preferred stock to 15 private investors.)

According to the stock purchase agreements entered into by the seven BVI companies and OSCAF on December 18, 2006, in exchange for the Gifted Time Holdings stock that it received, OSCAF agreed to pay the following consideration to the seven BVI companies: (a) upon the receipt by OSCAF of cash payment of $30 million from Advance Pacific, OSCAF would disburse the $30 million and the accrued interest (if any) to the seven BVI companies in proportion to their ownership interests in Gifted Time Holdings; and (b) OSCAF would similarly distribute the amounts received from Advance Pacific in satisfaction of the $200 Million Note.

As noted above, OSCAF sold 100% of the interest in Gifted Time Holdings (formerly owned by the seven BVI companies) to Advance Pacific, a British Virgin Islands company that is solely owned and controlled by Ka Wa Cheng, a resident of Canada, on December 20, 2006. Advance Pacific issued two notes payable to OSCAF as consideration for that ownership interest, one for $30 million (which has been paid) and the $200 Million Note. Neither Advance Pacific nor Ka Wa Cheng is an affiliate of Chardan or any of its affiliates or any of the affiliates of HollySys. Although Mr. Ka Wa Cheng was one of Madame Qiao’s classmates while they were pursuing an International Executive MBA at the Hong Kong University of Science & Technology and he is also trusted by Madame Qiao, until his acquisition of the ownership interests in Gifted Time Holdings, Mr. Cheng had no involvement in Gifted Time Holdings or HollySys and has not been affiliated with Madame Qiao Li or Dr. Wang Changli.

Ka Wa Cheng’s business experience includes over 14 years of experience in the investment industry. Mr. Cheng received an International Executive MBA from the Hong Kong University of Science and Technology in 2002. He is a founding member of The Hong Kong Institute of Financial Analysts and Professional Commentators, in which he still plays an active role, and he currently is an associate director with Shenyin Wanguo Securities (H.K.) Ltd., a subsidiary of one of the oldest investment banks in China.

Given the limited amount of time that was available to effect the reorganization of Gifted Time Holdings’ ownership, transfer to a party who was already known to the management of HollySys was the only feasible alternative for restructuring the ownership of Gifted Time Holdings to achieve the objectives of the Gifted Time Stockholders.  Ka Wa Cheng was identified as a potential purchaser based on his having come to know Qiao Li during their studies at the Hong Kong University of Science and Technology in 2002.

Although Mr. Cheng had significant business experience, he had only a passing familiarity with the business of HollySys prior to the discussions between the parties regarding this series of transactions. In the course of his discussions regarding the proposed acquisition of Gifted Time Holdings stock by Advance Pacific, he acquired a good deal more information about and understanding of the business of HollySys. However, as a financial investor who would not participate actively in the management of the business, either from the standpoint of setting policies or making significant financial and operational decisions, his knowledge about HollySys remained general in nature, and he has spent only a limited amount of time attending to the business of HollySys from Canada, his place of residence, since control of the business has remained with Qiao Li and Wang Changli.

The $230 million amount was established through negotiations directly between the principals of OSCAF (Qiao Li) and Advance Pacific (Ka Wa Cheng) in the course of their negotiations. Chardan understands that it was based on an estimate of the value of the 22.2 million shares of HLS (reduced from the original 23.5 million shares as a result of the issuance of the preferred stock) to be issued to Advance Pacific upon closing of the Chardan transaction. The closing price of Chardan’s stock on December 20, 2006 was $7.34, producing an aggregate value of just under $163,000,000. The per share price needed to produce sufficient funds to pay off the $200 Million Note, not including interest, is $9.01. Chardan’s stock had traded as high as $12.66 in April 2006 following Chardan’s entry into the stock purchase agreement in February 2006. At that price the 22,200,000 shares that Advance Pacific will acquire at closing of the Chardan transaction would have a value of over $280 million.

A-5

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Other than its ownership of shares of Gifted Time Holdings, Advance Pacific does not have any other material assets, and Mr. Cheng did not provide any personal guarantee of payment of these two notes issued to OSCAF. In the event that Advance Pacific defaults on the $200 Million Note, ownership of the shares of HLS to be received by Advance Pacific in exchange for its Gifted Time Holdings stock will return through OSCAF to the Gifted Time Stockholders (the seven BVI companies), which would then, among them, have a controlling interest in Gifted Time. As the $200 Million Note does not come due until September 15, 2007, or, under a recent amendment to the note, until 30 days after the closing of the Chardan stock purchase or the termination of the stock purchase agreement, if the date for Chardan to conclude a business combination is extended beyond the current August 10, 2007 date, the ownership interest that would revert to the Gifted Time Stockholders is the 22.2 million shares of HLS stock to be issued to Advance Pacific upon the closing of the transaction with Chardan North. Should that reversion occur, it would result in the seven BVI companies having the ability to control HLS.

In such a situation, HLS may be considered an Overseas Special-purpose Investment Company (“OSIC”) under Chinese law. As a result, it may be necessary for the principals of the seven BVI companies to make and maintain registration under SAFE 75 in order for dividends declared by HLS to be payable outside of China in foreign currency (i.e., US Dollars). In particular, in order for an OSIC to be able to obtain foreign exchange certificates from SAFE in order to distribute assets from China in foreign currencies, such as US Dollars, each Chinese owner of the OSIC must file a registration form with SAFE, and each owner must renew that registration each year. This process is a registration process that does not require government approval, only the willingness of the owners of the seven BVI companies to file and renew the registrations. While Chardan believes the owners of the seven BVI companies would have incentives to do so, as the only manner in which they can receive distributions from the profits generated in China is through the OSIC itself, in this case HLS. Nonetheless, this requirement for registration would not apply if Advance Pacific retains ownership of the HLS stock it will receive in the stock purchase with Chardan. Gifted Time Holdings itself would not be an OSIC, as it will be wholly owned by a BVI company and, to the extent participation in the exchange offer is not complete, one or more U.S.-based investors. However, distributions from HollySys to Gifted Time Holdings, its immediate parent, are not permitted under SAFE Notice 75 unless the applicable registration requirements for HLS are made and maintained.

 

As a result of these transactions, Advance Pacific became the sole owner of Gifted Time Holdings, and Mr. Cheng became its sole director. However, as had been discussed and agreed between Ka Wa Cheng and Qiao Li during negotiations of the purchase, control over Gifted Time Holdings remained with Qiao Li and Wang Chang Li, the chairperson and president of HollySys, respectively. The parties intended for Qiao Li and Wang Changli to continue to exercise control over Gifted Time Holdings, since they were substantially more familiar with the needs of the HollySys operating business, and as residents of China were in a much better position to exercise that control than was Mr. Cheng. In addition, both parties had an incentive to maximize the value of the company, which they agreed required the active input of Qiao Li and Wang Changli on an ongoing basis. In the case of Advance Pacific, its best prospect of realizing a benefit from the transaction was if the profitability of the business increased, which Ka Wa Cheng recognized was best achieved by active oversight from Qiao Li and Wang Changli. From the standpoint of Qiao Li, as it was at least possible, and perhaps probable, that the ownership of Gifted Time Holdings (other than that represented by the preferred stock) would revert to the Gifted Time Holdings Stockholders, she had insisted that Ka Wa Cheng could not change any policy or make any financial or operational changes regarding Gifted Time Holdings or HollySys without the consent of Qiao Li and Wang Changli.

This oral understanding, reached between the parties in the week preceding the sale of the Gifted Time Holdings common shares by OSCAF to Advance Pacific Holdings on December 20, 2006, has since been memorialized in a written voting agreement among Advance Pacific, Ka Wa Cheng and Qiao Li entered into on July 5, 2007. Under that voting agreement, the parties reaffirm their understanding regarding ongoing role of Qiao Li in the management of Gifted Time Holdings and HollySys notwithstanding the acquisition of the Gifted Time Holdings ownership interests by Advance Pacific. The voting agreement provides that Advance Pacific relinquishes its authority to appoint directors of Gifted Time Holdings to Qiao Li, and it also provides that Qiao Li and Wang Chang Li will act as directors of the company, Ka Wa Cheng having resigned from that post. The voting agreement terminates at the option of Qiao Li, upon Advance Pacific’s transfer of the Gifted Time Holdings stock to a third party or upon Advance Pacific’s default on the $200 Million Note. Consistent with that understanding, Ka Wa Cheng has agreed that Qiao Li and Wang Changli will serve as chairperson and as president and member of the HLS board, respectively, upon the completion of the Chardan stock purchase.

Ka Wa Cheng had two reasons for entering into the series of transactions described above. One was to assist Qiao Li in restructuring the transaction so that the Gifted Time Stockholders could receive the cash portion of the consideration payable under the stock purchase agreement with Chardan prior to the end of 2006, enabling them to fulfill their various obligations. The other was to be in a position to benefit from an increase in the stock price of Chardan if it were to reach the point by the due date of the $200 Million Note to enable him to pay the principal and interest due (most likely through substitute financing) and retain ownership of the Gifted Time Holdings stock. As discussed more fully below, the price of Chardan stock had been as high as $12.66 in April 2006, giving the 22.2 million shares that Ka Wa Cheng would own (through Advance Pacific) an aggregate value of more than $280 million. Were the price of Chardan’s stock to increase to near or above that level prior to the time that the $200 Million Note becomes due, the prospect of Ka Wa Cheng’s finding substitute financing to pay off the $200 Million Note would become more feasible. Should Advance Pacific manage to do so, the ownership of the Gifted Time Holdings stock would not revert to the Gifted Time Stockholders. However, even in such circumstances, the employment agreements of Qiao Li and Wang Changli as chairperson and president of HLS, respectively, would give them ongoing substantial control over HLS and HollySys.

A-6

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It appears more likely than not that legal ownership of the Gifted Time Holdings stock transferred to Advance Pacific will revert to the seven BVI companies, for various reasons. First, since Advance Pacific acquired the shares of Gifted Time Holdings the share price of Chardan stock has not reached the value of approximately $9.01 (the point where the HLS stock that Advance Pacific is to receive in the Chardan stock purchase equals its obligations under the $200 Million Note), and the current price is about $8.50. Second, it is likely that the value of the HLS stock that Advance Pacific would receive in the Chardan stock purchase would have to be substantially in excess of that value in order to refinance or pay the $200 Million Note, since the HLS stock Advance Pacific will receive will be unregistered, with restricted ability to be sold and reduced value as collateral for substitute financing. As an affiliate of HLS, Advance Pacific would have additional difficulty selling its stock. Finally, the Gifted Time Holdings stock, and any HLS stock issued in exchange for it in the Chardan stock purchase, has been pledged as security for repayment of the Bridge Loan. As a result, any lender in the substitute financing would either need to take a second position behind the bridge lenders, which have a first lien on the stock, or would need to increase the amount it was willing to finance by the roughly $8 million that could remain due to them after the payment of the cash consideration payable under the Chardan stock purchase was applied to reduce the balance owed to the bridge lenders.

Pursuant to the oral understanding that the parties had reached in the course of negotiations, as part of the restructuring of the Chardan stock purchase and the Bridge Loan, Mr. Cheng, with the knowledge and consent of Qiao Li, took the following actions to recapitalize Gifted Time Holdings: (i) the authorized ordinary shares of Gifted Time Holdings were increased from 50,000 shares with par value of $1.00 per share to 33.5 million shares with par value of $0.01 per share, with the result that the 50,000 shares that were then issued and outstanding were converted into 5 million ordinary shares (ii) 1.5 million preferred shares with a par value of 0.01 per share were authorized; and (iii) an additional 17.2 million ordinary shares were issued to Advance Pacific, its sole shareholder, resulting in a total of 22.2 million ordinary shares issued and outstanding. This recapitalization makes the exchange ratio of stock with HLS one-for-one in the Chardan stock purchase.

The Bridge Loan Transaction. The foregoing transactions accomplished the change of ownership of Gifted Time Holdings and, by virtue of the $30 million note payable by Advance Pacific to OSCAF, established a means of providing the $30 million in cash to the previous shareholders of Gifted Time Holdings before December 31, 2006. To satisfy this cash need, Gifted Time Holdings obtained a $30 million bridge loan from 15 non-affiliated investors. The Bridge Loan is in the face amount of $29,987,000 and carries an interest rate of 10% per annum. It is secured by a pledge of all of the common stock of Gifted Time Holdings. In addition, the parties making the Bridge Loan acquired an aggregate of 1.3 million shares of newly-issued preferred stock of Gifted Time Holdings, each in proportion to the amount of the Bridge Loan it had funded, for an aggregate purchase price of $13,000 (par value), constituting the balance of the $30 million. None of the 15 lenders in the Bridge Loan transaction had a relationship with Chardan or any of its affiliates, except that some of them are stockholders of Chardan and some of them are limited partners in a partnership managed by an affiliate of Chardan. That limited partnership was not involved in this transaction. None of the 15 lenders had any previous relationships with Advance Pacific, Gifted Time Holdings, the seven BVI companies that had owned Gifted Time Holdings, or the PRC operating companies. None of the officers, directors or affiliates of Chardan received any compensation in connection with the Bridge Loan, although Chardan Capital, LLC and Chardan Capital Markets, LLC both helped to identify potential lenders.

Advance Pacific, which received the proceeds of the Bridge Loan and preferred stock sale through a loan to it from Gifted Time Holdings, agreed to guarantee repayment of the Bridge Loan and pledged all of its shares in Gifted Time Holdings to secure that guarantee. As this entire series of transactions was designed to enable Chardan to retain the right to acquire Gifted Time Holdings, the terms were designed to work in conjunction with the anticipated closing of the stock purchase, with additional terms in the event that the Chardan - Gifted Time Holdings transaction does not occur. For example, the repayment terms of the Bridge Loan provide that an aggregate principal amount of $25 million, together with any then unpaid and accrued interest thereon and other amounts payable under the notes, is initially due and payable ten business days following the closing under the stock purchase agreement between Advance Pacific and Chardan. This is coordinated with the terms for payment of the cash consideration under the stock purchase agreement. The balance of the Bridge Loan is to be paid off 60 days following the call (as provided in the warrant agreement) of the publicly traded warrants to be assumed by HLS concurrently with the closing of the redomestication transaction in substitution for the warrants issued by Chardan, which is also coordinated with the terms for payment of the deferred portion of the cash consideration under the stock purchase agreement. As noted, additional provisions exist to govern repayment in the event that the transaction with Chardan is not completed, and there is an absolute repayment date of the entire amount due in repayment of the Bridge Loan of September 30, 2008.

A-7

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As discussed above, the $30 million in proceeds from the Bridge Loan and sale of preferred stock was in turn loaned to Advance Pacific on December 22, 2006 against a note for $30 million payable to Gifted Time Holdings. The repayment terms of this $30 million note issued by Advance Pacific are designed to allow it to repay the money owed to Gifted Time Holdings out of the cash consideration received at closing of the Chardan transaction. Specifically, upon closing of the stock purchase transaction with Chardan, Advance Pacific must make an initial payment of not less than $24 million but up to the full amount of the cash consideration received (potentially as high as $28 million or more, depending on how much interest is earned on the trust fund assets and the number of shares that are redeemed, if any). The balance of the principal sum not covered by the initial payment made by Advance Pacific must be repaid upon Advance Pacific’s receipt of the balance of the cash consideration due to it in connection with the stock purchase transaction. To facilitate this aspect of the transaction, Advance Pacific assigned to Gifted Time Holdings its right to receive the cash consideration payable in the Chardan stock purchase of Gifted Time Holdings.

