UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549


FORM
10-K





x
            ANNUAL REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934.




For the
fiscal year ended: December 31, 2008




 ̈
            TRANSITION REPORT PURSUANT TO
      SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For the
transition period from __________ to ____________




Commission
File Number: 001-33758


Fuqi
International, Inc.


(Exact
name of registrant as specified in its charter)





Delaware
              (State
      or other jurisdiction of
              incorporation
      or organization)
            20-1579407
              (I.R.S.
      Employer
              Identification
      No.)





5/F.,
      Block 1, Shi Hua Industrial Zone
              Cui
      Zhu Road North
              Shenzhen,
      518019
              People’s
      Republic of China
            
            N/A(Address
      of principal executive offices)
            
            (Zip
      Code)





REGISTRANT’S
TELEPHONE NUMBER, INCLUDING AREA CODE: +86(755)2580-1888





SECURITIES
REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:





Title of Each Class
                Name of Each Exchange on Which
      RegisteredCommon
      Stock, $0.001 par value
                NASDAQ
      Global Market





SECURITIES
REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:




None.




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





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





Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes x No  ̈









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





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





Large
      accelerated filer  ̈
                Accelerated
      filer xNon-accelerated
      filer  ̈
                Smaller
      reporting company  ̈(Do
      not check if a smaller reporting company)





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





The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant on June 30, 2008 (the last business day of the
registrant’s most recently completed second fiscal quarter), was approximately
$85.4 million based on the closing price of the registrant’s common stock on The
Nasdaq Global Market of $8.76 per share.




There
were 22,005,509 shares of common stock outstanding as of March 31,
2009.





DOCUMENTS
INCORPORATED BY REFERENCE: The information required by Part III of Form 10-K is
incorporated by reference from the Registrant's definitive proxy statement on
Schedule 14A that will be filed no later than the end of the 120-day period
following the Registrant's fiscal year end, or, if the Registrant's definitive
proxy statement is not filed within that time, the information will be filed as
part of an amendment to this Annual Report on Form 10-K/A, not later than the
end of the 120-day period.











FUQI
INTERNATIONAL, INC.




TABLE
OF CONTENTS TO ANNUAL REPORT ON FORM 10-K




For
the Fiscal Year Ended December 31, 2008





ITEM
                      
                      
                      
                      PagePART
      IItem
      1.
                      
                      Business
                      
                      1Item
      1A.
                      
                      Risk
      Factors
                      
                      9Item
      1B.
                      
                      Unresolved
      Staff Comments
                      
                      21Item
      2.
                      
                      Properties
                      
                      21Item
      3.
                      
                      Legal
      Proceedings
                      
                      21Item
      4.
                      
                      Submission
      of Matters to a Vote of Security Holders
                      
                      21PART
      IIItem
      5.
                      
                      Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                      
                      23Item
      6.
                      
                      Selected
      Consolidated Financial Data
                      
                      25Item
      7.
                      
                      Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      26Item
      7A.
                      
                      Quantitative
      and Qualitative Disclosures about Market Risk
                      
                      40Item
      8.
                      
                      Financial
      Statements and Supplementary Data
                      
                      41Item
      9.
                      
                      Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                      
                      41Item
      9A.
                      
                      Controls
      and Procedures
                      
                      41Item
      9B.
                      
                      Other
      Information
                      
                      44PART
      IIIItem
      10.
                      
                      Directors,
      Executive Officers and Corporate Governance
                      
                      45Item
      11.
                      
                      Executive
      Compensation
                      
                      45Item
      12.
                      
                      Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                      
                      45Item
      13.
                      
                      Certain
      Relationships and Related Transactions, and Director
      Independence
                      
                      45Item
      14.
                      
                      Principal
      Accounting Fees and Services
                      
                      45PART
      IVItem
      15.
                      
                      Exhibits
      and Financial Statement Schedules
                      
                      45Signatures
                      
                      46














CAUTIONARY
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS




The
information contained in this Form 10-K, including in the documents incorporated
by reference into this Form 10-K, includes some statements that are not purely
historical and that are “forward-looking statements.” Such forward-looking
statements include, but are not limited to, statements regarding the Company and
their management’s expectations, hopes, beliefs, intentions or strategies
regarding the future, including its financial condition, and results of
operations. In addition, any statements that refer to projections, forecasts or
other characterizations of future events or circumstances, including any
underlying assumptions, are forward-looking statements. The words “anticipates,”
“believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,”
“might,” “plans,” “possible,” “potential,” “predicts,” “projects,” “seeks,”
“should,” “will,” “would” and similar expressions, or the negatives of such
terms, may identify forward-looking statements, but the absence of these words
does not mean that a statement is not forward-looking.




The
forward-looking statements contained in this Form 10-K are based on current
expectations and beliefs concerning future developments and the potential
effects on the parties and the transaction. There can be no assurance that
future developments actually affecting the Company will be those anticipated.
These forward-looking statements involve a number of risks, uncertainties (some
of which are beyond the parties’ control) or other assumptions that may cause
actual results or performance to be materially different from those expressed or
implied by these forward-looking statements, including the
following:





·
            Vulnerability
      of discretionary jewelry purchases to general economic downturn in
      China;




·
            Fluctuation
      and unpredictability of costs related the gold, platinum and other
      precious metals and commodities used to manufacture the Company’s
      product;




·
            Fluctuations
      in economic conditions in the northeast region of China, where the
      Company’s sales are geographically
concentrated;




·
            Changes
      in the laws of the PRC that affect the Company’s
    operations;




·
            Potential
      strain on the Company’s resources caused from its retail expansion
      strategy;




·
            Competition
      in the jewelry industry in China;




·
            Any
      recurrence of severe acute respiratory syndrome (SARS) or Avian
      Flu;




·
            The
      Company’s ability to obtain and maintain all necessary government
      certifications and/or licenses to conduct the Company’s
      business;




·
            Development
      of a public trading market for the Company’s
  securities;




·
            The
      cost of complying with current and future governmental regulations and the
      impact of any changes in the regulations on the Company’s
      operations;




·
            The
      Company’s reliance on one source for precious
  metals;




·
            The
      Company’s reliance on its distribution network for a significant portion
      of our revenues;




·
            The
      Company’s requirement to maintain a large inventory of raw materials and
      jewelry products, and related risks of theft and
  fire;




·
            The
      Company’s reliance on, and ability to renew, outstanding short-term
      borrowings;




·
            Changes
      in the political and economic policies of the government in China, where
      all of the Company’s assets are located and all from where its revenues
      are derived;




·
            Acquisition
      of the operations of the Temix Companies in August 2008, which may not
      result in the expected benefits;




·
              Adverse
      capital and credit market conditions, and the Company’s ability to meet
      liquidity needs;




·
            Fluctuation
      of the foreign currency exchange rate between U.S. Dollars and Renminbi;
      and




·
            The
      other factors referenced in this Form 10-K, including, without limitation,
      under the sections entitled “Risk Factors,” “Financial Information,”
      “Management’s Discussion and Analysis of Financial Condition and Results
      of Operations,” and “Description of
Business.”




These
risks and uncertainties, along with others, are also described above under the
heading “Risk Factors.” Should one or more of these risks or uncertainties
materialize, or should any of the parties’ assumptions prove incorrect, actual
results may vary in material respects from those projected in these
forward-looking statements. The Company undertakes no obligation to update or
revise any forward-looking statements, whether as a result of new information,
future events or otherwise, except as may be required under applicable
securities laws.









PART
I




ITEM
1.  BUSINESS




Our
company, Fuqi International, Inc., operates through our wholly-owned subsidiary,
Fuqi International Holdings Co., Ltd., a British Virgin Islands corporation
(“Fuqi BVI”) and its wholly-owned subsidiary, Shenzhen Fuqi Jewelry Co., Ltd., a
company established under the laws of China (“Fuqi China”). Fuqi International,
Inc. effected a reverse merger transaction in November 2006 that resulted in our
current corporate structure and subsequently reincorporated in Delaware on
December 8, 2006. For further information concerning our reverse merger
transaction, see “Management’s Discussion and Analysis of Financial Condition
and Results of Operations — Corporate History.”




Overview




We are a
leading designer of high quality precious metal jewelry in China, developing,
promoting, and selling a broad range of products to the luxury goods market in
China. Our products consist of a range of unique styles and designs made from
gold and other precious metals such as platinum and Karat gold
(K-gold).  We also produce jewelry items that contain diamonds and
other precious stones on a custom-order basis. Our design database presently
contains over 30,000 unique products. We continuously innovate and change our
designs based upon consumer trends in China. By continuously creating new
designs and rapidly bringing them to market, we believe we are able to
differentiate ourselves from our competitors and strengthen our brand
identity.




Our
nationwide distribution network, significant relationships with retailers and
self-operated multi-brand retail outlets allow us to test-market, promote and
sell our products in almost every province in China. We believe our vertically
integrated direct sales operations, which include product development, sales and
marketing, and order fulfillment and delivery, allow us to effectively reach
consumers and maximize sales throughout China.




We have
historically sold our products directly to distributors, retailers and
wholesalers, who then sell our products to consumers through both retail
counters located in department stores and in traditional stand-alone jewelry
stores. We sell our products to our customers at price points that reflect the
market price of the base material, plus a mark-up reflecting our design fees and
processing fees. Typically this markup ranges from 8% to 14%. Our customers then
further mark up our products to the consumers up to an additional
30%.  Our target price points for our traditional line of gold jewelry
that we wholesale are primarily designed to appeal to China’s growing middle
class, with an emphasis on young women consumers.





In order
to capture the margin appreciation from direct sales to the consumer, we
recently initiated a retail strategy in 2007 in product categories that we
believe we will not compete with our existing sales channels. Our retail
strategy focuses on finished diamond and other gemstone jewelry, which we have
previously provided only on a custom-order basis and which has historically
represented only a nominal percentage of our overall sales.  Our
finished gemstone jewelry products are primarily designed to appeal to China’s
younger, urban customers, who are generally better educated and influenced more
by Western culture than older consumers.




We intend
to open new retail locations by leasing unoccupied space, acquiring existing
leases from third parties and/or acquiring the existing jewelry operations of
third parties that occupy retail space.  During 2008, we opened and/or
acquired 56 retail counters and acquired seven retail stores in municipalities
and provincial capitals throughout China.   A majority of these
retail locations were acquired in August 2008, when we started to operate the
Temix branded jewelry store chain that we acquired from two jewelry companies,
Shanghai Tian Mei Jewelry Co. Ltd. and Beijing Yinzhong Tian Mei Jewelry Co.
Ltd. (collectively known as the “Temix Companies”).  The Temix
Companies are a branded jewelry store chain that offer high quality diamond
products with 50 outlets located primarily in Beijing and
Shanghai.  Of the 50 outlets, 7 are standalone stores and 43 are store
counters within department stores.  We acquired all of the Temix
Companies’ stores, counters, leases, registered trade name, exchange membership,
and inventories for an aggregate purchase price of approximately $11.7
million.





Also in
August 2008, and as a part of the acquisition of Temix, we acquired all of the
intellectual property rights related to the business of the Temix Companies
pursuant to the Intellectual Property Transfer Agreement (“IP Transfer
Agreement”), which was entered into on April 18, 2008 by our wholly-owned
subsidiary and Mr. Huang. Pursuant to the IP Transfer Agreement, Mr. Huang
received 540,333 shares of our common stock at closing and another 540,333
shares is being placed into an escrow account for the two-year period following
the closing and will only be transferred to Mr. Huang if the business of the
Temix Companies meets certain performance targets as set forth in the IP
Transfer Agreement.





1





As of
December 31, 2008, we had 69 jewelry retail counters and stores in
China.  During 2009, we intend to open and/or acquire additional
retail counters and retail stores throughout the PRC. However, we intend to
continually monitor the results of operations of our current outlets and we may,
from time to time, close outlets that we believe are under performing and we
replace such outlets with more desirable locations in order to maintain our
profitability and cash liquidity.





For the
year ended December 31, 2008, wholesale jewelry sales accounted for
approximately 97% of our revenue and the remainder was attributable to retail
sales. We believe our expansion into the retail market will provide us
with:





·
            direct
      access to the consumer market, allowing us to respond more rapidly to
      changing consumer tastes;




·
            an
      opportunity to grow our revenue base as we roll out our retail
      strategy;




·
            improved
      net margins from higher markups in the retail market;
  and




·
            increased
      brand awareness.




Our
company is headquartered in the city of Shenzhen, in southern China, where we
have a large-scale production base that includes a modern factory of more than
53,000 square feet, a dedicated senior design, sales and marketing team, and we
have approximately 949 employees, including approximately 805 company-trained
production workers.




China
Jewelry Industry




China’s
market for jewelry and other luxury goods is expanding, due in part to the
country’s rapid economic growth. According to the National Bureau of Statistics
of China, China’s real gross domestic product, or GDP, grew by 9.0%, 11.4% and
11.1% in 2008, 2007 and 2006, respectively. Economic growth in China has led to
greater levels of personal disposable income and increased spending among
China’s expanding middle-class consumer base.  According to Economist
Intelligence Unit (EIU), private consumption has grown at approximately 9%
compound annual growth rate, or CAGR, over the last decade.




China—with
its 1.3 billion consumers, higher minimum wages, expanded welfare payments, and
reduced income taxes—is the world's third-largest consumer of luxury
goods.  China's younger generations, in particular, have bought into
consumerism more than their predecessors and been lured by flashy products and
high-end merchandise marketed to the wealthy, upper-middle and middle-market
consumers.  The jewelry industry in China has grown at an annual rate
of approximately 10 percent since the 1980’s and is expected to be the largest
market in the world by 2010.  In 2005, domestic sales of jewelry in
China amounted to RMB 140 billion, which is approximately US$19.8 billion, and
the industry earned $5.49 billion worth of foreign exchange for China through
exports.  In 2008, the growth in China’s jewelry industry was higher
than its general economic growth. As a result, China became the second largest
gold consumer and the largest platinum jewelry market in the world.




Our
Strategies




Our goal
is to be the leading vertically integrated designer, manufacturer, and retailer
of jewelry in China. We intend to achieve our goal by implementing the following
strategies:




Aggressively
pursue new wholesale distribution channels




We intend
to broaden the scope of our distribution arrangements to increase sales
penetration in targeted markets. We intend to select additional distributors
based on their access to markets and retail outlets that are candidates for our
jewelry products. Also, we believe that once we have established broad brand
awareness, more distributors from remote areas will seek access to our products
through our wholesale channel.




Expand
our retail market footprint




We have
developed and are executing a retail sales plan aimed at gaining market share in
the growing consumer market in China. We intend to acquire leases and open new
stores in markets that we believe have a sufficient concentration of our target
customers. Our retail expansion program is designed to reach new and existing
customers through the opening of new retail locations and through the
introduction of new jewelry designs, including our gemstone jewelry line. Retail
locations have been determined on the basis of various factors, including
geographic location, demographic studies and other jewelry stores or counters in
the vicinity of a retail location.





2





Our
retail expansion strategy is designed not to conflict with our existing
distributors. For example, generally we sell our traditional gold jewelry
products to distributors who then sell them to department stores. The department
stores display these products in a retail counter typically owned by the
department stores. In most cases there are other counters in the department
stores that are owned by third-party companies that sell non-competing products
to our gold jewelry products, such as finished gemstone jewelry items. These
third-party counters are our targets for the acquisition of leases, which means
we will not compete with our distributors or with the department stores. Also,
we initially plan to open stores at retail outlets not currently offering our
products. In this way we hope to increase market penetration and maintain
positive relationships with our distributors.




We intend
to open new retail locations by leasing unoccupied space, acquiring existing
leases from third parties and/or acquiring the existing jewelry operations of
third parties that occupy retail space.  During 2008, we opened and/or
acquired 56 retail counters and acquired 7 retail stores in municipalities and
provincial capitals throughout China.  As of December 31, 2008, we had
69 jewelry retail counters and stores in China.  During 2009, we
intend to open and/or acquire additional retail counters and retail stores
throughout the PRC.  However, we intend to continually monitor the
results of operations of our current outlets and we may, from time to time,
close outlets that we believe are under performing and we replace such outlets
with more desirable locations in order to maintain our profitability and cash
liquidity.




We
believe that China represents an excellent retail sales opportunity for our own
expansion into the retail market for various reasons that include:




·
            large pool of potential
      consumers— China has a large population including a rapidly
      expanding middle-class and younger, urban consumer
  bases.




·
            changing consumer
      preferences— we believe that Chinese consumers are embracing a more
      Western view of jewelry as a fashion accessory while also valuing the more
      traditional view of jewelry as an
investment.




·
            growing jewelry market—
      China’s jewelry market has experienced significant
  growth.




·
            large retail market—
      China’s retail sales market is one of largest in the
  world.




·
            favorable regulatory
      changes— as a member of the World Trade Organization (WTO), China
      has eliminated a number of restrictions on foreign ownership and
      operations of retail stores. Tariffs on colored gemstones, gold, silver
      and pearls have been reduced in the past and economic and trade
      relationships between China and other major economic powers have generally
      been liberalized.




·
            increased profit
      potential— we believe that the retail market is a viable method to
      increase our sales profitability and market
  exposure.





Expand
existing and new product offerings




Since the
commencement of our jewelry operations in 2001, we have expanded our line of
products from basic gold jewelry to a range of products that include rings,
bracelets, necklaces, earrings and pendants made from precious metals such as
platinum, gold, palladium and Karat gold (K-gold). We also manufacture jewelry
with diamond and other precious stone inlays, in addition to gold coins and gold
bars.





Our
jewelry product series include the following:





·
            Gold Series. This
      series includes K-gold, 24K gold ornaments, gold bars, gold coins, gifts,
      other gold charms and customized
products.




·
            Platinum Series (pt).This series includes pt990, pt950 and pt900 products. The quality
      markings for platinum are based on parts per thousand. For example, the
      marking pt900 means that 900 parts out of 1000 are pure platinum, or in
      other words, the item is 90% platinum and 10% other
  metals.




·
            K-Gold Series.This
      series is primarily derived from Italian-influenced arts and
      designs.




·
            Studded Jewelry Series.This series is made from pt950, pt900, 18K gold, 14K gold and other
      customer-designated rare metals studded with diamonds, emerald, jade and
      semi-precious stones.  We originally produced studded jewelry
      products on a custom-order basis only, but we have recently expanded our
      production to include new lines of studded jewelry products for sale in
      our retail outlets.




3





Our
in-house designers originate many of our designs. They are educated at art
schools or colleges in China and have gained an average of three to five years
of experience from other jewelry companies. In generating new design ideas, our
designers research and study designs that are popular in China and worldwide.
Our designers conduct design and market research through various forms,
including trade expositions, industrial magazines and the Internet. They also
receive feedback from, and respond to, our customers. We continuously design and
produce new styles of jewelry and currently carry more than 30,000 product
styles, which are growing at a rate of approximately 3,500 styles per annum. We
assign serial numbers to each of our products styles, and we maintain an
information management system utilizing a product database.




Since
2004, we have typically provided over three hundred new designs every month to
our wholesale customers.




In the
coastal cities of China, we believe the demand for platinum and gemstone
products has been increasing. In order to capitalize on the growth of demand, we
intend to develop platinum as the primary metal from which our jewelry is
manufactured. In 2006, we began to shift our product line to produce more
platinum jewelry and we intend to invest in the development of a new production
line to produce studded platinum jewelry. The production cycle of platinum
products is five to seven days while the cycle for gold products is about two
days. As such, more working capital will be needed to support this shift of
product mix.




We
recently began offering diamond products and intend to expand product offerings
to include jade, and other gemstone products. These products usually have a
longer turnover period of at least four to six months but offer higher margins.
We believe that it is critical for us to expand our product lines to include
these products to be sold in our own retail outlets and to our wholesale
customers. We will analyze sales data at all our retail outlets and determine
the best product mix a particular outlet will carry to achieve the highest sales
revenue. Our new diamond jewelry production line will be sold primarily through
our retail outlets.




Enhance
marketing and promotion efforts to increase brand awareness




We
continue to devote our efforts towards brand development and utilize marketing
concepts in an attempt to enhance the marketability of our products. During the
past several years, we have carried out a brand development strategy based on
product quality and design excellence. We have launched advertising campaigns
with television commercials and we have placed ads in major magazines throughout
China to promote our jewelry products. We have also participated and intend to
continue to participate in various exhibitions and similar promotional events to
promote our products and brand. We are working with professional advertising
agents to develop and implement media strategies to further strengthen brand
awareness of “Fuqi” and “Temix”.




Product
Pricing




The
wholesale pricing of our products is based on three primary components: price of
raw materials used, processing fee, and design fee. The price of the raw
materials for our jewelry highly depends on the spot price of the raw materials
(e.g., gold and platinum) at the time the jewelry is sold. The amount charged as
a design fee is determined by management based on various criteria, including
market conditions, and production complexity, popularity and uniqueness of the
design. Management meets on a monthly basis to determine the design fees charge
rate, which generally ranges from 6% to 10% of price of raw materials. The
processing fee ranges from 2% to 3% of the price for the raw materials. We pay
business tax on our design fee. We also pay a value added tax on the raw
materials and processing fee, which we bill to our customers and remit to the
local tax authority on a monthly basis. The sales amounts reported in the
statements of income are net of the value added tax. The invoices that we
provide to our wholesale customers itemize these raw material costs and design
and processing fees that make up the total cost charged to them. The retail mark
up from the wholesale price is approximately 30%, depending on the complexity of
design and other factors.




Credit
Terms




We offer
certain of our customers credit terms for payment. We have traditionally granted
credit to a customer if the customer has been in existence for at least five
years and/or has been doing business with us for at least three years. More
recently, we have increased credit decisions to new customers on credit checks
from various sources, including department store operators and industry
participants. We attempt to minimize credit risk by reviewing a customer’s
credit history before extending credit and by continually monitoring the
customer’s credit exposure. We maintain an allowance for doubtful accounts for
estimated losses resulting from the inability of our customers to make required
payments. Allowance for doubtful accounts is based on our assessment of the
collectability of specific customer accounts, the aging of accounts receivable,
our history of bad debts, and the general condition of the industry. If a major
customer’s credit worthiness deteriorates, or our customers’ actual defaults
exceed historical experience, our estimates could change and impact our reported
results. For the years ended December 31, 2008 and 2007, we had a provision for
bad debt expense of approximately $1.1 million and $0.3 million, respectively,
which represented approximately 1.5% and 1.2% of our gross accounts receivables
as of December 31, 2008 and 2007, respectively.





4





Manufacturing




We have a
large-scale production base that includes a modern factory of more than 53,000
square feet, a dedicated senior design team, and approximately 805
company-trained production workers. In the first quarter of 2008, we analyzed
and refined our production procedures to increase efficiency and reduced the
number of trained workers by approximately 15%. We periodically review and
analyze our production procedures and new technologies to maintain or enhance
our production efficiencies. We are in the process of negotiating a program to
commence research for new production technology with reputable university in
China. Since 2003, we have held an ISO 9001 accreditation, which is an
international standard of quality. The International Organization for
Standardization (ISO)
(http://www.iso.org/iso/en/iso9000-14000/understand/inbrief.html) defines the
ISO 9000 quality management system as one of international references for
quality management requirements in business-to-business dealings. An
organization being accredited by an independent assessment organization has to
fulfill:




·
            the customer’s quality
requirements,




·
            applicable regulatory requirements, while aiming to enhance customer
      satisfaction, and




·
            achieving continual improvement of its performance in pursuit of these
      objectives.




The ISO
9000 quality management system is well recognized by People’s Republic of China
(“PRC”)’s governmental bodies and businesses. This accreditation can serve as a
basis for our customers to determine the minimum standard of quality assurance
that we achieve. We believe that this accreditation also indicates to our
customers that we are running an effective system to track quality issues and
possible rework progress of our products. In January 2007, we also achieved the
ISO 14000 accreditation. ISO 14000 is an environmental management system in
which the organization being accredited has to (i) minimize harmful effects on
the environment caused by its activities, and (ii) achieve continual improvement
of its environmental performance.




Sales
and Marketing




We rely
on our sales and marketing division, which is located at our executive offices
in Shenzhen, China for the distribution of our products in China. With respect
to our wholesale distribution of our products, we sell our products primarily to
our national and provincial distributors that resell our products to end
customers through their own distribution networks, which are typically composed
of local distributors and retail outlets. Our wholesale distribution network
currently includes approximately 31 provincial distributors and more than 840
direct-sales distributors. These distributors sell our products to local
distributors, over 900 retail outlets and directly to end users in
China.




Our
wholesale marketing and distribution strategy is to screen and identify the
strongest customers in each distribution channel and to focus on our design and
sales efforts towards the largest and fastest growing retailers and
distributors. We maintain a broad base of customers and concentrate our efforts
on department stores, wholesalers, national jewelry chains, fine jewelers, and
stores that sell fashionable jewelry. We also work closely with our major
customers and attempt to adjust our product strategies and structure based on
customer feedback in order to decrease the likelihood of overstocked, undesired
products.




Our
traditional gold jewelry products that we wholesale are mainly designed for the
middle income class in China, with an emphasis on young women. Approximately 50%
of these designs are geared towards women between the ages of 20 to 40 years, 5%
of these designs are designed for new-born children, 20% of these designs are
for middle-aged men and 25% of these designs are for middle to older-aged women.
Our products are sold in China at average retail prices equivalent to $200 to
$300, including tax. At present, approximately 5 to 6% of our products are
marketed on a private label basis, but we anticipate that this percentage will
decrease as we continue to develop the “Fuqi” brand.




We
continue to invest in our brand and our marketing ability in order to increase
demand for our products. During the past several years, we have carried out a
brand development strategy based on product quality and design excellence. We
have participated in various marketing activities and exhibitions to promote our
products and brand. For example, in 2004, we were the laurel sponsor for
multiple beauty pageants, including the “Miss Intercontinental Final” and the
“Miss China Universe.” As a laurel sponsor, we designed and crafted the laurels
and/or batons that were presented to a contest winner, in addition to the
contest’s second and third place runner-ups. We have also sponsored numerous
beauty contests such as:




·
            the Final of Miss Global of WTO;




·
            the 17th World Miss Universe
Contest;




5





·
            the 1st China Miss University Contest;
and




·
            China Final of Miss World.




We
believe that the laurels and batons created in connection with our sponsorship
of beauty contests provided us an opportunity to showcase our design and
craftsmanship ability, in addition to strengthening our brand
recognition.





We have
received various governmental awards with respect to our brand, including
recognition by the China Light Product Quality Assurance Center as a “Chinese
Famous Brand,” which is reserved for the top ten most recognized brands of the
jewelry industry in China. We have also received other recognitions, including,
from the Gems & Jewelry Trade Association of China as a “Famous Brand in the
China Jewelry Industry”, from Committee of Shenzhen Famous Brand Accreditation
as a “Shenzhen Well-known Brand”, from the Shenzhen City Enterprises Evaluation
Association as one of the “Shenzhen 300 enterprises with Ultimate Growth” and
from Moody United Certification Ltd as “China Quality Promise Credit Management
Enterprise (Brand)”. In October 2007, “Fuqi” was recognized as a “China Top
Brand” by General Administration of Quality Supervision, Inspection and
Quarantine of the People's Republic of China. We believe that governmental
awards and other forms of recognition raise brand recognition for our
products.




The
“Fuqi” trademark has been registered in the United States, Italy, Japan, Hong
Kong and China.





We also
engage in marketing activities for our retail sales brand.  We
acquired the “Temix” brand with our acquisition of substantially all of the
assets of the Temix Companies in August 2008. We are working with professional
advertising agents to further strengthen our branding and media
strategies.




Supply
of Raw Materials




We are a
full member of the Shanghai Gold Exchange and a standing council member of the
Shenzhen Gold Association of China. The Shanghai Gold Exchange is China’s, and
our, sole supply source for precious metals.  We maintain our supply
of raw materials at our warehouse in Shenzhen, China. We traditionally purchase
large volumes of precious metals approximately five times per month from the
Shanghai Gold Exchange in advance and in anticipation of orders resulting from
our marketing programs. When we make purchases on the Shanghai Gold Exchange,
the Exchange issues a receipt to us that we can redeem for precious metals at
various commercial banks in Shenzhen.




In an
attempt to minimize the risk of storage and devaluation, we only purchase
pre-cut gemstones, including ruby and jade, upon customers’
requests.  We do not have a designated supplier for these pre-cut
stones. When a customer places an order that requires pre-cut stones, we have
traditionally purchased the pre-cut stones, on an as need basis from local
supplies in Shenzhen. As we have expanded our retail distribution of our
jewelry products and production of diamond jewelry products, we have also began
to purchase pre-cut diamonds from reputable internal suppliers through the
Shanghai Diamond Exchange.





Competition




The
jewelry production industry is highly competitive, and our competitors include
domestic and foreign jewelry manufacturers, wholesalers, and importers who may
operate on a national, regional and local scale. Many of our competitors have
substantially greater financial, technical and marketing resources and personnel
than us. Our strategy is to provide competitively priced, high-quality products
to the high-volume retail jewelry market. We believe competition is largely
based on quality, service, pricing, and established customer
relationships.




In 2007,
we entered into the retail jewelry industry, which is also highly competitive.
Many of our potential competitors in the retail industry have larger customer
bases, longer operating histories and significantly greater financial,
technical, marketing and other resources. Most of these retailers, including
Chow Sang Sang Group, Luk Fook Jewelry, TSL Jewelry and 3-D Gold Jewelry, have
numerous branches set up across China and may have secured the most desirable
locations for retail stores. It may be difficult for a newcomer to enter into
and expand in the retail industry, but based on our extensive analysis, market
review, and planning, we believe that our established production and wholesale
distribution business will facilitate our entrance into and expansion in the
retail market.




Major
Customers




During
the years ended December 31, 2008, 2007 and 2006, there were no single customers
that generated more than 10% of the total sales.





6




Seasonality




Our
business is seasonal in nature. Our sales and net income are generally higher in
the fourth calendar quarter than the rest of the year. The primary factors that
affect the seasonal changes in our business operations are holidays and
traditional Chinese festivals. In the fourth quarter, retailers often experience
increased sales due to the weeklong public holiday for Chinese National Day, as
well as Christmas and New Year’s Day. In addition, jewelry retailers commonly
stock up from wholesalers in the fourth quarter to prepare for potentially
higher sales in the following quarter for Chinese New Year. This quarter is also
a peak season for marriages and the birth of newborns in China, which have
historically resulted in higher sales. This seasonal trend in our business would
slightly shift in line with the gap between calendar quarter and lunar quarter
and occurred during 2004 and 2005. However, there was a slight variation during
2006. Because of rising precious metal prices in the fourth quarter of 2006,
many customers delayed their orders until the first quarter of 2007, resulting
in lower-than-expected sales volume in the fourth quarter of 2006, and higher
than expected sales in the first quarter of 2007. We experienced increased sales
in the fourth quarter of 2007.  For the year ended December 31, 2008,
our results of operations appeared to return to the trend of higher sales in the
fourth quarter.





Government
Regulations




We are
subject to various laws and regulations in the PRC, affecting all aspects of our
business. In April 2001, the Shenzhen Business Bureau granted our wholly-owned
subsidiary, Fuqi China, the right to operate for a period of ten years from the
date of inception. On May 17, 2006, we converted Fuqi China into a
wholly-foreign-owned enterprise, or WFOE, and formally transferred the ownership
of Fuqi China from the founder, Mr. Yu Kwai Chong, to Fuqi BVI. Neither this
transfer nor the reverse merger that we conducted in November 2006 changed our
business plan. The right to operate as a WFOE expires 30 years from the date of
establishment but, based on current PRC legislation, this right is renewable by
application. A WFOE can only conduct business within its approved business
scope, which appears on its business license. Our license permits us to design,
manufacture, sell and market jewelry products to department stores throughout
the PRC, and allows us to engage in the retail distribution of our products. Any
further amendment to the scope of our business will require additional
applications and government approval. We cannot assure you that we will be able
to obtain the necessary government approval for any change or expansion of our
business.




Under
applicable PRC laws, supplies of precious metals such as platinum, gold and
silver are highly regulated by certain government agencies, such as the People’s
Bank of China. Shanghai Gold Exchange is the only PBOC authorized supplier of
precious metal materials and, therefore, the primary source of supply for our
raw materials, which substantially consist of precious metals. We are required
to obtain several membership and approval certificates from these government
agencies in order to continue to conduct our business. We may be required to
renew such memberships and to obtain approval certificates periodically. If we
are unable to renew these periodic membership or approval certificates, it would
materially affect our business operations. We are currently in good standing
with these agencies.




We have
also been granted independent import and export rights. These rights permit us
to import and export jewelry in and out of China. Based on, in part, the recent
decline in the global economy, we do not currently have plans to import jewelry
into China.




Our
production facilities in Shenzhen are subject to environmental regulation by the
Environmental Protection Bureau of Shenzhen. We hold all requisite operating
permits from the Environmental Protection Bureau. Our permits confirm that we
are in compliance with local regulations governing waste production and disposal
and that our production facilities meet the public safety regulations regarding
refuse, emissions, lights, noise and radiation. To date, we have never been
cited for any environmental violations.




Employees




We have
approximately 949 employees, including approximately 805 trained production
workers.  In 2008, we began recruiting skilled laborers to fill
vacancies for our new diamond line products. As a result, the number of our
trained production workers includes approximately 108 trained diamond production
workers. Our employees are part of a labor association that represents employees
with respect to labor disputes and other employee matters. We have never
experienced a work stoppage or a labor dispute that has interfered with our
operations. We believe our relationship with our employees is good.




We are
required to contribute a portion of our employees’ total salaries to the Chinese
government’s social insurance funds, including medical insurance, unemployment
insurance and job injuries insurance, and a housing assistance fund, in
accordance with relevant regulations. Total contributions to the funds are
approximately $125,000, $46,000 and $34,000 for the years ended December 31,
2008, 2007 and 2006, respectively. We expect that the amount of our contribution
to the government’s social insurance funds will increase in the future as we
expand our workforce and operations. We also provide housing facilities for our
employees. At present, approximately 63% of our employees live in
company-provided housing facilities.





7




Effective
January 1, 2008, PRC introduced a new labor contract law that enhances rights
for the nation's workers, including open-ended work contracts and severance pay.
The legislation requires employers to provide written contracts to their
workers, restricts the use of temporary laborers and makes it harder to lay off
employees. It also requires that employees with short-term contracts become
full-time employees with lifetime benefits after a short-term contract is
renewed twice.  Although the new labor contract law will increase our
labor costs going forward, we do not anticipate there will be any significantly
effects on our overall profitability in the near future since such amount was
historically not material to our operating cost. The increase in our operation
costs due to the new labor law was not material, and our management anticipates
the law may be assist in improving candidate retention for skilled
workers.





Available
Information




Our
principal executive offices are located at 5/F., Block 1, Shi Hua Industrial
Zone, Cui Zhu Road North, Shenzhen, 518019, People’s Republic of China. Our
telephone number is +86 (755) 2580-1888. Our Internet address is www.fuqi.com.cn. We
make available free of charge on or through our Internet Website our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and amendments to those reports filed or furnished pursuant to Section
13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission.




8










ITEM
1A: RISK FACTORS




Any
investment in our common stock involves a high degree of risk. Potential
investors should carefully consider the material risks described below and all
of the information contained in this Form 10-K before deciding whether to
purchase any of our securities. Our business, financial condition or results of
operations could be materially adversely affected by these risks if any of them
actually occur. Some of these factors have affected our financial condition and
operating results in the past or are currently affecting our company. This
filing also contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from those anticipated
in these forward-looking statements as a result of certain factors, including
the risks faced described below and elsewhere in this Form
10-K.  Unless the context otherwise requires, the terms “we,” the
“Company,” “us,” or “Fuqi” refers to Fuqi International, Inc. and our
wholly-owned subsidiaries.




RISKS
RELATED TO OUR OPERATIONS




Jewelry
purchases are discretionary, may be particularly affected by adverse trends in
the general economy, and an economic decline will make it more difficult to
generate revenue.




The
success of our operations depends to a significant extent upon a number of
factors relating to discretionary consumer spending in China. These factors
include economic conditions and perceptions of such conditions by consumers,
employment rates, the level of consumers’ disposable income, business
conditions, interest rates, consumer debt levels, availability of credit and
levels of taxation in regional and local markets in China where we manufacture
and sell our products. There can be no assurance that consumer spending on
jewelry will not be adversely affected by changes in general economic conditions
in China and globally.





Most
of our sales are of products that include gold, platinum, precious metals and
other commodities, and fluctuations in the availability and pricing of
commodities would adversely impact our ability to obtain and produce products at
favorable prices.




The
jewelry industry generally is affected by fluctuations in the price and supply
of diamonds, gold, platinum and, to a lesser extent, other precious and
semi-precious metals and stones. Historically, we have not hedged our
requirements for gold, platinum or other raw materials through the use of
options, forward contracts or outright commodity purchasing.  In the
fourth quarter of 2007, we began to engage in such hedging activities for gold
by entering into gold futures contracts, but there is no guarantee that we will
benefit in our attempts to hedge against fluctuations in the price or
availability of gold.





A
significant disruption in our supply of gold, platinum, or other commodities
could decrease our production and shipping levels, materially increase our
operating costs and materially adversely affect our profit margins. Shortages of
gold, platinum, or other commodities, or interruptions in transportation
systems, labor strikes, work stoppages, war, acts of terrorism, or other
interruptions to or difficulties in the employment of labor or transportation in
the markets in which we purchase our raw materials, may adversely affect our
ability to maintain production of our products and sustain profitability.
Although we generally attempt to pass increased commodity prices to our
customers, there may be circumstances in which we are not able to do so. In
addition, if we were to experience a significant or prolonged shortage of gold,
platinum, or other commodities, we would be unable to meet our production
schedules and to ship products to our customers in timely fashion, which would
adversely affect our sales, margins and customer relations.





Furthermore,
the value of our inventory may be affected by commodity prices. We record the
value of our inventory at the lower of cost (using the first-in, first-out
method) or market. As a result, decreases in the market value of precious metals
such as gold and platinum would result in a lower stated value of our inventory,
which may require us to take a charge for the decrease in the value of our
inventory.




Due
to the geographic concentration of our sales in the northeast region of China,
our results of operations and financial condition are subject to fluctuations in
regional economic conditions.




A
significant percentage of our total sales are made in the northeast region of
China, particularly in the provinces of Liaoning, Jilin and Heilongjiang, and
the city of Beijing. For the years ended December 31, 2008 and 2007,
approximately 37.7% and 51.1% of revenues, respectively, was generated from this
area. Our concentration of sales in this area heightens our exposure to adverse
developments related to competition, as well as economic and demographic changes
in this region. Our geographic concentration might result in a material adverse
effect on our business, financial condition or results of operations in the
future.





9





Our
retail expansion strategy depends on our ability to open and operate a certain
number of new counters and stores each year, which could strain our resources
and cause the performance of our existing operations to suffer.




We have
historically been engaged only in the manufacture and wholesale distribution of
jewelry products and have only recently begun retail operations. Our retail
expansion strategy will largely depend on our ability to find sites for, open
and operate new retail locations successfully. Our ability to open and operate
new retail locations successfully depends on several factors, including, among
others, our ability to:




·
              identify
      suitable counter and store locations, the availability of which is outside
      our control;
 ·
              purchase
      and negotiate acceptable lease
terms;
 ·
              prepare
      counters and stores for opening within
budget;
 ·
              source
      sufficient levels of inventory at acceptable costs to meet the needs of
      new counters and stores;
 ·
                      hire,
      train and retain personnel;·
                      secure
      required governmental permits and approvals;·
                      successfully
      integrate new counters and stores into our existing
      operations;·
                      contain
      payroll costs; and·
                      generate
      sufficient operating cash flows or secure adequate capital on commercially
      reasonable terms to fund our expansion
plans.
  Any
failure to successfully open and operate new retail counters and stores could
have a material adverse effect on our results of operations. In addition, our
retail expansion program will place increased demands on our operational,
managerial and administrative resources. These increased demands could cause us
to operate our business less effectively, which, in turn, could cause
deterioration in the financial performance of our overall
business.




It is not
our intention to open new retail counters and stores that materially cannibalize
the sales of our existing distributors. However, as with most growing retail
operations, there can be no assurance that sales cannibalization will not
inadvertently occur or become more significant in the future as we gradually
increase our presence in existing markets over time to maximize our competitive
position and financial performance in each market.




Our
acquisition of substantially all of the assets of the Temix Companies in August
2008 may not result in the benefits and revenue growth we expect.





In August
2008, we completed our acquisition of substantially all of the assets of the
Temix Companies.  The Temix Companies was our first major acquisition
of a jewelry retail operation. We may continue to acquire additional businesses
in the future. This acquisition and future acquisitions involve substantial
risks, including:





·
            integration
      and management of the operations;


·
            Retention
      of key personnel;


·
            integration
      of information systems, internal procedures, accounts receivable and
      management, financial and operational
controls;


·
            retention
      of customer base of acquired
businesses;


·
            diversion
      of management’s attention from other ongoing business concerns; and
      exposure to unanticipated liabilities of acquired
    companies.





These and
other factors could harm our ability to achieve anticipated levels of
profitability or realize other anticipated benefits of an acquisition and could
adversely affect our business and operating results.





10





Competition
in the jewelry industry could cause us to lose market share, thereby materially
adversely affecting our business, results of operations and financial
condition.





The
jewelry industry in China is highly fragmented and very competitive. We believe
that the market may become even more competitive as the industry grows and/or
consolidates. We compete with local jewelry manufacturers and large foreign
multinational companies that offer products that are similar to ours. Some of
these competitors have larger local or regional customer bases, more locations,
more brand equity, and substantially greater financial, marketing and other
resources than we have. As a result of this increasing competition, we could
lose market share, thereby materially adversely affecting our business, results
of operations and financial condition.




We
may need to raise additional funds in the future. These funds may not be
available on acceptable terms or at all, and, without additional funds, we may
not be able to maintain or expand our business.





We expect
to expend significant resources to expand our retail distribution of jewelry in
China. We will require substantial funds in order to finance our retail
distribution, fund operating expenses, to develop manufacturing, marketing and
sales capabilities and to cover public company costs. In addition to the funds
required to open retail locations, additional working capital will be needed to
operate retail locations due to longer sales and collection cycles and higher
inventory levels required to support retail stores. We also expect to require
substantial funds to change our product mix to include more platinum products.
Without these funds, we may not be able to meet these goals.  Also, we
expect our general and administrative costs to substantially increase due to
higher salaries to be paid to our executive officers after the completion of our
initial listing in the United States in October 2007.  See “Executive
Compensation — Compensation Discussion and Analysis.”  We
may seek additional funding through public or private financing or through
collaborative arrangements with strategic partners.




You
should also be aware that in the future:




·
            We
      cannot be certain that additional capital will be available on favorable
      terms, if at all;


·
            Any
      available additional financing may not be adequate to meet our goals;
      and


·
            Any
      equity financing would result in dilution to
  stockholders.





If we
cannot raise additional funds when needed, or on acceptable terms, we may not be
able to effectively execute our growth strategy (including expanding our
business to the retail market), take advantage of future opportunities, or
respond to competitive pressures or unanticipated requirements. In addition, we
may be required to scale back or discontinue our production and development
program, or obtain funds through strategic alliances that may require us to
relinquish certain rights.




Our
ability to maintain or increase our revenue could be harmed if we are unable to
strengthen and maintain our brand image.




We
believe that primary factors in determining customer buying decisions in China’s
jewelry sector include price, confidence in the merchandise sold, and the level
and quality of customer service. The ability to differentiate our products from
competitors by our brand-based marketing strategies is a key factor in
attracting consumers, and if our strategies and efforts to promote our brand,
such as television and magazine advertising and beauty contest sponsorships,
fail to garner brand recognition, our ability to generate revenue may suffer. If
we are unable to differentiate our products, our ability to sell our products
wholesale and our sale of products retail will be adversely affected. If we fail
to anticipate, identify or react appropriately or in a timely manner to customer
buying decisions, we could experience reduced consumer acceptance of our
products, a diminished brand image, higher markdowns, and costs to recast
overstocked jewelry. These factors could result in lower selling prices and
sales volumes for our products, which could adversely affect our financial
condition and results of operations. This risk is particularly acute because we
rely on a limited demographic customer base for a large percentage of our
sales.




There
is only one source in China for us to obtain the precious metals used in our
jewelry products; accordingly, any interruptions of our arrangement with this
source would disrupt our ability to fill customer orders and substantially
affect our ability to continue our business operations.




Under PRC
law, supply of precious metals such as platinum, gold, and silver are highly
regulated by certain government agencies. Shanghai Gold Exchange is the only
authorized source of supply in China for precious metals used in our jewelry
products. We are required to obtain several membership and approval certificates
from government agencies in order to do business involving precious metals. We
may be required to renew such memberships and to obtain approval certificates
periodically. The loss of or inability to renew our membership relationship with
the Shanghai Gold Exchange, or its inability to furnish precious metals to us as
anticipated in terms of cost, quality, and timeliness, would adversely affect
our ability to fill customer orders in accordance with our required delivery,
quality, and performance requirements. If this were to occur, we would not have
any alternative suppliers in China to obtain our raw materials from, which would
result in a decline in revenue and revenue potential and risk the continuation
of our business operations.





11





If
we are not able to adapt to changing jewelry trends in China, our inventory may
be overstocked and we may be forced to reduce the price of our overstocked
jewelry or incur the cost to recast it into new jewelry.




We depend
on consumer fashions, preferences for jewelry and the demand for particular
products in China. Jewelry design trends in China can change rapidly, as
evidenced by the recent increase in the consumption of platinum jewelry in the
Chinese market. The ability to predict accurately future changes in taste,
respond to changes in consumer preferences, carry the inventory demanded by
customers, deliver the appropriate quality, price products correctly and
implement effective purchasing procedures, all have an important influence on
determining sales performance and achieved gross margin. If we fail to
anticipate, identify or react appropriately to changes in styles and trends, we
could experience excess inventories, higher than normal markdowns or an
inability to sell our products. If such a situation exists, we may need to incur
additional costs to recast our products to fit the demand, recovering only the
value of raw material and all labor invested in the product would be
lost.




Our
failure to manage growth effectively could have an adverse effect on our
employee efficiency, product quality, working capital levels, and results of
operations.




We have
been implementing a growth strategy into retail distribution of our products
that we believe will result in rapid growth, which will place significant
demands on our managerial, operational and financial resources. Any significant
growth in the market for our current wholesale business and our planned retail
distribution would require us to expand our employee base for managerial,
operational, financial, and other purposes. During any growth, we may face
problems related to our operational and financial systems and controls,
including quality control and delivery and service capabilities. We would also
need to continue to expand, train and manage our employee base. We currently
have approximately 949 employees, which include approximately 805
company-trained workers, and, at that size, a rapid increase in the number of
our employees would be difficult to manage. Continued future growth will impose
significant added responsibilities upon the members of management to identify,
recruit, maintain, integrate, and motivate new employees. If we are able to
expand our retail business, we would need to train or hire additional employees
with retail experience.




Aside
from increased difficulties in the management of human resources, we may also
encounter working capital issues, as we will need increased liquidity to finance
the purchases of raw materials and supplies, development of new products,
establishment of new retail stores, and the hiring of additional employees. Our
failure to manage growth effectively may lead to operational and financial
inefficiencies that will have a negative effect on our profitability. We cannot
assure you that we will be able to timely and effectively meet that demand and
maintain the quality standards required by our existing and potential
customers.




We
rely on our distribution network for a significant portion of our revenues.
Failure to maintain good distributor relations could materially disrupt our
distribution business and harm our net revenues.




Our
business has become increasingly dependent on the performance of our
distributors. During the years ended December 31, 2008, 2007, and 2006, 19%, 16%
and 13%, respectively, of our net revenues were generated through our
distributors. We currently have 192 distributors. Our largest distributor
accounted for approximately 6% and 7% of our gross revenues in fiscal 2008 and
2007, respectively. We do not maintain long-term contracts with our
distributors. Maintaining relationships with existing distributors and replacing
any distributor may be difficult or time consuming. Our failure to maintain good
relationships with our distributors could materially disrupt our distribution
business and harm our net revenues.




We
must maintain a relatively large inventory of our raw materials and jewelry
products to support customer delivery requirements, and if this inventory is
lost due to theft, our results of operations would be negatively
impacted.




We
purchase large volumes of precious metals approximately five times per month and
store significant quantities of raw materials and jewelry products at our
warehouse and show room in Shenzhen, China. Although we have an inventory
security system in place, in the past we have experienced minor inventory theft
at, or in transit to or from, certain of these facilities. We may be subject to
future significant inventory losses due to third-party or employee theft from
our warehouses or other forms of theft. The implementation of security measures
beyond those that we already utilize, which include metal detectors for
employees, security cameras, and alarm systems in our warehouse, would increase
our operating costs. Also, any such losses of inventory could exceed the limits
of, or be subject to an exclusion from, coverage under our insurance policies.
Claims filed by us under our insurance policies could lead to increases in the
insurance premiums payable by us or the termination of coverage under the
relevant policy.





12





Substantial
defaults by our customers on accounts receivable could have a material adverse
affect on our liquidity and results of operations.




A
substantial portion of our working capital consists of accounts receivable from
customers.  As of December 31, 2008 and 2007, approximately 57% and
25% of our working capital, respectively, was attributable to accounts
receivable. In addition, we have seen a significant increase in our provisions
for bad debt.  For the years ended December 31, 2008 and 2007, we had
a provision for bad debt expense of approximately $1.1 million and $0.3 million,
respectively, which represented approximately 1.5% and 1.2% of our gross
accounts receivables as of December 31, 2008 and 2007,
respectively.  If customers responsible for a significant amount of
accounts receivable were to become insolvent or otherwise unable to pay for our
products, or unable to make payments in a timely manner, our liquidity and
results of operations could be materially adversely affected. An economic or
industry downturn could materially adversely affect the servicing of these
accounts receivable, which could result in longer payment cycles, increased
collections costs and defaults in excess of management’s expectations. In
addition, as we increase our presence in the retail market, we expect the aging
of our accounts receivable generated from sales through retail counters to
increase as department stores typically defer payments to us of cash receipts
collected by them on our behalf. A significant deterioration in our ability to
collect on accounts receivable could affect our cash flow and working capital
position and could also impact the cost or availability of financing available
to us.




We
are dependent on certain key personnel and loss of these key personnel could
have a material adverse effect on our business, financial condition and results
of operations.




Our
success is, to a certain extent, attributable to the management, sales and
marketing, and operational and technical expertise of certain key personnel.
Each of our named executive officers, including our Chief Executive Officer, Mr.
Yu Kwai Chong, performs key functions in the operation of our business. There
can be no assurance that we will be able to retain these officers or that such
personnel may not receive and/or accept competing offers of employment. The loss
of a significant number of these employees could have a material adverse effect
upon our business, financial condition, and results of operations. We do not
maintain key-man life insurance for any of our senior management.




We
have significant outstanding short-term borrowings that have been increasing,
and we may not be able to obtain extensions when they mature.




Our notes
payable to banks for short-term borrowings as of December 31, 2008 and 2007,
were $21.9 million and $17.1 million, respectively, and bore weighted average
interest rates of 6.64% and 6.68%, respectively. Generally, these short-term
bank loans mature in one year or less and contain no specific renewal terms.
However, in China it is customary practice for banks and borrowers to negotiate
roll-overs or renewals of short-term borrowings on an on-going basis shortly
before they mature. Although we have renewed our short-term borrowings in the
past, we cannot assure you that we will be able to renew these loans in the
future as they mature. In particular, a substantial portion of our short-term
borrowings are arranged or guaranteed by Mr. Yu Kwai Chong, our controlling
stockholder and CEO, or one of his affiliated companies. Since Mr. Chong ceased
to be our sole stockholder in November 2006, he may be less inclined to
guarantee our bank borrowings. If we are unable to obtain renewals of these
loans or sufficient alternative funding on reasonable terms from banks or other
parties, we will have to repay these borrowings with the cash on our balance
sheet or cash generated by our future operations, if any. We cannot assure you
that our business will generate sufficient cash flow from operations to repay
these borrowings.





Adverse
capital and credit market conditions may significantly affect our ability to
meet liquidity needs, access to capital and cost of capital.





The
capital and credit markets have been experiencing extreme volatility and
disruption in recent months, including, among other things, extreme volatility
in securities prices, severely diminished liquidity and credit availability,
ratings downgrades of certain investments and declining valuations of others.
Governments have taken unprecedented actions intended to address extreme market
conditions that have included severely restricted credit and declines in real
estate values. In some cases, the markets have exerted downward pressure on
availability of liquidity and credit capacity for certain issuers. While
currently these conditions have not impaired our ability to utilize our current
credit facilities and finance our operations, there can be no assurance that
there will not be a further deterioration in financial markets and confidence in
major economies such that our ability to access credit markets and finance our
operations might be impaired. As of December 31, 2008, we had approximately
$21.9 million in short-term notes payable that are due and payable between
January 2009 and June 2009. If we are unable to obtain additional financing at
or prior to the maturity date of our notes payable, our liquidity will be
adversely affected, and without sufficient liquidity, we may be forced to
curtail our operations. Adverse market conditions may limit our ability to
replace, in a timely manner, maturing liabilities and access the capital
necessary to operate and grow our business. As such, we may be forced to delay
raising capital or bear an unattractive cost of capital which could decrease our
profitability and significantly reduce our financial flexibility. Demand for our
services is cyclical and vulnerable to economic downturns. Although our total
revenues continue to improve in the year ended December 31, 2008, the current
tightening of credit in financial markets could adversely affect the ability of
our customers to obtain financing for purchases of our services and could result
in a decrease in or cancellation of orders for our services. We are unable to
predict the duration and severity of the current disruption in financial markets
and the global adverse economic conditions and the effect such events might have
on our business. Our results of operations, financial condition, cash flows and
capital position could be materially adversely affected by disruptions in the
financial markets.





13





Our
quarterly results may fluctuate because of many factors and, as a result,
investors should not rely on quarterly operating results as indicative of future
results.




Fluctuations
in operating results or the failure of operating results to meet the
expectations of public market analysts and investors may negatively impact the
value of our securities. Quarterly operating results may fluctuate in the future
due to a variety of factors that could affect revenues or expenses in any
particular quarter. Fluctuations in quarterly operating results could cause the
value of our securities to decline. Investors should not rely on
quarter-to-quarter comparisons of results of operations as an indication of
future performance. As a result of the factors listed below, it is possible that
in future periods results of operations may be below the expectations of public
market analysts and investors. This could cause the market price of our
securities to decline.





Factors
that may affect our quarterly results include:




·
            vulnerability
      of our business to a general economic downturn in China and
      globally;




·
            fluctuation
      and unpredictability of costs related to the gold, platinum and precious
      metals and other commodities used to manufacture our
    products;




·
            seasonality
      of our business;




·
            changes
      in the laws of the PRC that affect our
  operations;




·
            our
      recent entry into the retail jewelry
market;




·
            competition;




·
            our
      ability to obtain and maintain all necessary government certifications
      and/or licenses to conduct our business;
and




·
            development
      of a public trading market for our
securities.




RISKS
RELATED TO DOING BUSINESS IN CHINA




All
of our assets are located in China and all of our revenues are derived from our
operations in China, and changes in the political and economic policies of the
PRC government could have a significant impact upon what business we may be able
to conduct in the PRC and accordingly on the results of our operations and
financial condition.




Our
business operations may be adversely affected by the current and future
political environment in the PRC. The Chinese government exerts substantial
influence and control over the manner in which we must conduct our business
activities. Our ability to operate in China may be adversely affected by changes
in Chinese laws and regulations, including those relating to taxation, import
and export tariffs, raw materials, environmental regulations, land use rights,
property and other matters. Under the current government leadership, the
government of the PRC has been pursuing economic reform policies that encourage
private economic activity and greater economic decentralization. There is no
assurance, however, that the government of the PRC will continue to pursue these
policies, or that it will not significantly alter these policies from time to
time without notice.




Our
operations are subject to PRC laws and regulations that are sometimes vague and
uncertain. Any changes in such PRC laws and regulations, or the interpretations
thereof, may have a material and adverse effect on our business.




The PRC’s
legal system is a civil law system based on written statutes. Unlike the common
law system prevalent in the United States, decided legal cases have little value
as precedent in China. There are substantial uncertainties regarding the
interpretation and application of PRC laws and regulations, including but not
limited to the laws and regulations governing our business, or the enforcement
and performance of our arrangements with customers in the event of the
imposition of statutory liens, death, bankruptcy or criminal proceedings. The
Chinese government has been developing a comprehensive system of commercial
laws, and considerable progress has been made in introducing laws and
regulations dealing with economic matters such as foreign investment, corporate
organization and governance, commerce, taxation and trade. However, because
these laws and regulations are relatively new, and because of the limited volume
of published cases and judicial interpretation and their lack of force as
precedents, interpretation and enforcement of these laws and regulations involve
significant uncertainties. New laws and regulations that affect existing and
proposed future businesses may also be applied retroactively.





14





Our
principal operating subsidiary, Fuqi China, is considered a foreign invested
enterprise under PRC laws, and as a result is required to comply with PRC laws
and regulations, including laws and regulations specifically governing the
activities and conduct of foreign invested enterprises. We cannot predict what
effect the interpretation of existing or new PRC laws or regulations may have on
our businesses. If the relevant authorities find us in violation of PRC laws or
regulations, they would have broad discretion in dealing with such a violation,
including, without limitation:




·
            levying
      fines;




·
            revoking
      our business license, other licenses or
  authorities;




·
            requiring
      that we restructure our ownership or operations;
  and




·
            requiring
      that we discontinue some or all of our
business.




A
recent increase in the rate of inflation in the PRC could negatively affect our
profitability and growth.





While the
PRC economy has experienced rapid growth, such growth has been uneven among
various sectors of the economy and in different geographical areas of the
country. Rapid economic growth can lead to growth in the money supply and rising
inflation. According to the National Bureau of Statistics of China, the
inflation rate in China reached a high point of 5.9% in 2008 as compared to the
past several years. The inflation rate in China was 1.5% in 2006 and 4.8% in
2007.  Many of our operating expenses were increased and are also
expected to increase with inflation. If prices for our products rise at a rate
that is insufficient to compensate for the rise in the costs of supplies, it may
have an adverse effect on profitability. In order to control inflation in the
past, the PRC government has imposed controls on bank credits, limits on loans
for fixed assets and restrictions on state bank lending. The implementation of
such policies may impede economic growth.





The
scope of our business license in China is limited, and we may not expand or
continue our business without government approval and renewal,
respectively.




Our
principal operating subsidiary, Fuqi China, is a wholly foreign-owned enterprise
organized under PRC law, commonly known as a WFOE. A WFOE can only conduct
business within its approved business scope, which ultimately appears on its
business license. Our license permits us to design, manufacture, sell and market
jewelry products to department stores throughout the PRC and to engage in the
retail distribution of our products. Any amendment to the scope of our business
requires further application and government approval. In order for us to expand
our business beyond the scope of our license, we will be required to enter into
a negotiation with the authorities for the approval to expand the scope of our
business. We cannot assure you that Fuqi China will be able to obtain the
necessary government approval for any change or expansion of our business
scope.




We
will not be able to complete an acquisition of prospective acquisition targets
in the PRC unless their financial statements can be reconciled to U.S. generally
accepted accounting principles in a timely manner.




Companies
based in the PRC may not have properly kept financial books and records that may
be reconciled with U.S. generally accepted accounting principles. If we attempt
to acquire a significant PRC target company and/or its assets, we would be
required to obtain or prepare financial statements of the target that are
prepared in accordance with and reconciled to U.S. generally accepted accounting
principles. Federal securities laws require that a business combination meeting
certain financial significance tests require the public acquirer to prepare and
file historical and/or pro forma financial statement disclosure with the SEC.
These financial statements must be prepared in accordance with, or be reconciled
to U.S. generally accepted accounting principles and the historical financial
statements must be audited in accordance with the standards of the Public
Company Accounting Oversight Board (United States), or PCAOB. If a proposed
acquisition target does not have financial statements that have been prepared in
accordance with, or that can be reconciled to, U.S. generally accepted
accounting principles and audited in accordance with the standards of the PCAOB,
we will not be able to acquire that proposed acquisition target. These financial
statement requirements may limit the pool of potential acquisition targets with
which we may acquire and hinder our ability to expand our retail operations.
Furthermore, if we consummate an acquisition and are unable to timely file
audited financial statements and/or pro forma financial information required by
the Exchange Act, such as Item 9.01 of Form 8-K, we will be ineligible to use
the SEC’s short-form registration statement on Form S-3 to raise capital, if we
are otherwise eligible to use a Form S-3. If we are ineligible to use a Form
S-3, the process of raising capital may be more expensive and time consuming and
the terms of any offering transaction may not be as favorable as they would have
been if we were eligible to use Form S-3.





15




Recent
PRC regulations relating to acquisitions of PRC companies by foreign entities
may create regulatory uncertainties that could restrict or limit our ability to
operate. Our failure to obtain the prior approval of the China Securities
Regulatory Commission, or the CSRC, for the listing and trading of our common
stock could have a material adverse effect on our business, operating results,
reputation and trading price of our common stock, and may also create
uncertainties in the future.




The PRC
State Administration of Foreign Exchange, or “SAFE,” issued a public notice in
November 2005, known as Circular 75, concerning the use of offshore holding
companies in mergers and acquisitions in China. The public notice provides that
if an offshore company controlled by PRC residents intends to acquire a PRC
company, such acquisition will be subject to registration with the relevant
foreign exchange authorities. The public notice also suggests that registration
with the relevant foreign exchange authorities is required for any sale or
transfer by the PRC residents of shares in an offshore holding company that owns
an onshore company. The PRC residents must each submit a registration form to
the local SAFE branch with respect to their ownership interests in the offshore
company, and must also file an amendment to such registration if the offshore
company experiences material events, such as changes in the share capital, share
transfer, mergers and acquisitions, spin-off transactions or use of assets in
China to guarantee offshore obligations.




On August
8, 2006, the PRC Ministry of Commerce (“MOFCOM”), joined by the State-owned
Assets Supervision and Administration Commission of the State Council, the State
Administration of Taxation, the State Administration for Industry and Commerce,
the China Securities Regulatory Commission and SAFE, released a substantially
amended version of the Provisions for Foreign Investors to Merge with or Acquire
Domestic Enterprises (the “Revised M&A Regulations”), which took effect
September 8, 2006. These new rules significantly revised China’s regulatory
framework governing onshore-to-offshore restructurings and foreign acquisitions
of domestic enterprises. These new rules signify greater PRC government
attention to cross-border merger, acquisition and other investment activities,
by confirming MOFCOM as a key regulator for issues related to mergers and
acquisitions in China and requiring MOFCOM approval of a broad range of merger,
acquisition and investment transactions. Further, the new rules establish
reporting requirements for acquisition of control by foreigners of companies in
key industries, and reinforce the ability of the Chinese government to monitor
and prohibit foreign control transactions in key industries.




Among
other things, the revised M&A Regulations include new provisions that
purport to require that an offshore special purpose vehicle, or SPV, formed for
listing purposes and controlled directly or indirectly by PRC companies or
individuals must obtain the approval of the CSRC prior to the listing and
trading of such SPV’s securities on an overseas stock exchange. On September 21,
2006, the CSRC published on its official website procedures specifying documents
and materials required to be submitted to it by SPVs seeking CSRC approval of
their overseas listings. However, the application of this PRC regulation remains
unclear with no consensus currently existing among the leading PRC law firms
regarding the scope and applicability of the CSRC approval requirement. Our PRC
counsel, Shujin Law Firm, has advised us that because we completed our
onshore-to-offshore restructuring before September 8, 2006, the effective date
of the new regulation, it is not necessary for us to submit the application to
the CSRC for its approval, and the listing and trading of our common stock does
not require CSRC approval.