Advance Pacific used the proceeds of the loan that it obtained from Gifted Time Holdings to pay the $30 million note to OSCAF. As a result, only the $200 Million Note issued by Advance Pacific remains outstanding. If the contemplated stock purchase transaction does not take place, Gifted Time Holdings remains responsible for repaying the Bridge Loan. As further assurance for repayment of the Bridge Loan, Advance Pacific guaranteed that repayment and secured its obligation to do so by pledging all of the stock of Gifted Time Holdings owned by it. The 15 lenders have consented to the transfer of that Gifted Time Holdings stock to HLS on the condition that the stock consideration received by Advance Pacific (the shares of HLS) will be substituted as collateral for that guarantee, with the cash consideration being used to make a partial repayment of the Bridge Loan. While the amount that Advance Pacific agreed to pay for the Gifted Time Holdings stock it acquired ($230 million) was substantially greater than the amounts due under the Bridge Loan, this “excess” security was designed to take into account the possibility that the Chardan transaction might not close and that Advance Pacific may not conclude an alternative financing transaction that would enable Advance Pacific to repay its loan from Gifted Time Holdings. In such a case, the value to be realized from a sale of the Gifted Time Holdings stock could be considerably less than the value that stock will have if the Chardan transaction occurs. In any case, the lenders will be entitled to retain only so much of the proceeds of the sale of the pledged Gifted Time Holdings stock as is needed to satisfy the obligations to them. Any excess will then belong to the party(ies) who own the Gifted Time Holdings Stock at that time. If that owner is OSCAF (which would acquire ownership on default of Advance Pacific’s $200 Million Note), OSCAF would have an obligation to distribute what it receives to the seven BVI companies under the terms of the agreements by which they sold their Gifted Time Holdings stock to OSCAF. The Bridge Loan documents do not require that the collateral securing repayment of the Bridge Loan (either the Gifted Time or the HLS stock, whichever is the case) is to be returned in whole or in part until the Bridge Loan is completely repaid, at which time the bridge lenders have an obligation to release the collateral.

The repayment of the $200 Million Note is not due until after the stock purchase is closed, which means that the initial portion of the cash consideration will have been paid to Advance Pacific and in turn used to reduce the amount of the Bridge Loan that remains outstanding. Should Advance Pacific default on the $200 Million Note, its only obligation is to transfer the HLS stock received in the stock purchase to OSCAF. Advance Pacific remains entitled to receive the balance of the cash consideration payable in the stock purchase, when it is due, and that amount will then be used to repay the loan from Gifted Time Holdings to Advance Pacific (those proceeds already having been assigned to Gifted Time Holdings by Advance Pacific). As a result of this arrangement, even in the event of a default by Advance Pacific on the $200 Million Note, the loan from Gifted Time to Advance Pacific can be repaid in full. Since the payment of the second portion of the cash consideration in the stock purchase must be made only after the exercise of the warrants or from net positive cash flow generated by HLS following the closing of the stock purchase, HLS will also have the financial resources necessary to cover the additional interest that will have become due on the Bridge Loan.

The foregoing transactions required that the stock purchase agreement with Chardan be amended, which occurred on December 20, 2006. The amendment provided that Advance Pacific would receive only 22,200,000 shares of HLS at closing rather than the 23,500,000 originally agreed upon and that the remaining 1.3 million shares would be available for payment to the parties making the Bridge Loan (who also acquired Gifted Time Holdings preferred stock) in exchange for their shares of Gifted Time Holdings preferred stock. In addition, the termination date of the stock purchase was extended to at least August 10, 2007 or such later date as Chardan’s shareholders might, by amendment to Chardan’s certificate of incorporation, agree to allow for the stock purchase to close. This latter change was designed to preserve the benefit of the stock purchase for Chardan’s stockholders. As discussed more fully in the section entitled “Amendments” above, the parties also made a change to the incentive share schedule, initially increasing the incentive shares that were issuable upon achieving the after-tax profit target for 2011 from 2,000,000 to 3,000,000. This change was agreed upon because the delay in concluding the stock purchase transaction had increased the difficulty of Gifted Time Holdings’ accomplishing the 2007 after-tax profit target.

A-8

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Under the regulations that took effect on September 8, 2006, transfer of legal title to the 74.11% of Beijing HollySys to Gifted Time Holdings will, as before, require government approval. Until that approval is sought and obtained, Advance Pacific and, following the Chardan transaction, HLS, will continue to enjoy the benefits of that ownership interest through the consignment agreements conferring the benefits of that ownership on Gifted Time Holdings. The legal opinion to be obtained from Chinese counsel regarding the enforceability of the consignment agreements will state that the consignment agreements are unaffected by the foregoing transactions and remain enforceable. The regulatory matters to be addressed are discussed above under the heading “Consideration of the Stock Purchase Transaction-Regulatory Matters.”

CRITICAL ACCOUNTING POLICIES

The discussion and analysis of the Company’s financial condition presented in this section are based upon the Company’s consolidated financial statements, which have been prepared in accordance with the generally accepted accounting principles in the United States. During the preparation of the consolidated financial statements, the Company is required to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates and judgments, including those related to sales, returns, pricing concessions, bad debts, inventories, investments, fixed assets, intangible assets, income taxes and other contingencies. The Company bases its estimates on historical experience and on various other assumptions that it believes are reasonable under current conditions. Actual results may differ from these estimates under different assumptions or conditions.

In response to the SEC’s Release No. 33-8040, “Cautionary Advice Regarding Disclosure about Critical Accounting Policy,” the Company has identified the most critical accounting policies upon which its financial status depends. It determined that those critical accounting policies are related to the use of estimates, inventory valuation, revenue recognition, income tax and impairment of intangibles and other long-lived assets. These accounting policies are discussed in the relevant sections in this management’s discussion and analysis, including the Recently Issued Accounting Pronouncements discussed below.

 

Revenue recognition

Revenues generated from designing, building, and delivering customized integrated industrial automation systems and providing relevant solutions are recognized over the contractual terms based on the percentage of completion method. The contracts for designing, building, and delivering customized integrated industrial automation systems are legally enforceable binding agreements between the Company and customers. Performance of these contracts often will extend over long periods, and the Company’s right to receive payments depends on its performance in accordance with these contractual agreements. The duration of contracts the Company performs depends on the dollar amount of the contracts. In general, the larger a contract’s size, the longer is the duration of that contract. The duration of small contracts is less than one year, without including the warranty period. The duration of a large contract is longer than one year, without including the warranty period. Including the warranty period, all contracts have a duration longer than one year, ranging from 16 months to 54 months. The operating cycle of the Company is determined by a composite of many individual contracts in various stage of completion and is measured by the duration of the average time intervening between the acquisition of materials or service entering the construction process and the substantial completion of contracts. Based on the historical experience, the operating cycle of the Company exceeds one year.

In accordance with AICPA’s SOP 81-1, “Accounting for Construction Contracts and Certain Production-Type Contracts,” revenue recognition is based on an estimate of the income earned to date, less income recognized in earlier periods. Estimates of the degree of completion are based on the costs incurred to date compared to the expected total costs for the contracts. Revisions in the estimated profits are made in the period in which the circumstances requiring the revision become known. Provisions, if any, are made currently for anticipated loss on the uncompleted contracts. Revenue in excess of billings on the contracts is recorded as unbilled receivables and included in accounts receivable. Billings in excess of revenues recognized on the contracts are recorded as deferred revenue until the above revenue recognition criteria are met. Billings are rendered based on agreed milestones included in the contracts with customers. There can be different milestones in the contracts for which the Company competes, but most often the following four are used: 1) system manufacturing, 2) system delivery, 3) installation, trial-run, and customer acceptance, and 4) expiration of a warranty period. The agreed upon amount to be billed at each milestone is specified in the contract. The first milestone means that work under the contract has started. All contracts have the first milestone, but not all contracts have a prepayment. The Company recognizes 100% of the contractual revenue at the end of the customer acceptance stage, as the Company estimates that no further major costs will be incurred under the contract, a signed customer acceptance document has been obtained, and a warranty period starts to run.

A-9

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Revenue generated from sales of electronic equipment is recognized when persuasive evidence of an arrangement exists, delivery of the products has occurred, customer acceptance has been obtained, which means the significant risks and rewards of the ownership have been transferred to the customer, the price is fixed or determinable and collectibility is reasonably assured.

Warranty

Warranty is a major term under an integrated contract. The warranty period is generally twelve months from customer acceptance, but it may vary in accordance with the terms of the contract. The Company estimates a warranty liability under each contract using a percentage of revenue recognized less warranty costs typically incurred, which is derived from its historical experience. Doing so enables the company to recognize a warranty cost for the appropriate period of time. In addition, at the end of each reporting period, the Company assesses whether or not the accrued warranty liabilities are adequate based on 1) the percentage used, 2) the outstanding warranty period of a contract which has entered the warranty period, 3) the total revenue recognized on a contract which has been under the warranty period, and 4) the aggregate amount of warranty costs incurred on all contracts in the warranty period. The Company adjusts the accrued warrant liabilities in line with the result of its assessment.

The impacts of warranties on the financial statements over the fiscal periods are presented in the table below:

 

		June 30,						June 30,
		2005			2006			2007
Beginning balance		$	881,052		$	1,594,215		$	1,430,736
Expense accrued			1,708,767			1,273,616			1,446,680
Expense incurred			(995,604	)		(1,437,095	)		(750,847	)
Ending balance		$	1,594,215		$	1,430,736		$	2,126,569

Accounts receivable and other receivables

Performance of the contracts often will extend over long periods and the Company’s right to receive payment depends on its performance in accordance with these contractual agreements. The Company bills a customer in accordance with the amount specified under the contract from the unbilled accounts receivable when the Company’s performance has reached a milestone. In general, among four billing milestones, each interval of two contiguous billings under a contract within one year (under certain railway control system contracts, the interval of two contiguous billings is longer than one year) and the last billing to be issued for a contract is at the end of the warranty period. When a customer makes a prepayment at the start of a contract, the amount received will be recorded as deferred revenue. The deferred revenue is recognized as revenue under the completion percentage method along with the progress of a contract. If no prepayment is received by the Company, revenue would be recognized through unbilled accounts receivable. Accordingly, when a particular milestone is reached, a particular amount of unbilled accounts receivable will be transferred into billed accounts receivable. Unbilled accounts receivable will be billed within one year. The Company does not specify credit terms in its invoices, with a hope that customers will make their payment upon receipt, even though the contract terms say that a specific amount is due when reaching a milestone. The Company does not required collateral from its customers. Based on the prevailing collection practice in China, it is a reasonable expectation for enterprises in the automation industry to take over one year to collect billed amounts. The Company considers billed accounts receivable over one year as past due in line with its operations cycle. The components of accounts receivable were as follows:

A-10

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		June 30,						June 30,
		2005			2006			2007
								(unaudited)
Billed accounts receivable		$	25,020,334		$	25,776,682		$	47,038,531
Unbilled account receivable			25,985,132			42,912,201			43,170,940
		$	51,005,466		$	68,688,883		$	90,209,471

Of the above balance of the unbilled accounts receivable, $8,538,259, $9,237,552, and $8,891,429 were related to contracts which have been completed but in the warranty period.

The Company issues invoices to customers without specifying credit terms or interest charges for later payments by its customers. The Company provides a bad debt provision based on the age of billed accounts receivable and factors surrounding the credit risk of specific customers. Management of the Company believes that the long-term relationships with customers and continuously providing services to these customers will minimize the risk of bad debts. Based on historical experience, the bad debt allowances are determined using a percentage method as follows.

		Within 1 year			1-2 years			2-3 years			3-5 years			Above 5 years
Percentage			2	%		5	%		15	%		50	%		100	%

The aging of billed accounts receivable and the corresponding bad debt provision at June 30, 2005 , 2006 and 2007 are as follows:

 

		Under 1 year			1-2 Years			2-3 Years			3-4 Years			4-5 Years			5+ Years
06/30/07
Ending Balance			37,634,850			4,008,102			3,325,697			1,105,508			255,006			709,368
Reported Bad Debt Provision			728,921			200,405			517,726			552,754			127,503			709,368
06/30/06
Ending Balance			18,117,014			4,791,406			1,452,371			313,733			625,792			476,365
Reported Bad Debt Provision			360,070			219,916			220,442			179,258			295,196			476,365
06/30/05
Ending Balance			20,191,612			3,175,337			323,995			638,553			291,382			399,455
Reported Bad Debt Provision			389,744			156,493			46,593			323,808			145,691			399,455

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Although these figures may seem optimistic based on western credit and payment practices, they are consistent with the experience that HollySys has had in the PRC, where many accounts outstanding for extended periods are eventually paid. The Company also establishes additional bad debt provisions for individual customers if there is a deterioration of the customer’s credit worthiness, and if actual defaults in a current period are higher than the historical experience.

 

The Company includes any account balances that are determined to be uncollectible in the allowance for doubtful accounts. After all attempts to collect a receivable have failed or are deemed futile, the receivable is written off against the allowance. Based on the information available to management, the Company believes that its allowances for doubtful accounts as of June 30, 2005, 2006 and 2007, respectively, were adequate. However, actual write-offs might exceed the recorded allowance.

The following table presents allowance activities in accounts receivable.

 

		June 30,						June 30,
		2005			2006			2007
								(Unaudited)
Beginning balance		$	1,113,084		$	1,461,645		$	1,751,247
Additions charged to expense			460,926			664,282			1,086,169
Recovery			(112,365	)		(179,059	)		-
Write-off			-			(195,621	)		(739	)
Ending balance		$	1,461,645		$	1,751,247		$	2,836,667

 

Based on the historical information regarding the recovery of doubtful accounts, the Company estimated that the recovery rate for doubtful billed accounts would be approximately 2%.

Other receivables include deposits required by the contract bidding service providers for every contract the Company has bid for. Contract bidding service providers will deduct a portion of the deposit as service fees if the Company wins a contract and the remaining balance will be returned to the Company after the bidding process completes. If the Company does not win a contract, the deposit will be returned in full amount to the Company after the bidding process completes.

The following table presents allowance activities in other receivables.

 

		June 30,						June 30,
		2005			2006			2007
								(Unaudited)
Beginning balance		$	107,400		$	139,924		$	77,856
Additions charged to expense			32,524			-			33,473
Recovery			-			(30,549	)		-
Write-off			-			(31,519	)		-
Ending balance		$	139,924		$	77,856		$	111,329

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Based on the historical information regarding the recovery of doubtful accounts, the Company estimated that the recovery rate for doubtful other receivables would be approximately 2%.

Inventories

Inventories are composed of raw materials and low value consumables, work-in-process and finished goods. Inventories are stated at the lower of cost or market based on the weighted average method. The work-in-process represents the costs of projects which have been initiated in accordance with specific contracts and are not yet complete. The Company makes provisions for estimated excess and obsolete inventory based on its regular reviews of inventory quantities on hand and the latest forecasts of product demand and production requirements from its customers. The Company writes down inventories for not saleable, excess or obsolete raw materials, work-in-process and finished goods by charging such write-downs to cost of sales. In addition to write-downs based on newly introduced parts, statistics and judgments are used for assessing a provision on the remaining inventory based on sale ability and obsolescence.