If the
CSRC or another PRC regulatory agency subsequently determines that CSRC approval
was required for our restructuring, we may face regulatory actions or other
sanctions from the CSRC or other PRC regulatory agencies. These regulatory
agencies may impose fines and penalties on our operations in the PRC, limit our
operating privileges in the PRC, or take other actions that could have a
material adverse effect on our business, financial condition, results of
operations, reputation and prospects, as well as the trading price of our Common
Stock.




Also, if
later the CSRC requires that we obtain its approval, we may be unable to obtain
a waiver of the CSRC approval requirements, if and when procedures are
established to obtain such a waiver. Any uncertainties and/or negative publicity
regarding this CSRC approval requirement could have a material adverse effect on
the trading price of our common stock. Furthermore, published news reports in
China recently indicated that the CSRC may have curtailed or suspended overseas
listings for Chinese private companies.




It is
uncertain how our business operations or future strategy will be affected by the
interpretations and implementation of Circular 75 and the Revised M&A
Regulations. It is anticipated that application of the new rules will be subject
to significant administrative interpretation, and we will need to closely
monitor how MOFCOM and other ministries apply the rules to ensure that our
domestic and offshore activities continue to comply with PRC law. Given the
uncertainties regarding interpretation and application of the new rules, we may
need to expend significant time and resources to maintain
compliance.





16





Failure
to comply with the United States Foreign Corrupt Practices Act could subject us
to penalties and other adverse consequences.




As our
ultimate holding company is a Delaware corporation, we are subject to the United
States Foreign Corrupt Practices Act, which generally prohibits United States
companies from engaging in bribery or other prohibited payments to foreign
officials for the purpose of obtaining or retaining business. Foreign companies,
including some that may compete with our company, are not subject to these
prohibitions. Corruption, extortion, bribery, pay-offs, theft and other
fraudulent practices may occur from time-to-time in the PRC. We can make no
assurance, however, that our employees or other agents will not engage in such
conduct for which we might be held responsible. If our employees or other agents
are found to have engaged in such practices, we could suffer severe penalties
and other consequences that may have a material adverse effect on our business,
financial condition and results of operations.





Because
our funds are held in banks in the PRC that do not provide insurance, the
failure of any bank in which we deposit our funds could affect our ability to
continue in business.





Banks and
other financial institutions in the PRC do not provide insurance for funds held
on deposit. A significant portion of our assets are in the form of cash
deposited with banks in the PRC, and in the event of a bank failure, we may not
have access to our funds on deposit. Depending upon the amount of money we
maintain in a bank that fails, our inability to have access to our cash could
impair our operations, and, if we are not able to access funds to pay our
suppliers, employees and other creditors, we may be unable to continue in
business.




We
had enjoyed certain preferential tax concessions and the loss of these
preferential tax concessions may cause our tax liabilities to increase and our
profitability to decline.




In 2004
and 2005, Fuqi China enjoyed a preferential income tax rate of 7.5% due to its
status as a new business. That status expired effective January 1, 2006. The
expiration of the preferential tax treatment has increased our tax liabilities
and reduced our profitability.  On March 16, 2007, the National
People’s Congress of China enacted a new PRC Enterprise Income Tax Law, under
which foreign invested enterprises and domestic companies will be subject to
enterprise income tax at a uniform rate of 25%. The new law became effective on
January 1, 2008. During the transition period for enterprises established before
March 16, 2007, the tax rate started gradually being increased in 2008 and will
be equal to the new tax rate of 25% in 2012. We believe that our profitability
will be negatively affected as a result of the new EIT Law. Any future increase
in the enterprise income tax rate applicable to us or other adverse tax
treatments could increase our tax liabilities and reduce our net
income.




If
we make equity compensation grants to persons who are PRC citizens, they may be
required to register with the State Administration of Foreign Exchange of the
PRC, or SAFE. We may also face regulatory uncertainties that could restrict our
ability to adopt additional equity compensation plans for our directors and
employees and other parties under PRC law.




On April
6, 2007, SAFE issued the “Operating Procedures for Administration of Domestic
Individuals Participating in the Employee Stock Ownership Plan or Stock Option
Plan of An Overseas Listed Company, also know as “Circular 78.” It is not clear
whether Circular 78 covers all forms of equity compensation plans or only those
which provide for the granting of stock options. For any plans which are so
covered and are adopted by a non-PRC listed company, such as our company, after
April 6, 2007, Circular 78 requires all participants who are PRC citizens to
register with and obtain approvals from SAFE prior to their participation in the
plan. In addition, Circular 78 also requires PRC citizens to register with SAFE
and make the necessary applications and filings if they participated in an
overseas listed company’s covered equity compensation plan prior to April 6,
2007. We believe that the registration and approval requirements contemplated in
Circular 78 will be burdensome and time consuming.




We intend
to make numerous stock option grants under our equity incentive plan to our
officers and directors, some of whom are PRC citizens and may be required to
register with SAFE. In addition to our officers and directors that received
option grants, future participants of our equity incentive plan or any other
equity compensation plan we may adopt who are PRC citizens may be required to
register with SAFE. If it is determined that any of our equity compensation
plans are subject to Circular 78, failure to comply with such provisions may
subject us and participants of our equity incentive plan who are PRC citizens to
fines and legal sanctions and prevent us from being able to grant equity
compensation to our PRC employees. In that case, our business operations may be
adversely affected.





17




Any
recurrence of severe acute respiratory syndrome, or SARS, the Avian Flu, or
another widespread public health problem in the PRC could adversely affect our
operations.




A renewed
outbreak of SARS, the Avian Flu or another widespread public health problem in
China, where all of our manufacturing facilities are located and where all of
our sales occur, could have a negative effect on our operations. Our business is
dependent upon our ability to continue to manufacture our products. Such an
outbreak could have an impact on our operations as a result of:




·
            quarantines
      or closures of our manufacturing facilities or the retail outlets, which
      would severely disrupt our
operations,




·
            the
      sickness or death of our key officers and employees,
  and




·
            a
      general slowdown in the Chinese
economy.




Any of
the foregoing events or other unforeseen consequences of public health problems
could adversely affect our operations.




Because
our business is located in the PRC, we may have difficulty establishing adequate
management, legal and financial controls, which we are required to do in order
to comply with U.S. securities laws.




PRC
companies have historically not adopted a Western style of management and
financial reporting concepts and practices, which includes strong corporate
governance, internal controls and, computer, financial and other control
systems. Most of our middle and top management staff are not educated and
trained in the Western system, and we may have difficulty hiring new employees
in the PRC with such training. In addition, we may need to rely on a new and
developing communication infrastructure to efficiently transfer our information
from retail nodes to our headquarters. As a result of these factors, we may
experience difficulty in establishing management, legal and financial controls,
collecting financial data and preparing financial statements, books of account
and corporate records and instituting business practices that meet Western
standards. Therefore, we may, in turn, experience difficulties in implementing
and maintaining adequate internal controls as required under Section 404 of the
Sarbanes-Oxley Act of 2002. This may result in significant deficiencies or
material weaknesses in our internal controls.  In recent years, we
have identified both significant deficiencies and material weaknesses in our
internal controls.  If we are not able to remediate these deficiencies
and material weaknesses, and prevent future deficiencies, it could impact the
reliability of our financial statements and prevent us from complying with SEC
rules and regulations and the requirements of the Sarbanes-Oxley Act of 2002.
Any such deficiencies, weaknesses or lack of compliance could have a materially
adverse effect on our business.




You
may experience difficulties in effecting service of legal process, enforcing
foreign judgments or bringing original actions in China based upon U.S. laws,
including the federal securities laws, or other foreign laws against us or our
management.




All of
our current operations, including the manufacturing and distribution of jewelry,
are conducted in China. Moreover, most of our directors and officers are
nationals and residents of China. All or substantially all of the assets of
these persons are located outside the United States and in the PRC. As a result,
it may not be possible to effect service of process within the United States or
elsewhere outside China upon these persons. In addition, uncertainty exists as
to whether the courts of China would recognize or enforce judgments of U.S.
courts obtained against us or such officers and/or directors predicated upon the
civil liability provisions of the securities laws of the United States or any
state thereof, or be competent to hear original actions brought in China against
us or such persons predicated upon the securities laws of the United States or
any state thereof.





RISKS
RELATED TO OUR CAPITAL STRUCTURE





We
are controlled by one stockholder, whose interests may differ from those of
other stockholders. As a result, we could be prevented from entering into
potentially beneficial transactions if they conflict with our major
stockholder’s interests.




As of
December 31, 2008, Mr. Yu Kwai Chong, our Chief Executive Officer and our
largest stockholder, beneficially owns more than 50% of our outstanding shares.
Mr. Chong possesses significant influence over us, giving him the ability, among
other things, to elect all or a majority of the Board of Directors and to
approve significant corporate transactions. Such stock ownership and control may
also have the effect of delaying or preventing a future change in control,
impeding a merger, consolidation, takeover or other business combination, or
discouraging a potential acquirer from making a tender offer or otherwise
attempting to obtain control of our company. Without the consent of Mr. Chong,
we could be prevented from entering into potentially beneficial transactions if
they conflict with our major stockholder’s interests. The interests of this
stockholder may differ from the interests of our other
stockholders.





18





Our
stock price is volatile and you might not be able to resell your securities at
or above the price you have paid.




Since our
initial public offering and listing of our common stock on the Nasdaq Global
Market on October 23, 2007, the price at which our common stock had traded has
been volatile, with a high and low sales price of $11.95 and $3.31,
respectively, as through March 23, 2009. You might not be able to sell the
shares of our common stock at or above the price you have paid. The stock market
has experienced extreme volatility that often has been unrelated to the
performance of its listed companies. Moreover, only a limited number of our
shares are traded each day, which could increase the volatility of the price of
our stock. These market fluctuations might cause our stock price to fall
regardless of our performance. The market price of our common stock might
fluctuate significantly in response to many factors, some of which are beyond
our control, including the following:




·
            actual
      or anticipated fluctuations in our annual and quarterly results of
      operations;




·
            changes
      in securities analysts’
expectations;




·
            variations
      in our operating results, which could cause us to fail to meet analysts’
      or investors’ expectations;




·
            announcements
      by our competitors or us of significant new products, contracts,
      acquisitions, strategic partnerships, joint ventures or capital
      commitments;




·
            conditions
      and trends in our industry;




·
            general
      market, economic, industry and political
  conditions;




·
            changes
      in market values of comparable
companies;




·
            additions
      or departures of key personnel;




·
            stock
      market price and volume fluctuations attributable to inconsistent trading
      volume levels; and




·
            future
      sales of equity or debt securities, including sales which dilute existing
      investors.




The
sale or availability for sale of substantial amounts of our common stock could
adversely affect its market price.




The
market price of our Common Stock could decline as a result of sales of a large
number of shares of our common stock in the market or the perception that these
sales could occur. These sales, or the possibility that these sales may occur,
also might make it more difficult for us to sell equity securities in the future
at a time and at a price that we deem appropriate.




As of
March 25, 2009, we had 22,005,509 shares of Common Stock outstanding, and
approximately 9,750,000 were freely tradable without further restriction under
the Securities Act of 1933, as amended, by persons other than our affiliates
(within the meaning of Rule 144 under the Securities Act). In addition, our
certificate of incorporation permits the issuance of up to approximately 78
million additional shares of common stock. Thus, we have the ability to issue
substantial amounts of common stock in the future, which would dilute the
percentage ownership held by the existing investors.




Effective
February 15, 2008, the SEC revised Rule 144, which provides a safe harbor for
the resale of restricted securities, shortening applicable holding periods and
easing other restrictions and requirements for resales by our non-affiliates,
thereby enabling an increased number of our outstanding restricted securities to
be resold sooner in the public market. Sales of substantial amounts of our stock
at any one time or from time to time by the investors to whom we have issued
them, or even the availability of these shares for sale, could cause the market
price of our common stock to decline.





19





If
we fail to maintain effective internal controls over financial reporting, the
price of our common stock may be adversely affected.




We are
required to establish and maintain appropriate internal controls over financial
reporting. Failure to establish those controls, or any failure of those controls
once established, could adversely impact our public disclosures regarding our
business, financial condition or results of operations. Any failure of these
controls could also prevent us from maintaining accurate accounting records and
discovering accounting errors and financial frauds. Rules adopted by the SEC
pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 require annual
assessment of our internal control over financial reporting, and attestation of
this assessment by our company’s independent registered public accountants. The
annual assessment of our internal controls requirement first applied to our
annual report for the 2007 fiscal year and the attestation requirement of
management’s assessment by our independent registered public accountants is
included in this annual report for the 2008 fiscal year. The standards that must
be met for management to assess the internal control over financial reporting as
effective are new and complex, and require significant documentation, testing
and possible remediation to meet the detailed standards. We may encounter
problems or delays in completing activities necessary to make an assessment of
our internal control over financial reporting. In addition, the attestation
process by our independent registered public accountants is new to us and we may
encounter problems or delays in completing the implementation of any requested
improvements and receiving an attestation of our assessment by our independent
registered public accountants. If we cannot assess our internal control over
financial reporting as effective, or our independent registered public
accountants are unable to provide an unqualified attestation report on such
assessment, investor confidence and share value may be negatively
impacted.




As
disclosed in Item 9A of this Form 10-K, management’s assessment of our internal
control over financial reporting identified certain material weaknesses and
significant deficiencies in areas discussed in Item 9A and management determined
that our internal control over financial reporting was not effective as of
December 31, 2008.  A material weakness is a deficiency, or a
combination of deficiencies, in internal control over financial reporting, such
that there is a reasonable possibility that a material misstatement of the
company’s annual or interim financial statements will not be prevented or
detected on a timely basis.  A significant deficiency is a control
deficiency, or a combination of control deficiencies, in internal control over
financial reporting that is less severe than a material weakness, yet important
enough to merit attention by those responsible for oversight of the company’s
financial reporting.




With
respect to the effectiveness of our controls and procedures as of December 31,
2007, Stonefield Josephson, Inc., our Independent Registered Public Accounting
Firm, indicated to us that our accounting for certain significant transactions
were incorrectly calculated or incorrectly recorded, which resulted in
adjustments that constituted significant deficiencies in our internal controls
over accounting and financial reporting.  Furthermore, in connection
with our assessment as of December 31, 2008, our management concluded that our
internal controls over financial reporting was not effective due to our failure
to maintain effective controls over the period-end closing process, which was
caused by an insufficient number of qualified resources.  Our
management determined that this deficiency was a material
weakness.  Our assessment also concluded that we did not maintain
effective control over revenue cycle with revenue recognition in improper
periods. While we have implemented steps to remediate the identified material
weaknesses, there can be no guarantee that we will be successful in our attempts
to correct our significant deficiencies. Our identified material weaknesses and
significant deficiencies may raise concerns for investors and may have an
adverse impact on the price of our common stock.  See “ITEM 9A.
CONTROLS AND PROCEDURES,” below, for additional information.




Restrictions
on the convertibility of RMB into foreign currency may limit our ability to make
dividends or other payments in U.S. dollars or fund possible business activities
outside China.




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




Because
our revenues are generated in RMB and our results are reported in U.S. dollars,
devaluation of the RMB could negatively impact our results of
operations.




The value
of RMB is subject to changes in China’s governmental policies and to
international economic and political developments. In January, 1994, the PRC
government implemented a unitary managed floating rate system. Under this
system, the People’s Bank of China, or PBOC, began publishing a daily base
exchange rate with reference primarily to the supply and demand of RMB against
the U.S. dollar and other foreign currencies in the market during the previous
day. Authorized banks and financial institutions are allowed to quote buy and
sell rates for RMB within a specified band around the central bank’s daily
exchange rate. On July 21, 2005, PBOC announced an adjustment of the exchange
rate of the U.S. dollar to RMB from 1:8.27 to 1:8.11 and modified the system by
which the exchange rates are determined. This modification has resulted in an
approximate 15.72% appreciation of the RMB against the U.S. dollar from July 21,
2005 to December 31, 2008. While the international reaction to the RMB
revaluation has generally been positive, there remains significant international
pressure on the PRC government to adopt an even more flexible currency policy,
which could result in further fluctuations of the exchange rate of RMB against
the U.S. dollar, including possible devaluations. As all of our net revenues are
recorded in RMB, any future devaluation of RMB against the U.S. dollar could
negatively impact our results of operations.





20





We
do not foresee paying cash dividends in the foreseeable future and, as a result,
our investors sole source of gain, if any, will depend on capital appreciation,
if any.




We do not
plan to declare or pay any further cash dividends on our shares of common stock
in the foreseeable future and we currently intend to retain any future earnings
for funding growth. Prior to the reverse merger we effected with VT Marketing
Services, the predecessor of Fuqi International, Inc. (the “Reverse Merger”) in
November 2006, we were wholly-owned by our founder and Chief Executive Officer,
Mr. Yu Kwai Chong. During the years ended December 31, 2008, 2007, and 2006, we
paid cash dividends of $0, $0, and $2.7 million, respectively, to Mr. Chong as
our sole stockholder prior to the Reverse Merger. We currently have no intention
to declare further dividends in the foreseeable future. Payment of dividends is
further restricted under the provisions of our existing loan agreements, which
prohibit Fuqi China from paying any dividends or making any other distributions
to Fuqi BVI without the consent of the lenders. As a result, you should not rely
on an investment in our securities if you require the investment to produce
dividend income. Capital appreciation, if any, of our shares may be your sole
source of gain for the foreseeable future. Moreover, you may not be able to
resell your shares in our company at or above the price you paid for
them.




ITEM
1B. UNRESOLVED STAFF COMMENTS




Not
applicable, as we have not received written comments from the Securities and
Exchange Commission Staff regarding our periodic or current reports under the
Securities Act of 1933, as amended, more than 180 days before the end of fiscal
year 2008 and no such comments remain unresolved.




ITEM
2. PROPERTIES




Our
principal executive offices are located at 5/F., Block 1, Shi Hua Industrial
Zone, Cui Zhu Road North, Shenzhen 518019, China. We own approximately 15,000
square feet of office and showroom space at this location.




Our
jewelry production facility is located in Shenzhen, China and, including office
spaces, consists of approximately 66,000 square feet of building space. We own
approximately 33,000 square feet of this space indirectly through our Chairman,
Yu Kwai Chong, and his wife, both of whom hold the property in trust for our
benefit. The remaining 33,000 square feet has been leased by us from Shenzhen
Jin Tong Hai Enterprises Ltd, since July 2005. We use the space for production
facilities, offices and showrooms. Pursuant to the terms of the lease, we lease
the space for approximately $130,000 per annum. The lease agreement will
terminate in June 2010. We have the right to renew the lease prior to its
termination. At the time of renewal, the lease amount will be renegotiated, and
based on the current industrial leasing market, we expect that the lease amount
will be increased by approximately 30% in the year 2010.




In
October 2007, we entered into a lease agreement for a 400-square-feet corporate
office in San Jose, California. This office lease has a term of two years,
expiring in October 2009. Monthly rent for this lease is $720. We intend to
terminate the lease in 2009, prior to October 2009.





In March
2008, we entered into a lease agreement for an 817-square-feet corporate office
in Hong Kong. This office lease has a term of two years, expiring in February
2010. Monthly rent for this lease is about $1,470.




ITEM
3. LEGAL PROCEEDINGS




We are
not involved in any material legal proceedings, nor are we aware of any
potential or threatened material litigation, or any asserted claims that may
result in material litigation or other legal proceedings.




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





On
October 10, 2008, we held our annual meeting of stockholders. Of the 22,005,509
shares eligible to vote, 20,047,631, or 91.1%, votes were returned, formulating
a quorum. At the annual stockholders meeting, the following matters were
submitted to stockholders for vote: Proposal I—Election of directors and
Proposal II—Ratification of the appointment of Stonefield Josephson, Inc. as our
independent auditors for the year ending December 31, 2008.





21




Proposal
I—Election of Directors




All
directors were elected at our annual meeting of stockholders.  The
results of voting on these proposals are as follows:




Director
                                
                                For
                                
                                Against
                                
                                Withheld
                                
                                ElectedYu
      Kwai Chong
                                
                                19,920,066
                                
                                0
                                
                                0
                                
                                YesChing
      Wan Wong
                                
                                19,919,016
                                
                                0
                                
                                0
                                
                                YesLie
      Xi Zhuang
                                
                                19,917,276
                                
                                0
                                
                                0
                                
                                YesLily
      Lee Chen
                                
                                19,920,895
                                
                                0
                                
                                0
                                
                                YesEileen
      B. Brody
                                
                                19,914,000
                                
                                0
                                
                                0
                                
                                YesVictor
      A. Hollander
                                
                                19,913,082
                                
                                0
                                
                                0
                                
                                YesJeff
      Haiyong Liu
                                
                                19,913,750
                                
                                0
                                
                                0
                                
                                Yes




Proposal
II—Ratification of the appointment of Stonefield Josephson, Inc. as our
independent auditors for the year ending December 31, 2008.




Proposal
II was approved with 19,866,006 shares voted for, 109,347 voted against and
72,277 abstained from voting, thereby, ratifying the appointment of Stonefield
Josephson, Inc. as our independent auditors for the year ending December 31,
2008.




22





PART
II




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




Market
Information




Prior to
October 23, 2007, our shares of common stock were not listed or quoted for
trading on any national securities exchange or national quotation system. On
October 23, 2007, we completed the initial public offering and our common stock
began trading on the NASDAQ Global Market under the symbol “FUQI.”




From our
date of listing on October 23, 2007 through December 31, 2008 as set forth
below.  The closing price of our common stock on March 26, 2009 on the
NASDAQ was $4.32.  As of March 26, 2009, we had approximately 120
common stockholders of record.




2008High
                    
                    
                    LowFourth
      Quarter
                    
                    $
                    8.77
                    
                    
                    $
                    5.12Third
      Quarter
                    
                    $
                    11.65
                    
                    
                    $
                    7.02Second
      Quarter
                    
                    $
                    11.95
                    
                    
                    $
                    6.02First
      Quarter
                    
                    $
                    10.65
                    
                    
                    $
                    6.07





2007High
                    
                    
                    LowFourth
      Quarter (from listing on October 23, 2007)
                    
                    $
                    11.75
                    
                    
                    $
                    6.02





The stock
market in general has experienced extreme stock price fluctuations in the past
few years.  In some cases, these fluctuations have been unrelated to
the operating performance of the affected companies. Many companies have
experienced dramatic volatility in the market prices of their common stock. We
believe that a number of factors, both within and outside its control, could
cause the price of our common stock to fluctuate, perhaps substantially. Factors
such as the following could have a significant adverse impact on the market
price of its common stock:




·
            Our
      ability to obtain additional financing and, if available, the terms and
      conditions of the financing;


·
            Our
      financial position and results of
operations;


·
            Concern
      as to, or other evidence of, the reliability and efficiency of our
      proposed products and services or our competitors’ products and
      services;


·
            Announcements
      of innovations or new products or services by we or our
      competitors;


·
            Federal
      and state governmental regulatory actions and the impact of such
      requirements on our business;


·
            The
      development of litigation against
us;


·
            Period-to-period
      fluctuations in our operating
results;


·
            Changes
      in estimates of our performance by any securities
  analysts;


·
            The
      issuance of new equity securities pursuant to a future offering or
      acquisition;


·
            Changes
      in interest rates;


·
            Competitive
      developments, including announcements by competitors of new products or
      services or significant contracts, acquisitions, strategic partnerships,
      joint ventures or capital
commitments;


·
            Investor
      perceptions of our company; and


·
            General
      economic and other national
conditions.




Recent
Sales of Unregistered Securities




None.





23




Dividends




The
Company has not paid or does not expect to declare or pay any cash dividends on
its common stock in the foreseeable future, and it currently intends to retain
future earnings, if any, to finance the expansion of its business. The decision
whether to pay cash dividends on the Company’s common stock will be made by the
Company’s board of directors, in their discretion, and will depend on its
financial condition, operating results, capital requirements and other factors
that the board of directors considers significant. Payment of dividends by Fuqi
China is further restricted under the provisions of our existing loan
agreements, which prohibit Fuqi China from paying any dividends or making any
other distributions to Fuqi BVI without the consent of the lenders.




The
Company’s wholly-owned subsidiary, Fuqi China, prior to merger with the Company,
paid cash dividends of $0, $0, and $2.7 million, during the years ended December
31, 2008, 2007 and 2006, respectively. Each of these dividends was paid by the
Company’s subsidiary to Mr. Chong, as its sole stockholder, which offset
partially the amounts due to the Company’s subsidiary by Mr. Chong.




Transfer
Agent and Registrar




The
transfer agent and registrar for our common stock is Computershare Trust
Company, Inc.




Equity
Compensation Plan Information




Our
equity compensation plan information is provided as set forth in Part III, Item
11 herein.




24




ITEM
6.   SELECTED CONSOLIDATED FINANCIAL DATA




The
following consolidated statements of income data for each of the five years
ended December 31, 2008 and the consolidated balance sheet data as of the end of
each of the foregoing years are derived from our audited consolidated financial
statements.  Historical results are not necessarily indicative of the
results of operations for future years. The following data is qualified in its
entirety by and should be read in conjunction with “Management’s Discussion and
Analysis of Financial Condition and Results of Operations” and our consolidated
financial statements and related notes included elsewhere in this Form
10-K.




Consolidated
Statement of Income Data:





Years Ended December
      31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(In
      Thousands, Except Share Amounts and Earnings per Share)Net
      salesWholesale
      and distribution
              
              $
              356,471
              
              
              $
              144,314
              
              
              $
              92,409
              
              
              $
              72,580
              
              
              $
              56,765Retail
              
              
              11,134
              
              
              
              1,245
              
              
              
              —
              
              
              
              —
              
              
              
              —367,605
              
              
              
              145,559
              
              
              
              92,409
              
              
              
              72,580
              
              
              
              56,765Cost
      of salesWholesale
      and distribution
              
              
              313,645
              
              
              
              128,110
              
              
              
              83,619
              
              
              
              64,964
              
              
              
              50,862Retail
              
              
              8,976
              
              
              
              935
              
              
              
              —
              
              
              
              —
              
              
              
              —322,621
              
              
              
              129,045
              
              
              
              83,619
              
              
              
              64,964
              
              
              
              50,862Gross
      profit
              
              
              44,984
              
              
              
              16,514
              
              
              
              8,790
              
              
              
              7,616
              
              
              
              5,903Operating
      expenses:Selling
      and marketing
              
              
              4,910
              
              
              
              1,105
              
              
              
              490
              
              
              
              624
              
              
              
              549General
      and administrative
              
              
              6,715
              
              
              
              2,919
              
              
              
              794
              
              
              
              671
              
              
              
              1,006Total
      operating expenses
              
              
              11,625
              
              
              
              4,024
              
              
              
              1,284
              
              
              
              1,295
              
              
              
              1,555Income
      from operations
              
              
              33,359
              
              
              
              12,490
              
              
              
              7,506
              
              
              
              6,321
              
              
              
              4,348Other
      income (expenses):Interest
      expense
              
              
              (1,437
              )
              
              
              (1,239
              )
              
              
              (799
              )
              
              
              (498
              )
              
              
              (100
              )Interest
      income
              
              
              123
              
              
              
              166
              
              
              
              70
              
              
              
              —
              
              
              
              —Change
      of fair value on inventory loan payable
              
              
              —
              
              
              
              (46
              )
              
              
              —
              
              
              
              —
              
              
              
              —Loss
      on disposal of fixed assets
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              (45
              )Exemption
      of tax liabilities and estimated penalty payable
              
              
              —
              
              
              
              4,162
              
              
              
              —
              
              
              
              —
              
              
              
              —Gain
      from derivative instrument
              
              
              2,362
              
              
              
              80
              
              
              
              —
              
              
              
              —
              
              
              
              —Miscellaneous
              
              
              333
              
              
              
              —
              
              
              
              13
              
              
              
              (1
              )
              
              
              4Total
      other income (expenses)
              
              
              1,381
              
              
              
              3,123
              
              
              
              (716
              )
              
              
              (499
              )
              
              
              (141
              )Income
      before provision for income taxes
              
              
              34,740
              
              
              
              15,613
              
              
              
              6,790
              
              
              
              5,822
              
              
              
              4,207Provision
      for income taxes
              
              
              6,861
              
              
              
              2,097
              
              
              
              995
              
              
              
              452
              
              
              
              359Net
      income
              
              
              27,879
              
              
              
              13,516
              
              
              
              5,795
              
              
              
              5,370
              
              
              
              3,848Other
      comprehensive income - foreign currency translation
      adjustments
              
              
              6,635
              
              
              
              2,553
              
              
              
              288
              
              
              
              143
              
              
              
              —Comprehensive
      income
              
              $
              34,514
              
              
              $
              16,069
              
              
              $
              6,083
              
              
              $
              5,513
              
              
              $
              3,848Earnings
      per share - basic
              
              $
              1.32
              
              
              $
              0.96
              
              
              $
              0.51
              
              
              $
              0.48
              
              
              $
              0.34Earnings
      per share – diluted
              
              $
              1.32
              
              
              $
              0.86
              
              
              $
              0.50
              
              
              $
              0.48
              
              
              $
              0.34Weighted
      average number of common shares - basic
              
              
              21,142,457
              
              
              
              14,105,791
              
              
              
              11,260,544
              
              
              
              11,175,543
              
              
              
              11,175,543Weighted
      average number of common shares - diluted
              
              
              21,142,457
              
              
              
              15,627,494
              
              
              
              11,631,459
              
              
              
              11,175,543
              
              
              
              11,175,543




Consolidated Balance Sheet
Data:


As of December
      31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(In
      Thousands)Cash
              
              $
              56,570
              
              
              $
              63,294
              
              
              $
              13,355
              
              
              $
              71
              
              
              $
              256Total
      assets
              
              
              194,849
              
              
              
              122,715
              
              
              
              31,125
              
              
              
              28,115
              
              
              
              11,230Total
      liabilities
              
              
              58,020
              
              
              
              25,455
              
              
              
              20,180
              
              
              
              20,508
              
              
              
              8,535Total
      stockholders’ equity
              
              
              136,829
              
              
              
              97,260
              
              
              
              10,945
              
              
              
              7,607
              
              
              
              2,695




25




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




The
following discussion contains forward-looking statements that involve risks and
uncertainties. Forward-looking statements include, but are not limited to,
statements regarding future events, our plans and expectations and financial
projections. Our actual results could differ materially from those discussed
herein. Factors that could cause or contribute to such differences include, but
are not limited to, those discussed elsewhere in this Form 10-K. See “Risk
Factors.”  Unless the context otherwise requires, the terms “we,” the
“Company,” “us,” or “Fuqi” refers to Fuqi International, Inc. and our
wholly-owned subsidiaries.




Overview




We are a
leading designer of high quality precious metal jewelry in China, developing,
promoting, and selling a broad range of products in the large and rapidly
expanding Chinese luxury goods market. Our products consist of a range of unique
styles and designs made from precious metals such as platinum, gold, and Karat
gold (K-gold).  We also produce jewelry items that contain diamonds
and other precious stones on a custom-order basis. We continuously innovate and
change our designs based upon consumer trends in China. By continuously creating
new designs and rapidly bringing them to market, we are able to differentiate
ourselves from our competitors and strengthen our brand identity. Our design
database presently contains over 30,000 unique products.