Impairment of long-lived assets

The Company reviews long-lived assets for impairment when certain indicators are present that suggest the carrying amount may not be recoverable. This review process primarily focuses on other intangible assets from business acquisitions and property, plant and equipment. Factors considered include the under performance of a business compared to expectations and shortened useful lives due to planned changes in the use of the assets. Recoverability is determined by comparing the carrying amount of long-lived assets to estimated future discounted cash flows. If future discounted cash flows are less than the carrying amount of the long-lived assets, an impairment charge would be recognized for the excess of the carrying amount over fair value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. Additionally, in the case of assets that will continue to be used in future periods, a shortened life may be utilized, if appropriate, resulting in accelerated amortization or depreciation based upon the expected net realizable value of the asset at the date the asset will no longer be utilized by us. Actual results may vary from estimates due to, among other things, differences in operating results, shorter asset useful lives and lower market values.

 

Income taxes

The Company recognizes deferred tax liabilities and assets for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are measured using the enacted tax rate 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 included the enactment date.

The Company assesses the likelihood that its deferred tax assets can be recovered. If recovery is not likely, the provision for taxes must be increased by recording a reserve in the form of a valuation allowance for the deferred tax assets that are estimated not to be ultimately recoverable. In this process, certain relevant criteria are evaluated, including the existence of deferred tax liabilities that will absorb deferred tax assets, the taxable income that can be used to absorb net operating losses and credit carry-backs, and taxable income in future years. The Company’s judgment regarding future profitability may change due to future market conditions, changes in tax laws and other factors. These changes, if any, may require material adjustments to these deferred tax assets and an accompanying reduction or increase in net income in the period when such determinations are made. In addition to the risks described above, the effective tax rate is based on current enacted tax law. Significant changes during the year in enacted tax law could affect these estimates.

In China, the statutory income tax rate is 33%. Beijing HollySys is viewed as a high-tech company by the Chinese government and has been granted favorable treatment on enterprise income tax matters. Under the Chinese government’s current policy, Beijing HollySys is applying for a 15% income tax rate.

Hangzhou HollySys is a foreign invested enterprise located in a coastal city where the statutory income tax rate is 24%, which will be applicable until the Chinese government decides to change this income tax rate. In addition, Hangzhou HollySys has been entitled to a 100% exemption of enterprise income tax for two years and a 50% exemption of enterprise income tax   for three years under Chinese tax laws. Under China tax laws, a tax year is based on a calendar year. Accordingly, the tax incentive programs are also based on a calendar year. Since January 1, 2006, Hangzhou HollySys has been under a 50% tax exemption of income tax, while from January 1, 2009, Hangzhou HollySys will apply for a statutory income tax rate for income tax purposes. Prior to December 23, 2006, Hangzhou HollySys enjoyed a 50% exemption under a 26.4% income tax rate for the first year. On December 23, 2006, Hangzhou HollySys received a notice from the Hangzhou income tax authority, which indicated that the income tax rate applicable to Hangzhou HollySys should be adjusted to 16.5% effective January 1, 2006 in accordance with relevant regulations regarding the development zones, as Hangzhou HollySys is located in a development zone recognized by the Ministry of Land and Resource in China. In addition, Hangzhou HollySys received a tax refund of approximately $555,000 as of December 31, 2006. This refund and corresponding amortization of deferred tax liabilities using the newly enacted tax rate were recognized in the income tax provision for the year ended June 30, 2007.

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Government Subsidies

Each of the three subsidiaries of the Company has received certain government subsidies from local Chinese government agencies during the past three years, which accounted for 21.55%, 27.11%and 38.6%, respectively, of the income before income tax on a gross basis. In general, the Company presents the government subsidies received as part of other income unless the subsidies received are earmarked to compensate certain expenses, which are accounted for by offsetting the specific expense, such as research and development expense.

The PRC government has provided various incentives to high technology companies, including HollySys, in order to promote the development of the high technology sector of China’s economy. HollySys has received government incentives in the form of various government grants, which have been granted by certain government agencies in terms of their respective agenda.

The local governments in Beijing and Hangzhou have provided high technology companies with various subsidies to support various research and development efforts conducted by these companies. The most notable form of subsidy is the refund of value added tax (‘VAT’) paid by the recipient companies. Being approved by the relevant tax authority, Beijing HollySys and Hangzhou HollySys have been entitled to receive a refund, which is the amount beyond the 3% of the actual VAT paid to the government over the current revenue associated with this VAT. Based on the information available to date, the government subsidies sourcing from VAT paid will cease at the end of 2010.

 

The Company is unable to predict whether or not any other forms of government subsidies will be available for the upcoming years or whether current subsidies will be decreased or terminated. The Company is unable to anticipate any changes of government policies or decisions. Any reduction or termination of incentives or grants currently received by the Company would have a material adverse effect on its results of operations.

Notes Payable

During the period from December 18 to 20, 2006, the Company and the original Chinese owners entered into a series of significant transactions with Chardan North China Acquisition, Inc. (“Chardan”), Advance Pacific Holdings Limited (“APH”), which is solely owned by Mr. Ka Wa Cheng, and 15 investors who provided a bridge loan and purchased 1.3 million preferred shares in the aggregate amount of $30 million in order to satisfy the financing needs from the original Chinese owners of the Company. These transactions are disclosed under the heading “Recent Significant Transactions”.

On December 20, 2006, the Company issued 15 notes in aggregate of $29.87 million payable to 15 investors and 1.3 million preferred shares with a part value of $0.01 per share in exchange for the proceeds of $30 million. The notes issued to the 15 investors bear an interest at 10% per annum. The repayment terms are pretty much depending on the completion of the amended stock purchase transaction between the original Chinese owners of the Company and Chardan unless this contemplated transaction will not be approved by the stockholders of Chardan. The newly issued 1.3 million preferred shares in conjunction with the 22.2 million common shares (which are disclosed in Note 12) will be converted into, in aggregate, 23.5 million of common shares of HLS, the successor company of Chardan. In accordance with EITF 00-27, the Company identified the fact that the closing price of Chardan’s common share was $7.34 per share on December 20, 2006 and believed that this price was the most objective indicator of the fair value of these 1.3 million preferred shares. Using the relative fair value method, the Company allocated the entire $30 million proceeds between the $29.987 million notes payable and 1.3 million preferred shares, resulting in a discount of $7,239,390 to the $29.987 million notes payable. The Company estimated that the life of these notes payable will be about nine months with the expectation that the contemplated stock purchase transaction will be approved by the stockholders of Chardan before on September 20, 2007. With such estimated life of the Bridge Loan, the Company adopted the effective interest rate method to amortize the discount of $7,239,390 over the nine-month period. As of June 30, 2007, the outstanding balance of 15 notes payable was $27,566,936, net of the discount of $4,819,326.

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Note Receivable from the Stockholder

On December 21, 2006, in accordance with a series of sales and purchase agreements between the original Chinese owners and Mr. Ka Wa Cheng, the entire proceeds of $30 million were wired to the original Chinese owners’ bank accounts through Chardan Capital, Inc, a related party to Chardan and the note receivable was legally under the name of APH. The repayment obligation will be discharged by using the proceeds collected from Chardan after the contemplated stock purchase transaction would have been consummated in September 2007. Because APH is the sole legal owner of the Company now without substantial operating activities and material assets, the note receivable from APH was presented in the stockholder equity section on the balance sheet as of June 30, 2007.

FINANCIAL POSITION

During the fiscal year ended June 30, 2007, total assets increased by $34,906,411 from $120,024,159 at June 30, 2006 to $154,930,570 at June 30, 2007. The majority of the increase was in accounts receivables, advance to suppliers, inventories and long-term investments, but offset with a decrease of $451,601 in property, plant and equipment.

Accounts receivable at June 30, 2007 was $87,372,794, an increase of $20,435,158, or 30.53%, compared to $66,937,636 at June 30, 2006. The increase was attributable mainly to higher revenues from both integrated contract and product sales in fiscal 2007, compared to the same category of revenue in fiscal 2006. And another reason for the increase in accounts receivables was a result of the increase in long-term contracts performed in fiscal 2007.

Advance to suppliers at June 30, 2007 was $8,146,854, an increase of $2,600,769, or 46.89%, compared to $5,546,085 at June 30, 2006. The increase was mainly for supporting sales backlog from newly won railway contracts.

Inventory at June 30, 2007 was $13,907,280, increased by $6,076,438, or 77.6%, compared to $7,830,842 at June 30, 2006. Significant increase in inventories is caused by significant increase in work-in-progress goods for supporting the newly won contracts, specially railway contract. The turnover of inventory was 61 days for fiscal 2007, increased by 9 days, or 18%, compared to 52 days for fiscal 2006.

Long-term investment at June 30, 2007 was $9,192,888, increased by $3,911,725, or 74.07%, compared to $5,281,163 at June 30, 2006. The increase in long-term investment is mainly caused by investment in IPE biotechnology Co., and Beijing Best Power electrical technology Co., Ltd. during fiscal 2007.

Total liabilities at June 30, 2007 were $104,703,288, increased by $39,041,911, or 59.46%, compared to $65,661,377 at June 30, 2006. The increase in liabilities was mainly due to the increase in short-term bank loan, notes payable and accounts payable, offset by the decrease in short-loan from related parties, long-term loan, and dividend payable.

Short-term bank loan at June 30, 2007 was increased by $9,291,359 from $7,130,081 in fiscal 2006 to $16,421,440 in fiscal 2007. The increase in short-term bank loan was to finance the working capital to support the business growth of the Company.

Note payable at June 30, 2007 was increased by $27,566,936 from $0 in fiscal 2006 to $27,566,936 in fiscal 2007. The increase in note payable is a result of a series of private placement related transactions took place in December 2006.

Accounts payable at June 30, 2007 increased by $5,786,229 from $16,523,600 in fiscal 2006 to $22,309,829 in fiscal 2007. The increase in accounts payable was a result of the increase in inventory purchases to support the sales backlog in newly won contracts, specially in railway contracts.

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RESULTS OF OPERATIONS

Comparison of Fiscal Years Ended June 30, 2007 and 2006

Operating Revenues

For the year ended June 30, 2007, total revenues amounted to $101.89 million, an increase of $11.97 million, compared to $89.92 million for the prior fiscal year, representing a significant increase of 13.3%.

Of the total revenues of $101.89 million, the integrated contract revenue accounted for $97.38 million, an increase by $11.19 million, compared to $86.19 million for the prior fiscal year, representing a 13.0% increase. The increase of revenue was due to the number of total integrated contracts under operations was greater than those for the prior fiscal year. There were 2,089 contracts under operations for the year ended June 30, 2007 compared to 1,609contracts for the prior fiscal year, a 29.8% increase. In addition, the overall completion percentage of all contracts under operations for the fiscal year ended June 30, 2007 was higher than that for the prior fiscal year.

Of the $101.89 million of total revenues, approximately $4.51 million related to product revenue, an increase of approximately $776,000, compared to $3.73 million of product revenue for the prior year, a 20.8% increase. The increase was mainly due to the increase in customers’ demands for the Company’s equipment for customers’ maintenance and replacement purposes during this period.

Revenue Backlog

An important measure of the stability and growth of the Company’s business is the size of its backlog, which represents the total amount of unrecognized revenue associated with existing contracts. Any deferral of revenue recognition is reflected in an increase in backlog as of the end of current period. The backlog as of June 30, 2007 amounted to $101.92 million, representing an increase of 17.5%, compared to $86.75 million as of June 30, 2006.

Of the total backlog, the aggregate contract values of the contracts unstarted, started and unfinished in the current period was $67.60 million and the amount of the contracts started in the prior year and unfinished was $34.32 million, while the total backlog at June 30, 2006 comprised of $54.95 million from the contracts unstarted, started and unfinished and $31.80 million from contracts started in the prior year and unfinished, respectively.

Cost of Revenues

The total cost of revenues amounted to $66.10 million, an increase by $8.15 million, compared to $57.95 million for the prior fiscal year, representing a 14.1% increase. The increase was in line with the increase in total revenues. The increase of $8.15 million comprised of the increase in cost of integrated contracts by $7.18 million and an increase in cost of products sold by $976,000. The increase percentage in cost of integrated contracts was lower than revenue increase percentage in integrated contracts mainly related to the higher gross margin embedded in the integrated contracts from transportation industry, such as railway and city light rail.

Cost of revenues can be divided into cost of integrated contracts and cost of products sold, in line with the categories of revenues. The components of cost of revenues shifted immaterially, as the cost of integrated contract revenue accounted for 97.2% of the total cost of revenues for the fiscal year ended June 30, 2007, compared to 98.5% for the prior fiscal year.

The cost of integrated contract revenue consists primarily of three components: cost of equipment and materials, labor costs and other manufacturing expenses incurred from designing, building and delivering customized automation solutions to customers. The total cost of integrated contracts was $64.28 million for the fiscal year ended June 30, 2007, compared to $57.11 million for the prior fiscal year, representing an increase of $7.18 million, or a 11.2% increase. The increase was primarily due to the following factors: 1) an increase of $2.82 million in cost of equipment and materials, and 2) an increase of $3.34 million in other manufacturing expense incurred, which was primarily due to the proportion of cost of equipment and materials accounted for the total cost of integrated contracts declined while the proportion of manufacturing expenses increased significantly, resulting a significant increase in the amount of manufacturing expenses under an increased aggregate amount of cost of integrated contracts., and 3) an increase of $1.02 million in labor cost, primarily due to the increase in average labor salary and welfare costs.

A-16

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As a percentage of cost of integrated contract revenue, labor cost accounted for 7.8%, compared to 7.0% for the prior fiscal year; cost of equipment and materials accounted for 68.0%, compared to 71.6% for the prior fiscal year; and other manufacturing expenses accounted for 24.2%, compared to 21.4% for the prior fiscal year. As a percentage of integrated contract revenue, labor cost accounted for 5.2%, compared to 4.6% for the prior fiscal year, which was caused by the increase in average labor cost and welfare cost; cost of equipment and materials accounted for 44.8%, compared to 47.4% for the prior fiscal year, the decrease was driven by the embedded high gross margin associated with railway and city light rail contracts; and other manufacturing expenses accounted for 16.0%, which increased from 14.2% for the prior fiscal year, mainly due to the components of cost of integrated contracts varied in the current period. The components of cost of integrated contracts were determined and varied based on respective customized individual integrated solution contract according to requirements of different customers. Due to the combined impact of these changes in cost of integrated contract revenue, gross margin for integrated contracts increased significantly from 33.7% for the fiscal year ended June 30, 2006 to 34.0% for the fiscal year ended June 30, 2007.

Sales of products represent sales of spare parts (either self-made or purchased from outside vendors) to customers for maintenance and replacement purposes. The outside purchased products and self-made products have different functions and capabilities. The Company decides whether or not to purchase from outside vendors or make the necessary products itself based on the needs and preferences of different customers and efficiency considerations. Therefore, as a percentage of the cost of products sold, the self-made products and outsourced products have varied significantly from time to time. As self-made products generally contribute higher margin than outside purchased products, sales of a greater portion of self-made products generally result in lower cost of products sold. Cost of products sold for the fiscal year ended June 30, 2007 was $1.82 million, an increase of $976,000, compared to $842,000 for the prior fiscal year. The increase in cost of products sold was due mainly to the fact that outside purchased products contributed a bigger portion of cost of product sold for the fiscal year ended June 30, 2007 than what it did in the prior fiscal year.

Gross Margin

As a percentage of total revenues, the overall gross margin declined slightly to 35.1% for the fiscal year ended June 30, 2007 from 35.6% for the prior fiscal year, primarily because gross margin for products sold declined though gross margin for integrated contracts increased.