We have
historically sold our products directly to distributors, retailers and other
wholesalers, who then sell our products to consumers through both retail
counters located in department stores and in other traditional stand-alone
jewelry stores. In the coastal cities of China, we believe the demand for
platinum and gemstone products has been increasing. In order to capitalize on
the growth in demand, we intend to develop platinum as one of the primary metals
from which our jewelry is manufactured. In 2006, we began to shift our product
line to produce more platinum jewelry and we intend to invest in the development
of a new production line to produce finished gemstone platinum jewelry. The
production lead time of platinum products, starting from purchase of raw
materials and ending with finished products, is about six to eight days, while
the lead time for gold products is about two to four days. Lead-time also varies
on the complexity of production and design of our products. As such, we
anticipate that more working capital will be needed to support this shift of
product mix.




Our
wholesale prices are based on the spot prices of the raw material that make up
our products, with the spot price measured at the time our products are sold.
Similarly, the value of our inventory on hand is based on spot prices of the raw
materials that make up the inventory. We record the value of our inventory at
the lower of cost (using the first-in, first-out method) or market. Our gross
margin is therefore affected by changes in the price of raw materials. The
increase in our net sales for the year ended December 31, 2008 and the value of
inventory as of December 31, 2008 was due in part to the general increase in the
market value of precious metals and, to a lesser extent, our expansion of our
retail business by our acquisition of substantially all of the assets of the
Temix Companies. Any fluctuation in the spot price of precious metal would
result in a change in our wholesale revenue and our gross margin, as our sales
price is based, in part, on the spot price of the precious metal contained in
the product sold. We cannot predict and foresee the volatility of the market
value of precious metals in the future. We closely monitor the market price of
precious metals and, commencing in the fourth quarter of 2007, have entered into
certain gold futures contracts with our supplier, Shanghai Gold Exchange, to
manage our consolidated exposure to changes in inventory values due to
fluctuations in market prices.  Gold futures offered by Shanghai Gold
Exchange are designed for full members to hedge or to acquire inventory at a
preset price.  Our futures contracts are not considered as hedges for
accounting purposes.  We do not conduct any trading or speculating of
these precious metals.





In order
to capture the margin appreciation from direct sales to the consumer, we, in
2007, initiated a retail strategy.  During 2008, we opened and/or
acquired 56 retail counters and acquired seven retail stores in municipalities
and provincial capitals throughout China.  A majority of these retail
locations were acquired in August 2008, when we acquired substantially all of
the assets of the Temix Companies.





As of
December 31, 2008, we held a total of 6 retail counters in two department
stores located in Shenyang, 5 retail counters in Beijing, 2 retail
counters in Dalian and 6 retail counters in other regions in China under the
“Fuqi” brand.   As of the same date, we held a total of
twenty-three retail counters in Beijing and twenty retail counters and seven
retail stores in Shanghai under the “Temix” brand. Total retail sales generated
by our counters and retail stores for the year ended December 31, 2008 was
approximately $11.1 million, which was approximately 3% of our sales for the
fiscal year. As of December 31, 2008, we had 69 jewelry retail counters and
stores in China.  During 2009, we intend to open and/or acquire
additional retail counters and retail stores throughout the PRC.  Our
retail operations are discussed more fully below under the caption “Retail
Operations.”





26





By
initiating our retail strategy, we intend to enhance our profitability in 2009
and further develop our brand reputation.





We
originally produced studded jewelry products on a custom-order basis only, but
we have recently expanded our production to include new lines of studded jewelry
products for sale in our retail outlets.  We believe our new retail
strategy creates a significant opportunity for us to both improve our return on
capital and increase shareholder value. There are, however, risks related to our
planned expansion. Our retail expansion strategy will largely depend on our
ability to find sites for, open and operate new retail locations successfully.
Our ability to open and operate new retail locations successfully depends on
several factors, including, among others, our ability to identify suitable
counter and store locations, the availability of which is outside our control;
purchase and negotiate acceptable lease terms; prepare counters and stores for
opening within budget; source sufficient levels of inventory at acceptable costs
to meet the needs of new counters and stores; secure required governmental
permits and approvals; successfully integrate new counters and stores into our
existing operations; and generate sufficient operating cash flows or secure
adequate capital on commercially reasonable terms to fund our expansion plans.
Any failure to successfully open and operate new retail counters and stores
could have a material adverse effect on our results of operations in the future.
In addition, our retail expansion program will place increased demands on our
operational, managerial and administrative resources. These increased demands
could cause us to operate our business less effectively, which, in turn, could
cause deterioration in the financial performance of our overall
business.




Recent
Events




Acquisition
of Temix




On August
7, 2008, we acquired substantially all of the assets of Shanghai Tian Mei
Jewelry Co., Ltd. and Beijing Yinzhong Tian Mei Jewelry Co., Ltd., collectively
referred to as the “Temix Companies.” The Temix Companies are a 50-outlet
branded jewelry store chain with locations primarily in Beijing, Shanghai and
Ningbo. Of the 50 outlets, 7 are stand alone stores and 43 are store counters
within department stores.





We
acquired the substantially all the assets of Temix Companies through our
wholly-owned subsidiary, Fuqi International Holdings Co., Ltd., a British Virgin
Islands company (“Fuqi Subsidiary”), which entered into an asset purchase
agreement dated April 18, 2008, and as amended on August 7, 2008 (the “Asset
Purchase Agreement”) with the Temix Companies and Mr. Chujian Huang, the
principal of the Temix Companies. According to the terms of the Asset Purchase
Agreement, Fuqi Subsidiary acquired substantially all of the assets of the Temix
Companies for an aggregate purchase price of 80 million Yuan RMB, which is equal
to approximately USD $11.7 million. Per the terms of the agreement, we agreed to
pay 80% of the purchase price to the Temix Companies at closing and we will pay
the remaining 20% of the purchase price to the Temix Companies on the six-month
anniversary of the closing, with such payment being subject to set-off for
undiscovered inventory defects.  As of December 31, 2008, the Company
paid a total of $7.3 million (approximately 62.4% of the purchase
price).  The Temix Companies agreed that we will have additional time
to complete our examination of the acquired inventories.  Upon the
completion of our examination, we will remit the remaining purchase price to Mr.
Chujian Huang.





In
addition, we acquired all of the intellectual property used in the operations of
the Temix Companies pursuant to an Intellectual Property Transfer Agreement
dated April 18, 2008 (“IP Transfer Agreement”) entered into with Fuqi Subsidiary
and Mr. Huang. In accordance with the IP Transfer Agreement, Mr. Huang received
a total of 1,080,666 shares, which was fixed upon signing of definitive
agreement on April 18, 2008. One-half of the shares were issued to Mr. Huang at
closing and the other one-half will be subject to an escrow account for a
two-year period. The shares held in escrow will be subject to indemnification
claims and conditions of the Temix Companies meeting certain performance targets
as set forth in the IP Transfer Agreement.





Also, in
connection with and as a condition to the closing of the Asset Purchase
Agreement and IP Transfer Agreement, the Company entered into an employment
agreement with Mr. Huang, pursuant to which he will serve as our Associate
Retail Director. The employment agreement has a term of three years unless
terminated earlier in accordance with the terms of the agreement.




Corporate
History




We
operate through our wholly-owned subsidiary Fuqi International Holdings Co.,
Ltd., a British Virgin Islands corporation (“Fuqi BVI”) and its wholly-owned
subsidiary, Shenzhen Fuqi Jewelry Co., Ltd., (“Fuqi China”) a company
established under the laws of the People’s Republic of China. Our company’s
principal office is in the city of Shenzhen, in southern China, where we have a
large-scale production base that includes a modern factory of more than 53,000
square feet, a dedicated senior design, sales and marketing team, and
approximately 949 employees, including approximately 805 company-trained
production workers. We believe our current facilities provide adequate space for
our planned expansion of our production lines, which will include diamond and
other finished gemstone jewelry.





27





On
November 20, 2006, Fuqi BVI entered into a share exchange agreement with VT
Marketing Services, Inc. (“VT”) and Mr. Yu Kwai Chong, who is our current Chief
Executive Officer and Chairman of the Board of the Directors, to effect a
reverse merger transaction (the “Reverse Merger”). Pursuant to the Reverse
Merger, Mr. Chong, as the sole shareholder of Fuqi BVI, agreed to exchange all
of his shares of Fuqi BVI for shares of VT and VT agreed to acquire all of the
issued and outstanding capital stock of Fuqi BVI. VT was formed as part of the
implementation of the Chapter 11 reorganization plan (the “Visitalk Plan”) of
visitalk.com, Inc., which became effective on September 17, 2004. The Reverse
Merger closed on November 22, 2006 and VT issued an aggregate of 11,175,543
shares of common stock in exchange for all of the issued and outstanding
securities of Fuqi BVI. Upon the close of the Reverse Merger, VT became the 100%
parent of Fuqi BVI and assumed the operations of Fuqi BVI and its subsidiary as
its sole business. On November 8, 2006, VT reincorporated from Arizona to Nevada
and on December 8, 2006, after the Reverse Merger, VT reincorporated from the
Nevada to Delaware and changed its corporate name from “VT Marketing Services,
Inc.” to “Fuqi International, Inc.” The transactions contemplated by the Reverse
Merger were intended to be a “tax-free” transaction pursuant to the provisions
of Section 351 of the Internal Revenue Code of 1986, as amended.




For
financial accounting purposes, the Reverse Merger was treated as a reverse
acquisition by Fuqi BVI, under the purchase method of accounting, and was
treated as a recapitalization with Fuqi BVI as the accounting acquirer.
Accordingly, our historical financial statements have been prepared to give
retroactive effect to the reverse acquisition completed on November 22, 2006,
and represent the operations of Fuqi BVI and its wholly-owned subsidiary, Fuqi
China.




Critical
Accounting Policies, Estimates and Assumptions




Management’s
discussion and analysis of results of operations and financial condition are
based upon our consolidated financial statements. These statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America. These principles require management to make certain
estimates and assumptions that affect amounts reported and disclosed in the
financial statements and related notes. The most significant estimates and
assumptions include valuation of inventories, provisions for income taxes,
allowance for doubtful accounts, and purchase price allocation relating to the
business acquired. Actual results could differ from these estimates.
Periodically, we review all significant estimates and assumptions affecting the
financial statements and record the effect of any necessary
adjustments.




The
following critical accounting policies rely upon assumptions and estimates and
were used in the preparation of our consolidated financial
statements:




Revenue
Recognition




Wholesale
revenue is recognized upon delivery and acceptance of jewelry products by our
customers while the retail revenue is recognized upon receipt and acceptance of
jewelry products by our customers, provided in each case that the other
conditions of sales are satisfied: (i) persuasive evidence of an arrangement
exists; (ii) delivery has occurred, upon shipment when title passes, or services
have been rendered; (iii) our price to the buyer is fixed or determinable; and
(iv) collectibility is reasonably assured.




Currency
Reporting




Amounts
reported are stated in U.S. Dollars, unless stated otherwise. Our functional
currency is the RMB. Foreign currency transactions (outside the PRC) are
translated into RMB according to the prevailing exchange rate at the transaction
dates. Assets and liabilities denominated in foreign currencies at the balance
sheet dates are translated into RMB at period-end exchange rates. For the
purpose of preparing the consolidated financial statements, the consolidated
balance sheets of our company have been translated into U.S. dollars at the
current rates as of the end of the respective periods and the consolidated
statements of income have been translated into U.S. dollars at the weighted
average rates during the periods the transactions were recognized. The resulting
translation gain adjustments are recorded as other comprehensive income in the
statements of income and comprehensive income and as a separate component of
statements of stockholders’ equity.




Allowance
for Doubtful Accounts




We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability of our customers to make required payments. Allowance for doubtful
accounts is based on our assessment of the collectibility of specific customer
accounts, the aging of accounts receivable, our history of bad debts, and the
general condition of the industry. If a major customer’s credit worthiness
deteriorates, or our customers’ actual defaults exceed historical experience,
our estimates could change and impact our reported results. We have not
experienced any significant amount of bad debt in the past.





28





Inventory




Inventories
are stated at the lower of cost or market. The first-in-first-out method is used
to account for gold and platinum jewelries and the specific identification
method for diamond jewelries. An inventory reserve is maintained where the cost
exceeds the net realizable vale.





Taxation




We are
incorporated in the State of Delaware, and our wholly owned subsidiary, Fuqi
BVI, is a British Virgin Islands company. We are subject to franchise taxes in
Delaware and U.S. federal income taxes, but we are not currently generating any
taxable operating income. We are not subject to taxation in the British Virgin
Islands. Fuqi BVI’s wholly-owned subsidiary, Fuqi China, is a PRC
company.




Prior to
2006, we were under the preferential income tax rate of 7.5% in 2005, due to our
status of being a new business. That status expired effective January 1,
2006.  On March 16, 2007, the National People’s Congress of China
enacted a new PRC Enterprise Income Tax Law, under which foreign invested
enterprises and domestic companies will be subject to enterprise income tax at a
uniform rate of 25%.  The new law became effective on January 1,
2008.





Prior to
the enactment of China’s Enterprise Income Tax Law, which became effective from
January 1, 2008, foreign-invested enterprises, or FIEs, were generally
subject to a 30% state enterprise income tax plus a 3% local income tax. As
result of the new EIT law, our income tax provision increased, which could
adversely affect our financial condition and results of operations. Prior to
effectiveness of the EIT law, we had enjoyed certain preferential tax
concessions and the loss of these preferential tax concessions may cause our tax
liabilities to increase and our profitability to decline.





Pursuant
to the implementation rules to the new tax law issued in December 2007, and the
several subsequent transition rules, Fuqi China has become subject to a normal
25% rate, but are still eligible for lower rates, which are 18%, 20% 22% and 24%
in 2008, 2009, 2010 and 2011, under the transition rules. Our effective income
tax rates for the years ended December 31, 2008, 2007 and 2006 were 19.8%,
13.4%, and 14.7%, respectively.




We are
also subject to a 5% business tax on our design fees and a 17% value added tax
on the processing fee. The 5% business tax is borne by us while the 17% value
added tax is a component of the prices that we charge our customers. The sum of
the design fee, processing fee, and the market price of raw materials used to
manufacture our products is the wholesale price at which we sell our products.
We treat the business tax as a sales-related expense and thus report it under
selling and marketing in our statements of income.




From the
inception of Fuqi China in 2001 to December 31, 2006, we failed to report a
cumulative amount of approximately $26 million in cash revenues related to
design fees. As of December 31, 2006, we had an accrual of approximately $3.8
million in tax liabilities representing business tax and fees of 5.2% and income
tax on the unreported design revenues since inception and an accrual of
approximately $1.1 million in estimated penalties. In April 2006, the Shenzhen
local tax department levied a $1.8 million assessment against us for unpaid
business taxes, fees, and income taxes related to these unreported cash revenues
up to the period from inception to December 31, 2005. The assessment was
originally due at the end of April 2006 and subject to 0.05% per day of interest
and penalties thereafter. On April 28, 2006, we filed for an extension of the
deadline to remit these outstanding taxes payable to December 20, 2006, and the
extension request was approved by the tax department in July 2006. On December
28, 2006, Shenzhen City Tax Bureau granted a further extension to us from
December 20, 2006 to April 25, 2007.




On April
25, 2007, we appointed a registered tax agent to apply on behalf of our company
for a special reduction or exemption for the unpaid tax liabilities for the
period from inception to December 31, 2006. On May 14, 2007, we received a
notice from the Shenzhen tax department accepting our application for a tax
reduction or exemption and were granted an additional period to remit our
outstanding tax liabilities until August 9, 2007. The tax department agreed not
to assess any interest and penalties during this review process until August 9,
2007. On August 10, 2007, we received a notice from the tax department
conditionally agreeing to fully exempt our tax liabilities in the amount of
approximately $3 million on unreported design fee income for the period from
inception of our operations in 2001 to December 31, 2006, provided that our
common stock is successfully listed on a major overseas stock exchange within
180 days from the date of the tax notice. We fulfilled such condition in October
2007 and obtained acknowledgement from the Shenzhen tax department in November
2007. As a result, the accrued business and income tax liabilities, and the
accrued estimated and penalties totaling $4.2 million, was reversed and recorded
as non-operating income in our consolidated statement of income for the year
ended December 31, 2007.




All of
the design fee income starting 2007 was properly reported and accounted for and
has been fully paid by the tax filing deadline.




29




Derivative
Instruments





Commencing
in the fourth quarter of 2007, we have entered into certain gold future
contracts with our supplier, Shanghai Gold Exchange. Gold futures offered by
Shanghai Gold Exchange are designed for full members to hedge or to acquire
inventory at a preset price. We utilized these future contracts to manage our
consolidated exposure to changes in inventory values due to fluctuations in
market prices and are not considered as hedges for accounting purpose. Our gold
futures positions are marked to market at each reporting date and all unrealized
gains and losses are recognized in earnings currently. These contract positions
have not had a material effect on our consolidated financial position, results
of operations, or cash flows.




Stock-based
Compensation





In
accordance with SFAS No. 123R, “Share-based Payment: An amendment of FASB
Statement No. 123” (“SFAS 123R”), effective January 1, 2006, we are required to
recognize compensation expense related to stock options granted to employees
based on: (a) compensation cost for all share-based payments granted prior to,
but not yet vested as of December 31, 2005, based on the grant date fair value
estimated in accordance with SFAS No 123, “Accounting for Stock-Based
Compensation” (“SFAS 123”), and (b) compensation cost for all share-based
payments granted subsequent to December 31, 2005, based on the grant-date fair
value estimated in accordance with the provisions of SFAS123R. 123R requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from initial estimates. We did
not issue any stock options in 2005 and 2006 and had no outstanding options as
of December 31, 2006. On October 26, 2007, we granted options to purchase a
total of 1,320,000 shares of our common stock to two executives and four
directors. We expect these options to be fully vested and therefore did not
account for any forfeiture as the vesting periods of these options are
relatively short. We use the Black-Scholes option-pricing model to value stock
option awards and expensed the stock-based compensation based on the vesting
periods.




In August
2007, we entered into employment agreements with three of our executive officers
pursuant to which we agreed to grant stock options to acquire shares of the
Company’s common stock with a value equal to certain percentage of our annual
income before income taxes not to exceed an aggregate market value of $440,000.
Options to purchase totaling 121,776 shares were granted to these three
executive officers.  The number of options granted was computed based
on the aggregate market value of $440,000 dividing by the fair value of each
option measured on December 31, 2008 using the Black-Scholes option pricing
model.





Fair
Value Measurement





On
January 1, 2008, the Company adopted the provisions of
SFAS No. 157, Fair Value Measurements (“SFAS No. 157”) for
financial assets and liabilities. SFAS No. 157 establishes a framework
for using fair value to measure assets and liabilities, and expands disclosures
about fair value measurements. SFAS No. 157 is effective for fiscal years
beginning after November 15, 2007, except for non-financial assets and
liabilities that are recognized or disclosed at fair value in the financial
statements on a nonrecurring basis, for which application has been deferred for
one year.




SFAS No.
157 established the following fair value hierarchy that prioritizes the inputs
used to measure fair value:




Level
      1:
            Quoted
      prices are available in active markets for identical assets or liabilities
      as of the reporting
date.




Level
      2:
            Pricing
      inputs are other than quoted prices in active markets included in Level 1,
      which are either directly or indirectly observable as of the reporting
      date.




Level
      3:
            Pricing
      inputs include significant inputs that are generally less observable from
      objective sources.  These inputs may be used with internally
      developed methodologies that result in management’s best estimate of fair
      value.




30




SFAS No. 157
requires us to maximize the use of observable inputs and minimize the use of
unobservable inputs. If a financial instrument uses inputs that fall in
different levels of the hierarchy, the instrument will be categorized based upon
the lowest level of input that is significant to the fair value
calculation.




Our
derivative financial instruments are gold futures contracts based on gold price
rates, which are observable at commonly quoted intervals for the full term of
the derivatives and therefore considered a Level 2 input.




Purchase
Price Allocations





We
accounted for our Temix’s acquisition using the purchase method of accounting.
This method requires that the acquisition cost be allocated to the assets we
acquired based on their fair values. We make estimates and judgments in
determining the fair value of the acquired assets. We base our estimate on the
purchase price allocation analysis reports prepared by an independent valuation
service group, which have been finalized, as well as our internal judgments
based on the existing facts and circumstances. If we were to use different
judgments or assumptions, the amounts assigned to the individual assets could be
materially different.





Results
of Operations




The
following table sets forth certain financial information from our audited
consolidated statements of income expressed as a percentage of revenues and
should be read in conjunction with our consolidated financial statements and
notes thereto included elsewhere in this Form 10-K.





Years
      Ended December 31,2008
                
                2007
                
                
                2006Net
      salesWholesale
      and distribution
                
                
                96.97
                %
                99.14
                %
                
                100.00
                %Retail
                
                
                3.03
                %
                0.86
                %
                
                0.00
                %100.00
                %
                100.00
                %
                
                100.00
                %Cost
      of salesWholesale
      and distribution
                
                
                85.32
                %
                88.01
                %
                
                90.49
                %Retail
                
                
                2.44
                %
                0.64
                %
                
                0.00
                %87.76
                %
                88.65
                %
                
                90.49
                %Gross
      profit
                
                
                12.24
                %
                11.35
                %
                
                9.51
                %Operating
      expenses:Selling
      and marketing
                
                
                1.34
                %
                0.76
                %
                
                0.53
                %General
      and administrative
                
                
                1.83
                %
                2.01
                %
                
                0.86
                %Total
      operating expenses
                
                
                3.17
                %
                2.77
                %
                
                1.39
                %Income
      from operations
                
                
                9.07
                %
                8.58
                %
                
                8.12
                %Other
      income (expense), net
                
                
                0.38
                %
                2.15
                %
                
                (0.77
                )%Income
      before provision for income taxes
                
                
                9.45
                %
                10.73
                %
                
                7.35
                %Provision
      for income taxes
                
                
                1.87
                %
                1.44
                %
                
                1.08
                %Net
      income
                
                
                7.58
                %
                9.29
                %
                
                6.27
                %




31




Year
Ended December 31, 2008 and 2007




Net
sales




Net sales
derived from our wholesale and distribution segment, which consist of gross
sales net of returns, for the year ended December 31, 2008 increased to $356.5
million, an increase of $212.2 million, or 147%, from net sales of $144.3
million for the year ended December 31, 2007. The increase was primarily
attributable to a combination of an increase in both selling price and sales
volume. The selling price of our jewelry products is based on the market price
of the precious metals (e.g., gold and platinum) in the periods when the
products are sold. During 2008, the average price of gold and platinum increased
by 18.5% and 20.0%, respectively, as compared with 2007. In addition, there was
an increase of 103% in sales volume from approximately 5.9 tons for 2007 to 12.0
tons for 2008 as result of an increase in jewelry products demand by our
existing consumers and orders placed by our new customers. Sales volume of gold
and platinum for the year ended December 31, 2008 increased by 120% and
decreased by 32% to 11 tons and 500kg for 2008 from 5 tons and 736kg for 2007,
respectively.





Net sales
from wholesale and distribution for the years ended December 31, 2008 and 2007
were comprised of the following:





Years
      Ended December 31,2008
                
                2007Amount
      in
                    Millions
                
                Percentage
                
                Amount
      in
                    Millions
                
                PercentagePlatinum
                
                $
                31.2
                
                8.7
                %
                $
                30.3
                
                
                21.0
                %Gold
                
                
                241.6
                
                67.8
                
                
                80.9
                
                
                56.1K-gold
      and Studded Jewelry
                
                
                71.7
                
                20.1
                
                
                33.1
                
                
                22.9Diamond
                
                
                12.0
                
                3.4
                
                
                0.0
                
                
                0.0Total
                
                $
                356.5
                
                100.0
                %
                $
                144.3
                
                
                100.0
                %




Net sales
derived from our retail segment for the year ended December 31, 2008 increased
by $9.9 million to $11.1 million from $1.2 million in 2007. The increase in
retail revenue for the year ended December 31, 2008 is primarily due to the
Temix acquisition which accounted for $6.2 million of this
increase.





Cost
of sales




Cost of
sales is mainly comprised of costs of raw materials, primarily gold and
platinum, in addition to direct manufacturing costs and factory overhead. Cost
of sales for the year ended December 31, 2008 increased to $322.6 million, an
increase of $193.6 million, or 150%, from $129.0 million for the same period in
2007.





Wholesale
and distribution cost of sales increased by $185.5 million, or 145%, in 2008 to
$313.6 million from $128.1 million in 2007.  The increase in cost of sales,
which was consistent with the increase in net sales, was primarily due to an
increase in the cost of raw materials, which resulted from the increase in both
sales volume and the general increase in the cost of precious metals. In
addition, our direct labor costs increased at a higher rate during 2008 as
compared to the same period in 2007 due to the inflationary pressure and
enforcement of the New Labor Law effective January 1, 2008.




Cost of
retail sales for the year ended December 31, 2008 increased by $8.0 million to
$9.0 million from approximately $935,000 for the same period in 2007. The
increase in cost of retail sales for the year ended December 31, 2008 included
$4.4 million since the Temix acquisition.




Gross
profit





Gross
profit for the year ended December 31, 2008 increased to $45.0 million, an
increase of $28.5 million, or 173%, from $16.5 million for 2007. Gross profit
margin increased to 12.2% for year ended December 31, 2008, compared to 11.4%
for the same period in 2007. The increase in profit margin was primarily derived
from an increase in subcontracting fee income, a slight increase in processing
fees of our products, which resulted primarily from an increase in sales price
of precious metal jewelry, an increase in design styles, an increase in brand
awareness, and an expansion in retail presence by our opening up more jewelry
counters in new locations and acquisition of Temix’s 50 retail stores during the
year ended December 31, 2008.




Selling
and marketing expenses




Selling
and marketing expenses are primarily comprised of business taxes, advertising
expenses, traveling expenses, production costs of marketing materials, fees to
the malls for retail counters, insurance, and delivery expenses. Selling and
marketing expenses for the year ended December 31, 2008 were approximately $4.9
million, an increase of $3.8 million, or 345%, from $1.1 million for 2007.
Selling and marketing expenses were 1.34% of net sales for the year ended
December 31, 2008 compared to 0.76% for the prior year. The increase in selling
and marketing expenses as a percentage of net sales was primarily due to an
increase of business tax expenses that resulted from an overall increase in our
net revenue and salaries for our sales and marketing executives.





32




General
and administrative expenses




General
and administrative expenses consist primarily of payroll expenses, benefits and
travel expenses for our staff, professional fees including audit, accounting,
legal and financial advisory, depreciation expenses, and general office
expenses. General and administrative expenses for the year ended December 31,
2008 were $6.7 million, an increase of $3.7 million, or 123%, from $3.0 million
for 2007. General and administrative expenses were 1.83% of net sales for the
year ended December 31, 2008 compared to 2.01% for the prior year. The dollar
amount increase was primarily due to an increase of legal and professional fees
incurred as a result of being a publicly reporting company in the United States
and an unsuccessful acquisition attempt of a third-party competitor, expenses
related to options granted, and increased salaries to certain executives under
the employment agreements executed in October 2007. We anticipate general and
administrative expense to remain constant in 2009 due to the non-recurring legal
expenses for the unsuccessful attempted acquisition of a third-party competitor
in 2008, assuming to no similar expense occurs in 2009, and partly offset by an
increase number of staff to support of our retail strategy.




Other
income (expense), net




Other
income, net was $1.4 million of income in 2008 compared to $3.1 million of
income in 2007. The decrease was a result of the one-time exemption of tax
liabilities and estimated penalty payable of $4.2 million in 2007, partly offset
by the realized gain approximately $2.4 million from our gold future contracts
in 2008. We have entered into the gold future contracts with our supplier, the
Shanghai Gold Exchange in 2008 in order to reduce our exposure to volatility in
the price of gold.





Provision
for income tax




Provision
for income tax expense was approximately $6.9 million for the year ended
December 31, 2008, an increase of $4.8 million, or 229%, from approximately $2.1
million for 2007. The increase was primarily due to an increase in the taxable
income for the year ended December 31, 2008.




Net
income




As a
result of the foregoing, net income increased to $27.9 million in 2008, an
increase of 107% from $13.5 million in 2007.




Year
Ended December 31, 2007 and 2006





Net
sales




Net sales
for the year ended December 31, 2007 increased to $145.6 million, an increase of
$53.2 million, or 57.6%, from net sales of $92.4 million for the year ended
December 31, 2006. The increase was primarily attributable to a combination of
an increase in both selling price and sales volume. The selling price of our
jewelry products is based on the market price of the precious metals (e.g., gold
and platinum) in the periods when the products are sold. During 2007, the
average price of gold and platinum increased by 9.94% and 9.33%, respectively,
as compared with 2006. In addition, there was an increase of 34% in sales volume
from approximately 4.4 tons for 2006 to 5.9 tons for 2007 as result of increase
in jewelry products demand by our existing consumers and engaging of new
customers. Sales volume of gold and platinum for the year ended December 31,
2007 increased by 39% and 28% to 5 tons and 736kg for 2007 from 3.6 tons and
573kg for 2006, respectively.




Net sales
for the years ended December 31, 2007 and 2006 were comprised of the
following:





Years
      Ended December 31,2007
                                                              
                                                              
                                                              2006Amount
      in
                                                                Millions
                                                              
                                                              
                                                              Percentage
                                                              
                                                              
                                                              Amount
      in
                                                                Millions
                                                              
                                                              PercentagePlatinum
                                                              
                                                              $
                                                              30.9
                                                              
                                                              
                                                              21.2
                                                              %
                                                              
                                                              $
                                                              21.0
                                                              
                                                              
                                                              22.7
                                                              %Gold
                                                              
                                                              
                                                              81.0
                                                              
                                                              
                                                              55.8
                                                              
                                                              
                                                              
                                                              43.6
                                                              
                                                              
                                                              47.2K-gold
      and Studded Jewelry
                                                              
                                                              
                                                              33.7
                                                              
                                                              
                                                              23.0
                                                              
                                                              
                                                              
                                                              27.8
                                                              
                                                              
                                                              30.1Total
                                                              
                                                              $
                                                              145.6
                                                              
                                                              
                                                              100.0
                                                              %
                                                              
                                                              $
                                                              92.4
                                                              
                                                              
                                                              100.0
                                                              %




33





Cost
of sales




Cost of
sales for the year ended December 31, 2007 increased to $129 million, an
increase of $45 million, or 54%, from $84 million for the same period in 2006.
The increase in cost of sales, which was consistent with the increase in net
sales, was primarily due to an increase in the cost of raw materials, which
resulted from the increase in sales volume for the year ended December 31,
2007.




Gross
profit





Gross
profit for the year ended December 31, 2007 increased to $16.5 million, an
increase of $7.7 million, or 88%, from $8.8 million for 2006. Gross profit
margin increased to 11.3% for year ended December 31, 2007, compared to 9.5% for
the same period in 2006. The increase in profit margin was primarily derived
from a general increase in the design fees of our products, which resulted
primarily from an increase in design styles, an increase in brand awareness, and
our receipt of various national awards during the year ended December 31, 2007,
partially offset by a slight decrease in profit margin during the fourth quarter
of 2007, which was primarily related to a limited-time, promotional discount on
our design fees and a fluctuation the price of raw materials.




Selling
and marketing expenses




Selling
and marketing expenses for the year ended December 31, 2007 were approximately
$1.1 million, an increase of $0.6 million, or 120%, from $0.5 million for 2006.
Selling and marketing expenses were 0.76% of net sales for the year ended
December 31, 2007 compared to 0.53% for the prior year. The slight increase in
selling and marketing expenses as a percentage of net sales was primarily due to
our extended advertising campaign during Chinese New Year in 2007, an increase
in utility cost, higher insurance premium for product delivery, and an increase
in retail related expenses.




General
and administrative expenses




General
and administrative expenses for the year ended December 31, 2007 were $2.9
million, an increase of $2.1 million, or 263%, from $0.8 million for 2006.
General and administrative expenses were 2.01% of net sales for the year ended
December 31, 2007 compared to 0.86% for the prior year. The increase as a
percentage of revenue was primarily due to an increase of legal and professional
fees incurred as a result of being a publicly reporting company in the United
States, expenses related to options granted, and increased salaries to certain
executives under the employment agreements executed in October
2007.