The gross margin for integrated contracts was 34.0% for the year ended June 30, 2007 compared to 33.7% for the prior year. The increase in gross margin was due mainly to the fact that more contracts relating to railway and city light rail transportation were started in the fiscal year ended June 30, 2007, which contribute higher margins, than contracts in process in the prior fiscal year. Additionally, more efficient deployment of the work force and improved project management capabilities and other cost-saving measures contributed to the increase.

The gross margin for products sold was 59.6% for the fiscal year ended June 30, 2007 compared to 77.4% for the prior fiscal year. The bigger proportion of outside purchased products with lower gross margins resulted in the decline in gross margin for products sold.

Operating Expenses

Selling Expenses

Selling expenses mainly consist of compensation, traveling and administrative expenses related to marketing and sales and promotion activities of the Company’s marketing and credit departments. Selling expenses were approximately $7.58 million for the fiscal year ended June 30, 2007, an increase of 15.8%, or roughly $1.20 million, compared to approximately $6.38 million for the prior fiscal year. Of the total increase, $418000 was related to payroll expense of sales personnel, $272,000 was for travel expense, $51,000 was for sales promotion and advertisement, and $461,000 was for office expenses, including telephone and other utilities, and office supplies, offset little by a decrease of $3,000 in bidding expenses for the fiscal year ended June 30, 2007, compared to the same category of selling expenses for the prior fiscal year. As a percentage of total revenues, selling expenses accounted for 7.4% and 7.1% for the fiscal year ended June 30, 2007 and 2006, respectively. The Company has established guidelines to monitor and evaluate sales performance for its products to customers in different industries and regions to control selling expenses.

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General and Administrative Expenses

General and administrative expenses mainly include compensation, traveling and other administrative expenses of non-sales-related departments, such as the planning and financial department, information systems department and human resources department. The legal and accounting expenses associated with the efforts of HollySys to enter into a business combination with Chardan are also a component of general and administrative expenses.

General and administrative expenses amounted to approximately $7.10 million for the fiscal year ended June 30, 2007, an increase of roughly $615,000, compared to approximately $6.48 million for the prior fiscal year, representing an increase of 9.5%. The increase in general and administrative expenses was the result of several factors: 1) an increase of $594,000 in bad debt provision; 2) an increase of $406,000 in office expense. The above increases were offset by the following items:1) a decrease of $112,000 in compensation paid to non-sales-related employees; 2) a decrease of $17,000 in travel expenses; 3) a decrease of $153,000 in depreciation and amortization expenses; and 4) a decrease of $104,000 in guarantee expense, etc. As a result of the above net decreases, general and administrative expense accounted for 7.0% and 7.2% of total revenues for the fiscal year ended June 30, 2007 and 2006, respectively.

Research and Development Expenses

Research and development expenses comprise mostly employee compensation, materials consumed and experiment expenses for specific new product research and development, and any expenses incurred for basic research on advanced technologies. The nature of our business entitles us to receive governmental subsidies to support our research and development activities. In our financial statements, we present our research and development expenses as a net figure, which is the amount we spent on research and development less the amount of government subsidies that we received for encouraging research and development purposes.

Research and development expenses were presented on the statement of income as $2.64 million in the fiscal year ended June 30, 2007 and $78,000 for the prior fiscal year. The actual research and development expenses amounted to $4.68 million and $1.94 million for the fiscal years ended June 30, 2007 and 2006, respectively. The actual research and development expenses was offset of $2.04 million and $1.86 million against subsidy income for the fiscal years ended June 30, 2007 and 2006, respectively. The significant increase in R&D expenses was due that approximate $ 2.56 million R&D expenditures related to railway signaling control systems had been expensed in the current period, which were not offset by subsidy income.

Income from Operations

Income from operations decreased by approximately $563,000, or 3.0%(negative), from $18.99 million for the fiscal year ended June 30, 2006 to $18.43 million for the fiscal year ended June 30, 2007, due primarily to the increase of $4.38 million, or 33.8%, in total operating expenses, though an increase of $3.82 million, or 11.9%, in gross profit was achieved in the current year. The increase in total operating expenses was affected significantly by the increase in Research and development expenses. Therefore, as a percentage of total revenue, the operating income for the fiscal year ended June 30, 2007 was 18.1% compared to 21.1% for the prior fiscal year. The slight decrease as a percentage of total revenues was due mainly to the fact that the degree of increase in gross profit was lower than that in total operating expenses.

Interest Expenses, Net

For the year ended June 30, 2007, net interest expenses increased by $6.52 million, or 599.0%, from $1.09 million for the prior year to $7.61 million for the current period. The increase was primarily due to $6.40 million interest expenses related to a $29.987 million bridge loan, including the amortization of $4.82 million from discount to notes payable and the accrued interest of $1.58 million based on an interest rate specified on the 15 notes payable. The Bridge Loan of $29.987 million was part of significant transactions entered by the Company and among other parties in December 2006.

In addition, the Company received $157,000 of interest income for the fiscal year ended June 30, 2007, compared to $134,000 in the prior fiscal year, a increase of $23,000, mainly due to the increased average outstanding bank deposit.

Also, the Company incurred interest expenses of $2.46 million in the current period compared to $1.22 million in the prior year. Except for the above interest expenses related to the Bridge Loan, the remaining increase of $ 142,000 was due to the following reasons: On one side, in the fiscal year ended June 30, 2007, the Company’s average outstanding bank loans were $2.42 million higher than that of the prior fiscal year. Among the average outstanding bank loans, the long-term bank loans were $1.82 million higher than that in the prior fiscal year, and short-term bank loans increased by $602,000. On the other side, because of the fact that the People’s Bank of China (PBC, the central bank of China) had raised the benchmark interest rate of the one-year loan to financial institutions five times since April 28, 2006, resulting in a fact that the benchmark interest rate of the one-year loan to financial institutions increased by 1.35 percent in total, the Company was exposed to 5.83% average interest rate of short-term bank loan in the fiscal year ended June 30, 2007 compared to 5.60% in the prior fiscal year, representing a 0.23% increase of interest rate, which resulted in that the Company were exposed to the higher interest expense level than the prior period.

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As a percentage of total revenues, the net interest expense for the fiscal year ended June 30, 2007 was 7.5%, compared to 1.2% for the prior fiscal year.

Other Income (Expense), Net

Other income (expense) consists of miscellaneous income from non-operating activities. For the fiscal year ended June 30, 2007, the company generated $411,000 other income and incurred $238,000 other expense. The amount in other income (expense) was immaterial to the Company’s financial performance.

Subsidy Income

The local governments in Beijing and Hangzhou provide financial subsidies out of the value added tax they collect in order to encourage the research and development efforts of certain enterprises. Beijing HollySys, Haotong and Hangzhou HollySys all receive such subsidies. All subsidies were accounted for based on hard evidence that the operations of those companies were entitled to receive these subsidies or that cash had been received. Value added tax refunds recognized for supporting research and development efforts were first offset against research and development expenses, and the remaining balance, if any, together with other subsidies, was recognized as subsidy income in accordance with internationally prevailing practice.

Subsidy income received from the government for the fiscal year ended June 30, 2007 amounted to $9.32 million, compared to $6.22 million for the prior fiscal year. Proceeds from subsidies used to offset actual research and development expenses amounted to $2.04 million and $1.86 million for the fiscal years ended June 30, 2007 and 2006, respectively. The remaining amounts of subsidy income of $7.28 million and $4.36 million for the fiscal years ended June 30, 2007 and 2006, respectively, were presented as a separate line item on the statement of income.

Income Tax Provision

For the year ended June 30, 2007, the Company’s income tax provision was $2.50 million for financial reporting purposes, whereas the income tax provision was $1.37 million for the prior year. This change was due mainly to the three factors. Beijing HollySys had an income tax provision of approximately $1.30 million for the year ended June 30, 2007, compared to $128,000 income tax provision for the prior fiscal year. The increase in income tax was due to the taxable income for the year ended June 30, 2007 was higher than that for the prior year after deduction of deductible items under PRC income tax law. Haotong had an income tax provision of approximately $1,000 for the year ended June 30, 2007 compared to $72,000 for the prior fiscal year. Hangzhou HollySys had income of approximately $18.78 million before income tax for the fiscal year ended June 30, 2007 compared to $19.15 million for the prior fiscal year. However, Hangzhou HollySys was under 100% exemption from income taxes for the first half in the fiscal year 2006, and starting from January 1, 2006, Hangzhou HollySys was entitled to a 50% exemption for the second half of fiscal year 2006, while it was entitled to receive a 50% exemption for the whole fiscal year 2007 (Hangzhou HollySys’ tax year is based on a calendar year and 50% exemption was 8.25% out of 16.5% tax rate, which is specified by Zhejiang province tax authority. Hangzhou is entitled to have three years with 50% exemption beginning January 1, 2006.). The income tax provision of Hangzhou HollySys was $1.20 million for the fiscal year ended June 30, 2007, compared to $1.17 million of tax provision for the prior fiscal year. The increase due to the Company was exposed to a higher effective income tax rate was offset by the tax refund of approximately $555,000 received in December 2006 from the Chinese tax authority for the overpaid income tax due to the change of effective income tax rate from 26.4% to 16.5% was offset from the tax provision for the fiscal year ended June 30, 2007.

Minority Interest

The minority interest of the Company includes other parties’ interests in Beijing HollySys and Haotong. The ownership interests of minorities in these two Operating entities were 25.89% and 30%, respectively.

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The minority interest for the fiscal year ended June 30, 2007 was approximately $3.06 million, a decrease by $461,000 compared to $3.52 million for the prior year. The minority interest percentage in Beijing HollySys and Haotong did not change during the fiscal year ended June 30, 2007. The decrease was attributable to the decrease in net income of Haotong, which led to the decrease in minority interests of $229,000, and minority interests of Beijing HollySys decreased by $232,000, which resulted from a decrease in net income of Beijing HollySys for the fiscal year ended June 30, 2007 compared with the prior fiscal year.

Net Income

For the fiscal year ended June 30, 2007, the Company’s net income amounted to $13.08million after deducting the portion attributed to the minority interest, a decrease by $4.97 million, compared to $18.05 million for the prior fiscal year, or 27.5%. This decrease was attributable primarily to the significant increase in interest expenses related to the $29.987 million bridge loan, offset by increased gross profits and subsidy income.

Comparison of Fiscal Years Ended June 30, 2006 and 2005

Operating Revenues

 

For the fiscal year ended June 30, 2006, total revenues amounted to $89.92 million, an increase by $10.35 million compared to $79.57 million for fiscal 2005, representing a 13% increase.

 

Of the total revenue of $89.92 million, the integrated contract revenue accounted for $86.19 million, an increase by $11.16 million compared to $75.03 million for fiscal 2005, representing a 14.9% increase. The increase was primarily due to a greater number of integrated contracts being performed during the fiscal year ended June 30, 2006. There were 1,609 contracts being performed during fiscal 2006 compared to 1,514 in the prior year, representing a 6.27% increase.

 

Of the total revenues of $89.92 million, approximately $3.73 million was derived from product sales, a decrease of approximately $817,000 over the $4.55 million in product revenue in the prior year, an 18% decrease. The decrease was mainly due to the reduced demand for the Company’s equipment for customers’ maintenance and replacement purposes during this year.

Revenue Backlog

 

An important measure of the stability and growth of the Company’s business is the size of its backlog, which represents the total amount of unrecognized revenue associated with the existing contracts the Company has won. Any deferral of revenue recognition or newly won contracts but not completed are reflected in an increase in backlog as of the period end. The Company’s revenue backlog growth rate was higher than the preceding year. The backlog as of June 30, 2006 amounted to $86.75 million, representing an increase of 22.3% compared to $70.93 million as of June 30, 2005.

Of the total backlog of $86.75 million at June 30, 2006, the amount attributable to contracts awarded in the current year was $54.95 million, while $31.80 million was from contracts awarded prior to the current year. Of the total backlog of $70.93 million at June 30, 2005, $46.95 million was attributed to contracts awarded in fiscal 2005, and $23.98 million was attributable to contracts awarded prior to fiscal 2005. The increase in both revenues and backlog indicated that the Company’s business continued to expand in 2006 in terms of the ability to generate revenues.

Cost of Revenues

 

The total cost of revenues amounted to $57.95 million, an increase by $3.27 million compared to $54.68 million in the prior year, a 6.0% increase.

 

Cost of revenues can be divided into cost of integrated contracts and cost of products sold, in line with the categories of revenues. The components of cost of revenues shifted somewhat, as the cost of integrated contract revenue increased from 95.4% of the total cost of revenues for the prior year to 98.5% for the current year ended June 30, 2006. That is consistent with the fact that the Company’s integrated contract revenues increased by about 13% compared with 2005, while its product sales revenues decreased slightly.

 

The cost of integrated contract revenue consists primarily of three components: cost of equipment and materials, labor costs and other manufacturing expenses incurred from designing, building and delivering customized automation solutions to customers. The total cost of integrated contracts was $57.11 million for fiscal year 2006, compared to $52.16 million in the prior year, representing an increase of $4.94 million, or a 9.5% increase. The increase was primarily due to the following factors: first, an increase of $4.19 million in the cost of equipment and materials, accounting for 84.7% of the total increase, was primarily due to the increased volume of materials and equipment required according to the needs of customers. Second, an increase of $642,000 in labor cost, accounting for 13.0% of total increase, was primarily due to the increase in average labor salary and welfare costs. Third, an increase of $112,000 was from other manufacturing expenses.

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As a percentage of cost of integrated contract revenue, labor cost accounted for 7.0% compared to 6.4% in the prior year, cost of equipment and materials accounted for 71.6% compared to 70.3% in the prior year, and other manufacturing expenses accounted for 21.5%, which decreased slightly from 23.3% in the prior year. As a percentage of integrated contract revenue, labor cost accounted for 4.6% compared to 4.4% in the prior year, representing a minor change, which was caused by the increase in average labor cost, and cost of equipment and materials accounted for 47.4% compared to 48.9% in the prior year, the decrease was driven by adopting cost saving measures and strengthening ability on price bargain, and other manufacturing expenses accounted for 14.2%, which decreased slightly from 16.2% in the prior year, mainly due to the economies of scale as business expanded. The components of cost of integrated contract were determined and varied based on customized individual integrated solution contract according to requirements of different customers. The varied component of costs led to insignificant fluctuation of gross margin year over year. Due to the combined impact of these changes in cost of integrated contract revenue, gross margin for integrated contracts increased from 30.5% for the fiscal year ended June 30, 2005 to 33.7% for the fiscal year ended June 30, 2006.

 

Sales of products represent sales of spare parts (either self-made or purchased from outside vendors) to customers for maintenance and replacement purposes. The outside purchased products and self-made products have different functions and capabilities. The Company decides whether or not to purchase from outside vendors or make the necessary products itself based on the needs and preferences of different customers and efficiency considerations. Therefore, the components of self-made products and outsourced products under the cost of products sold have varied significantly each year. Since self-made products generally contribute higher margin than outside purchased products, sales of a greater portion of self-made products result in lower cost of products sold. Cost of products sold for the fiscal 2006 was only $843,000, a decrease of $1.68 million, or 66.0%, compared to $2.52 million in the prior year, since outside purchased products contributed a much bigger portion of cost of product sales in fiscal 2005 than that in fiscal 2006.