Other
income (expense), net




Other
income, net was $3.1 million of income in 2007 compared to $0.7 million of
expense in 2006. The increase was a result of the exemption of tax liabilities
and estimated penalty payable of $4.2 million. See the section entitled
“Taxation” above, for additional information.




Provision
for income tax




Provision
for income tax expense was approximately $2.1 million for the year ended
December 31, 2007, an increase of $1.1 million, or 111%, from approximately
$995,000 for 2006. The increase was primarily due to an increase in the taxable
income for the year ended December 31, 2007.




Net
income




As a
result of the foregoing, net income increased to $13.5 million in 2007, an
increase of 133% from $5.8 million in 2006.




Quarterly
Results of Operations





The
following table presents the unaudited consolidated statements of income data
for each of eight fiscal quarters through December 31, 2008, in dollars. The
first quarter is from January 1 to March 31, the second quarter is from April 1
to June 30, the third quarter is from July 1 to September 30, and the fourth
quarter is from October 1 to December 31. In management’s opinion, this
unaudited information has been prepared on the same basis as our audited
consolidated financial statements and includes all adjustments, consisting only
of normal recurring adjustments, necessary for a fair presentation of the
unaudited information for the quarters presented. The results of operations for
any quarter are not necessarily indicative of results that we might achieve for
any subsequent periods. In addition, our operating results have in the past and
may in the future fluctuate significantly as a result of many factors, including
the seasonality of our business and the unpredictable fluctuation of prices of
precious metals. Consequently, we believe that period-to-period comparisons of
our operating results may not necessarily be meaningful, and as a result, you
should not rely on them as an indication of future performance.





34





Fiscal
      Year 2008
              
              
              Fiscal
      Year 2007Q4
              
              
              
              Q3
              
              
              
              Q2
              
              
              
              Q1
              
              
              
              Q4
              
              
              
              Q3
              
              
              
              Q2
              
              
              
              Q1(in
      thousands, except for per share data)Net
      sales
              
              $
              129,485
              
              
              $
              93,678
              
              
              $
              66,876
              
              
              $
              77,566
              
              
              $
              55,070
              
              
              $
              36,248
              
              
              $
              26,281
              
              
              $
              27,960Gross
      profit
              
              
              18,078
              
              
              
              10,998
              
              
              
              7,097
              
              
              
              8,811
              
              
              
              5,820
              
              
              
              4,477
              
              
              
              3,053
              
              
              
              3,164Net
      profit
              
              
              9,712
              
              
              
              6,521
              
              
              
              5,251
              
              
              
              6,395
              
              
              
              7,413
              
              
              
              2,730
              
              
              
              1,489
              
              
              
              1,883Earnings
      per share - basic
              
              
              0.45
              
              
              
              0.31
              
              
              
              0.25
              
              
              
              0.31
              
              
              
              0.39
              
              
              
              0.21
              
              
              
              0.12
              
              
              
              0.15Earnings
      per share - diluted
              
              
              0.45
              
              
              
              0.31
              
              
              
              0.25
              
              
              
              0.31
              
              
              
              0.39
              
              
              
              0.21
              
              
              
              0.10
              
              
              
              0.12




Liquidity
and Capital Resources




At
December 31, 2008, we had retained earnings of $44.7 million and cash and cash
equivalents of $56.6 million.  In October 2007, we completed an
initial public offering of a total of 8,088,888 shares of our common stock at
$9.00 per share. We have used such capital funding for expanding and financing
our retail distribution, enhancing our product lines, and for general working
capital for our retail operations. We paid a total of approximately $11.7
million to acquire substantially all of the assets of the Temix Companies in
August 2008, with $7.3 million having been paid in cash and the remaining $4.4
million is recorded as other payable, related parties in the consolidated
balance sheets as of December 31, 2008. We expect to pay the remaining $4.4
million in the second quarter of 2009.  In 2009, we currently plan to open
a total of 10 to 20 retail counters and one to three retail stores. The
foregoing is subject to change at any given time as our management continually
reviews our retail expansion plans, particularly in light of the recent
fluctuations in the economy. Our retail operations are discussed more fully
below under the caption of “Retail Operations”.




At
December 31, 2008, we had working capital of $129.4 million and no long-term
liabilities. Except for cash and cash equivalents, a majority of our net working
capital consisted of inventories and accounts receivable, both of which
increased by 50% and 210%, respectively, as of December 31, 2008 as compared to
December 31, 2007. The increase in inventory was a result of significant
purchases of raw materials of precious metals incurred towards the end of 2008
and was used to expand our sales capabilities by accepting larger sales orders
from our customers during the peak holiday season. We do not conduct any trading
of our precious metal raw materials.   The increase in accounts
receivable was attributable to a substantial increase in revenue generated in
November and December, which is the beginning of our traditional peak season,
and extending credit terms to some of our customers with high credit standings.
We typically offer certain of our customers 30-days credit terms for payment. We
maintain an allowance for doubtful accounts for estimated losses resulting from
the inability of our customers to make required payments. Allowance for doubtful
accounts is based on our assessment of the collectability of specific customer
accounts, the aging of accounts receivable, our history of bad debts, and the
general condition of the industry. If a major customer’s credit worthiness
deteriorates, or our customers’ actual defaults exceed historical experience,
our estimates could change and impact our reported results. We have not
experienced any significant amount of bad debt since the inception of our
operation.




We had
outstanding short-term notes payables with banks in an aggregate amount of $21.9
million that are due and payable on dates between January 2009 and June 2009.
Our loans are secured by inventory, real properties owned by our affiliated
companies and/or guaranteed by our affiliates and our controlling
stockholder.




We have a
general banking facility line of credit with Agricultural Bank of China pursuant
to a Maximum Banking Facility Agreement dated August 24, 2006 which was renewed
in September 2007 and December 2008. The terms of the agreement enable us to
borrow up to a maximum facility amount of $14.6 million. We executed notes
payable with this bank under this facility line with terms less than one year.
As of December 31, 2008, we had $14.6 million outstanding under the facility,
with interest rates ranging from 6.831% to 8.217%. In addition, we have a
one-year term loan with the Shenzhen Development Bank that provides for a
maximum borrowing of up to approximately $7.3 million. This facility expires in
June 2009 and is secured by certain real properties owned by an affiliate
company.  As of December 31 2008, we had a total of $7.3 million
outstanding under this term loan agreement with interest rates ranging from
4.86% to 5.04% and is secured by certain real properties owned by an affiliate
company   The remaining outstanding loans are secured by our
inventory, real properties owned by affiliated companies, and/or guaranteed by
our affiliates and our controlling stockholder and have certain restrictions and
covenants. We do not guarantee any indebtedness of our affiliates.





35




Prior to
the Reverse Merger in November 2006, our then-sole stockholder, Mr. Yu Kwai
Chong, who is also our President, Chief Executive Officer and Chairman of the
Board, made loans to us on a regular basis to meet short term financing needs of
our company. Typically, these advances were in amounts ranging from $30,000 to
$5.5 million, with no more than $10.0 million outstanding at any time. We did
not pay interest on any of these advances. During the same period, Mr. Chong
borrowed from our company primarily to fund personal liquidity needs. Since the
closing of the Reverse Merger, at which time Mr. Chong ceased to be our sole
stockholder, we have not engaged in any cash advance transactions with Mr. Chong
and will not engage in these transactions in the future. Prior to the Reverse
Merger, effective in November 2006, we paid dividends to our then sole
stockholder, Mr. Chong. During the years ended December 31, 2008, 2007, and
2006, we paid cash dividends of $0, $0, and $2.7 million, respectively, to Mr.
Chong. We currently have no intention to declare further dividends in the
foreseeable future. Payment of dividends is further restricted under the
provisions of our existing loan agreements.




On our
consolidated statements of cash flows, we recorded advances by Mr. Chong to us
and related repayments to him as financing activities, and advances by us to Mr.
Chong and related repayments by him as investing activities. Advances and
repayments were not subject to written loan agreements; the advances were
partially repaid within three months while the remaining portions were repaid
over three months. In accordance with SFAS 95, we present the gross amounts of
the advances and repayments in our consolidated statements of cash
flows.




A
substantial portion of our working capital consists of accounts receivable from
customers. If customers responsible for a significant amount of accounts
receivable were to become insolvent or otherwise unable to pay for our products,
or to make payments in a timely manner, our liquidity and results of operations
could be materially adversely affected. An economic or industry downturn could
materially adversely affect the servicing of these accounts receivable, which
could result in longer payment cycles, increased collections costs and defaults
in excess of management’s expectations. In addition, as we increase our presence
in the retail market, we expect the aging of our accounts receivable generated
from sales through retail counters to increase as department stores typically
defer payments to us of cash receipts collected by them on our behalf. A
significant deterioration in our ability to collect on accounts receivable could
affect our cash flow and working capital position and could also impact the cost
or availability of financing available to us.




We expect
to expend significant resources to continue to expand our retail distribution of
our jewelry in China. We will require substantial funds of approximately $25
million in order to finance our expansion, fund operating expenses, to develop
manufacturing, marketing and sales capabilities and to cover public company
costs.  In addition to the funds required to open retail locations, we
believed that significant working capital of approximately $20 million will be
needed to operate retail locations due to longer sales and collection cycles and
higher inventory levels required to support retail stores. We also expect to
require substantial funds of approximately $8 million to change our product mix
to include more platinum products. Without these funds, we may not be able to
meet these goals.





We
believe that our current cash and cash flow from operations will be sufficient
to meet our anticipated cash needs, including our cash needs for working
capital, for the next 12 months. We believe that the sources of the funding for
our expected expenditures in 2009 include our current cash and cash flow from
operations.  At December 31, 2008, we had cash and cash equivalents of
approximately $56.6 million and retained earnings of approximately $44.7
million.  However, net cash used for operating activities for the year
ended December 31, 2008 was approximately $8.0 million, and there is no
guarantee that we be able to generate positive cash flow from operations for the
year ending December 31, 2009.  In addition, we may require additional
cash resources due to our inability to generate positive cash flow from our
operations, changing business conditions or other future developments, including
any investments or acquisitions we may decide to pursue. We may seek additional
funding through public or private financing or through collaborative
arrangements with strategic partners.  We cannot be certain that
additional capital will be available on favorable terms, if at all, and any
available additional financing may not be adequate to meet our
goals.  Moreover, any equity financing would result in dilution to
stockholders.  If we cannot raise additional funds when needed, or on
acceptable terms, we may not be able to effectively execute our growth strategy
(including expanding our business to the retail market), take advantage of
future opportunities, or respond to competitive pressures or unanticipated
requirements. In addition, we may be required to scale back or discontinue our
production and development program, or obtain funds through strategic alliances
that may require us to relinquish certain rights.




36





The
following table sets forth a summary of our cash flows for the periods
indicated:




Years
      Ended December 31,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006(In
      Thousands)Net
      cash (used for) provided by operating activities
                                    
                                    $
                                    (7,959
                                    )
                                    
                                    $
                                    (21,737
                                    )
                                    
                                    $
                                    4,037Net
      cash (used for) provided by investing activities
                                    
                                    
                                    (7,088
                                    )
                                    
                                    (768)
                                    
                                    
                                    9,613Net
      cash provided by (used for) financing activities
                                    
                                    
                                    4,563
                                    
                                    
                                    71,082
                                    
                                    
                                    (595)Effect
      of exchange rate changes on cash
                                    
                                    
                                    3,760
                                    
                                    
                                    1,362
                                    
                                    
                                    229Net
      (decrease) increase in cash
                                    
                                    $
                                    (6,724
                                    )
                                    
                                    $
                                    49,939
                                    
                                    
                                    $
                                    13,284Cash
      at beginning of year
                                    
                                    
                                    63,294
                                    
                                    
                                    13,355
                                    
                                    
                                    71Cash
      at end of year
                                    
                                    $
                                    56,570
                                    
                                    
                                    $
                                    63,294
                                    
                                    
                                    $
                                    13,355




Net cash (used
for) provided by operating activities.





Net cash
used for operating activities was $8.0 million for the year ended December 31,
2008, compared to net cash used for operating activities of $21.7 million for
the same period in 2007. The $13.7 million decrease was primarily due to a
increase in inventory in the amount of $3.4 million during the year ended
December 31, 2008 compared to an increase of $22.2 million during the same
period in 2007, in additional to an increase of accounts payable in the amount
of $10.8 million during the year 2008 compared to an increase of $906,000 in the
same period in 2007.




Net cash
used for operating activities was $21.7 million for the year ended December 31,
2007, compared to net cash provided by operations of $4.0 million for the same
period in 2006. The $25.7 million decrease was primarily due to an increase in
inventory in the amount of $22.2 million during the year ended December 31, 2007
compared to an increase of $109,000 during the same period in 2006, in addition
to an increase of accounts receivable in the amount of $13.6 million during the
year 2007 compared to an increase of $1.96 million in the same period in
2006.




Net cash (used
for) provided by investing activities.





Net cash
used for investing activities amounted to $7.1 million for the year ended
December 31, 2008, compared to net cash used for investing activities of
$768,000 for the year ended December 31, 2007. The change was due to $6.5
million cash paid for business acquisitions and $1.0 million spent on additional
plant assets.




Net cash
used for investing activities amounted to approximately $768,000 for the year
ended December 31, 2007, compared to net cash provided by investing activities
of $9.6 million for the year ended December 31, 2006. The change was due to an
increase in restricted cash of approximately $395,000, in addition to the
absence of loans and related repayments between our controlling stockholder and
us, as had occurred during the year of 2006.




Net cash provided
by (used for) financing activities.





Net cash
provided by financing activities amounted to $4.6 million for the year ended
December 31, 2008, compared to net cash provided by financing activities of $71
million for the same period of 2007. The decrease of cash provided was primarily
a result of increased bank loan of $3.6 million and no further capital raised
since the initial public offering.





Net cash
provided by financing activities amounted to $71 million for the year ended
December 31, 2007, compared to net cash used for financing activities of
$595,000 for the same period of 2006. The increase of cash provided was
primarily a result of net proceeds of $67 million raised from the initial public
offering of 8,088,888 shares of our common stock, in addition to net proceeds of
$2.8 million from the exercise of warrants that occurred during the second
quarter of 2007.




Contractual
obligations




The
following table describes our contractual commitments and obligations as of
December 31, 2008:





Payments due by Period (in $)Contractual Obligations
                  
                  Total
                  
                  
                  Less Than
                    1 Year
                  
                  
                  1 - 3
                    Years
                  
                  
                  3 - 5
                    Years
                  
                  
                  More
                    Than
                    5 YearsShort-term
      borrowings
                  
                  $
                  21,944,904
                  
                  
                  $
                  21,944,904
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —Lease
      of Plant & Office
                  
                  $
                  306,516
                  
                  
                  $
                  237,730
                  
                  
                  $
                  68,786
                  
                  
                  $
                  —
                  
                  
                  $
                  —Lease
      of Staff Dormitory
                  
                  $
                  1,434
                  
                  
                  $
                  1,434
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —$
                  22,252,854
                  
                  
                  $
                  22,184,068
                  
                  
                  $
                  68,786
                  
                  
                  $
                  —
                  
                  
                  $
                  —




37





Employment
Agreements of Executive Officers and New Labor Contract Law




In
October 2007, we entered into three-year employment contracts with our five
executive officers each of which includes a fixed amount of annual salary and
stock options to purchase the Company’s common stock. See “Stock-based
Compensation” and Item 11 of Part III, for additional information.




Effective
January 1, 2008, the PRC introduced a new labor contract law that enhances
rights for the nation’s workers, including open-ended work contracts and
severance pay. The legislation requires employers to provide written contracts
to their workers, restricts the use of temporary laborers and makes it harder to
lay off employees. It also requires that employees with short-term contracts
become full-time employees with lifetime benefits after a short-term contract is
renewed twice.  The new labor contract law has increased our labor
costs, but we do not believe such increases have been material to our results of
operations, such labor expenses have not historically been material to our
operating cost.




Retail
Operations




In April
2007, we entered into a transfer agreement with an unrelated party (the
“Transferor”), which has operation agreements with department stores for five
jewelry retail counters. Under the terms of the agreement, the Transferor agreed
to assign all of the operation rights to us for a fee of $400,000, which was
payable in three separate installments. On October 28, 2007, after the
Transferor was not able to complete the transfer of the counters, we entered
into a cancellation agreement with the Transferor to terminate the transfer
transaction as of November 30, 2007. Prior to the termination of the transfer,
we had obtained temporary operation rights from the Transferor to operate these
counters, and revenue derived from these five retail counters from the period of
May to November 2007 amounted to $937,000. Pursuant to the cancellation
agreement, we were not obligated to pay the $400,000 transfer fee of $400,000.
All the inventory remained in the five counter stores at the last day of the
operation was sold to the Transferor based on the pre-determined price. As of
December 31, 2008, there was no outstanding balance due to the
Transferor.




Subsequent
to the cancellation agreement, in November 2007, we entered into one-year
operating agreements to operate 6 retail jewelry counters at two department
stores located in the Shenyang region. We agreed to pay the department stores a
commission fee ranging 4.5% to 8% based on types of jewelry sales generated in
these jewelry counters. Fees paid to the two department stores totaled $20,669
in 2007 and $200,089 in 2008 and are included in cost of sales expenses in 2007
and marketing expenses in 2008. We recognize revenues when the titles of the
merchandises are transferred to the ultimate consumers. Sales generated from
counters in these two department stores totaled $3,307,000 and $308,000 for the
years ended December 31, 2008 and 2007, respectively.





For the
year ended December 31, 2008, the Company opened a total
of sixteen new retail counters, of which thirteen of the counters
are under the FUQI brand and three counters are under the Temix brand. Including
the retail counters and shops acquired through the Temix acquisition, the
Company had a total of 62 jewelry counters and 7 jewelry shops located in
Beijing, Shanghai, and other PRC regions as of December 31, 2008.





The
retail counters and shops are operating under operating leases with terms
ranging from 6 months to 1 year with options of extensions. A majority of the
leases require payment of contingent rent based on a percentage of store sales.
The leasing agreements for five of the retail shops provide for the payment of
fees under a fixed rate rent ranging from $826 to $21,740. Fees paid to the
department stores and shopping malls totaling $1,362,277, $269,189 and $0
for the years ended December 31, 2008, 2007 and 2006, respectively, are included
in selling and marketing expenses.





Seasonality




Our
business is seasonal in nature. Our sales and net income are generally higher in
the fourth calendar quarter than the rest of the year. The primary factors that
affect the seasonal changes in our business operations are holidays and
traditional Chinese festivals. In the fourth quarter, retailers often experience
increased sales due to the weeklong public holiday for Chinese National Day, as
well as Christmas and New Year’s Day. In addition, jewelry retailers commonly
stock up from wholesalers in the fourth quarter to prepare for potentially
higher sales in the following quarter for Chinese New Year. This quarter is also
a peak season for marriages and the birth of newborns in China, which have
historically resulted in higher sales. This seasonal trend in our business would
slightly shift in line with the gap between calendar quarter and lunar quarter
and occurred during 2004 and 2005. However, there was a slight variation during
2006. Because of rising precious metal prices in the fourth quarter of 2006,
many customers delayed their orders until the first quarter of 2007, resulting
in lower-than-expected sales volume in the fourth quarter of 2006, and higher
than expected sales in the first quarter of 2007. We experienced increased sales
in the fourth quarter of 2007.  For the year ended December 31, 2008,
our results of operations appeared to return to the trend of higher sales in the
fourth quarter.


38




Off-Balance
Sheet Transactions




We have
no material off-balance sheet transactions.




Impact
of Recent Currency Exchange Rate Increase




We use
the U.S. dollar as the reporting currency for our financial statements. Our
operations are conducted through our PRC operating subsidiary, Fuqi China, and
our functional currency is the RMB. On July 21, 2005, the PRC government changed
its policy of pegging the value of the RMB to the U.S. dollar and, as a result,
the RMB has appreciated against the U.S. dollar by approximately 17.35% from
1:8.27 on July 21, 2005 to 1:6.8353 on December 31, 2008. In converting our RMB
income statement amounts into U.S. dollars we used the following RMB/$ exchange
rates: 7.959 for 2006, 7.587 for 2007, and 6.925 for 2008. Our operating results
in 2006, 2007 and 2008 have benefited as a result of appreciation of the RMB
against the U.S. dollar. There is no guarantee that we will benefit from the
exchange rate in the future and our operations may suffer if a less favorable
exchange rate develops.




New Accounting
Pronouncements





In
December 2007, the FASB issued SFAS No. 141, Business Combinations:
(Revised 2007) (“SFAS 141R”). SFAS 141R is relevant to all transactions or
events in which one entity obtains control over one or more other businesses.
SFAS 141R requires an acquirer to recognize any assets and noncontrolling
interest acquired and liabilities assumed to be measured at fair value as of the
acquisition date. Liabilities related to contingent consideration are recognized
and measured at fair value on the date of acquisition rather than at a later
date when the amount of the consideration may be resolved beyond a reasonable
doubt. This revised approach replaces SFAS 141’s cost allocation process in
which the cost of an acquisition was allocated to the individual assets acquired
and liabilities assumed based on their respective fair value. SFAS 141R requires
any acquisition-related costs and restructuring costs to be expensed as incurred
as opposed to allocating such costs to the assets acquired and liabilities
assumed as previously required by SFAS 141. Under SFAS 141R, an acquirer
recognizes liabilities for a restructuring plan in purchase accounting only if
the requirements of SFAS 146, Accounting for Costs Associated with Exit or
Disposal Activities, are met. SFAS 141R allows for the recognition of
pre-acquisition contingencies at fair value only if these contingencies are
likely to materialize. If this criterion is not met at the acquisition date,
then the acquirer accounts for the non-contractual contingency in accordance
with recognition criteria set forth under SFAS 5, Accounting for Contingencies,
in which case no amount should be recognized in purchase accounting. SFAS 141R
is effective as of the beginning of an entity’s first fiscal year that begins
after December 15, 2008. The Company is in the process of assessing the
potential impact the adoption of SFAS 141R may have on its consolidated
financial position or results of operations.





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests
in Consolidated Financial Statements—An Amendment of ARB No. 51
(“SFAS 160”). This Statement amends ARB 51 to establish accounting and
reporting standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in
a subsidiary is an ownership interest in the consolidated entity and should be
reported as equity on the financial statements. SFAS 160 requires consolidated
net income to be reported at amounts that include the amounts attributable to
both the parent and the noncontrolling interest. Furthermore, disclosure of the
amounts of consolidated net income attributable to the parent and to the
noncontrolling interest is required on the face of the financial statements.
SFAS 160 is effective as of the beginning of an entity’s first fiscal year that
begins after December 15, 2008. The Company is in the process of assessing
the potential impact the adoption of SFAS 160 may have on its consolidated
financial position or results of operations.


In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and
Hedging Activities, which requires additional disclosure related to derivatives
instruments and hedging activities. These enhanced disclosures will discuss
(a) how and why a company uses derivative instruments, (b) how
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133 and its related interpretations and (c) how
derivative instruments and related hedged items affect a company’s financial
position, results of operations and cash flows. SFAS No. 161 is
effective for fiscal years beginning on or after November 15, 2008, with
earlier adoption allowed. The Company is currently evaluating the impact of
adopting SFAS No. 161.




In April
2008, the FASB issued FASB Staff Position FAS142-3: Determination of the Useful
Life of Intangible Assets. This FSP amends the factors that should be considered
in developing renewal or extension assumptions used to determine the useful life
of a recognized intangible asset under FASB Statement No. 142, Goodwill and
Other Intangible Assets. This FSP is effective for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years. Early
adoption is prohibited. The guidance for determining the useful life of a
recognized intangible asset in this FSP shall be applied prospectively to
intangible assets acquired after the effective date. The Company is in the
process of assessing the potential impact the adoption of FSP 142-3 may
have on its consolidated financial position or results of
operations.




39




In May
2008, the FASB issued Statement No. 162, The Hierarchy of Generally Accepted
Accounting Principles ("SFAS 162"). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of non-governmental entities that are
presented in conformity with GAAP. SFAS 162 directs the GAAP hierarchy to
the entity, not the independent auditors, as the entity is responsible for
selecting accounting principles for financial statements that are presented in
conformity with GAAP. SFAS 162 is effective 60 days following the Securities and
Exchange Commission’s approval of the Public Company Accounting Oversight Board
amendments to remove the GAAP hierarchy from the auditing standards. The Company
is currently evaluating the impact of adopting
SFAS No. 162.




In
June 2008, the FASB issued FASB Staff Position EITF 03-6-1, Determining
Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities. This FSP gives guidance on the computation of earnings
per share and the impact of share-based instruments that contain certain
nonforfeitable rights to dividends or dividend equivalents. The FSP is
effective for fiscal years beginning after December 31, 2008 and early
application is prohibited. The Company is in the process of assessing the
potential impact the adoption of FSP 03-6-1 may have on its consolidated
financial position or results of operations.





At a
November 24, 2008 meeting, the FASB ratified the consensus reached by the
Task Force in Issue No. 08-6: Equity Method Investment Accounting
Considerations (“EITF 08-6”). Because of the significant changes to the guidance
on subsidiary acquisitions and subsidiary equity transactions and the increased
use of fair value measurements as a result of Statements 141(R) and 160,
questions have arisen regarding the application of that accounting guidance to
equity method investments. EITF 08-6 provides guidance for entities that acquire
or hold investments accounted for under the equity method. This issue is
effective for transactions occurring in fiscal years and interim periods
beginning on or after December 15, 2008. Early adoption is not permitted.
The Company is in the process of assessing the potential impact the adoption of
EITF 08-6 may have on its consolidated financial position or results of
operations.




ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Foreign
Exchange Risk




We use
the U.S. dollar as the reporting and functional currency for our financial
statements. As we conduct our operations through our PRC subsidiary, the
functional currency of our PRC subsidiary is RMB. Substantially all our revenue
and related expenses, including cost of revenues and advertising expenses, are
denominated and paid in RMB. Transactions in other currencies are recorded in
RMB at the rates of exchange prevailing when the transactions occur. Monetary
assets and liabilities denominated in other currencies are remeasured into RMB
at rates of exchange in effect at the balance sheet dates. Exchange gains and
losses are recorded in our statements of operations as other comprehensive
income.




The value
of RMB is subject to changes in China’s governmental policies and to
international economic and political developments. In January, 1994, the PRC
government implemented a unitary managed floating rate system. Under this
system, the People’s Bank of China, or PBOC, began publishing a daily base
exchange rate with reference primarily to the supply and demand of RMB against
the U.S. dollar and other foreign currencies in the market during the previous
day. Authorized banks and financial institutions are allowed to quote buy and
sell rates for RMB within a specified band around the central bank’s daily
exchange rate. On July 21, 2005, PBOC announced an adjustment of the exchange
rate of the U.S. dollar to RMB from 1:8.27 to 1:8.11 and modified the system by
which the exchange rates are determined. This modification has resulted in an
approximate 15.72% appreciation of the RMB against the U.S. dollar from July 21,
2005 to December 31, 2008. While the international reaction to the RMB
revaluation has generally been positive, there remains significant international
pressure on the PRC government to adopt an even more flexible currency policy,
which could result in further fluctuation of the exchange rate of RMB against
the U.S. dollar. As all of our net revenues are recorded in RMB, any future
devaluation of RMB against the dollar could negatively impact our results of
operations.




Interest
Rate Risk




As of
December 31, 2008, we had $21.9 million outstanding under short term credit
facilities from banks, with interest rates ranging from 4.860% to 8.217%. As all
of these borrowings are short term borrowings, we believe our exposure to
interest rate risk is not material. We do not use any derivative financial
instruments to manage interest rate risks.




40





Inflation




According
to the National Bureau of Statistics of China, the inflation rate in China
reached a high point of 5.9% in 2008 as compared to the past several years. The
inflation rate in China was 1.5% in 2006 and 4.8% in 2007.  Many of
our operating expenses were increased and are also expected to increase with
inflation. In management's opinion, changes in revenues, net earnings and
inventory valuation that have resulted from inflation and changing prices have
not been material during the years presented. Management does not expect that
the effect of inflation on our overall operating costs will be greater for us
than for our competitors within China.




Commodity
Price Sensitivity




As a
leading designer and wholesaler of high quality precious metal jewelry in China,
we believe that we have to maintain a sufficient inventory to meet demands for
our products based on customer orders, sales projection and finished goods for
sales to retailers, who will purchase from our show room in our head office in
Shenzhen. We are exposed to market risk in connection with our inventory
balances, which are comprised primarily of gold, platinum, and jewelry made from
gold and platinum. Our inventories are stated at the lower of cost or market
value using the “first in, first out” method for gold and platinum jewelries and
the specific identification method for diamond jewelries. If there is a downward
change in the market price of gold, we are required to mark-down the value of
our inventory and record a loss in our statement of income. We cannot predict
the extent to which high raw material price levels will continue in the future.
We do not have any long-term raw material purchase contracts.





In
attempt to protect us against price increases of precious metals, we, in
December 2007, entered into future purchase contracts with our supplier, the
Shanghai Gold Exchange, to purchase gold. As of December 31, 2008, the fair
value of the future gold contracts outstanding was approximately $1,426,000
which was recorded as Gold Future Contracts under current assets. The gain
derived from these contracts of approximately $2,362,000 was classified as gain
from derivative instrument in the accompanying consolidated statements of
income.




ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA




The
information required by this Item 8 is incorporated by reference to information
begins on Page F-1 at the end of this Form 10-K.




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




None.




ITEM
9A. CONTROLS AND PROCEDURES.




(A)
Disclosure Controls and Procedures




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




As
required by Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act, our
management has carried out an evaluation, with the participation and under the
supervision of our Chief Executive Officer and our Chief Financial Officer, of
the effectiveness of the design and operation of our disclosure controls and
procedures as of December 31, 2008.  As discussed in more detail below, our
Chief Executive Officer and our Chief Financial Officer concluded that our
disclosure controls and procedures are ineffective as of December 31, 2008, due
to material weaknesses that we identified in internal control over financial
reporting, specifically related to period-end closing process and revenue
recognition in improper periods.





(B)
Report of Management on Internal Control over Financial Reporting




Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f)
under the Securities Exchange Act.  Because of its inherent
limitations, internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies and
procedures may deteriorate.


41





Our
management has assessed the effectiveness of our internal control over financial
reporting as of December 31, 2008. In making its assessment, management used the
criteria described in Internal Control - Integrated Framework, issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(“COSO”).  The assessment excluded the internal controls over
financial reporting relating to substantially all of the assets and operations
of the Temix Companies that we acquired on August 7, 2008, as described in note
2 to the Consolidated Financial Statements, and their combined financial
statements constitute 11.2 percent of total assets, 1.7 percent of revenues, and
(2.8) percent of net income of the consolidated financial statement amounts as
of December 31, 2008 and for the year then ended.  Pursuant to
guidance issued by the SEC, a company can exclude a material acquired business’s
internal controls from management’s report on internal control over financial
reporting in the first year of acquisition if it is not possible to conduct an
assessment of an acquired business’s internal control over financial
reporting.




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company’s annual or interim financial
statements will not be prevented or detected on a timely basis. A significant
deficiency is a control deficiency, or a combination of control deficiencies, in
internal control over financial reporting that is less severe than a material
weakness, yet important enough to merit attention by those responsible for
oversight of the company’s financial reporting. The following material
weaknesses have been identified and included in our management’s assessment as
of December 31, 2008:




1.
            We did not
      maintain effective control over the period-end closing
      process.  Due to the insufficient number of qualified
      resources, we were unable to timely and accurately complete our work
      needed to close our books and prepare financial statements in accordance
      with accounting principles generally accepted in the United States of
      America. This control deficiency resulted in significant amounts of audit
      adjustments to our 2008 financial statements.  In addition, this
      control deficiency could result in a material misstatement to annual or
      interim financial statements that would not be prevented or
      detected.   Accordingly, management determined that this
      control deficiency constitutes a material
  weakness.