Gross Margin

As a percentage of total revenues, the overall gross margin was 35.6% for the fiscal year ended June 30, 2006 compared to 31.3% in the prior year.

The gross margin for integrated contracts was 33.7% for the fiscal year ended June 30, 2006 compared to 30.5% in the prior year. The Company’s ability to improve its gross margins was a result of adopting some new cost-saving measures, such as centralized procurement with volume discounts and rebates, a more efficient deployment of its work force and improved project management capabilities. The Company intends to continue to strengthen its cost-saving measures.

Operating Expenses

Selling Expenses

Selling expenses mainly consist of payroll and welfare costs of marketing and sales staff, traveling and administrative expenses related to marketing and sales and promotion activities of the Company’s marketing and credit departments. Selling expenses were approximately $6.38 million for the fiscal year ended June 30, 2006, an increase of 13.0%, or roughly $732,000, compared to approximately $5.65 million in the prior year. Of the total increase, $609,000 was related to payroll and welfare of marketing and sales staff, $176,000 was for travel expense, $16,000 was for bidding expense, and $6,000 was for administrative expenses, including telephone and other utilities, and office supplies, all of which was offset by the decrease of $75,000 in advertising expenses, compared to the prior year. As a percentage of total revenues, selling expenses accounted for 7.2% and 7.1% for the fiscal year ended June 30, 2006 and 2005, respectively. The Company has established guidelines to monitor and evaluate sales performance for its products to customers in different industries and regions to control selling expenses.

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General and Administrative Expenses

General and administrative expenses mainly include payroll and welfare, traveling and other administrative expenses of administrative departments, such as the planning and financial department, information systems department and human resources department. The legal and accounting expenses associated with the efforts of HollySys to enter into a business combination with Chardan are also a component of general and administrative expenses.

General and administrative expenses amounted to approximately $6.48 million for the fiscal year ended June 30, 2006, an increase of roughly $1.34 million compared to approximately $5.14 million in the prior year, representing an increase of 26.2%. The increase in general and administrative expenses was the result of several factors. First, the activities connected with the efforts to become listed in a stock exchange outside China caused us to incur $929,000 in professional service fees, such as fees charged by lawyers and auditors, during this period, while there were no such expenses during the same period the prior year. Second, payroll and welfare increased by $385,000, primarily due to implementation of Chinese government rules which require foreign invested enterprises to provide for employee welfare according to the discretion of the board of directors based on PRC reported net income. Third, travel expenses increased by $62,000. Fourth, an increase of $16,000 in guarantee expenses paid to assurance companies. Fifth, depreciation expenses increased by $10,000. Sixth, bad debt provision increased by $74,000. The above increases were offset by decreases in office expenses (such as supplies, copying expenses, mailing fees, and utilities) of $130,000. As a result of the above net increases, general and administrative expense accounted for 7.2% versus 6.5% of total revenues for the fiscal year ended June 30, 2006 and 2005, respectively.

Research and Development Expenses

 

Research and development expenses comprise mostly payroll and welfare of research and development personnel, materials consumed and experiment expenses for specific new product research and development, and any expenses incurred for basic research on advanced technologies. The nature of the business entitles us to receive governmental subsidies to support research and development activities. In the financial statements, HollySys presents its research and development expenses as a net figure, which is the amount HollySys spent on research and development less the amount of government subsidies that HollySys received for research and development.

 

Research and development expenses were presented on the statement of income as $78,000 for the fiscal year ended June 30, 2006 compared to $202,344 in the prior year. This was due to the fact that subsidy income received from the government increased to $6.22 million from $3.55 million for the fiscal year ended June 30, 2006 and 2005, respectively. This subsidy income was offset against actual research and development expenses of $1.86 million and $1.02 million for the fiscal year ended June 30, 2006 and 2005, respectively. Among the $1.86 million of research and development expense offset against subsidy income received, the amount for Beijing HollySys, Hangzhou HollySys and Haotong was $677,000, $1.16 million and $23,000, respectively; and the research and development expenses incurred in Beijing HollySys and Hangzhou HollySys were offset totally in the current year.

Income from Operations

Income from operations increased significantly by approximately $5.12 million, or 36.9%, from $13.87 million for the fiscal year ended June 30, 2005 to $18.99 million for the fiscal year ended June 30, 2006, as a result of the following reasons: $10.34 million in total revenues, $3.27 million in cost of revenues, $732,000 in selling expenses and $1.35 million in general and administrative expenses. Therefore, as a percentage of total revenue, the operating income for the fiscal year ended June 30, 2006 was 21.1% compared to 17.4% in the prior year. The increase as a percentage of total revenues was due mainly to the increase in revenue and gross profit which were contributed by the expansion of business scale based on increased demand from customers and the cost-saving measures.

Interest Expenses, Net

For the fiscal year ended June 30, 2006, net interest expenses increased by $533,000, or 95.9%, from $556,000 in the prior year to $1.09 million. The increase in interest expenses was mainly due to the fact that the Company received specified governmental subsidies of approximately $242,000 for the purpose of offsetting interest expense for the fiscal year ended June 30, 2005 that it did not receive in the current year. In addition, the Company’s outstanding bank loans especially short-term bank loans in the fiscal year ended June 30, 2006 were higher than the outstanding bank loans during the prior year, which increased interest expense from $646,000 to $1.22 million for the fiscal year ended June 30, 2005 and 2006, respectively. Also, the Company received $134,000 of interest income for the fiscal year ended June 30, 2006, compared to $91,000 for the prior year. As a percentage of total revenues, the net interest expense for the fiscal year ended June 30, 2006 was 1.2% compared to 0.7% for the prior year.

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Other Income (Expenses), Net

Other income (expense) consists of miscellaneous income from non-operating activities. For the fiscal year ended June 30, 2006, other net income (expenses) decreased by $133,000, or 68.5%, from $195,000 for the prior year to $61,000. The decrease was mainly due to the fact that Beijing HollySys sold some technology to another subsidiary and thus incurred related business taxes and urban construction and maintenance fees. Overall, the change in other income (expense) was immaterial to the Company’s financial performance for the fiscal year ended June 30, 2006 compared with the fiscal 2005.

Subsidy Income

Subsidy income received from the government for the fiscal year ended June 30, 2006 amounted to $6.22 million, compared to $3.55 million for the fiscal year ended June 30, 2005, representing an increase of $2.67 million or 75.2%. Of the increase of $2.67 million, the refund sourcing from value added tax increased by $911,000, mainly attributed to the increase in revenue generated in Hangzhou HollySys in terms of nationwide implementation of the government policy. Of the increase of $2.67 million, $1.76 million was a result of implementing incentive programs initiated by various government agencies and received by HollySys in its Beijing location. These grants would take place from time to time, and the Company has no controls on when to receive these grants. Any reduction of these grants will have a material impact on the Company’s operation results.

Proceeds from subsidies were used to offset actual research and development expenses amounted to $1.86 million and $1.02 million for the fiscal years ended June 30, 2006 and 2005, respectively. Also, approximately $242,000 of financial subsidies from the government was used to offset interest expenses incurred for the prior year. The remaining amounts of subsidy income of $4.36 million and $2.29 million for the fiscal years ended June 30, 2006 and 2005, respectively, were presented as a separate line item on the statement of income.

Income Tax Provision

For the fiscal year ended June 30, 2006, the Company’s income tax provision was $1.37 million for financial reporting purposes, whereas there was an income tax provision of $401,000 for the prior year. This change was due mainly to the following factors: Beijing HollySys had an income tax provision of approximately $128,000 for the fiscal year ended June 30, 2006 (as its taxable income decreased) compared to $381,000 for the prior fiscal year. Haotong had an income tax provision of approximately $72,000 for the fiscal year ended June 30, 2006 compared to $20,000 for the prior fiscal year. Hangzhou HollySys had income of approximately $19.15 million before income tax for the fiscal year ended June 30, 2006 compared to $11.97 million for the prior fiscal year. However, Hangzhou HollySys was under a 100% exemption from income taxes for the fiscal year ended June 30, 2005, while it is entitled to receive only a 50% exemption from income tax for three calendar years starting January 1, 2006. Therefore, the income tax of Hangzhou HollySys was $1.17 million for the fiscal year ended June 30, 2006, compared to nil for the prior fiscal year.

Minority Interest

The minority interest of the Company includes other parties’ interests in Beijing HollySys and Haotong. The ownership interests of minorities in these two Operating entities were 25.89% and 30%, respectively.

The minority interest for the fiscal year ended June 30, 2006 was approximately $3.52 million, an increase by $1.15 million compared to $2.37 million for the prior year. The minority interest percentage in Beijing HollySys and Haotong did not change during the fiscal year ended June 30, 2006. The increase was attributable to the increase in net income of Beijing HollySys and Haotong which led to the increase in minority interests of $3.27 million and $254,000, respectively, for the fiscal year ended June 30, 2006.

Net Income

For the fiscal year ended June 30, 2006, the Company’s net income amounted to $18.05 million after deducting the portion attributed to the minority interest, an increase by $4.35 million compared to $13.70 million for the prior year, or 31.7%. This increase was attributable primarily to the significant growth in revenue and operating income.

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LIQUIDITY AND CAPITAL RESOURCES

To date, the Company has financed its operations primarily through cash flows from operations as well as through short term and long term borrowings from banks.

As of June 30, 2007, the Company had total assets of $154.93 million, of which cash amounted to $11.67 million, accounts receivable amounted to $87.37 million and inventories amounted to $13.91 million. While working capital was approximately $26.99 million, equity amounted to $37.03 million and the quick ratio was approximately 1.13:1.

During December 2006, the Company entered into a series of significant transactions among other parties in order to, under a single effort, move $30 million from 15 investors to Gifted Time Holdings to the individual Chinese owners of the BVI companies. Among a series of significant transactions, the Company revised its company’s capital structure as follows: 1) the Company’s authorized common shares increased to 33.5 million; 2) the par value of a common share was revised from $1 per share to $0.01 per share (accordingly 50,000 shares of common stock with par value of $1 per share were split into 5 million shares with par value of $0.01 per share); 3) 17.2 million shares of common stock were issued to the new sole owner, Ka Wa Cheng, resulting in 22.2 million shares issued and outstanding in total; and 4) the Company newly authorized 1.5 million of preferred shares with a par value of $0.01 per share and the rights of holders of these preferred shares were given the same rights as those of the holders of common shares. Consequently, the above common stock restructure was accounted for as stock split; accordingly, the 22.2 million shares issued were presented on the financial statement on a retrospective basis. Out of the 1.5 million of preferred shares, 1.3 million shares were issued to 15 investors, who provided the funding of $29.987 million, for the proceeds of $13,000. A bridge loan transaction was part of the series of transactions and is discussed under the heading “Recent Significant Transactions.” The Company expects that the holders of the 1.3 million preferred shares will accept the exchange offer tendered by Chardan to convert into common shares issued by the successor company of Chardan on a one-to-one basis when the contemplated stock purchase transaction will be consummated before September 2007.

Comparison of fiscal years ended June 30, 2007 and 2006

Net cash provided in operating activities totaled $3.77 million for the year ended June 30, 2007, a decrease by $3.52 million compared to $7.29 million during the prior year, representing a 48.2% decrease. This decrease resulted primarily from the increase in net income of $4.97 million; and the aggregate negative impacts due to the following changes in the operating assets and liabilities:

	·	$3.42 million increase from accounts receivable (negative);
	·	$6.10 million increase from inventory (negative);
	·	$260,000 increase from other receivable (negative);
	·	$531,000 decrease from deposits and other assets (positive);
	·	$3.97 million increase in advance to suppliers (negative);
	·	$3.22 million increase from advance from customers (positive);
	·	$395,000 increase in tax payable (positive);
	·	$6.31 million decrease from accounts payable; and
	·	$107,000 decrease from accrued liabilities.

And the decrease was offset by the aggregate positive impacts of the following reconcile items: 1) a positive $4.82 million increase in amortization of discount to notes payable, a negative $461,000 cash flow in minority interest, and a positive $664,000 cash flow in bad debt allowance, a positive $248,000 cash flow in income from equity investment).

The increase in inventory, advance to suppliers, accounts receivable and other receivable were in accordance with the increase in revenue and backlog based on the scale expansion of the business. The increase in inventory reflected the Company’s need to stock more inventory to meet the requirements for implementing contracts, considering the increased amount of backlog to be fulfilled in the subsequent period. The increase in advance to suppliers was in line with the increase in inventory. The increases in advance from customers were consistent with the Company’s better working capital position than the prior period, which enabled the Company to enjoy the additional cash provided by the customers, which enhanced the company’s liquidity. The decreases in accounts payable and accrued liabilities were reflections that the Company made its efforts to reduce the operating liabilities.

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Net cash used by investing activities was $34.85 million and $6.02 million for the year ended June 30, 2007 and 2006, respectively. The cash used by investing activities consisted mainly of capital expenditures related to purchases of property, plant and equipment, construction projects, long-term investments and note receivable from the sole stockholder. The material increase in the net cash used in investing activities was because of notes receivable of $30 million from the sole stockholder, APH, related to the December 2006 financing and reorganization transactions disclosed in detail under the heading “Recent Significant Transactions”, which discusses this note receivable in conjunction with the 15 notes payable for a total principal of $29.987 million. The decrease in purchases of fixed assets was approximately $4.10 million from $5.47 million for the fiscal year 2006 to $1.37 million for the fiscal year 2007. The decrease was mainly due to none of disbursements related to the construction of the Hangzhou office building which was made in the fiscal year 2007 based on the fact the construction has been accomplished before June 30, 2006. Additions to long-term investments increased by $2.06 million, from $1.30 million to $3.36 million for the current period. Additions to long-term investments for the current period were primarily because Beijing HollySys made cash disbursements of approximately $2.94 million for three long-term investments in the current period, including that approximately $1.52 million (equivalent to RMB12 million) for a 31.15% interest in IPE Biotechnology Co., Ltd. and approximately $1.42 million (equivalent to RMB11.24 million) in exchange of a 18.49% interest in Beijing Bestpower Electrical Technology Co., Ltd, and about $394,000 (equivalent to RMB 3 million) in exchange of a 5% interest in Zhongjijing Investment Consulting, Ltd.. HollySys received $179,000 of dividends from long-term investment in fiscal year 2006, while none of dividends in fiscal year 2007.

Cash flows provided by financing activities amounted to $29.54 million and $660,000 (negative) for the fiscal year 2007 and 2006, respectively. Cash flows generated by financing activities consist of proceeds of bank borrowings, proceeds from 15 notes payable, proceeds from issuing preferred stock and disbursements for repayments to bank loans, dividend payments and amounts due to related parties. For the fiscal year 2007, the Company obtained net proceeds of $6.49 million from short-term bank loans, while the Company disbursed a net proceed of $1.88 million to repay the due short-term bank loan in the prior year. The Company didn’t obtain long-term bank loans during the fiscal year 2007, in comparison that the Company obtained a long-term bank loan of approximately 3.94 million (equivalent to RMB 30 million from the State Development Bank)during the fiscal year 2006. And the Company made repayments to long-term bank loans of $5.10 million in the current period while approximately $1.25 million in the prior year. In addition, there was a dividend payment of approximately $1.91 million, compared to $1.08 million in the prior year. The dividend payment of $1.91 million primarily included $769,000 dividend declared and paid by Haotong and $1.02 million dividend paid by Hangzhou HollySys in the first half of calendar year 2007. Amounts due to related parties were $59,000 and $210,000 (negative) for the fiscal year 2007 and 2006, respectively.