2.
            We did not
      maintain effective control over the revenue cycle with revenue
      recognition.  We did not properly perform and follow the
      control procedures set forth in the revenue cycle.  This control
      deficiency resulted in  significant amounts of sales not being
      recorded in the proper periods.  Accordingly, management
      determined that this control deficiency constitutes a material
      weakness.




Based on
our management’s assessment of the effectiveness of our internal control over
financial reporting, our management has concluded that, as of December 31, 2008,
the Company’s internal control over financial reporting was not effective as a
result of the aforementioned material weaknesses.





Management’s
assessment of the effectiveness of our internal control over financial reporting
as of December 31, 2008 has been audited by Stonefield Josephson, Inc., an
independent registered public accounting firm, as stated in their report which
is included under “Report of Independent Registered Public Accounting
Firm.”




Remediation
Measures of Material Weaknesses




We have
implemented, or plan to implement, the measures described below under the
supervision and guidance of our management to remediate the above control
deficiencies and to strengthen our internal controls over financial reporting.
Key elements of the remediation effort include, but are not limited to, the
following initiatives, which have been implemented, or are in the process of
implementation, as of the date of filing of this Annual Report:




1.
            We
      have increased efforts to enforce internal control
      procedures.  We have also reorganized the structure of our China
      financial department and clarified the responsibilities of each key
      personnel in order to increase communications and
      accountability.





2.
            We
      have recruited and will continue to bring in additional qualified
      financial personnel for the accounting department to further strengthen
      our China financial reporting
function.




3.
            We
      will provide additional training on accounting principles and internal
      control procedures for our existing staffs. We have also required all
      personnel in our China financial department to obtain additional
      accounting certifications.




42




4.
            We
      continually review and improve our standardization of our monthly and
      quarterly data collection, analysis, and reconciliation procedures. To
      further improve the timeliness of data collection, we are selecting and
      will install new point of sale systems and enterprise resource planning
      systems for our wholesale and retail
operations.




5.
            We
      have increased the level of communication and interaction among our China
      management, audit committee, independent auditors and other external
      advisors. In addition, our Chief Financial Officer and US GAAP team are
      becoming increasingly involved in and monitor the financial accounting and
      reporting process in China
operations.




6.
            We
      are in the process of expanding the internal control functions and honing
      related policies and procedures. We have hired a qualified and experienced
      Internal Audit Manager, who commenced work in January 2009. We also plan
      to allocate transfer additional resources to the internal audit department
      for the purpose of enhancing the internal audit
  function.




We
believe that we are taking the steps necessary for remediation of the material
weaknesses identified above, and we will continue to monitor the effectiveness
of these steps and to make any changes that our management deems
appropriate




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Stockholders of


Fuqi
International, Inc.


Shenzhen,
China





We have
audited Fuqi International, Inc. and its subsidiaries (“the Company”)’s internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). As described in
Management’s Report on Internal Control Over Financial Reporting, management
excluded from its assessment the internal control over financial reporting on
the assets and operations of Shanghai Tian Mei Jewelry Co. Ltd. and Beijing
Yinzhong Tian Mei Jewelry Co. Ltd. (collectively referred to as “Temix”) which
were acquired on August 7, 2008 and whose financial statements constitute 11.2%
of total assets, 1.7% of net revenues, and (2.8)% of net income of the
consolidated financial statement amounts as of December 31, 2008 and for the
year then ended.  Accordingly, our audit did not include the internal
control over financial reporting at Temix. Fuqi International, Inc.’s management
is responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control over
financial reporting included in the accompanying “Report of Management on
Internal Control over Financial Reporting.” Our responsibility is to express an
opinion on the company’s internal control over financial reporting based on our
audit.





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




A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a material effect on the
financial statements.


43




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company's annual or interim financial
statements will not be prevented or detected on a timely basis.  The
following material weaknesses have been identified and included in management’s
assessment:





·
            The
      Company did not maintain effective control over the period-end closing
      process. Specifically, due to the insufficient number of qualified
      resources, the Company was unable to timely and accurately complete its
      work needed to close its books and prepare financial statements in
      accordance with accounting principles generally accepted in the United
      States of America. This control deficiency resulted in significant amounts
      of audit adjustments to the Company's 2008 financial
      statements.  In addition, this control deficiency could result
      in a material misstatement to annual or interim financial statements that
      would not be prevented or detected.   Accordingly,
      management determined that this control deficiency constitutes a material
      weakness.





·
            The
      Company did not maintain effective control over the revenue cycle with
      revenue recognition.  The Company did not properly perform and
      follow the control procedures set forth in the revenue
      cycle.  This control deficiency resulted in significant amounts
      of revenues not being recorded in the proper
  periods.





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




In our
opinion, management’s assessment that the Company did not maintain effective
internal control over financial reporting as of December 31, 2008, is
fairly stated, in all material respects, based on the criteria established in
Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  Also in our opinion, because of the effect of
the material weaknesses described above on the achievement of the control
objectives of the control criteria, the Company has not maintained effective
internal control over financial reporting as of  December 31, 2008,
based on the criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets as of
December 31, 2008 and 2007 and the related consolidated statements of
income and comprehensive income, stockholders’ equity, and cash flows and the
related financial statement schedules for each of the years in the three-year
period ended December 31, 2008, of Fuqi International, Inc., and our report
dated March 30, 2009 expressed an unqualified opinion.





/s/  Stonefield
Josephson, Inc.


Wanchai,
Hong Kong


March 30,
2009




(C)
Changes in Internal Controls over Financial Reporting




Due to
the implementation of the remedial measures to address the material weaknesses
as described above, in addition to the designing, planning, and integration of
the internal controls over financial reporting for Temix, there were changes in
our internal controls over financial reporting during the fourth quarter of
fiscal 2008 that have materially affected, or are reasonably likely to
materially affect our internal control over financial reporting.




ITEM
9B. OTHER INFORMATION





None


44




PART
III




ITEM
10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE




The
information required by this Item 10 is incorporated by reference from our
definitive proxy statement on Schedule 14A which will be filed before the end of
the 120-day period immediately following the end of our 2008 fiscal year, or, if
our definitive proxy statement is not filed within that time, the information
will be filed as part of an amendment to this Annual Report on Form 10-K/A, not
later than the end of the 120-day period.




ITEM
11. EXECUTIVE COMPENSATION




The
information required by this Item 11 is incorporated by reference from our
definitive proxy statement on Schedule 14A which will be filed before the end of
the 120-day period immediately following the end of our 2008 fiscal year, or, if
our definitive proxy statement is not filed within that time, the information
will be filed as part of an amendment to this Annual Report on Form 10-K/A, not
later than the end of the 120-day period.




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




The
information required by this Item 12 is incorporated by reference from our
definitive proxy statement on Schedule 14A which will be filed before the end of
the 120-day period immediately following the end of our 2008 fiscal year, or, if
our definitive proxy statement is not filed within that time, the information
will be filed as part of an amendment to this Annual Report on Form 10-K/A, not
later than the end of the 120-day period.




ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS




The
information required by this Item 13 is incorporated by reference from our
definitive proxy statement on Schedule 14A which will be filed before the end of
the 120-day period immediately following the end of our 2008 fiscal year, or, if
our definitive proxy statement is not filed within that time, the information
will be filed as part of an amendment to this Annual Report on Form 10-K/A, not
later than the end of the 120-day period.




ITEM
14. PRINCIPAL ACCOUNTING FEES AND SERVICES.




The
information required by this Item 14 is incorporated by reference from our
definitive proxy statement on Schedule 14A which will be filed before the end of
the 120-day period immediately following the end of our 2008 fiscal year, or, if
our definitive proxy statement is not filed within that time, the information
will be filed as part of an amendment to this Annual Report on Form 10-K/A, not
later than the end of the 120-day period.




PART
IV




ITEM
15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES





1.
Financial Statements: See “Index to Consolidated Financial Statements” in Part
II, Item 8 of this annual report on Form 10-K.





2.
Financial Statement Schedules: See “Schedule I – Condensed Financial
Information of Registrant” and   “Schedule II—Valuation and
Qualifying Accounts”from page F-38 to F-43 of the Financial Statements
of this annual report on Form 10-K.





3.
Exhibits: The exhibits listed in the accompanying “Index to Exhibits” are filed
or incorporated by reference as part of this Form 10-K.


45




SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, in the City of Shenzhen, People’s
Republic of China, on March 31, 2009.





FUQI
      INTERNATIONAL, INC.By:
                /s/
      Yu Kwai ChongName
      Yu Kwai ChongTitle:
      Chief Executive Officer and
President




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




SIGNATURE
                                  
                                  TITLE
                                  
                                  DATE/s/  Yu
      Kwai Chong
                                  
                                  Chief
      Executive Officer and President (Principal
                                    Executive
      Officer)
                                  
                                  March
      31, 2009Yu
      Kwai Chong/s/  Ching
      Wan Wong
                                  
                                  Chief
      Financial Officer and Director (Principal
                                    Financial
      Officer and Accounting Officer)
                                  
                                  March
      31, 2009Ching
      Wan Wong/s/  Lie
      Xi Zhuang
                                  
                                  Chief
      Operating Officer and Director
                                  
                                  March
      31, 2009Lie
      Xi Zhuang/s/  Lily
      Lee Chen
                                  
                                  Director
                                  
                                  March
      31, 2009Lily
      Lee Chen/s/  Eileen
      B. Brody
                                  
                                  Director
                                  
                                  March
      31, 2009Eileen
      B. Brody/s/  Victor
      A. Hollander
                                  
                                  Director
                                  
                                  March
      31, 2009Victor
      A. Hollander/s/  Jeff
      Haiyong Liu
                                  
                                  Director
                                  
                                  March
      31, 2009Jeff
      Haiyong Liu




46


EXHIBIT
INDEX





Exhibit Number
                                
                                Description
      of Exhibit2.1
                                
                                Share
      Exchange Agreement dated November 20, 2006 by and between Fuqi
      International, Inc., a Delaware corporation (f/k/a VT Marketing Services,
      Inc.) (the “Registrant”) and Fuqi International Holdings Ltd., a British
      Virgin Islands company (incorporated by reference from Exhibit 2.1 to the
      Registrant’s Form 10 filed with the Securities and Exchange Commission on
      December 29, 2006).3.1
                                
                                Certificate
      of Incorporation of the Registrant (incorporated by reference from Exhibit
      3.1 to the Registrant’s Form 10 filed with the Securities and Exchange
      Commission on December 29, 2006).3.1(a)
                                
                                Amendment
      of the Certificate of Incorporation of the Registrant dated February 21,
      2007 to increase authorized shares (incorporated by reference from Exhibit
      3.1(a) to the Registrant’s Form S-1/A (file no. 333-144290) filed with the
      Securities and Exchange Commission on August 28, 2007).3.2
                                
                                Bylaws
      of the Registrant (incorporated by reference from Exhibit 3.2 to the
      Registrant’s Form 10 filed with the Securities and Exchange Commission on
      December 29, 2006).4.1
                                
                                Specimen
      Common Stock Certificate (incorporated by reference from Exhibit 4.1 to
      the Registrant’s Form S-1/A (file no. 333-144290) filed with the
      Securities and Exchange Commission on July 2, 2007).10.1
                                
                                Plan
      Warrant Agreement (incorporated by reference from Exhibit 10.1 to the
      Registrant’s Form 10 filed with the Securities and Exchange Commission on
      December 29, 2006).10.2
                                
                                2006
      Equity Incentive Plan (incorporated by reference from Exhibit 10.2 to the
      Registrant’s Form 10 filed with the Securities and Exchange Commission on
      December 29, 2006).10.3
                                
                                Real
      Property Lease dated May 8, 2005 (incorporated by reference from Exhibit
      10.3 to the Registrant’s Form 10 filed with the Securities and Exchange
      Commission on December 29, 2006).10.4
                                
                                Employment
      Agreement dated August 30, 2007 entered into by and between the Company
      and Yu Kwai Chong (incorporated by reference from Exhibit 10.1 to the
      Registrant’s Form 8-K filed with the Securities and Exchange Commission on
      September 6, 2007).10.5
                                
                                Employment
      Agreement dated August 30, 2007 entered into by and between the Company
      and Ching Wan Wong (incorporated by reference from Exhibit 10.2 to the
      Registrant’s Form 8-K filed with the Securities and Exchange Commission on
      September 6, 2007).10.6
                                
                                Employment
      Agreement dated August 30, 2007 entered into by and between the Company
      and Lie Xi Zhuang (incorporated by reference from Exhibit 10.3 to the
      Registrant’s Form 8-K filed with the Securities and Exchange Commission on
      September 6, 2007).10.7
                                
                                Employment
      Agreement dated August 30, 2007 entered into by and between the Company
      and Heung Sang Fong (incorporated by reference from Exhibit 10.4 to the
      Registrant’s Form 8-K filed with the Securities and Exchange Commission on
      September 6, 2007).10.8
                                
                                Employment
      Agreement dated August 30, 2007 entered into by and between the Company
      and Xi Zhou Zhuo (incorporated by reference from Exhibit 10.5 to the
      Registrant’s Form 8-K filed with the Securities and Exchange Commission on
      September 6, 2007).10.9
                                
                                Registration
      Rights Agreement dated September 18, 2007 entered into by and between the
      Company and Bay Peak, LLC (incorporated by reference from Exhibit 10.9 to
      the Registrant’s Form S-1/A (file no. 333-144290) filed with the
      Securities and Exchange Commission on October 2, 2007).10.10
                                
                                Maximum
      General Facility Agreement dated September 27, 2007 entered into by and
      between the Company and Agriculture Bank of China (incorporated by
      reference from Exhibit 10.10 to the Registrant’s Form S-1/A (file no.
      333-144290) filed with the Securities and Exchange Commission on October
      2,
2007).




47





Exhibit Number
                    
                    Description of Exhibit10.11
                    
                    2007
      Equity Incentive Plan (incorporated by reference from Exhibit 99.1 to the
      Registrant’s Form S-1/A (file no. 333-144290) filed with the Securities
      and Exchange Commission on August 28, 2007).10.12
                    
                    Form
      of Notice of Grant of Stock Option for the 2007 Equity Incentive Plan
      (incorporated by reference from Exhibit 99.2 to the Registrant’s Form
      S-1/A (file no. 333-144290) filed with the Securities and Exchange
      Commission on August 28, 2007).10.13
                    
                    Form
      of Stock Option Agreement (including Addendum) for the 2007 Equity
      Incentive Plan (incorporated by reference from Exhibit 99.3 to the
      Registrant’s Form S-1/A (file no. 333-144290) filed with the Securities
      and Exchange Commission on August 28, 2007).10.14
                    
                    Form
      of Stock Issuance Agreement (including Addendum) for the 2007 Equity
      Incentive Plan (incorporated by reference from Exhibit 99.4 to the
      Registrant’s Form S-1/A (file no. 333-144290) filed with the Securities
      and Exchange Commission on August 28, 2007).10.15
                    
                    Form
      of Stock Purchase Agreement (including Addendum) for the 2007 Equity
      Incentive Plan (incorporated by reference from Exhibit 99.5 to the
      Registrant’s Form S-1/A (file no. 333-144290) filed with the Securities
      and Exchange Commission on August 28, 2007).10.16
                    
                    Lease
      agreement dated October 10, 2007 for office space in San Jose, California
      (incorporated by reference from Exhibit 10.16 to the Registrant’s Form
      10-K filed with the Securities and Exchange Commission on March 28,
      2008).10.17
                    
                    Lease
      agreement dated February 20, 2008 for office space in Hong Kong
      (incorporated by reference from Exhibit 10.17 to the Registrant’s Form
      10-K filed with the Securities and Exchange Commission on March 28,
      2008).10.18(a)
                    
                    Asset
      Purchase Agreement dated April 18, 2008 entered into between the Fuqi
      International Holdings Co., LTD., Beijing Yinzhong Tianmei Jewelry Co.,
      LTD., Shanghai Tianmei Jewelry Co., LTD., and Chujian Huang (incorporated
      by reference from Exhibit 10.1 to the Registrant’s Current Report on Form
      8-K filed with the Securities and Exchange Commission on April 21,
      2008).10.18(b)
                    
                    Amendment
      to Asset Purchase Agreement dated August 7, 2008 entered into between the
      Fuqi International Holdings Co., LTD., Beijing Yinzhong Tianmei Jewelry
      Co., LTD., Shanghai Tianmei Jewelry Co., LTD., and Chujian Huang
      (incorporated by reference from Exhibit 10.1 to the Registrant’s Current
      Report on Form 8-K filed with the Securities and Exchange Commission on
      August 12, 2008).10.19
                    
                    Intellectual
      Property Transfer Agreement dated April 18, 2008 entered into between the
      Registrant, the Fuqi International Holdings Co., LTD., and Chujian Huang
      (incorporated by reference from Exhibit 10.2 to the Registrant’s Current
      Report on Form 8-K filed with the Securities and Exchange Commission on
      April 21, 2008).10.20
                    
                    Employment
      Agreement dated August 7, 2008 by and between the Registrat and Chujian
      Huang (incorporated by reference from Exhibit 10.2 to the Registrant’s
      Current Report on Form 8-K filed with the Securities and Exchange
      Commission on August 12, 2008).21.1
                    
                    List
      of Subsidiaries of the Registrant (incorporated by reference from Exhibit
      21.1 to the Registrant’s Form 10 filed with the Securities and Exchange
      Commission on December 29, 2006).23.1
                    
                    Consent
      of Stonefield Josephson, Inc.31.1
                    
                    Certification
      of Chief Executive Officer pursuant to Item 601(b)(31) of Regulation S-K,
      as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002.31.2
                    
                    Certification
      of Chief Financial Officer pursuant to Item 601(b)(31) of Regulation S-K,
      as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002.




48





Exhibit Number
                  
                  Description of Exhibit32.1*
                  
                  Certifications
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350 as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of
2002.







* This
exhibit shall not be deemed "filed" for purposes of Section 18 of the Securities
Exchange Act of 1934 or otherwise subject to the liabilities of that section,
nor shall it be deemed incorporated by reference in any filing under the
Securities Act of 1933 or the Securities Exchange Act of 1934, whether made
before or after the date hereof and irrespective of any general incorporation
language in any filings.




49




FUQI
INTERNATIONAL, INC.




CONSOLIDATED
FINANCIAL STATEMENTS




INDEX
TO FINANCIAL STATEMENTS





PageReport
      of Independent Registered Public Accounting Firm
                                F-2Financial
      Statements:Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                                F-3Consolidated
      Statements of Income and Comprehensive Income for the years ended December
      31, 2008, 2007, and 2006
                                F-4Consolidated
      Statements of Stockholders’ Equity for the years ended December 31, 2008,
      2007, and 2006
                                F-5Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007, and
      2006
                                F-6Notes
      to Consolidated Financial Statements
                                F-8Schedule
      I — Condensed Financial Information of Registrant
                                F-38Schedule
      II — Valuation and Qualifying Accounts and Reserves
                                F-43




F-1




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Stockholders of


Fuqi
International, Inc.


Shenzhen,
China




We have
audited the accompanying consolidated balance sheets of Fuqi
International, Inc. and its subsidiaries (the “Company”) as of
December 31, 2008 and 2007, and the related consolidated statements of
income and comprehensive income, stockholders’ equity, and cash flows for each
of the years in the three-year period ended December 31, 2008. Our audits
also included the financial statement schedules listed in the index at Item 15.
These financial statements and the schedules are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these
financial statements and schedules based on our audits.




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




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Fuqi International, Inc. as of
December 31, 2008 and 2007, and the results of its operations and its cash
flows for each of the years in the three-year period ended December 31, 2008, in
conformity with accounting principles generally accepted in the United States of
America. Also in our opinion, the related financial statement schedules, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth
therein.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial
reporting as of December 31, 2008, based on criteria established in
Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) and our report dated March 30,
2009 expressed an adverse opinion.




/s/
Stonefield Josephson, Inc.





Wanchai,
Hong Kong


March 30,
2009


F-2


FUQI
INTERNATIONAL, INC.


CONSOLIDATED
BALANCE SHEETS





As of December 31,2008
                  
                  
                  2007ASSETSCurrent
      assets:Cash
                  
                  $
                  56,569,733
                  
                  
                  $
                  63,293,653Restricted
      cash
                  
                  
                  -
                  
                  
                  
                  410,700Accounts
      receivable, including amount due from related party of $2,837,907 for 2008
      and $0 for 2007, net of allowance for doubtful accounts of $1,620,000 for
      2008 and $470,000 for 2007
                  
                  
                  73,949,200
                  
                  
                  
                  23,864,141Value
      added taxes receivable
                  
                  
                  2,170,669
                  
                  
                  
                  2,094,946Inventories
                  
                  
                  44,409,645
                  
                  
                  
                  29,639,236Prepaid
      expenses and other current assets
                  
                  
                  286,405
                  
                  
                  
                  956,419Advances
      to supplier
                  
                  
                  8,468,971
                  
                  
                  
                  744,013Gold
      future contracts
                  
                  
                  1,426,236
                  
                  
                  
                  -Deferred
      taxes
                  
                  
                  142,608
                  
                  
                  
                  79,402Total
      current assets
                  
                  
                  187,423,467
                  
                  
                  
                  121,082,510Property,
      equipment, and improvements, net
                  
                  
                  3,400,642
                  
                  
                  
                  1,495,861Deposits
                  
                  
                  104,414
                  
                  
                  
                  97,706Goodwill
                  
                  
                  583,269
                  
                  
                  
                  -Acquired
      intangibles, net
                  
                  
                  3,197,344
                  
                  
                  
                  -Other
      assets
                  
                  
                  140,278
                  
                  
                  
                  38,513$
                  194,849,414
                  
                  
                  $
                  122,714,590LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Notes
      payable
                  
                  $
                  21,944,904
                  
                  
                  $
                  15,743,504Line
      of credit
                  
                  
                  -
                  
                  
                  
                  1,369,000Accounts
      payable and accrued liabilities
                  
                  
                  11,969,849
                  
                  
                  
                  662,662Other
      payable, related parties
                  
                  
                  6,287,102
                  
                  
                  
                  -Accrued
      business tax
                  
                  
                  541,670
                  
                  
                  
                  498,792Customer
      deposits
                  
                  
                  14,474,178
                  
                  
                  
                  5,278,534Income
      tax payable
                  
                  
                  2,802,110
                  
                  
                  
                  1,902,443Total
      current liabilities
                  
                  
                  58,019,813
                  
                  
                  
                  25,454,935STOCKHOLDERS'
      EQUITYPreferred
      stock, $0.001 par value, 5,000,000 shares authorized, none issued and
      outstanding
                  
                  
                  -
                  
                  
                  
                  -Common
      stock, $0.001 par value, 100,000,000 shares authorized, shares issued and
      outstanding - 22,005,509 for 2008 and 20,924,843 for 2007
                  
                  
                  22,006
                  
                  
                  
                  20,925Additional
      paid in capital
                  
                  
                  82,503,638
                  
                  
                  
                  77,449,355Accumulated
      foreign currency translation adjustments
                  
                  
                  9,620,524
                  
                  
                  
                  2,985,035Retained
      earnings
                  
                  
                  44,683,433
                  
                  
                  
                  16,804,340Total
      stockholders' equity
                  
                  
                  136,829,601
                  
                  
                  
                  97,259,655$
                  194,849,414
                  
                  
                  $
                  122,714,590





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


F-3


FUQI
INTERNATIONAL, INC.


CONSOLIDATED
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME




YearsEndedDecember31,2008
                
                
                2007
                
                
                2006Net
      sales:Wholesale
      and distribution
                
                $
                356,471,362
                
                
                $
                144,313,478
                
                
                $
                92,408,539Retail
                
                
                11,134,243
                
                
                
                1,245,189
                
                
                
                -367,605,605
                
                
                
                145,558,667
                
                
                
                92,408,539Cost
      of sales:Wholesale
      and distribution
                
                
                313,645,557
                
                
                
                128,110,346
                
                
                
                83,618,526Retail
                
                
                8,975,792
                
                
                
                934,531
                
                
                
                -322,621,349
                
                
                
                129,044,877
                
                
                
                83,618,526Gross
      profit
                
                
                44,984,256
                
                
                
                16,513,790
                
                
                
                8,790,013Operating
      expenses:Selling
      and marketing
                
                
                4,909,581
                
                
                
                1,105,168
                
                
                
                490,191General
      and administrative
                
                
                6,715,682
                
                
                
                2,919,140
                
                
                
                793,453Total
      operating expenses
                
                
                11,625,263
                
                
                
                4,024,308
                
                
                
                1,283,644Income
      from operations
                
                
                33,358,993
                
                
                
                12,489,482
                
                
                
                7,506,369Other
      income (expenses):Interest
      expense
                
                
                (1,436,661
                )
                
                
                (1,238,505
                )
                
                
                (798,868
                )Interest
      income
                
                
                122,792
                
                
                
                166,230
                
                
                
                69,628Change
      of fair value of inventory loan payable
                
                
                -
                
                
                
                (46,083
                )
                
                
                -Exemption
      of tax liabilities and estimated penalty payable
                
                
                -
                
                
                
                4,161,533
                
                
                
                -Gain
      from derivative instrument
                
                
                2,362,421
                
                
                
                79,734
                
                
                
                -Miscellaneous
                
                
                332,901
                
                
                
                573
                
                
                
                12,564Total
      other income (expenses)
                
                
                1,381,453
                
                
                
                3,123,482
                
                
                
                (716,676
                )Income
      before provision for income taxes
                
                
                34,740,446
                
                
                
                15,612,964
                
                
                
                6,789,693Provision
      for income taxes
                
                
                6,861,353
                
                
                
                2,097,050
                
                
                
                995,462Net
      income
                
                
                27,879,093
                
                
                
                13,515,914
                
                
                
                5,794,231Other comprehensive
      income - foreign currency translation adjustments
                
                
                6,635,489
                
                
                
                2,552,910
                
                
                
                288,419Comprehensive
      income
                
                $
                34,514,582
                
                
                $
                16,068,824
                
                
                $
                6,082,650Earnings
      per share – basic
                
                $
                1.32
                
                
                $
                0.96
                
                
                $
                0.51Earnings
      per share – diluted
                
                $
                1.32
                
                
                $
                0.86
                
                
                $
                0.50Weighted
      average number of common shares - basic
                
                
                21,142,457
                
                
                
                14,105,791
                
                
                
                11,260,544Weighted
      average number of common shares- diluted
                
                
                21,142,457
                
                
                
                15,627,494
                
                
                
                11,631,549





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


F-4


FUQI
INTERNATIONAL, INC.


CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY


Years
Ended December 31, 2008, 2007 and 2006





Common Stock
                
                
                Additional
                
                
                Other
                  Comprehensive
                
                
                Retained
                
                
                Total
                  Stockholders'Shares
                
                
                Amount
                
                
                Paid in Capital
                
                
                Income
                
                
                Earnings
                
                
                EquityBalance,
      December 31, 2005
                
                
                11,175,543
                
                
                $
                11,176
                
                
                $
                7,217,740
                
                
                $
                143,706
                
                
                $
                233,921
                
                
                $
                7,606,543Reverse
      acquisition of Fuqi BVI
                
                
                1,082,081
                
                
                
                1,082
                
                
                
                (5,610
                )
                
                
                -
                
                
                
                -
                
                
                
                (4,528
                )Dividend
      paid
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (2,739,726
                )
                
                
                (2,739,726
                )Foreign
      currency translation adjustments
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                288,419
                
                
                
                -
                
                
                
                288,419Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                5,794,231
                
                
                
                5,794,231Balance,
      December 31, 2006
                
                
                12,257,624
                
                
                
                12,258
                
                
                
                7,212,130
                
                
                
                432,125
                
                
                
                3,288,426
                
                
                
                10,944,939Issuance
      of common stock related to initial public offering, net of financing
      cost
                
                
                8,088,888
                
                
                
                8,089
                
                
                
                66,780,438
                
                
                
                -
                
                
                
                -
                
                
                
                66,788,527Issuance
      of common stock for exercise of stock warrants
                
                
                578,331
                
                
                
                578
                
                
                
                2,754,931
                
                
                
                -
                
                
                
                -
                
                
                
                2,755,509Fair
      value of stock options granted to executives and directors
                
                
                -
                
                
                
                -
                
                
                
                701,856
                
                
                
                -
                
                
                
                -
                
                
                
                701,856Foreign
      currency translation adjustments
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                2,552,910
                
                
                
                -
                
                
                
                2,552,910Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                13,515,914
                
                
                
                13,515,914Balance,
      December 31, 2007
                
                
                20,924,843
                
                
                
                20,925
                
                
                
                77,449,355
                
                
                
                2,985,035
                
                
                
                16,804,340
                
                
                
                97,259,655Issuance
      of common stock on acquisition of a business, net of financing
      cost
                
                
                1,080,666
                
                
                
                1,081
                
                
                
                4,020,079
                
                
                
                -
                
                
                
                -
                
                
                
                4,021,160Fair
      value of stock options granted to executives and directors
                
                
                -
                
                
                
                -
                
                
                
                1,034,204
                
                
                
                -
                
                
                
                -
                
                
                
                1,034,204Foreign
      currency translation adjustments
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                6,635,489
                
                
                
                -
                
                
                
                6,635,489Net
      income
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                27,879,093
                
                
                
                27,879,093Balance,
      December 31, 2008
                
                
                22,005,509
                
                
                $
                22,006
                
                
                $
                82,503,638
                
                
                $
                9,620,524
                
                
                $
                44,683,433
                
                
                $
                136,829,601





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


F-5


FUQI
INTERNATIONAL, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(Decrease)
Increase in Cash





Years Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Cash
      flows provided by operating activities:Net
      income
                  
                  $
                  27,879,093
                  
                  
                  $
                  13,515,914
                  
                  
                  $
                  5,794,231Adjustments to reconcile net
      income to net cash provided by (used for)
      operating activities:Depreciation
      and amortization
                  
                  
                  622,267
                  
                  
                  
                  326,784
                  
                  
                  
                  326,852Provision
      for (reversal of provision for) bad debt
                  
                  
                  1,103,249
                  
                  
                  
                  251,746
                  
                  
                  
                  (115,592
                  )Stock
      based compensation
                  
                  
                  1,034,204
                  
                  
                  
                  701,856
                  
                  
                  
                  -Exemption
      of tax liabilities and estimated penalty payable
                  
                  
                  -
                  
                  
                  
                  (4,161,534
                  )
                  
                  
                  -Loss
      on disposal of fixed assets
                  
                  
                  18,270
                  
                  
                  
                  -
                  
                  
                  
                  -Changes
      in operating assets and liabilities, net of effects of acquisition in
      2008:Accounts
      receivable
                  
                  
                  (48,922,304
                  )
                  
                  
                  (13,590,622
                  )
                  
                  
                  (1,958,441
                  )Value
      added taxes receivable
                  
                  
                  1,632,680
                  
                  
                  
                  (2,153,866
                  )
                  
                  
                  387,787Inventories
                  
                  
                  (3,361,938
                  )
                  
                  
                  (22,292,543
                  )
                  
                  
                  (109,243
                  )Inventory
      loan receivable
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  697,530Prepaid
      expenses and other current assets
                  
                  
                  47,678
                  
                  
                  
                  (809,178
                  )
                  
                  
                  (24,903
                  )Advance
      to supplier
                  
                  
                  (7,632,120
                  )
                  
                  
                  (744,013
                  )
                  
                  
                  -Gold
      future contracts
                  
                  
                  (1,407,762
                  )
                  
                  
                  -
                  
                  
                  
                  -Deposits
      - short term
                  
                  
                  -
                  
                  
                  
                  757,875
                  
                  
                  
                  (376,932
                  )Deposits
      related to borrowing on notes payable / long term debt
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (8,004
                  )Deferred
      taxes
                  