Without taking into account the $30 million proceeds from issuing 15 notes payable and 1.3 million of preferred shares, the cash flows in financing activities were quite simple for the fiscal year 2007.

However, the Company received, during December 2006, the proceeds of $30 million in aggregate from issuing 15 notes payable and 1.3 million of preferred shares and loan the proceeds of $30 million to its sole owner of APH for its purpose to pay the $30 million to the individual owners of the BVI companies. The Bridge Loan of $29.987 million was borrowed under Gifted Time Holdings’ name and these proceeds were not used in China. If the proceeds were used inside China, these notes payable debts denominated in the US dollars should be registered with Chinese government in accordance with Chinese regulations. Accordingly, the interest burden associated with the 15 notes will not be recorded on either Beijing HollySys’ or Hangzhou HollySys’ books and will not have any income tax deduction effect for China income tax purposes. The Company is expecting to use the proceeds from the contemplated stock purchase transaction with Chardan to pay off these 15 notes payable. Once APH receives the first tranche of $25 million proceeds from Chardan through consummation of the contemplated stock purchase transaction, a majority of the note receivable from APH will be collected; simultaneously, a majority of 15 notes payable will be paid. If the contemplated stock purchase transaction with Chardan is not consummated, Gifted Time Holdings will bear the ultimate responsibility to repay the outstanding notes of $30 million held by the 15 outside investors. If Gifted Time Holdings is unable to repay the outstanding notes of $30 million, the investors may sell a portion of their interest pledged by APH to secure its guarantee until they receive full payment of principal and accrued interest due under their notes. Any residual interest would be returned to OSCAF, which in turn would be obligated to transfer that residual interest back to the individual owners of the seven BVI companies.

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Comparison of Fiscal Year Ended June 30, 2006 and 2005

Net cash provided by operating activities totaled $7.29 million for the fiscal year ended June 30, 2006, an increase in positive cash flow by $3.74 million compared to $3.55 million in the prior year, representing a 105.5% increase. This increase resulted primarily from the following factors: 1) the increase of the changes in non-cash items included in the statement of income ( a positive $74,000 cash flow in bad debt allowance, a positive $147,000 cash flow in deferred income tax asset, a positive $752,000 cash flow in depreciation and amortization, $1.15 million increase in minority interest, a positive $393,000 cash flow in provision for inventories, and a negative $46,000 cash flow in investment income); and 2) the following changes in the operating assets and liabilities:

	·	$2.09 million decrease from accounts receivable (positive);
	·	$946,000 million increase from inventory;
	·	$885,000 million decrease from other receivable (positive);
	·	$1.37 million increase from deposits and other assets (negative);
	·	$3.28 million decrease in advance to suppliers (positive);
	·	$69,000 decrease from advance from customers (negative);
	·	$1.21 million increase in tax payable (positive);
	·	$7.25 million decrease from accounts payable; and
	·	$1.02 million decrease from accrued liabilities.

 

The decrease in accounts receivable was due to the fact that the Company has enhanced its collection effort to collect as much as possible of its receivables. The decrease in other receivable also accounts for the Company’s enhanced ability of receivable collections. The decreases in accounts payable and accrued liabilities were consistent with the Company’s better working capital position than the prior year, which enabled the Company to settle down these payables in a relatively short period of time although the Company has obtained very favorable payment terms with its suppliers to enhance its working capital position. The decrease of $3.29 million in advance to customers provided the Company with a reasonable cushion for working capital purpose. The increase in tax payable of $1.21 million was due to the increase in revenue and net income in the current year.

Net cash used by investing activities was $6.02 million and $3.51 million for the fiscal year ended June 30, 2006 and 2005, respectively. The cash used by investing activities consisted mainly of capital expenditures related to purchases of property, plant and equipment, construction projects and long-term investments. The decrease in purchases of fixed assets was approximately $154,000 from $5.47 million for the fiscal year ended June 30, 2006 compared to $5.63 million for the prior year. The addition of purchases of fixed assets in the current year was mainly related to the construction of the Hangzhou office building. The short-term investment consisted of term deposits. In the fiscal year ended June 30, 2006, the Company increased short-term investment of $797,000 and disposed short-term investment of $932,000, and received interest income of $54,000 related to short-term investment. While the company increased short-term investments of $604,000 in the prior year and disposed short-term investments of $2.41 million, and received interest income of $149,000 from short-term investments in the prior year. In addition, it also had cash disbursements for long-term investments of approximately $1.30 million for a 50% interest in Beijing Tech Energy Co., Ltd. and a 20% interest in Beijing HollySys Equipment Technology Co., Ltd. for future automation systems development. HollySys also received the proceeds from disposing assets of $389,000 compared to $358,000 in the prior year. HollySys gained the dividends received from long-term investment of $179,000 compared to $20,000 in the prior year, an increase of $159,000 was consistent with the dividend policy issued by the investee companies.

Cash flows provided by financing activities amounted to $660,000 (negative) and $1.90 million for the fiscal year ended June 30, 2006 and 2005, respectively. Cash flows generated by financing activities consist of proceeds of bank borrowings and disbursements for repayments to bank loans, dividend payments and amounts due to related parties. For the fiscal year ended June 30, 2006, the Company obtained net proceeds of $1.88 million from short-term bank loans compared to $3.02 million in the prior year. Also, it obtained proceeds of long-term bank loans up to $3.75 million from China development bank and made repayments of long-term bank loans up to $1.25 million during the fiscal year 2006 while it obtained proceeds of long-term bank loans up to $6.65 million and made repayments of $6.40 million during the prior year. In addition, there was a dividend payment of approximately $1.08 million by Hangzhou HollySys compared to $1.51 million in the prior year. Amounts due to related parties were $210,000 and $144,000 for the fiscal year ended June 30, 2006 and 2005, respectively. As a result of these changes, the financing activities for fiscal year ended June 30, 2006 created a decrease of $2.56 million compared to the financing activities for the prior year.

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Working Capital

The Company’s working capital has been increasing over the reporting periods with growth rates of 64.9% between the fiscal 2006 and 2005, while 26.9%(negative) between the fiscal 2007 and 2006.

Total current assets at June 30, 2007 amounted to $128.40 million, an increase by approximately $31.45 million compared to $96.96 million at June 30, 2006. The increase was attributable mainly to larger amounts of contract performance deposits in banks of 1.95 million (associated with the contracts on which the Company is bidding), an increase of $20.44 million in accounts receivable and an increase of 6.08 million in inventories. Contract performance deposits were in connection with the Company’s bidding processes. Normally, customers require the Company to deposit money with a bank as a guarantee for the bids. The accounts receivable were classified into billed and unbilled accounts receivables based on the percentage of completion method for revenue recognition. Therefore, the growing balances of contract performance deposits in banks, accounts receivable and inventories have been a result of the increase in operating revenues and the backlog revenue.

Current liabilities amounted to $101.42 million at June 30, 2007, in comparison to $60.03 million at June 30, 2006. The increases have been attributable mainly to the following factors: First, an increase of $27.57 million in notes payable, representing as a net value after the discount of $4,819,326 from the principle amount of $29.987 million which were issued by the Company in the December 2006 financing and reorganization transactions disclosed in detail under the heading “Recent Significant Transactions” and “Notes Payable”; second, an increase of $9.29 million in the short-term bank loans, the increase in short-term loans was a supplement to liquidity financing for the expansion of business; third, an increase of $2.09 million in deferred revenue; Deferred revenue resulted from the excess of the billed amounts over revenues recognized on the contracts and the billings rendered based on agreed milestones included in the contracts with customers. Therefore, deferred revenue was in the nature of advances from customers. The increases in deferred revenue were a result of revenue growth. Forth, an increase of $5.79 million in accounts payable. The increases were offset mainly by several factors as follows: First, a decrease of $1.25 million in dividend payable was a result of the dividend declared as of the end of 2005 had already been paid as of December 31, 2006. Second, a decrease of $2.50 million in short-term loan from related parties was because that the Company had repaid the loan from related parties before March 31, 2007. Third, the decrease in accrued liabilities was $48,000. The decrease was a reflection that the Company made an effort to decline the operating liabilities. Fourth, a decrease of $3.03 million in current portion of long-term loans because of the repayment of due long-term loans.

The current ratio increased from 1.62 at June 30, 2006 to 1.27 at June 30, 2007. The changes in current ratio were due mainly to the growth rate of current liabilities which were higher than that of the current assets in the current period, but the change in current ratio had an immaterial impact to the operating liquidity of the Company. In order to finance operating activities, the Company had maintained a good standing of current ratio due primarily to the following two factors: first, enhance accounts receivable collection; and second, increase short-term debts in order to facilitate flexibility of borrowing.

As discussed above under Recent Developments, in December 2006 the Company was involved in a series of transactions involving a change in its ownership, a recapitalization, the sale of preferred stock and a series of loan transactions. The original shareholders of the Company transferred their interests to Advance Pacific Holdings Limited, a British Virgin Islands Company which is solely owned by Ka Wa Cheng, a resident of Canada. The Company issued notes with a principal amount of $29.987 million and 1,300,000 shares of preferred stock to new investors for an aggregate payment of $30 million. The Company loaned the $30 million in proceeds to Advance Pacific, which in turn used the funds to pay for a portion of the purchase price of the shares of the Company which Advance Pacific acquired from OSCAF International, Ltd. Advance Pacific has assigned the cash proceeds it receives from the stock purchase transaction with Chardan to the Company for purposes of repayment of Advance Pacific’s debt to the Company. As a result of this series of transactions, the Company’s financial statements as of June 30, 2007 showed the changes in obligations (an increase in note payable of $27.57 million, reflecting the net value of notes payable after the discount) and stockholder’s equity (an increase of $30 million in note receivable from the sole stockholder).

Capital Resources

The Company has obtained working capital through several ways. First, it obtained short-term and long-term bank loans. Second, its suppliers were willing to provide it with extended payment terms which would not force it to increase bank borrowings unless it planned to increase its operating scale significantly. Third, through the improved bidding mechanism, it asked its customers to increase their payments in the early stage of the contract performance process to diminish its working capital demands for daily operations. Fourth, it has maintained good relationships with commercial banks which provided it with the necessary bank financing. At June 30, 2007, the Company had established standby credit facilities with domestic commercial banks for aggregate approximately $43.31 million to finance any funding needs related to its projects and relevant working capital requirements. Finally, it may issue corporate bonds to the public in the future. The Company believes that it will be able to obtain adequate cash flow for its operating activities and will continue to improve its cash collection to satisfy the cash demands from its daily operations.

A-27

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CONTRACTUAL OBLIGATIONS AND COMMITMENTS

The following table sets forth the Company’s contractual obligations, including long-term and short-term loans and operating leases, and capital and operational commitments at of June 30, 2007.

Item		Less than 1 year			1-2 years			2-3 years			3-5 years			More than 5 years			Total
		$			$			$			$			$			$
Long-term Bank Loans			1,970,573						3,284,288			-			-			5,254,861
Interest payable			5.49	%					6.03	%		-			-
Short-term Bank Loans			16,421,440			-			-			-			-			16,421,440
Interest payable			5.875	%
Short-term loan from a related party						-			-			-			-
Interest payable
Operating Lease Commitment (1)			75,301			138,199			149,353			157,062			173,520			693,435
Purchase Commitment (2)			14,493,920			5,001,614			-			-			-			19,495,534
Total			32,961,234			5,139,813			477,781			157,062			173,520			41,865,270

 

(1) Operating Lease Commitment

Beijing HollySys entered into a lease agreement with HollySys Information Technology Co., Ltd., in which HollySys holds 40% interest, to lease office space. The lease agreement is renewable on an annual basis, and the agreement is still in effect. The basic rental price has ranged from RMB1.4 or RMB1.5 per square meter per day during the past five years. The total rental per year depends on the actually total square meters leased each year. The total rental expense for the years ended June 30, 2005, 2006 and 2007 was$57,000, $92,000, and $39,453, respectively.

A-28

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Years ended June 30,		Amount
2008			143,198
2009			154,755
2010			162,743
2011			170,880
2012			8,916
		$	640,492

(2) Purchase Commitment

As of June 30, 2007, the Company had approximately $19.50 million in purchase obligations for the next two years, including $19,000 for construction of factory premises and $19.48 million for purchases of equipment, mainly for fulfillment of in-process or newly entered into contracts resulted from operation expansion.

		RMB			US Dollars
Plant and building construction			143,376			18,836
Equipment			148,256,628			19,476,698
Total			148,400,004			19,495,534

Other than the contractual obligation and commercial commitments set forth above, the Company does not have any other long-term debt obligations, operating lease obligations, purchase obligations or other long-term liabilities.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has not entered into any financial guarantees or other commitments to guarantee the payment obligations of any third parties as of June 30, 2007. It has not entered into any foreign currency forward contract. It does not have any other off-balance sheet arrangements except for the contractual obligations and commitments mentioned above as of June 30, 2007. The Company believes that there are no off-balance sheet arrangements that have or are reasonably likely to have a material effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

EMPLOYEES AND THEIR BENEFITS

At June 30, 2007, Beijing HollySys and Hangzhou HollySys had a total of 1,276 employees. The remuneration package of the employees includes salary, bonuses and allowances. Employees also receive welfare benefits including workers’ insurance, medical care, housing subsidies, child care and education, and other miscellaneous items.

The Company believes that its success in attracting and retaining highly skilled technical employees and sales and marketing personnel is largely a product of its commitment to providing a motivating and interactive work environment that features continuous and extensive professional development opportunities, as well as frequent and open communications at all levels of the organization.

RECENT ACCOUNTING PRONOUNCEMENTS

 

In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the provisions of Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation).” EITF Issue No. 06-3 requires that the presentation of taxes within revenue-producing transactions between a seller and a customer, including but not limited to sales, use, value added, and some excise taxes, should be on either a gross (included in revenue and cost) or a net (excluded from revenue) basis. In addition, for any such taxes that are reported on a gross basis, a company should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented if those amounts are significant. The disclosure of those taxes can be done on an aggregate basis. EITF Issue No. 06-3 is effective for fiscal years beginning after December 15, 2006, which will be our third quarter of fiscal 2007. The Company expects that the adoption of EITF Issue No. 06-3 will not have a material impact on its consolidated results of operations or financial position.

A-29

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In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”) which prescribes a recognition threshold and measurement attribute, as well as criteria for subsequently recognizing, derecognizing and measuring uncertain tax positions for financial statement purposes. FIN 48 also requires expanded disclosure with respect to the uncertainty in income tax assets and liabilities. FIN 48 is effective for fiscal years beginning after December 15, 2006, which will be adopted by the Company beginning July 1, 2007, and is required to be recognized as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. The Company has completed its preliminary assessment of the impact of adopting FIN No. 48 and does not expect that the adoption of FIN 48 will have a material impact on our consolidated results of operations or financial position.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatement when Quantifying Misstatements in Current Year Financial Statements’ (SAB 108) , which will be effective for the fiscal year ending after November 15, 2006. The objective of SAB 108 is to eliminate diversity in practice surrounding how public companies quantify financial statement misstatements. SAB requires quantification of financial statement misstatements based on the effects of the misstatements on the consolidated statement of income, the consolidated balance sheet and related financial statement disclosures.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (FAS No. 157), which provides guidance on how to measure assets and liabilities that use fair value. This Statement clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. FAS No. 157 will apply whenever another generally accepted accounting principle requires, or permits, assets or liabilities to be measured at fair value but does not expand the use of fair value to any new circumstances. This statement will also require additional disclosures in both annual and quarterly reports. FAS No. 157 is effective for fiscal years beginning after November 2007, and will be adopted by us beginning June 30, 2008. We are currently evaluating the potential impact the adoption of FAS No. 157 may have on our financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 provides a company with the option to measure selected financial instruments and certain other items at fair value at specified election dates. The election may be applied on an item by item basis, with disclosure regarding reasons for partial election and additional information about items selected for fair value option. The fair value measurement election is irrevocable and subsequent changes in fair value must be recorded in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007 and interim period within these fiscal years. The Company is currently evaluating the potential impact the adoption of SFAS No. 159 may have on the Company’s financial statements.