                  
                  (57,006
                  )
                  
                  
                  (46,395
                  )
                  
                  
                  (5,654
                  )Other
      assets
                  
                  
                  (78,950
                  )
                  
                  
                  4,215
                  
                  
                  
                  (35,504
                  )Accounts
      payable and accrued liabilities
                  
                  
                  10,766,389
                  
                  
                  
                  906,006
                  
                  
                  
                  257,800Other
      payable, related parties
                  
                  
                  919,555
                  
                  
                  
                  -
                  
                  
                  
                  -Customer
      deposits
                  
                  
                  8,718,812
                  
                  
                  
                  3,811,563
                  
                  
                  
                  (1,614,529
                  )Income
      tax payable
                  
                  
                  759,131
                  
                  
                  
                  1,785,619
                  
                  
                  
                  821,571Net
      cash (used for) provided by operating activities
                  
                  
                  (7,958,752
                  )
                  
                  
                  (21,736,573
                  )
                  
                  
                  4,036,969Cash
      flows provided by (used for) investing activities:Purchase
      of property, equipment and improvements
                  
                  
                  (1,023,758
                  )
                  
                  
                  (373,080
                  )
                  
                  
                  (31,873
                  )Disbursements
      on loans to stockholder
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (51,529,693
                  )Proceeds
      from collections on loans to stockholder
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  58,409,847Business
      acquisition
                  
                  
                  (6,498,195
                  )
                  
                  
                  -
                  
                  
                  
                  -Decrease
      (Increase) in restricted cash
                  
                  
                  433,213
                  
                  
                  
                  (395,413
                  )
                  
                  
                  2,764,166Net
      cash (used for) provided by investing activities
                  
                  
                  (7,088,740
                  )
                  
                  
                  (768,493
                  )
                  
                  
                  9,612,447


F-6


FUQI
INTERNATIONAL, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


Increase
(Decrease) in Cash - continued





Year Ended December
      31,2008
                
                
                2007
                
                
                2006Cash
      flows provided by (used for) financing activities:Proceeds
      from short-term borrowing
                
                $
                3,610,109
                
                
                $
                1,977,066
                
                
                $
                -Advance
      from a related party
                
                
                953,069
                
                
                
                -
                
                
                
                -Proceeds
      from exercise of warrants, net of financing cost
                
                
                -
                
                
                
                2,755,509
                
                
                
                -Reverse
      acquisition of Fuqi BVI
                
                
                -
                
                
                
                -
                
                
                
                (4,528
                )Repayment
      to a related party
                
                
                -
                
                
                
                -
                
                
                
                (1,005,151
                )Issuance
      of common stock related initial public offering, net of financing
      cost
                
                
                -
                
                
                
                66,788,527
                
                
                
                -Proceeds
      from loans borrowed from stockholder
                
                
                -
                
                
                
                203,506
                
                
                
                23,545,485Repayments
      to loans payable to stockholder
                
                
                -
                
                
                
                (642,295
                )
                
                
                (23,130,562
                )Net
      cash provided by (used for) financing activities
                
                
                4,563,178
                
                
                
                71,082,313
                
                
                
                (594,756
                )Effect
      of exchange rate changes on cash
                
                
                3,760,394
                
                
                
                1,361,425
                
                
                
                228,842Net
      (decrease) increase in cash
                
                
                (6,723,920
                )
                
                
                49,938,672
                
                
                
                13,283,502Cash, beginning of
      year
                
                
                63,293,653
                
                
                
                13,354,981
                
                
                
                71,479Cash, end of
      year
                
                $
                56,569,733
                
                
                $
                63,293,653
                
                
                $
                13,354,981Supplemental
      disclosure of cash flow information:Interest
      paid
                
                $
                1,388,040
                
                
                $
                1,210,667
                
                
                $
                786,941Income
      taxes paid
                
                $
                6,157,628
                
                
                $
                357,826
                
                
                $
                71,479Non-cash
      activities:Issuance
      of common stock for the acquisition of Temix acquisition
                
                $
                4,021,160
                
                
                $
                -
                
                
                $
                -Non
      monetary exchanges related to certain retail sales
                
                $
                1,107,680
                
                
                $
                -
                
                
                $
                -Transfer
      of acquisition deposit as a payment of the purchase price of business
      acquisition
                
                $
                722,022
                
                
                $
                -
                
                
                $
                -Decrease
      in due from stockholder for dividend declared and paid
                
                $
                -
                
                
                $
                -
                
                
                $
                2,739,726





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




F-7




FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
              Summary
      of Significant Accounting
Policies:





Organization,
Nature of Business and Basis of Presentation




Fuqi
International, Inc. (“Fuqi” or “the Company”) operates through its wholly-owned
subsidiary Fuqi International Holdings Co., Ltd., a British Virgin Islands
corporation (“Fuqi BVI”) and its wholly-owned subsidiary, Shenzhen Fuqi Jewelry
Co., Ltd., (“Shenzhen Fuqi”) a company established under the laws of the
People’s Republic of China.





On
November 20, 2006, Fuqi BVI entered into a share exchange agreement with VT
Marketing Services, Inc. (“VT”) and Mr. Yu Kwai Chong, who is the Company’s
current Chief Executive Officer and Chairman of the Board of the Directors, to
effect a reverse merger transaction (the “Reverse Merger”). Pursuant to the
Reverse Merger, Mr. Chong, as the sole shareholder of Fuqi BVI, agreed to
exchange all of his shares of Fuqi BVI for shares of VT and VT agreed to acquire
all of the issued and outstanding capital stock of Fuqi BVI. VT was formed as
part of the implementation of the Chapter 11 reorganization plan (the “Visitalk
Plan”) of visitalk.com, Inc., which became effective on September 17, 2004. The
Reverse Merger closed on November 22, 2006 and VT issued an aggregate of
11,175,543 shares of common stock in exchange for all of the issued and
outstanding securities of Fuqi BVI. Upon the close of the Reverse Merger, VT
became the 100% parent of Fuqi BVI and assumed the operations of Fuqi BVI and
its subsidiary as its sole business. On November 8, 2006, VT reincorporated from
Arizona to Nevada and on December 8, 2006, after the Reverse Merger, VT
reincorporated from the Nevada to Delaware and changed its corporate name from
“VT Marketing Services, Inc.” to “Fuqi International, Inc.” The transactions
contemplated by the Reverse Merger were intended to be a “tax-free” transaction
pursuant to the provisions of Section 351 of the Internal Revenue Code of 1986,
as amended.





For
financial accounting purposes, the Reverse Merger was treated as a reverse
acquisition by Fuqi BVI, under the purchase method of accounting, and was
treated as a recapitalization with Fuqi BVI as the accounting acquirer.
Accordingly, the Company’s historical financial statements have been prepared to
give retroactive effect to the reverse acquisition completed on November 22,
2006, and represent the operations of Fuqi BVI and its wholly-owned subsidiary,
Shenzhen Fuqi.





The
Company operates in two divisions: (i) wholesale of jewelry products and (ii)
retail jewelry products. The wholesale division is responsible for designing,
manufacturing, selling and marketing its products to other wholesalers and
distributors. Since May 2007, the Company has been expanding its retail jewelry
strategy. This retail strategy focuses on customer segmentation with emphasis on
expansion of its product range to meet differing customer requirements in the
various regions.  In 2007, the Company formally started operating retail
jewelry counters under the brand name of “FUQI,” which is targeted to a broad
group of middle class consumers that purchase more traditional gold and platinum
jewelry and jewelry gift items. In August 2008, the Company acquired Temix, a
jewelry retail chain with 50 jewelry counters and shops offering high quality
diamond products, located in Beijing and Shanghai.  As of December 31,
2008, the Company had 69 jewelry retail counters and stores in
China.





Consolidation
Policy





The
consolidated financial statements include the consolidated financial statements
of Fuqi International and its wholly owned subsidiaries, Fuqi BVI and Shenzhen
Fuqi. All significant intercompany accounts and transactions have been
eliminated in preparation of the consolidated financial
statements.


F-8


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Cost
of Sales





Cost of
sales includes raw material, direct labor and overhead costs. Overhead costs
consist of depreciation for improvements related to the Company’s factory and
machinery and equipment, indirect labor, utilities, factory rent and warehouse
costs. The Company does not incur any significant amount of inbound freight
charges, purchasing and receiving costs since the Company’s raw material,
including primarily gold and platinum, are handled by the Company’s operation
manager. All the costs related to the Company’s distribution network are
included in the cost of sales.





Operating
Costs





Selling
and marketing expenses include salaries and employee benefits, advertising,
travel and entertainment, insurance, amortization of cost for operation rights
acquired, business taxes and occupancy costs at department stores.





General
and administrative expenses include management and office salaries and employee
benefits, deprecation for office facility and office equipment, travel and
entertainment, insurance, legal and accounting, consulting fees, workers’
compensation insurance, and other office expenses.





Revenue
Recognition





Wholesale
revenue is recognized upon delivery and acceptance of jewelry products by the
customers while retail revenue is recognized upon receipts and acceptance of
jewelry products by the customers, provided that the other conditions of sales,
as established by the Securities and Exchange Commission’s Staff Accounting
Bulletin (“SAB”) No. 104, are satisfied:





·
            persuasive
      evidence of an arrangement exists;


·
            delivery
      has occurred, upon shipment when title passes, or services have been
      rendered;


·
            the
      seller’s price to the buyer is fixed or determinable;
  and


·
            collectibitliy
      is reasonably assured.




Value
Added Taxes represent amounts collected on behalf of specific regulatory
agencies that require remittance by a specified date. These amounts are
collected at the time of sales and are detailed on invoices provided to
customers. In compliance with the Emerging Issues Task Force consensus on issue
number 06-03 (EITF 06-03), the Company accounts for value added taxes on a net
basis.





Currency
Reporting





The
Company’s operations in China use the local currency - Renminbi (“RMB”) as their
functional currency whereas amounts reported in the accompanying consolidated
financial statements and disclosures are stated in United States Dollars, the
reporting currency of the Company, unless stated otherwise. As such, the
consolidated balance sheets of the Company have been translated into U.S.
dollars at the current rates as of December 31, 2008 and 2007 and the
consolidated statements of income have been translated into U.S. dollars at the
weighted average rates during the periods the transactions were
recognized.





The
resulting translation gain adjustments are recorded as other comprehensive
income in the consolidated statements of income and comprehensive income and as
a separate component of consolidated statements of stockholders’
equity.





Reverse
Stock Split





On August
23, 2007, the Company’s Board of Directors unanimously authorized a 1.69-to-1
reverse stock split of the Company’s common stock. The reverse stock split
became effective on October 22, 2007. All references to shares in the
consolidated financial statements and the accompanying notes, including but not
limited to the number of shares and per share amounts, unless otherwise noted,
have been adjusted to reflect the reverse stock split
retroactively.


F-9


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Basic
and Diluted Earnings Per Share





The basic
earnings per common share is computed by dividing net income available to common
stockholders by the weighted average number of common shares outstanding.
Diluted income per common share is computed similarly to basic income per common
share, except that the denominator is increased to include the number of
additional common shares that would have been outstanding if the potential
common shares had been issued and if the additional common shares were dilutive.
In accordance with the Visitalk Plan (See Note 12), the Company issued six
series of common stock purchase warrants allowing holders to purchase additional
shares of common stock (“Plan Warrants”). The Company delivered a notice of
redemption to the warrant holders in May 2007, and all of the warrants were
either exercised or redeemed and cancelled in June 2007.  As of December
31, 2008 and 2007, the Company did not have any common stock equivalents that
were issuable upon the exercise of the plan warrants. Contingency shares of
540,333 issued and held in the escrow were excluded from the calculations as the
contingency has not yet been resolved as of December 31, 2008. As of December
31, 2008 and 2007, the Company had common stock equivalents of 1,441,776 and
1,320,000, respectively, upon the exercise of the stock options which were
excluded from the computation of diluted earnings per share as their effect is
not dilutive. The computation of dilutive potential common shares for the
periods is shown as follows:





December31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006Basic
      weighted average shares
                                        
                                        
                                        21,142,457
                                        
                                        
                                        
                                        14,105,791
                                        
                                        
                                        
                                        11,260,544Effect
      of dilutive securities
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,521,703
                                        
                                        
                                        
                                        370,915Dilutive
      potential common shares
                                        
                                        
                                        21,142,457
                                        
                                        
                                        
                                        15,627,494
                                        
                                        
                                        
                                        11,631,459





Share-Based
Payment





In
accordance with SFAS No. 123R, “Share-based Payment: An amendment of FASB
Statement No. 123” (“SFAS 123R”), effective January 1, 2006, the Company is
required to recognize compensation expense related to stock options granted to
employees based on: (a) compensation cost for all share-based payments granted
prior to, but not yet vested as of December 31, 2005, based on the grant date
fair value estimated in accordance with SFAS No 123, “Accounting for Stock-Based
Compensation” (“SFAS 123”), and (b) compensation cost for all share-based
payments granted subsequent to December 31, 2005, based on the grant-date fair
value estimated in accordance with the provisions of SFAS123R. 123R requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from initial estimates. The
Company did not issue any stock options in 2006 and had no outstanding options
as of December 31, 2006. On October 26, 2007, the Company granted options to
purchase a total of 1,320,000 shares of its common stock to two executives and
four directors. The Company expected these options to be fully vested and
therefore did not account for any forfeiture as the vesting periods of these
options are relatively short. The Company uses the Black-Scholes option-pricing
model to value stock option awards and expensed the stock-based compensation
based on the vesting periods.





The fair
value of these options was calculated using the following assumptions:
(1) risk-free interest rates of 3.8% to 4.0%, (2) an expected life of
one to two years, (3) expected volatility of 28%, (4) expected
forfeitures of 0%, and (5) a dividend yield of 0%. Because there was no
public market or trading history at the time of the grant in October 2007 and in
accordance with SFAS 123R, the Company computed the expected volatility based on
the average historical volatilities of entities in the similar industries and
sizes. For the years ended December 31, 2008 and 2007, approximately
$594,000 and $702,000, respectively, were expensed related to the grant of these
options.


F-10


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Share-Based
Payment (continued)





On
December 31, 2008, in accordance with a year end performance condition in
the Employment Agreements of three executive officers, $440,000 in value of
share options were granted.  The value was determined based on a
certain percentage of the Company’s annual income before taxes not to exceed an
aggregate value of $440,000.   Options to purchase totaling
121,776 shares were granted to these three executive officers on December 31,
2008.  The number of options granted was computed based on the
aggregate value of $440,000 dividing by the fair value of each option measured
on December 31, 2008 using the Black-Scholes option pricing
model.   The Company expensed the full amount during the year
ended December 31, 2008.





The fair
value of these options was calculated using the following assumptions:
(1) risk-free interest rates of 1.55%, (2) an expected life of five
years, (3) expected volatility of 71%, (4) expected forfeitures of 0%,
and (5) a dividend yield of 0%. For the year ended December 31, 2008,
approximately $440,000 was expensed related to the grant of these
options.




Use
of Estimates





The
preparation of consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the dates of the consolidated financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those
estimates.





Cash





For
purposes of the consolidated statements of cash flows, cash equivalents include
all highly liquid debt instruments with original maturities of three months or
less which are not securing any corporate obligations. The Company had no cash
equivalents at December 31, 2008 and 2007. As of December 31, 2008 and 2007,
majority of the cash, including restricted cash, were in RMB dollars maintained
by the PRC financial institutions under the Company’s wholly PRC subsidiary,
Shenzhen Fuqi. Cash remittance in or out of PRC are subject to PRC foreign
exchange control regulations pursuant to which PRC government approval is
required for Shenzhen Fuqi to receive funds from or distribute funds to outside
PRC.





Restricted
Cash





As of
December 31, 2008 and 2007, the Company was required to maintain a fixed deposit
of $0 and $410,700 respectively as a condition to borrow under a bank loan
agreement. The amount was classified as restricted cash as of December 31, 2008
and 2007.





Fair
Value and Fair Value Disclosures of Financial Instruments





The
Company adopted Statement of Financial Accounting Standards (“SFAS”)
No. 157, “Fair Value Measurements” (“SFAS 157”) on January 1, 2008 for
all financial assets and liabilities and nonfinancial assets and liabilities
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually). SFAS 157 defines fair value,
establishes a framework for measuring fair value, and expands disclosures about
fair value measurements.





SFAS 157
defines fair value as the price that would be received from selling an asset or
paid to transfer a liability in an orderly transaction between market
participants at the measurement date. When determining the fair value
measurements for assets and liabilities required or permitted to be recorded at
fair value, the Company considers the principal or most advantageous market in
which it would transact and it considers assumptions that market participants
would use when pricing the asset or liability.


F-11


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Fair
Value and Fair Value Disclosures of Financial Instruments
(continued)





SFAS 157
establishes a fair value hierarchy that requires an entity to maximize the use
of observable inputs and minimize the use of unobservable inputs when measuring
fair value. A financial instrument’s categorization within the fair value
hierarchy is based upon the lowest level of input that is significant to the
fair value measurement. SFAS 157 establishes three levels of inputs that may be
used to measure fair value:





Level
1


Level 1
applies to assets or liabilities for which there are quoted prices in active
markets for identical assets or liabilities.





Level
2


Level 2
applies to assets or liabilities for which there are inputs other than quoted
prices included within Level 1 that are observable for the asset or liability
such as quoted prices for similar assets or liabilities in active markets;
quoted prices for identical assets or liabilities in markets with insufficient
volume or infrequent transactions (less active markets); or model-derived
valuations in which significant inputs are observable or can be derived
principally from, or corroborated by, observable market data.





Level
3


Level 3
applies to assets or liabilities for which there are unobservable inputs to the
valuation methodology that are significant to the measurement of the fair value
of the assets or liabilities.





The
Company has estimated the fair value amounts of its financial instruments using
the available market information and valuation methodologies considered to be
appropriate and has determined that the book value of the Company’s accounts
receivable, value added taxes receivable, inventories, notes payable, accounts
payable and accrued expenses, other payable, accrued business tax, customer
deposits, and income tax payable at December 31, 2008 and 2007 approximate fair
value. The fair value of the gold future contracts was measured based on the
quoted market prices for gold as of December 31, 2008.





Comprehensive
Income





Statement
on Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive
Income,” establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. For the years ended
December 31, 2008, 2007, and 2006, other comprehensive income includes foreign
currency translation adjustments.





Commitments
and Contingencies





Liabilities
for loss contingencies arising from claims assessments and litigation and other
sources are recorded when it is probable that a liability has been incurred and
the amount of assessment can be realized. In the opinion of management, after
consultation with legal counsel, there are no claims assessments and litigation
against the Company.





Accounts
Receivable





The
Company provides an allowance for doubtful accounts equal to the estimated
uncollectible amounts. The Company’s estimate is based on historical collection
experience and a review of the current status of trade accounts receivable. It
is reasonably possible that the Company’s estimate of the allowance for doubtful
accounts will change. Accounts receivable are presented net of an allowance for
doubtful accounts of approximately $1,620,000 and $470,000 at December 31, 2008
and 2007, respectively.


F-12


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Provision
for Returns





The
Company does not grant any rights of returns for its wholesale customers unless
the products are found defective.  The Company has not experienced any
significant amounts of returns since the inceptions of its
operations.





The
Company grants rights of return to its retail customers.  The Company
performed an analysis to estimate the amounts of subsequent returns after the
year end and found that the total amount of returns was insignificant to the
consolidated financial statements.





Concentration
of Credit Risk





The
Company’s product revenues are concentrated in production and sales of fine
jewelry products, which are highly competitive with frequent changes in styles
and fashion. Significant customer preference changes in the industry or customer
requirements, or the emergence of competitive products with better marketing
strategies and more well-known brand names, could adversely affect the Company’s
operating results.





Financial
instruments that potentially subject the Company to concentration of credit risk
consist principally of trade accounts receivable from jewelry retailers and
distributors located throughout China. The credit risk in the Company’s accounts
receivable is mitigated by the fact that the Company performs ongoing
credit evaluations of its customers’ financial condition and that accounts
receivable are primarily derived from large credit-worthy companies throughout
the PRC. In addition, the Company has a diversified customer base. Historically,
the Company has not experienced significant losses related to trade receivables.
Generally, no collateral is required.





Derivative
Instruments





SFAS No.
133, “Accounting for Derivative Instruments and Hedging Activities”, establishes
accounting and reporting standards for derivative instruments as either assets
or liabilities in the statement of financial position based on their fair
values. Changes in the fair values are required to be reported in earnings or
other comprehensive income depending on the use of the derivative and whether it
qualifies for hedge accounting. Derivative instruments are designated and
accounted for as a hedge of a recognized asset or liability (fair value hedge),
a hedge of a forecasted transaction (cash flow hedge) or a hedge of a foreign
currency transaction (foreign currency hedge). For derivatives designated as
effective cash flow hedges or foreign currency hedge, changes in fair values are
recognized in other comprehensive income. Changes in fair values related to fair
value hedges as well as the ineffective portion of cash flow hedges are
recognized in earnings. For derivatives not designated as a hedging instrument,
changes in fair values are recognized in earnings in the period of
change.





The
Company entered into certain gold future contracts with its supplier, Shanghai
Gold Exchange. Gold futures offered by Shanghai Gold Exchange are designed for
full members to hedge or to acquire inventory at a preset price. The Company
utilized these future contracts to manage its consolidated exposure to changes
in inventory values due to fluctuations in market prices and is not considered
as hedges. The Company’s gold futures positions are marked to market at each
reporting date and all unrealized gains and losses are recognized as
non-operating income in the consolidated statements of income.





Major
Customer




During
the year ended December 31, 2008, the Company did not have any customers
generating over 10% of the Company’s total net sales. During the year ended
December 31, 2007, 10% of the Company sales were generated from one customer,
which had an outstanding sales deposit of $342,666 as of December 31, 2007.
During the year ended December 31, 2006, 9% of the Company sales were generated
from one customer. Accounts receivable from this customer totaled $2,234,959,
which represented 22% of the total accounts receivable as of December 31,
2006.


F-13





FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Major
Supplier





Under PRC
law, supply of precious metals such as platinum, gold, and silver are highly
regulated under certain government agencies. The Shanghai Gold Exchange is the
Company’s primary source of supply for its raw materials, which consist of
precious metals. The Company is required to obtain several memberships and
approval certificates from these government agencies in order to continue to do
business involving precious metals. The Company may be required to renew such
memberships and to obtain approval certificates periodically. If the Company is
unable to renew these periodic membership or approval certificates, it could
materially affect the Company’s business operations. The Company was in good
standing with these agencies as of December 31, 2008 and 2007.  The
Company purchased approximately 95%, 100%, and 100% of its inventories from
Shanghai Gold Exchange, for the years ended December 31, 2008, 2007 and
2006.





Subsequent
to the acquisition of Temix, the Company also purchases materials from other
vendors for finished goods sold at the Temix retail counters.





Inventories





Inventories
consist of raw material, direct labor and manufacturing overhead
costs.  Inventories are primarily comprised of precious metals stated
at the lower of cost or market and include raw materials, work in process, and
finished goods. The first-in-first-out method is used to account for gold and
platinum jewelries and the specific identification method for diamond
jewelries.





Property,
Plant and Equipment





Property,
plant and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed on the straight-line
method based on the estimated useful life as follows:




Production
      equipment
                5
      yearsFurniture
      and fixtures
                5
      yearsComputer
      hardware and software
                3 -
      5 yearsAutomobiles
                4 -
      5 yearsLeasehold
      improvement
                2 - 5
      yearsBuilding
                20
      years




Goodwill





Goodwill
was acquired through the purchase transaction of Temix.  The excess of
the purchase price over the fair value of net assets acquired is recorded on the
consolidated balance sheet as goodwill. Goodwill is not amortized but is tested
for impairment annually or more frequently if events or changes in circumstances
indicate that it might be impaired. The Company performs its annual goodwill
impairment test during the fourth quarter of each fiscal year for all reporting
units. Goodwill is tested following a two-step process. The first step compares
the fair value of each reporting unit to its carrying amount, including
goodwill. If the fair value of each reporting unit exceeds its carrying amount,
goodwill is not considered to be impaired and the second step will not be
required. If the carrying amount of a reporting unit exceeds its fair value, the
second step compares the implied fair value of goodwill to the carrying value of
a reporting unit’s goodwill. The implied fair value of goodwill is determined in
a manner similar to accounting for a business combination with the allocation of
the assessed fair value determined in the first step to the assets and
liabilities of the reporting unit. The excess of the fair value of the reporting
unit over the amounts assigned to the assets and liabilities is the implied fair
value of goodwill. An impairment loss is recognized for any excess in the
carrying value of goodwill over the implied fair value of goodwill. . The
Company’s evaluation of goodwill completed during 2008 resulted in no impairment
losses.


F-14


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
            Summary
      of Significant Accounting Policies:
(continued)





Other
Intangible Assets





Other
acquired intangible assets with definite lives are amortized on a straight-line
basis over their expected economic useful lives. Other acquired intangible
assets with definite lives include non-compete agreement and strategic alliance
agreement. Trade names are the intangible asset with indefinite useful lives.
For intangible assets with definite lives, the Company periodically estimates
future undiscounted cash flows to be derived from an intangible asset with
definite life to determine whether a potential impairment exists when
events or circumstances indicate the carrying value of an intangible asset with
definite life may be impaired. If the carrying value exceeds the Company’s
estimate of future undiscounted cash flows, the Company then calculates the
impairment loss as the excess of the carrying value of the asset over the
Company’s estimate of its fair market value. For intangible assets with
indefinite lives, the Company performs its test annually or more frequently if
events or changes in circumstances indicate that the asset might be impaired
using a one-step (fair value to carrying value) test. The Company recognized no
impairment loss on intangible assets in 2008.





The
estimated economic useful lives of acquired intangible assets are as
follows:




Non-compete
      agreement
                  3
      yearsStrategic
      Alliance Agreement
                  2
      years





Long-Lived
Assets





In
accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,
“Accounting for the Impairment or Disposal of Long-Lived Assets,” long-lived
assets to be held and used are analyzed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. SFAS No. 144 relates to assets that can be amortized and for
which the life can be determinable. The Company evaluates at each balance sheet
date whether events and circumstances have occurred that indicate possible
impairment. If there are indications of impairment, the Company uses future
undiscounted cash flows of the related assets or asset grouping over the
remaining life in measuring whether the assets are recoverable. In the event
such cash flows are not expected to be sufficient to recover the recorded asset
values, the assets are written down to their estimated fair value. Long-lived
assets to be disposed of are reported at the lower of the carrying amount or
fair value of asset less disposal costs. The Company determined that there was
no impairment of long-lived assets as of December 31, 2008 and
2007.





Operating
Leases





The
Company enters into operating leases for its retail locations. Other than the
five retail shops which a monthly fixed rate of lease amount is charged, all
store lease agreements are provided with contingent rent provisions based on a
percentage of sales generated in the jewelry counters within department stores.
Majority of the Company’s lease agreements include renewal periods at its
option. Lease expenses are recorded in selling and marketing expenses in the
Company’s consolidated statements of income.





Non-monetary
(Barter) Exchanges





Barter
exchanges are incurred when retail customers trade-in their jewelries to obtain
barter credits that can be used in lieu of cash to buy jewelry products in the
Company’s retail counters. In accordance with APB 29 paragraph 20, as amended by
SFAS 153, as the fair value of the customers’ jewelry is not determinable, the
transaction was valued at the non-monetary asset relinquished in barter credits.
These transactions have not had significant impact to the Company’s consolidated
financial position, results of operations, or cash flows.





Advertising





The
Company expenses advertising costs when incurred. The Company incurred
approximately $166,000, $177,000, and $33,000 of advertising expense for the
years ended December 31, 2008, 2007, and 2006, respectively.


F-15


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
              Summary
      of Significant Accounting Policies:
(continued)





Income
Taxes





Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets, including tax loss and credit carryforwards, and liabilities are
measured using enacted tax rates in the applicable tax jurisdiction expected to
apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred
tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. Deferred income tax expense
represents the change during the period in the deferred tax assets and
deferred tax liabilities. The components of the deferred tax assets and
liabilities are individually classified as current and non-current based on
their characteristics. Realization of the deferred tax asset is dependent
on generating sufficient taxable income in future years.





Segment
Reporting





SFAS
No. 131 “Disclosures about Segments of an Enterprise and Related
Information,” established standards for reporting information about operating
segments in financial statements. Operating segments are defined as components
of an enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision maker, or decision making
group, in deciding how to allocate resources and assessing performance. Upon the
acquisition of Temix, the Company is considered to be comprised of two operating
segments: (i) wholesale and distribution and (ii) retail. The Company measures
segment profit as operating profit. All of the Company’s sales are generated in
the PRC and substantially all of the Company’s assets are located in the
PRC.





New Accounting
Pronouncements





In
September 2006, FASB issued Statement of Financial Accounting Standards (SFAS)
No. 157, “Fair Value Measurements” (“SFAS 157”). Effective January 1,
2008, the Company adopted the measurement and disclosure other than those
requirements related to nonfinancial assets and liabilities in accordance with
guidance from FASB Staff Position 157-2, “Effective Date of FASB Statement
No. 157,” which delayed the effective date of SFAS 157 for all nonfinancial
assets and nonfinancial liabilities, except for items that are recognized or
disclosed at fair value in the financial statements on a recurring basis (at
least annually), until the beginning of fiscal year 2009. The Company does not
expect the adoption of SFAS 157 for nonfinancial assets and liabilities will
have a significant effect on the Company’s consolidated financial
statements.





In
December 2007, the FASB issued SFAS No. 141, Business Combinations:
(Revised 2007) (“SFAS 141R”). SFAS 141R is relevant to all transactions or
events in which one entity obtains control over one or more other businesses.
SFAS 141R requires an acquirer to recognize any assets and noncontrolling
interest acquired and liabilities assumed to be measured at fair value as of the
acquisition date. Liabilities related to contingent consideration are recognized
and measured at fair value on the date of acquisition rather than at a later
date when the amount of the consideration may be resolved beyond a reasonable
doubt. This revised approach replaces SFAS 141’s cost allocation process in
which the cost of an acquisition was allocated to the individual assets acquired
and liabilities assumed based on their respective fair value. SFAS 141R requires
any acquisition-related costs and restructuring costs to be expensed as incurred
as opposed to allocating such costs to the assets acquired and liabilities
assumed as previously required by SFAS 141. Under SFAS 141R, an acquirer
recognizes liabilities for a restructuring plan in purchase accounting only if
the requirements of SFAS 146, Accounting for Costs Associated with Exit or
Disposal Activities, are met. SFAS 141R allows for the recognition of
pre-acquisition contingencies at fair value only if these contingencies are
likely to materialize. If this criterion is not met at the acquisition date,
then the acquirer accounts for the non-contractual contingency in accordance
with recognition criteria set forth under SFAS 5, Accounting for Contingencies,
in which case no amount should be recognized in purchase accounting. SFAS 141R
is effective as of the beginning of an entity’s first fiscal year that begins
after December 15, 2008. The Company is in the process of assessing the
potential impact the adoption of SFAS 141R may have on its consolidated
financial position or results of operations.


F-16


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
              Summary
      of Significant Accounting Policies:
(continued)





New
Accounting Pronouncements (continued)





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests
in Consolidated Financial Statements—An Amendment of ARB No. 51
(“SFAS 160”). This Statement amends ARB 51 to establish accounting and
reporting standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in
a subsidiary is an ownership interest in the consolidated entity and should be
reported as equity on the financial statements. SFAS 160 requires consolidated
net income to be reported at amounts that include the amounts attributable to
both the parent and the noncontrolling interest. Furthermore, disclosure of the
amounts of consolidated net income attributable to the parent and to the
noncontrolling interest is required on the face of the financial statements.
SFAS 160 is effective as of the beginning of an entity’s first fiscal year that
begins after December 15, 2008. The Company is in the process of assessing
the potential impact the adoption of SFAS 160 may have on its consolidated
financial position or results of operations.