QUANTITATIVE AND QUALITATIVE MARKET RISKS

Industrial environment and national industrial development policies

The Company is highly sensitive to industry environment changes and state industrial development policies. State industrial development policies have established clear targets for market capacities of automation systems in the short and long run. These are crucial to the development of the Company, especially for rail transport and nuclear power plant automation systems. At present, state policies are favorable to the Company’s development. If the government ceases supporting the rail transportation and nuclear industries, however, it would bring about a negative impact on operating results in the next few years.

The Company relies on market research and technology development to ensure that it delivers attractive, high-quality products and services to its customers as a way to protect against risks connected with a change in the competitive environment.

A-30

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Taxation risk

As a result of various tax regulations, Beijing HollySys, Hangzhou HollySys and Haotong HollySys are entitled to the benefits afforded by certain preferential income tax policies. These preferential tax policies will terminate in one to three years.

With the aim of attracting foreign investment, the Chinese government provides favorable income tax rates to foreign-invested enterprises in China at the levels of 15%, 24% and 30%. Domestic-invested enterprises, on the other hand, normally are subject to a 33% income tax rate. The Chinese government has indicated that it intends to eliminate differences between the applicable tax rates of domestic and foreign-invested enterprises, but the schedule for the unification of tax rates has not yet been established. When the preferential tax treatment ends, it will increase taxes and reduce the Company’s after tax profits.

Additionally, the Chinese government provides subsidies (sourcing from the proceeds of VAT collected) to all domestic enterprises which are involved in software development. Since this subsidy policy became effective, the Company has enjoyed subsidies for software development, which has been an integral part of the Company’s integrated contracts. The subsidy policy will cease at the end of 2010. When the termination of the subsidy policy occurs, it will cause after-tax income to decline by approximately 3%.

The Company is confident that its continuing business development coupled with effective cost-control methods, will contribute to achieving positive financial results that will offset the adverse impacts that will result from the elimination of these tax preferences.

Foreign exchange risk

The Company conducts its business primarily in Chinese RMB currency, although it does have plans to expand its business internationally.

RMB is not a freely convertible currency. The restrictions on foreign exchange imposed by the Chinese government may result in the material differences between the future exchange rate and the current exchange rate or historical exchange rate. The changes in the exchange rate of RMB currency will impose foreign exchange translation risk on the Company’s financial statements and impact the Company’s ability to carry out operations related to foreign exchange. Those changes also will impact its ability to pay dividends in US dollars. The Company believes that, however, it is, and will be, able to obtain sufficient foreign exchange to implement the above-mentioned operations and hedge against foreign exchange risk.

Interest rate risk

Over the years, the Company has tended to obtain proceeds from short-term bank loans for working capital financing purpose. Therefore, it is subject to market rate risks due to fluctuations in interest rates charged on these loans. At June 30, 2007, the Company’s short-term bank loan balance was $16,421,440, of which $8,539,149was located in Beijing HollySys, and $7,882,291 was located in Hangzhou HollySys. All the short-term bank loans are mature from six months to one year bearing fixed interest rates ranging from 5.022% to 6.696% per annum. However, when these short-term bank loans are renewed, the interest rates are subject to change based on the notice from the People’s Bank of China, the central bank of China. Since April 28, 2006, the People’s Bank of China (PBC, the central bank of China) had raised the benchmark interest rate of the one-year loan to financial institutions five times resulting in a fact that the benchmark interest rate of the one-year loan to financial institutions increased by 1.26 percent in total, reaching 6.84%, which make the Company expose a higher financing cost level in the near future if the Company renews bank loans.

Some short-term bank loans were guaranteed by the Company related parties and third parties and one bank loan of $2,416,480 at June 30, 2005, $1,250,891 at June 30, 2006 and $0 at June 30, 2007 in Hangzhou HollySys was collateralized by its plant and property. At June 30, 2006, there was a bank loan of $2,501,783 payable to a commercial bank, bearing a 5.76% interest rate, which served as a trustee appointed by HollySys Information Technology Co., Ltd. in which HollySys holds 40% interest. This loan had been repaid in full in fiscal year 2007 and the balance for this loan was nil as of June 30, 2007.

The following table provides information, by maturity dates, regarding the Company’s interest rate sensitive financial instruments, which consist of fixed rate short-term and long-term debt obligations as of June 30, 2007.

A-31

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Lender		Balance at June 30, 2007			Maturity Date			Interest Rate			Floating or Fixed Interest Rate			Current portion
Long-term loans
Bank of Beijing			1,970,573			July 15, 2007			5.49	%		Fixed rate			1,907,573
China Development Bank			3,284,288			June 28, 2009			6.03	%		Fixed rate
Total			5,254,861												1,907,573
Short-term loans
CITIC Industrial Bank			2,627,430			September 9, 2007			6.696	%		Fixed rate
China Merchants Bank			2,627,430			October 12, 2007			6.12	%		Fixed rate
The Bank of Communications (Hangzhou)			1,970,573			November 7, 2007			5.508	%		Fixed rate
The Bank of Communications (Hangzhou)			1,970,573			August 28, 2007			5.508	%		Fixed rate
Industrial and Commercial Bank of China (Hangzhou)			1,313,715			September 14, 2007			5.022	%		Fixed rate
Industrial and Commercial Bank of China (Hangzhou)			1,313,715			September 21, 2007			5.103	%		Fixed rate
Industrial and Commercial Bank of China (HangZhou)			1,313,715			May 16, 2008			5.751	%		Fixed rate
Total			16,421,440

 

FUTURE DEVELOPMENT AND BUSINESS STRATEGIES

The Company’s goal is to become one of the leading automation and process control system companies in the world. It plans to concentrate its research and development resources on core technologies such as I/O signal processing technology, network protocol interface, its HOLLiAS DCS platform, software development and application system design to maintain a technological advantage over the Company’s competitors. The principal elements of the Company’s business strategies are:

	·	To maintain leadership in China’s DCS market;
	·	To enhance Gifted Time’s leading position in technology;
	·	To leverage Gifted Time’s large customer base to offer total solutions; and
	·	To focus on high-value tailored technology services.

A-32

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GIFTED TIME HOLDINGS LIMITED

REPORT ON AUDITED FINANCIAL STATEMENTS

FOR YEARS ENDED JUNE 30, 2005, 2006 AND 2007

 

 

 

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GIFTED TIME HOLDINGS LIMITED

CONTENTS

Report of Independent Registered Public Accounting Firm	F-2
Consolidated Financial Statements
Consolidated Balance Sheets	F-3
Consolidated Statements of Income	F-4
Consolidated Statements of Stockholders’ Equity	F-5
Consolidated Statements of Cash Flows	F-6
Notes to Consolidated Financial Statements	F-7

 

F-1

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F-2

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GIFTED TIME HOLDINGS LIMITED

CONSOLIDATED BALANCE SHEETS

(In US Dollars)

		June 30,
		2006			2007
ASSETS
Current Assets:
Cash and cash equivalents		$	10,979,248		$	11,668,761
Contract performance deposit in banks			2,551,098			3,524,317
Term deposit			562,901			853,915
Accounts receivable, net of allowance for doubtful accounts $1,751,247 and $2,836,677			66,937,636			87,372,794
Other receivables, net of allowance for doubtful accounts $77,856 and $111,329			2,545,941			2,856,404
Advances to suppliers			5,546,085			8,146,854
Inventories, net of provision $392,807 and $345,976			7,830,842			13,907,280
Prepaid guarantee fee			4,691			74,404
Total current assets			96,958,442			128,404,729
Property, plant and equipment, net			17,784,554			17,332,953
Long term investments			5,281,163			9,192,888
Total assets		$	120,024,159		$	154,930,570
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Short-term bank loans		$	7,130,081		$	16,421,440
Short-term bank loan from related parties			2,501,783			-
Current portion of long-term loans			5,003,565			1,970,573
Notes payables, net of discount of $4,819,326			-			27,566,936
Accounts payable			16,523,600			22,309,829
Deferred revenue			9,526,769			11,620,046
Dividend payable			1,250,891			-
Accrued payroll and related expense			5,311,795			6,959,187
Income tax payable			518,293			804,156
Warranty liabilities			1,430,736			2,126,569
Other tax payables			6,109,895			6,492,801
Accrued liabilities			3,953,885			3,905,481
Amounts due to related parties			479,124			768,781
Deferred tax liabilities			291,949			473,201
Total current liabilities			60,032,366			101,419,000
Long-term liabilities:
Long-term loans			5,629,011			3,284,288
Total liabilities			65,661,377			104,703,288
Minority interest			9,801,634			13,200,169
Stockholder’s equity:
Preferred stock, par value $0.01 per share,1,500,000 shares authorized, 1,300,000 shares issued and outstanding			-			13,000
Common stock, par value $0.01 per share, 33,500,000 shares authorized, 22,200,000 shares issued and outstanding.			222,000			222,000
Additional paid-in capital			11,778,663			19,022,795
Appropriated earnings			6,316,795			8,768,174
Note receivable from the sole stockholder						(30,000,000	)
Retained earnings			25,093,814			35,127,764
Cumulative translation adjustments			1,149,876			3,873,380
Total stockholder’s equity			44,561,148			37,027,113
Total liabilities and stockholders' equity		$	120,024,159		$	154,930,570

See accompanying notes to financial statements.

F-3

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GIFTED TIME HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF INCOME

AND COMPREHENSIVE INCOME

(In US Dollars)

		Years Ended June 30,
		2005			2006			2007
Revenues:
Integrated contract revenue		$	75,027,422		$	86,187,820		$	97,380,399
Products sales			4,545,410			3,728,784			4,505,087
Total revenues			79,572,832			89,916,604			101,885,486
Cost of integrated contracts			52,164,176			57,107,242			64,284,550
Cost of products sold			2,518,835			842,813			1,818,715
Gross profit			24,889,821			31,966,549			35,782,221
Operating expenses:
Selling			5,646,565			6,378,462			7,577,371
General and administrative			5,136,383			6,483,223			7,098,112
Research and development			202,344			77,724			2,638,622
Impairment loss			-			-			-
Loss on disposal of assets			29,511			32,706			37,109
Total operating expenses			11,014,803			12,972,115			17,351,214
Income from operations			13,875,018			18,994,434			18,431,007
Other income (expense), net			194,547			61,228			172,977
Interest expense, net			(555,796	)		(1,088,582	)		(7,608,792	)
Investment income			664,889			618,843			370,410
Subsidy income			2,292,880			4,355,367			7,280,766
Income before income taxes			16,471,538			22,941,290			18,646,368
Income taxes expenses			401,468			1,368,838			2,501,104
Income before minority interest			16,070,070			21,572,452			16,145,264
Minority interest			2,366,549			3,521,197			3,060,513
Net income		$	13,703,521		$	18,051,255		$	13,084,751
Weighted average number of common shares			22,200,000			22,200,000			22,200,000
Weighted average number of diluted common shares			22,200,000			22,200,000			22,883,836
Basic earnings per share		$	0.62		$	0.81		$	0.59
Diluted earnings per share		$	0.62		$	0.81		$	0.57
Other comprehensive income:
Net income		$	13,703,521		$	18,051,255		$	13,084,751
Translation adjustments			(2,119	)		1,149,579			2,723,504
Comprehensive income		$	13,701,402		$	19,200,834		$	15,808,255

See accompanying notes to financial statement

F-4

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GIFTED TIME HOLDINGS LIMITED

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(In US Dollars)

														Additional																Accumulated
		Common Stock						Preferred Stock						Paid-in			Note					Appropriated			Retained					Comprehensive
		Shares			Amount			Shares			Amount			Capital			Receivable					Earnings			Earnings					Income (Loss)			Total
Balance at July 1, 2003			22,200,000		$	222,000			-		$	-		$	8,751,044		$	-				$	527,153		$	(176,052	)		$	1,204		$	9,325,349
Capital infused			-			-			-			-			600,000			-					-			-				-			600,000
Forgiveness of accounts payable			-			-			-			-			301			-					-			-				-			301
Net income for the year			-			-			-			-			-			-					-			4,735,276				-			4,735,276
Appropriation			-			-			-			-			-			-					683,890			(683,890	)			-			-
Translation adjustments			-			-			-			-			-			-					-			-				1,212			1,212
Balance at June 30, 2004			22,200,000			222,000			-			-			9,351,345								1,211,043			3,875,334				2,416			14,662,138
Donation received			-			-			-			-			11,715			-					-			-				-			11,715
Net income for the year			-			-			-			-			-			-					-			13,703,521				-			13,703,521
Appropriation			-			-			-			-			-			-					2,084,965			(2,084,965	)			-			-
Dividends declared			-			-			-			-			-			-					-			(1,372,799	)			-			(1,372,799	)
Converted into capital			-			-			-			-			2,400,000			-					-			(2,400,000	)			-			-
Translation adjustments			-			-			-			-			-			-					-			-				(2,119	)		(2,119	)
Balance at June 30, 2005			22,200,000			222,000			-						11,763,060								3,296,008			11,721,091				297			27,002,456
Forgiveness of accounts payable			-			-			-			-			10,018			-					-			-				-			10,018
Donation received			-			-			-			-			5,585			-					-			-				-			5,585
Net income for the period			-			-			-			-			-			-					-			18,051,255				-			18,051,255
Appropriation			-			-			-			-			-			-					3,020,787			(3,020,787	)			-			-
Dividends declared			-			-			-			-			-			-					-			(1,657,745	)			-			(1,657,745	)
Translation adjustments			-			-			-			-			-			-					-			-				1,149,579			1,149,579
Balance at June 30, 2006			22,200,000			222,000			-			-			11,778,663			-					6,316,795			25,093,814				1,149,876			44,561,148
Issuing preferred shares			-			-			1,300,000		$	13,000			7,239,390			-					-			-				-			7,252,390
Donation received			-			-			-			-			3,066			-					-			-				-			3,066
Forgiveness of accounts payable			-			-			-			-			1,676			-					-			-				-			1,676
Net income for the period			-			-			-			-			-			-					-			13,084,751				-			13,084,751
Appropriation			-			-			-			-			--			-					2,451,379			(2,451,379	)			-			-
Dividends declared			-			-			-			-			-			-					-			(599,422	)			-			(599,422	)
Note receivable			-			-			-			-			-			(30,000,000	)				-			-				-			(30,000,000	)
Translation adjustments			-			-			-			-			-			-					-			-				2,723,504			2,723,504
Balance at June 30, 2007			22,200,000		$	222,000			1,300,000		$	13,000		$	19,022,795		$	(30,000,000	)			$	8,768,174		$	35,127,764			$	3,873,380		$	37,027,113

See accompanying notes to financial statements

F-5

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GIFTED TIME HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF CASH FLOWS

Increase (Decrease) in Cash and Cash Equivalents

(In US Dollars)

		Years Ended June 30,
		2005			2006			2007
Cash flows from operating activities:
Net income		$	13,703,521		$	18,051,255		$	13,084,751
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Minority interests			2,366,549			3,521,197			3,060,513
Depreciation and amortization			820,863			1,570,135			1,566,876
Amortization of long term deferred assets			49,840			52,292			-
Allowance for doubtful accounts			381,085			454,674			1,118,903
Provision for inventories			-			392,807			66,559
Amortization of discount to notes payable			-			-			4,819,326
Loss on disposal of fixed assets			29,511			32,706			37,109
Income from equity investment			(664,889	)		(618,843	)		(370,410	)
Deferred tax assets (liabilities)			61,211			207,929			162,418
Changes in operating assets and liabilities:
Accounts receivables			(19,389,033	)		(17,294,804	)		(20,712,133	)
Inventories			1,174,095			228,392			(5,871,319	)
Advance to suppliers			(1,807,680	)		1,479,866			(2,486,265	)
Other receivables			(958,797	)		(74,103	)		(333,791	)
Deposits and other assets			(162,771	)		(1,533,590	)		(1,002,649	)
Advance from customers			(1,135,349	)		(1,204,724	)		2,016,054
Accounts payable			6,711,573			(538,111	)		5,769,921
Accruals and other payable			3,339,142			2,317,997			2,210,885
Tax payable			(970,732	)		241,052			635,691
Net cash provided by (used in) operating activities			3,548,139			7,286,127			3,772,439
Cash flows from investing activities:
Purchase of fixed assets			(5,627,592	)		(5,473,890	)		(1,370,533	)
Note receivable from the sole stockholder			-			-			(30,000,000	)
Disposal (Purchase) of short-term investments			1,812,331			135,556			(278,449	)
Addition to long-term investments			(225,368	)		(1,300,927	)		(3,361,756	)
Proceeds from disposing assets			358,443			389,462			157,260
Dividends received from long-term investments			20,165			178,950			-
Interest received from short-term investments			148,837			53,837			-
Net cash used in investing activities			(3,513,184	)		(6,017,012	)		(34,853,478	)
Cash flows from financing activities:
Proceeds from notes payable			-			-			29,987,000
Proceeds from issuing preferred shares			-			-			13,000
Proceeds from (Repayments to) short-term loans			3,020,600			(1,876,337	)		6,488,021
Proceeds from long-term bank loans			6,645,321			3,752,674			-
Repayments to long term loans			(6,403,581	)		(1,250,891	)		(5,095,007	)
Due to related parties			143,763			(209,558	)		59,473
Donation received			2,892			-			-
Dividend paid			(1,508,125	)		(1,075,559	)		(1,913,137	)
Net cash provided by financing activities			1,900,870			(659,671	)		29,539,350
Effect of foreign exchange rate changes			5,573			1,135,665			2,231,202
Net increase (decrease) in cash and cash equivalents			1,941,398			1,745,109			689,513
Cash and cash equivalents, beginning of period			7,292,741			9,234,139			10,979,248
Cash and cash equivalents, end of period		$	9,234,139		$	10,979,248		$	11,668,761

See accompanying notes to financial statements

F-6

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GIFTED TIME HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED JUNE 30, 2005, 2006 AND 2007

NOTE 1 ─ ORGANIZATION AND BUSINESS BACKGROUND

Gifted Time Holdings Limited (the “Company”) was established under the law of British Virgin Island on September 21, 2005 for the purpose to hold investment in the following entities:

·

Beijing HollySys Co., Ltd. (74.11%); and

·

Hangzhou HollySys Automation Co., Ltd. (60% as Beijing HollySys Co., Ltd. holds the remaining 40% interest in Hangzhou HollySys Automation Co., Ltd.)

Under a reorganization agreement entered on September 20, 2005, the owners accounting for 74.11% interest in Beijing HollySys and the two owners accounting for 60% interest in Hangzhou HollySys transferred their respective interest in the above two entities to the Company in exchange for 68.137% and 31.863% interest of the Company, essentially based on the book value of net assets as of June 30, 2005 transferred by the both parties into the Company. Consequently, the Company has combined 74.11% net assets of Beijing HollySys and 60% net assets of Hangzhou HollySys as the total equity interest of the Company as of June 30, 2005.

In accordance with paragraph 11 in SFAS No. 141 and Appendix D, paragraph D14 in SFAS No. 141, this reorganization transaction was accounted for under carry-over basis as there was a voting together agreement among the owners of 74.11% interest in Beijing HollySys and a voting together agreement between the two owners of 60% interest in Hangzhou HollySys. Furthermore, these two executed voting together agreements have given the voting control to the same individual, who is the founder of Beijing HollySys. Therefore, there is a control group which has voting control over both entities.

As a result of exchanging the ownership between the Company and the above two parties, both Beijing HollySys and Hangzhou HollySys became subsidiaries of the Company and the Company became the reporting entity for financial reporting purpose. Accordingly, the consolidated financial statements of the above two entities became the historical financial statements of the Company. Prior to June 30, 2005 there were no operating activities in the Company.

Beijing HollySys Co., Ltd. (thereafter HollySys) was established on September 25, 1996 under the laws of People’s Republic of China with a registered capital of RMB15 million (equivalent of approximately $1.8 million based on the exchange rate on September 30, 1996) and a 30-year operation life. A Chinese citizen (who is the founder of HollySys, thereafter “the founder”) infused cash of RMB5 million (equivalent approximately $602,228) and a state-owned company named Beijing Huake Hi-Tech Co., Ltd. contributed physical assets valued at RMB10 million (equivalent approximately $1,204,457), which was based on a valuation report rendered by a third-party valuation service provider.

   

On March 2, 1998, HollySys increased its registered capital by receiving RMB5 million (equivalent approximately $603,916), of which RMB4.1 million (equivalent approximately $495,211) was from another Chinese citizen and the remaining RMB900,000 (equivalent approximately $108,705) was from the founder. Consequently, the state-owned company accounted for only 50% interest in HollySys. On December 25, 1998, the owners of HollySys and three state-owned companies namely Beijing Science and Technology Venture Co., Ltd., Beijing State-Owned Assets Management Co., Ltd., and Zhongguancun Hi-Tech Industry Promotion Center entered into a sponsor agreement to convert HollySys into a share-issuing company which is going to be listed on one of Stock Exchanges in China. During the process of applying for being a listing company, HollySys received cash infusion of approximately RMB51.78 million (equivalent approximately $6.25 million) from three state-owned companies. Of the total RMB51.78 million cash infusion, RMB30 million (equivalent approximately $3.62 million, accounting for 30% interest) from Beijing Science and Technology Venture Co., Ltd.; RMB20 million (equivalent approximately $2.42 million, accounting for 20% interest) from Beijing State-Owned Assets Management Co., Ltd.; and the remaining RMB1,777,676 (equivalent approximately $214,734, accounting for approximately 1.78% interest) from Zhongguancun Hi-Tech Industry Promotion Center.

F-7

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GIFTED TIME HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED JUNE 30, 2005, 2006 AND 2007

NOTE 1 ─ ORGANIZATION AND BUSINESS BACKGROUND (Continued)

 

By infusing cash of approximately RMB51.78 million, three new investors accounted for approximately 51.78 % interest in HollySys whereas the three original owners, Huake, the founder and another Chinese citizen, accounted for approximately 24.11%, 14.23%, and 9.88% interest in HollySys. Due to the facts that there was a long waiting list for approval from China Security Regulatory Commission (CSRC) and that certain business opportunities were no longer in existence in 1999 and 2000, HollySys ceased its effort to become a listing company in China in 2000.

On January 16, 2004 through the merger and acquisition auction market under Chinese government regulation, Beijing Science and Technology Venture sold its 30% interest in HollySys to a Chinese citizen who represents two individual investors in China.

On July 13, 2005 through the merger and acquisition auction market regulated by Chinese government, Beijing State-Owned Assets Management sold its 20% interest in HollySys to Jinqiaotong Industry Development Co., Ltd., which is a privately owned investment company in China and joined in the voting together agreement with the owners of the 54.11% interest in Beijing HollySys.

During the period from 1999 to 2001 HollySys used the newly infused cash to expand its business scope through investing in several investee companies that those investee companies have been conducting similar or relevant businesses except the 5% interest in Zhongjijing Consulting in which the Company is only a passive investor. These long-term investments were accounted for under either equity method or cost method.

On May 15, 2002, the Board of Directors of HollySys decided to acquire 40% interest in Beijing Haotong Science and Technology Development Co., Ltd. (thereafter Haotong) which is a privately owned company doing business focused on railway signal automated control with a 20-year operation life from October 26, 2000 to October 25, 2020, 32% interest from a private investment company and 8% from an individual investor. The acquisition price was RMB5.72 million (equivalent approximately $691,000) and the acquisition transaction was closed on July 1, 2002. On December 13, 2002, the Board of HollySys approved the decision to purchase additional 30% interest from two individual investors to increase HollySys’ interest holding from 40% to 70% for business development consideration and the incremental purchase price was RMB3 million (equivalent $362,000 based on the exchange rate on December 31, 2002). The acquisition was closed on December 31, 2002, resulting in an accumulated goodwill of approximately $449,592. After this acquisition, HollySys consolidated the financial statements of Haotong into its financial statements. On June 30, 2003, HollySys determined that the goodwill was impaired based on the estimated cash flow to be generated by Haotong in the future at that date.

 

On June 3, 2003 the Board of Directors of HollySys decided to expand its presence in Southern China through setting up a new subsidiary to expand its industrial automation business. The Board found that the proper location was the capital city of Zhejiang Province, Hangzhou, because the local city government offered very attractive land usage right and income tax incentive program for HollySys investment decision. On September 24, 2003, a new entity named Hangzhou HollySys Co., Ltd. was set up with a total registered capital of $5 million and a 50-year operation life. On November 20, 2003, Hangzhou HollySys received capital of $1 million, of which HollySys accounted for $400,000, Jingboyuan Automation Co., Ltd., a Chinese company which is related to the founder and another Chinese investor, accounted for $300,000, and OSCAF Limited, a Cayman Islands based company which is related to one member of management in HollySys, accounted for the remaining $300,000.

 

F-8

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GIFTED TIME HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED JUNE 30, 2005, 2006 AND 2007

NOTE 1 ─ ORGANIZATION AND BUSINESS BACKGROUND (Continued)

On April 16, 2004, Jingboyuan transferred its 30% interest in Hangzhou HollySys to Team Spirit Industrial Ltd., a British Virgin Islands based company which also is a related party to the other Chinese investor. On March 16, 2005, Hangzhou HollySys declared dividend distribution of approximately $4.05 million to the above three owners in proportion to their respective interest holding. In turn, the three owners used proceeds of $4 million from dividends received to send back to Hangzhou HollySys in order to fulfill the requirement to contribute the total registered capital up to $5 million on April 14, 2005, which was substantiated by a capital verification report rendered by a CPA firm registered in China. Based on the concept of substance over form, the dividends distributed and capital of $2.4 million received belonging to two 60% interest owners in Hangzhou HollySys were deemed non-cash transaction for financial reporting purpose.

HollySys has conducted its business focusing on industrial automation systems which are used in many industries including power generating, electric grid, computer controlled manufacturing, chemistry, cement, petrochemical, glass manufacturing, pharmaceutical, etc. and integrated automation control systems including monitoring systems, signal distributing systems and other control systems mainly used in city railway transportation.

During the period from December 18 to 20, 2006, the Company and its original Chinese owners entered into a series of significant transactions, which are disclosed in detail in Note 16 to the consolidated financial statements. The accounting for relevant transactions has been presented in Note 8 regarding the $29.987 million notes payable, Note 11 regarding a related party note receivable, and Note 12 regarding certain equity transactions, respectively.

NOTE 2 ─ SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation

The consolidated financial statements include the financial statements of the Company and its subsidiaries. All significant inter-company transactions and balances are eliminated during the process of consolidation. Investments in the investee companies in which the Company does not have a controlling interest (interest holding by the Company from 20% up to 50%), or in which the Company holds more than 51% interest, however, the minority interest in that entity has participation rights defined in EITF 96-16, are accounted for using the equity method. The Company’s shares of earnings (losses) of these investee companies are included in the accompanying consolidated statement of income. These consolidated financial statements have been prepared in accordance with the accounting principles generally accepted in the United States of America (“U.S. GAAP”).

F-9

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GIFTED TIME HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED JUNE 30, 2005, 2006 AND 2007

NOTE 2 ─ SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Foreign Currency Translations and Transactions

The Renminbi (“RMB”), the national currency of PRC, is the primary currency of the economic environment in which the operations of the Company are conducted. The Company uses the United States dollar (“U.S. dollars”) for financial reporting purposes.

The Company translates assets and liabilities into U.S. dollars using the rate of exchange prevailing at the balance sheet date, and the consolidated statement of income is translated at average rates during the reporting period. Adjustments resulting from the translation of financial statements from RMB into U.S. dollars are recorded in stockholders' equity as part of accumulated comprehensive loss - translation adjustments. Gains or losses resulting from transactions in currencies other than RMB are reflected in income for the reporting period.

Revenue Recognition

Revenues generated from designing, building, and delivering customized integrated industrial automation systems and providing relevant solutions are recognized over the contractual terms based on the percentage of completion method. The contracts for designing, building, and delivering customized integrated industrial automation systems are legally enforceable binding agreements between the Company and customers. Performance of these contracts often will extend over long periods, and the Company’s right to receive payments depends on its performance in accordance with these contractual agreements. The duration of contracts the Company performs is depending on the contracts size in term of dollar amounts. In general, the bigger a contract size is, the longer the duration of that contract is. The duration of a small contract is less than one year without including warranty period. The duration of a large contract is longer than one year without including warranty period. Including the warranty period, all of contracts have their duration longer than one year, ranging from 16 months to 61 months. The operating cycle of the Company is determined by a composite of many individual contracts in various stage of completion and is measured by the duration of the average time intervening between the acquisition of materials or service entering the construction process and the substantial completion of contracts. Based on the historical experience, the operating cycle of the Company exceeds one year.

  

In accordance with AICPA’s SOP 81-1, “Accounting for Construction Contracts and Certain Production-Type Contracts,” revenue recognition is based on an estimate of the income earned to date, less income recognized in earlier periods. Estimates of the degree of completion are based on the costs incurred to date comparing to the expected total costs for the contracts. Revisions in the estimated profits are made in the period in which the circumstances requiring the revision become known. Provisions, if any, are made currently for anticipated loss on the uncompleted contracts. Revenue in excess of billings on the contracts is recorded as unbilled receivables and included in accounts receivable. Billings in excess of revenues recognized on the contracts are recorded as deferred revenue until the above revenue recognition criteria are met. Billings are rendered based on agreed milestones included in the contracts with customers. There are different milestones among the contracts the Company has won. In general, there are four milestones: 1) system manufacturing, 2) system delivery, 3) installment, trial-run, and customer acceptance, and 4) expiration of a warranty period. The amount to be billed when each of the specified milestones is reached has been specified in a contract. All contracts have the first milestone, but not all contracts have a prepayment. The Company recognizes 100% of the contractual revenue at the end of customer acceptance stage as the Company estimates that no further major costs will incur under a contract, a signed customer acceptance document has been obtained, and a warranty period starts to count. Revenues are presented net of taxes collected on behalf of government.