In March
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 161,Disclosures about
Derivative Instruments and Hedging Activities, which requires additional
disclosure related to derivatives instruments and hedging activities. These
enhanced disclosures will discuss (a) how and why a company uses derivative
instruments, (b) how derivative instruments and related hedged items are
accounted for under FASB Statement No. 133 and its related interpretations
and (c) how derivative instruments and related hedged items affect a
company’s financial position, results of operations and cash flows.
SFAS No. 161 is effective for fiscal years beginning on or after
November 15, 2008, with earlier adoption allowed. The Company is currently
evaluating the impact of adopting SFAS No. 161.





In April
2008, the FASB issued FASB Staff Position FAS142-3: Determination of the Useful
Life of Intangible Assets. This FSP amends the factors that should be considered
in developing renewal or extension assumptions used to determine the useful life
of a recognized intangible asset under FASB Statement No. 142, Goodwill and
Other Intangible Assets. This FSP is effective for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years. Early
adoption is prohibited. The guidance for determining the useful life of a
recognized intangible asset in this FSP shall be applied prospectively to
intangible assets acquired after the effective date. The Company is in the
process of assessing the potential impact the adoption of FSP 142-3 may
have on its consolidated financial position or results of
operations.





In May
2008, the FASB issued Statement No. 162, The Hierarchy of Generally Accepted
Accounting Principles ("SFAS 162"). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of non-governmental entities that are
presented in conformity with GAAP. SFAS 162 directs the GAAP hierarchy to the
entity, not the independent auditors, as the entity is responsible for selecting
accounting principles for financial statements that are presented in conformity
with GAAP. SFAS 162 is effective 60 days following the Securities and Exchange
Commission’s approval of the Public Company Accounting Oversight Board
amendments to remove the GAAP hierarchy from the auditing standards. The Company
is currently evaluating the impact of adopting
SFAS No. 162.




In
June 2008, the FASB issued FASB Staff Position EITF 03-6-1, Determining
Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities. This FSP gives guidance on the computation of earnings
per share and the impact of share-based instruments that contain certain
nonforfeitable rights to dividends or dividend equivalents. The FSP is
effective for fiscal years beginning after December 31, 2008 and early
application is prohibited. The Company is in the process of assessing the
potential impact the adoption of FSP 03-6-1 may have on its consolidated
financial position or results of operations.




At a
November 24, 2008 meeting, the FASB ratified the consensus reached by the
Task Force in Issue No. 08-6: Equity Method Investment Accounting
Considerations (“EITF 08-6”). Because of the significant changes to the guidance
on subsidiary acquisitions and subsidiary equity transactions and the increased
use of fair value measurements as a result of Statements 141(R) and 160,
questions have arisen regarding the application of that accounting guidance to
equity method investments. EITF 08-6 provides guidance for entities that acquire
or hold investments accounted for under the equity method. This issue is
effective for transactions occurring in fiscal years and interim periods
beginning on or after December 15, 2008. Early adoption is not permitted.
The Company is in the process of assessing the potential impact the adoption of
EITF 08-6 may have on its consolidated financial position or results of
operations.


F-17





FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(1)
              Summary
      of Significant Accounting Policies:
(continued)





Reclassifications




Certain
reclassifications have been made to the 2007 and 2006 consolidated financial
statements to conform to the 2008 presentation.





(2)
              Acquisition
      of Temix:





On August
7, 2008, the Company closed the asset acquisition of Shanghai Tian Mei Jewelry
Co. Ltd. and Beijing Yinzhong Tian Mei Jewelry Co. Ltd. (collectively referred
to as “Temix” or the “Temix Companies”) pursuant to Asset Purchase Agreement
(the “Asset Purchase Agreement”) entered into on April 18, 2008 by and between
the Company, the Temix Companies and Mr. Chujian Huang, as the principal of the
Temix Companies. The Temix Companies are a branded jewelry store chain with 50
outlets located primarily in the Beijing and Shanghai regions. The acquisition
of the Temix Companies includes obtaining all of the Temix Companies’ stores,
counters, leases, registered trade name, exchange membership, fixed assets, and
inventories. The products sold in these outlets are primarily diamond and
gemstone jewelry, including ruby, jade, and karat gold. According to the terms
of the Asset Purchase Agreement, the Company, through its wholly-owned
subsidiary, acquired substantially all of the assets of the Temix Companies for
an aggregate purchase price of approximately $11.7 million (RMB80,000,000),
including transaction costs of approximately $31,251, and 20% of this amount
will be remitted six months after the closing date of this transaction, subject
to the Company’s review and verification of the inventory and any uncovered
inventory defects.   As of December 31, 2008, the Company paid a
total of $7.3 million (approximately 62.4% of the purchase
price).  The Company negotiated with Mr. Chujian Huang to extend the
due date for the remaining payments due to additional time needed to examine the
acquired inventories.  On March 21, 2009, the Company had a verbal
agreement with Mr. Huang to extend the due date of the remaining payments until
a future date to be determined at a later time. Based on the Company's
evaluation, the Company did not expect any adjustment to the inventory value.
The outstanding payable due to Mr. Chujian Huang in the amount of approximately
$4.4 million was included in other payable, related parties as of December 31,
2008.




On August
7, 2008, and as a part of the acquisition of Temix, the Company acquired all of
the intellectual property rights related to the business of the Temix Companies
pursuant to the Intellectual Property Transfer Agreement (“IP Transfer
Agreement”), which was entered into on April 18, 2008 by the Company’s
wholly-owned subsidiary and Mr. Huang. Pursuant to the IP Transfer Agreement,
Mr. Huang received 540,333 shares of the Company’s common stock at closing and
another 540,333 shares is being placed into an escrow account for the two-year
period following the closing and will only be transferred to Mr. Huang if the
business of the Temix Companies meets certain performance targets as set forth
in the IP Transfer Agreement. The value of the 540,333 shares was determined
based on the average market prices of the Company’s common stock during the two
day-period before and after the terms of the acquisitions were agreed on and
announced on April 18, 2008. The value of the shares held in escrow was not
included in computing the purchase price until the contingency is resolved. The
purchase price will be adjusted for the fair value of contingency shares when
the contingency is resolved and such additional shares become
distributable.





The
Company acquired substantially all the tangible, including inventories and
property and equipment, and intangible assets, including trade names and certain
strategic alliance agreements, of the Temix related assets and operations,
through the execution of these two agreements. Accordingly, the acquisition of
these assets is considered acquisition of the “Business” of Temix for accounting
and reporting purpose under SFAS141, “Business
Combinations”.


F-18


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(2)
            Acquisition of Temix:
      (continued)





The
Company’s purpose of the acquisition is to complement and diversify its existing
business and provide the opportunity to expose its retail presence in the
first-tier cities in China. The operating results of Temix have been included as
part of the Company’s retail segment since the date of acquisition.





The
transaction was recorded using the purchase method of accounting, and
accordingly, the acquired assets were recorded at their estimated fair values on
the acquisition date. The Company allocated the initial purchase price of $15.7
million to the tangible assets and intangible assets acquired based on their
estimated fair values. The purchase price does not include the contingent escrow
amount described above.




The
excess of initial purchase price over the preliminary estimated fair value of
net tangible and intangibles acquired was recorded as goodwill and is
attributable to the retail segment. Other acquired intangibles will be amortized
over a straight line basis based on the estimated useful lives. The amounts
recognized and their respective lives are shown in the following
table.





Identifiable Intangible
    Asset
                    
                    Value
                    
                    Estimated Useful LivesTrade
      names
                    
                    $
                    2,952,820
                    
                    IndefiniteNon-compete
      agreement
                    
                    
                    123,318
                    
                    3
      yearsStrategic
      Alliance Agreement
                    
                    
                    174,538
                    
                    2
      yearsTotal
                    
                    $
                    3,250,676




The
following table is a condensed consolidated balance sheet based on the current
assessment of fair values of the assets acquired as of August 7, 2008 and the
components of purchase price.




Inventories
                    
                    $
                    9,301,866Value
      added taxes receivable
                    
                    
                    1,576,415Property
      and equipment
                    
                    
                    1,006,854Intangible
      assets
                    
                    
                    3,250,676Goodwill
                    
                    
                    583,269Total
      assets acquired
                    
                    $
                    15,719,080Cash
                    
                    $
                    11,697,920Stock
                    
                    
                    4,021,160Total
      purchase price
                    
                    $
                    15,719,080




The fair
values of the intangible assets were determined using the Income
Approach-“Discounted Cash Flow Method” and “Relief from Royalty Method”. In
performing the purchase price allocation, the Company considered, among other
factors, forecast financial performance of acquired business, market
performance, and market potentials of acquired business in China. The acquired
goodwill is not deductible for tax purposes.


F-19


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(2)
              Acquisition of Temix:
      (continued)





The
following unaudited pro forma combined results of operations of the Company
assume that the Temix acquisition was completed as of the beginning of periods
presented below.




YearendedDecember31,2008
                  
                  
                  2007
                  
                  
                  2006Net
      sales
                  
                  $
                  374,912,544
                  
                  
                  $
                  155,472,060
                  
                  
                  $
                  101,028,491Income
      from operations
                  
                  
                  33,742,784
                  
                  
                  
                  12,642,1460
                  
                  
                  
                  7,410,384Net
      income
                  
                  
                  28,291,515
                  
                  
                  
                  13,595,108
                  
                  
                  
                  5,898,333Earnings
      per share - basic
                  
                  $
                  1.34
                  
                  
                  $
                  0.93
                  
                  
                  $
                  0.50Earnings
      per share - diluted
                  
                  $
                  1.34
                  
                  
                  $
                  0.84
                  
                  
                  $
                  0.48





The pro
forma results above are not necessarily indicative of the operating results that
would have actually occurred if the acquisitions had been in effect on the date
indicated, nor are they necessarily indicative of future results of the combined
companies.




(3)
Inventories:





A summary
of inventory is as follows:





December31,2008
                    
                    
                    2007Raw
      Materials
                    
                    $
                    2,438,800
                    
                    
                    $
                    61,570Work
      in progress
                    
                    
                    12,710,735
                    
                    
                    
                    12,588,152Finished
      goods
                    
                    
                    7,781,159
                    
                    
                    
                    13,732,098Merchandise
      - retail
                    
                    
                    21,478,951
                    
                    
                    
                    3,257,416$
                    44,409,645
                    
                    
                    $
                    29,639,236




Inventories
are stated at the lower of cost or market. The first-in-first-out method is used
to account for gold and platinum jewelries and the specific identification
method for diamond jewelries.


F-20


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(4)
Property, Plant and Equipment:





A summary
of property, plant and equipment is as follows:





December31,2008
                              
                              
                              2007Production
      equipment
                              
                              $
                              1,578,682
                              
                              
                              $
                              1,108,045Computer
      hardware and software
                              
                              
                              255,376
                              
                              
                              
                              52,697Furniture
      and fixtures
                              
                              
                              220,441
                              
                              
                              
                              114,403Automobiles
                              
                              
                              637,137
                              
                              
                              
                              486,539Leasehold
      improvement
                              
                              
                              1,964,445
                              
                              
                              
                              448,000Building
                              
                              
                              622,906
                              
                              
                              
                              582,8865,278,987
                              
                              
                              
                              2,792,570Less
      accumulated depreciation and amortization
                              
                              
                              1,878,345
                              
                              
                              
                              1,296,709$
                              3,400,642
                              
                              
                              $
                              1,495,861





Depreciation
and amortization expense for property, equipment, and improvements amounted to
approximately $577,000, $327,000, and $327,000 for the years ended December 31,
2008, 2007, and 2006, respectively.




(5)
Acquired Intangible Assets:




Acquired
intangible assets, net consisted of the following:





December 31,2008
                            
                            
                            2007Trade
      names
                            
                            $
                            2,952,820
                            
                            
                            $
                            -Non-compete
      agreement
                            
                            
                            123,318
                            
                            
                            
                            -Strategic
      alliance agreement
                            
                            
                            174,538
                            
                            
                            
                            -Total
                            
                            $
                            3,250,676
                            
                            
                            $
                            -Less:
      accumulated amortization
                            
                            
                            (53,332
                            )
                            
                            
                            -Acquired
      intangible assets, net
                            
                            $
                            3,197,344
                            
                            
                            $
                            -




Amortization
expenses for the years ended December 31, 2008, 2007, and 2006 were
approximately $53,000, nil and nil, respectively.





Amortization
expense is estimated to be $128,375 in 2009, $92,013 in 2010, and $24,136 in
2011 and the weighted average amortization lives are approximately 2.26
years.


F-21


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(6)
Retail Operation Lease Agreements:





In
April 2007, the Company entered into a transfer agreement with an unrelated
party (the “Transferor”), which has operation agreements with department stores
for five jewelry retail counters. Under the terms of the agreement, the
Transferor agreed to assign all of the operation rights to the Company for a fee
of $400,000. The fee is payable in three separate installments. The first
payment of $120,000 is due upon completion of the transfer of the operation
rights by the department stores to the Company. The second installment of
$120,000 is due within 30 days after the remittance of the first installment
while the final installment of $160,000 is due within 90 days after the
remittance of the first installment.





During
the time of finalizing the transfer of operation rights by the department stores
to the Company, the Company obtained temporary operation rights from the
Transferor to operate these counters. Revenue derived from these five retail
counters from the period of May to November 2007 (before execution of the
cancellation agreement) amounted to $937,000.





On
October 28, 2007, due to the operation rights not being properly transferred
from the Transferor to the Company within a reasonable period of time, the
Company entered into a cancellation agreement with the Transferor to terminate
the transfer transaction effective November 30, 2007. Pursuant to the
cancellation agreement, the Company was not obligated to pay the transfer fee of
$400,000. All the inventory remained in the five counter stores at the last day
of the operation was sold to the Transferor based on the pre-determined price.
As of December 31, 2008 and 2007, the outstanding balance due to the Transferor
was approximately $0 and $204,000, respectively.




In
November 2007, the Company entered into operating agreements to operate retail
jewelry counters at two department stores located in Shenyang region. Both of
the agreements had a term of one year and expired in November 2008. The Company
renewed one of the agreements which has a term of two year and expires in
November 2010.  In accordance to the terms of this agreement, the
Company pays the department stores a commission fee ranging 4.5% to 8% based on
types of jewelry sales generated in these jewelry counters. Fees paid to the two
department stores totaled $200,089 and $20,669 in 2008 and 2007, respectively
and are included in selling and marketing expenses in 2008 and 2007. Fuqi
recognizes revenues when the titles of the merchandises are transferred to the
ultimate consumers. Fuqi determines the product pricing, provides staff training
at the counters, controls merchandising and display at the counters, manages
inventory, and controls and pays for all the advertising and marketing campaign
with respect to Fuqi merchandise. Sales generated from these two retail counters
totaled $3,307,000 and $308,000 for the year ended December 31, 2008 and 2007,
respectively.


F-22


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(6)
Retail Operation Lease Agreements: (continued)





For the
year ended December 31, 2008, the Company opened a total of sixteen new retail
counters, respectively of which thirteen of the counters are under the FUQI
brand and the other three counters are under the Temix brand. Including the
retail counters and shops acquired through the Temix acquisition, the Company
had a total of 62 jewelry counters and 7 jewelry shops located in
Beijing, Shanghai, and other PRC regions. A summary of retail presences as
of December 31, 2008 is summarized as follows:





Brand
                                            
                                            
                                            Counters
                                            
                                            
                                            Shops
                                            
                                            
                                            TotalFUQI
                                            Beijing
                                            
                                            
                                            5
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            5Shenyang
                                            
                                            
                                            6
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            6Dailian
                                            
                                            
                                            2
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            2Haerbin,
      Jilin
                                            
                                            
                                            1
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            1Xinxiang,
      Henan
                                            
                                            
                                            2
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            2Shunyang,
      Henan
                                            
                                            
                                            1
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            1Shandong
                                            
                                            
                                            1
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            1Yancheng,
      Jiangsu
                                            
                                            
                                            1
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            119
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            19TEMIX
                                            Beijing
                                            
                                            
                                            23
                                            
                                            
                                            
                                            0
                                            
                                            
                                            
                                            23Shanghai
                                            
                                            
                                            20
                                            
                                            
                                            
                                            7
                                            
                                            
                                            
                                            2743
                                            
                                            
                                            
                                            7
                                            
                                            
                                            
                                            5062
                                            
                                            
                                            
                                            7
                                            
                                            
                                            
                                            69





The
retail counters and shops are operating under operating leases with a term in a
range of 6 months to 1 year with an option of extensions. A majority of the
leases require payment of contingent rent based on a percentage of store sales.
The leasing agreements for five of the retail shops provide for the payment of
fees under a fixed rate rent in a range of $826 to $21,740. Fees paid to the
department stores and shopping malls totaling $1,362,277, $269,189
and $0 for the years ended December 31, 2008, 2007 and 2006, respectively,
are included in selling and marketing expenses.





The
Company recognizes revenues generated from these retail counters when the titles
of the merchandise are transferred to the ultimate consumers. The Company
determines the product pricing, provides staff training at the counters,
controls merchandising and display at the counters, manages inventory, and
controls and pays for all the advertising and marketing with respect to the
Company’s merchandise.




(7) Line of Credit:




In
February 2007, the Company entered into a facility line of credit with a bank.
Under the terms of the agreement, the Company can borrow a maximum amount of
$2,053,501 (RMB 15,000,000) and each of the borrowings cannot be less than
$136,900 and have a maturity of less than 90 days. This facility line of credit
expires in February 2012 and is secured by an affiliated company and certain
real properties owned by an affiliated company. Interest is charged at 1.2 times
the bank’s prime rate (7.776% at December 31, 2007). The facility line of credit
agreement has certain conditions for the Company to fulfill prior to the
withdrawals and to continue to borrow from the bank, including execution of the
fixed deposit agreement and maintaining approximately $684,500 (RMB 5,000,000)
in fixed deposit with this bank. During 2007, the bank has allowed the Company
to draw on the line of credit without fulfilling these conditions. The facility
line of credit agreement also has certain restrictions and covenants with which
the Company must comply during the terms of the agreement. In January 2008,
the facility line of credit agreement was amended under which the maximum
borrowing amount was decreased to $1,369,000 (RMB10,000,000) and  the
requirement of fixed deposit amounted of $684,500 was removed. Outstanding
balance for this line was $0 and $1,369,000 as of December 31, 2008 and 2007,
respectively. The facility line of credit agreement was fully repaid and not
renewed in 2008.


F-23


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(8)
Notes Payable:




As of
December 31, 2008 and 2007, outstanding notes payable to the bank consisted of
loan agreements that are covered by a Maximum Banking Facility Agreement dated
August 24, 2006 which was renewed on September 27 2007 and December 17, 2008
with the Agricultural Bank of China. Under the agreement, the maximum facility
amount, which was $14,629,936 and $13,690,000 (RMB100,000,000) at December 31,
2008 and 2007, respectively, is secured by the Company’s inventories. The
agreement has certain restrictions and covenants, including restriction on
dividend payment. The Company has been in compliance with these restrictions and
covenants since the execution of the agreement. As of December 31, 2008 and
2007, the Company had outstanding loan balances with this bank totaling
$14,629,936 and $13,690,000, respectively.





In
January 2007, the Company entered into a note payable with Construction Bank in
the amount of $2,053,501 (RMB15,000,000) that bears interest at 1.1 times of
prime rate. As of December 31, 2007, the outstanding balance of the loan was
$2,053,501 which was fully repaid in January 2008 and was not
renewed.





In June
2008, the Company entered into a Maximum Banking Facility Agreement with the
Shenzhen Development Bank that provides for a maximum borrowing of up to
$7,314,968 (RMB 50,000,000). This facility has a term of one year and expires in
June 2009 and is secured by certain real properties owned by an affiliated
company. Interest is charged at the bank’s prime rate. A portion of the loan
proceeds were used to repay the facility line of credit with another bank
executed in February 2007. As of December 31, 2008, the outstanding balance was
$7,314,968.





December 31,2008
                                
                                2007A
      note payable with interest at a rate of 6.732%, secured by the Company’s
      inventories and certain real estate properties owned by affiliated
      companies, guaranteed by affiliated companies and personally guaranteed by
      the Company’s controlling stockholder, matured in January 2008
      and  was repaid.
                                
                                $
                                -
                                
                                $
                                1,848,150A
      note payable with interest at a rate of 6.732%, guaranteed by affiliated
      companies, matured in January 2008 and was repaid.
                                
                                
                                -
                                
                                
                                2,053,501A
      note payable with interest at a rate of 7.227%, secured by the Company’s
      inventories and certain real estate properties owned by affiliated
      companies, guaranteed by affiliated companies and personally guaranteed by
      the Company’s controlling stockholder, matured in February 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                1,026,750A
      note payable with interest at a rate of 7.227%, secured by the Company’s
      inventories and certain real estate properties owned by affiliated
      companies, guaranteed by affiliated companies and personally guaranteed by
      the Company’s controlling stockholder, matured in February 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                889,850A
      note payable with interest at a rate of 6.030%, secured by the Company’s
      inventories, guaranteed by affiliated companies and personally guaranteed
      by the Company’s controlling stockholder, matured in January 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                1,369,000A
      note payable with interest at a rate of 6.030%, secured by the Company’s
      inventories and certain real estate properties owned by affiliated
      companies, guaranteed by affiliated companies and personally guaranteed by
      the Company’s controlling stockholder, matured in February 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                2,121,951A
      note payable with interest at a rate of 8.019%, secured by the Company’s
      inventories and guaranteed by affiliated companies and personally
      guaranteed by the Company’s controlling stockholder, matured in October
      2008 and was repaid.
                                
                                
                                -
                                
                                
                                1,369,000




F-24


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(8)
Notes Payable: (continued)





December 31,2008
                                
                                
                                2007A
      note payable with interest at a rate of 8.019%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matured in May 2008 and was
      repaid.
                                
                                $
                                -
                                
                                
                                $
                                958,300A
      note payable with interest at a rate of 8.019%, secured by the Company’s
      inventories, guaranteed by affiliated companies and personally guaranteed
      by the Company’s controlling stockholder, matured in June 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                
                                1,369,000A
      note payable with interest at a rate of 7.29%, secured by the Company’s
      inventories, guaranteed by affiliated companies and personally guaranteed
      by the Company’s controlling stockholder, matured in July 2008 and was
      repaid.
                                
                                
                                -
                                
                                
                                
                                2,738,002A
      note payable with interest at a rate of 8.217%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matures in March 2009.
                                
                                
                                
                                1,024,096
                                
                                
                                -A
      note payable with interest at a rate of 8.217%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matures in March 2009.
                                
                                
                                
                                1,462,994
                                
                                
                                -A
      note payable with interest at a rate of 6.831%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matures in March 2009.
                                
                                
                                
                                1,462,994
                                
                                
                                -A
      note payable with interest at a rate of 6.831%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matures in March 2009.
                                
                                
                                
                                2,267,640
                                
                                
                                -A
      note payable with interest at a rate of 7.227%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matured in January 2009 and was
      repaid.
                                
                                
                                
                                1,975,041
                                
                                
                                -A
      note payable with interest at a rate of 8.217%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matures in March 2009.
                                
                                
                                
                                2,925,987
                                
                                
                                -A
      note payable with interest at a rate of 7.227%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matured in January 2009 and was
      repaid.
                                
                                
                                
                                1,462,994
                                
                                
                                -A
      note payable with interest at a rate of 7.227%, secured by the Company’s
      inventories, certain real estate properties owned by affiliated companies,
      guaranteed by affiliated companies and personally guaranteed by the
      Company’s controlling stockholder, matured in January 2009 and was
      repaid.
                                
                                
                                
                                2,048,190
                                
                                
                                -




F-25


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(8)
Notes Payable: (continued)




December 31,2008
                                                            
                                                            
                                                            
                                                            2007A
      note payable with interest at a rate of 5.04%, secured by certain real
      properties owned by an affiliate, matures in June 2009.
                                                            
                                                            $
                                                            3,364,885
                                                            
                                                            
                                                            $
                                                            -A
      note payable with interest at a rate of 4.86%, secured by certain real
      properties owned by an affiliate, matures in June 2009.
                                                            
                                                            
                                                            3,950,083
                                                            
                                                            
                                                            
                                                            -$
                                                            21,944,904
                                                            
                                                            
                                                            $
                                                            15,743,504





(9)  Gold Futures
Contracts:




In 2008,
the Company entered into certain gold futures contracts with its supplier,
Shanghai Gold Exchange. Gold futures offered by Shanghai Gold Exchange are
designed for full members to hedge or to acquire inventory at a preset price.
The futures contract arrangements include purchase call and/or put options. The
Company utilized these futures contracts to manage its consolidated exposure to
changes in inventory values due to fluctuations in market prices and is not
considered as hedges under SFAS 133. The Company’s gold futures positions are
marked to market at each reporting date and all unrealized gains and losses are
recognized in earnings. For the year ended December 31, 2008, a total of 5.3
tons of gold and platinum were purchased under the gold futures contract
arrangements which represented approximately 42% of the Company’s total
purchases during the year. A substantial majority of these purchases were
settled during the year and a total gain of approximately $2,362,421 was
recognized as non-operating income in the consolidated statements of income for
the year ended December 31, 2008.





(10)  Fair
Value Measurement:




On
January 1, 2008, the Company adopted the provisions of
SFAS No. 157,Fair
Value Measurements (“SFAS No. 157”) for financial assets and
liabilities. SFAS No. 157 establishes a framework for using fair value
to measure assets and liabilities, and expands disclosures about fair value
measurements. SFAS 157 is effective for fiscal years beginning after
November 15, 2007, except for non-financial assets and liabilities that are
recognized or disclosed at fair value in the financial statements on a
non-recurring basis, for which application has been deferred for one
year.




SFAS 157
established the following fair value hierarchy that prioritizes the inputs used
to measure fair value:




Level 1:
            Quoted
      prices are available in active markets for identical assets or liabilities
      as of the reporting
date.




Level
      2:
            Pricing
      inputs are other than quoted prices in active markets included in Level 1,
      which are either directly or indirectly observable as of the reporting
      date.




Level
      3:
            Pricing
      inputs include significant inputs that are generally less observable from
      objective sources.  These inputs may be used with internally
      developed methodologies that result in management’s best estimate of fair
      value.




F-26


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(10)  Fair
Value Measurement: (continued)





The
following table presents the Company’s financial assets and liabilities that
were accounted for at fair value on a recurring basis as of December 31, 2008 by
level within the fair value hierarchy:




Fair Value Measurements UsingLevel 1
                                                                  
                                                                  
                                                                  Level 2
                                                                  
                                                                  Level 3AssetsDerivative
      financial instruments
                                                                  $
                                                                  —
                                                                  
                                                                  
                                                                  $
                                                                  1,426,236
                                                                  
                                                                  $
                                                                  —Liabilities:
                                                                  $
                                                                  —
                                                                  
                                                                  
                                                                  $
                                                                  —
                                                                  
                                                                  $
                                                                  —




The
Company’s derivative financial instruments are gold future contracts based on
gold price rates, which are observable at commonly quoted intervals for the full
term of the derivatives and therefore considered a Level 2 input. Unrealized
gain of these gold future contracts at December 31, 2008 was immaterial to the
consolidated financial statements.





(11)
Related-Party Transactions:





For the
year ended December 31, 2008, approximately $357,000 of operating expenditure,
respectively, including wages and benefits of production workers and material
tools and supplies was paid by the Company’s affiliate, Rong Xing Company
Limited, on behalf of the Company. The Company repaid the full outstanding
amount as of December 31, 2008.





For the
year ended December 31, 2008, Rong Xing Company advanced an interest-free loan
of $965,576 to the Company for short term financing purpose.  Such
amount was outstanding as of December 31, 2008.





For the
year ended December 31, 2008, due to certain legal titles of the retail counters
have not yet been transferred to Shenzhen Fuqi, Mr. Chujian Huang, collected a
total of $2,837,907 from the shopping malls on behalf of the Company which was
classified as account receivable from related party at December 31,
2008.  For the year ended December 31, 2008, Mr. Chujian Huang also
paid certain expenses for operating the retail counters totaling $1,002,875
which was classified as part of other payable, related party at December 31,
2008.





The
Company earned certain cash revenues from its customers that were subsequently
collected by its controlling stockholder. Total cash revenues amounted to $0,
$0, and $5,896,354 and the amounts collected by its controlling stockholder
totaled $0, $0, and $3,018,144 respectively, for the years ended December 31,
2008, 2007, and 2006. Beginning December 2006, this stockholder is no longer
collecting cash revenue on behalf of the Company and all the cash revenues are
deposited through the Company’s bank accounts.




The
Company’s controlling stockholder borrowed from the Company on a non-interest
bearing and frequent basis since the inception of its operations. Since the end
of 2006 and during 2007, the Company discontinued such practice and the
receivable balance due from the controlling stockholder was repaid to the
Company in full. For the years ended 31 December 2008, 2007, and 2006, the
Company loaned an aggregate amount of $0, $0, and $51,529,693 to the controlling
stockholder, and collected $0, $0, and $58,409,847, respectively. As at December
31, 2008 and 2007, there was no outstanding balance due from the controlling
stockholder.




The
Company borrowed from its controlling stockholder at a non-interest bearing
basis to satisfy the Company’s short term capital needs since the inception of
its operations. The Company borrowed $0, $203,506, and $23,545,485, from the
controlling stockholder and repaid $0, $642,295, and $23,130,562 during the
years ended December 31, 2008, 2007, and 2006. Outstanding loan payable to the
controlling stockholder was nil as of December 31, 2008 and 2007.




The
Company declared and paid dividends to its controlling stockholder, prior to the
closing of the Share Exchange Agreement and Reverse Split, totaling $0, $0, and
$2,739,726 for the years ended December 31, 2008, 2007, and 2006 which offset
the amounts due from this stockholder.


F-27


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(12)
Stockholders’ Equity:




(a)
Common Stock




On
February 23, 2007, the Company filed an amendment to its certificate of
incorporation to increase its authorized shares. Upon the amendment, the total
number of shares of stock which the Company has the authority to issue is one
hundred and five million (105,000,000) shares. The Company is authorized to
issue two classes of shares of stock, designated, “Common Stock” and “Preferred
Stock.” The Company is authorized to issue one hundred million (100,000,000)
shares of Common Stock, each share to have a par value of $.001 per share, and
Five Million (5,000,000) shares of Preferred Stock, each share to have a par
value of $.001 per share.





On August
23, 2007, the Company’s Board of Directors unanimously authorized a 1.69-to-1
reverse stock split of the Company’s common stock. The reverse stock split
became effective on October 22, 2007. All references to shares in the
consolidated financial statements and the accompanying notes, including but not
limited to the number of shares and per share amounts, unless otherwise noted,
have been adjusted to reflect the reverse stock split retroactively. Previously
awarded warrants to purchase the Company’s common shares have been also
retroactively adjusted to reflect the reverse stock split.




On
October 23, 2007, the Company publicly offered 7,033,816 shares of the Company’s
common stock at $9.00 per share. On October 25, 2007, the Company’s underwriters
elected to fully exercise their over-allotment option to purchase an additional
1,055,072 shares of the Company’s common stock. In total, including the
over-allotment shares, the Company sold 8,088,888 shares of the Company's common
stock at $9.00 per share. The shares offered were listed and traded on the
NASDAQ Global Market under the ticker symbol “FUQI”. After underwriting
discounts and commissions and estimated offering costs, the Company received net
proceeds of approximately $67.0 million





In August
2008, the Company completed the acquisition of the Temix Companies. As
stipulated in the IP Transfer Agreement (Note 2) entered into with Mr. Huang,
the Company issued 1,080,666 shares of Company common stock to acquire all of
the intellectual property rights related to the business of Temix Companies.
One-half of the shares issued, 540,333 shares, are to be held in escrow over a
two-year period and will be released when certain performance targets are
met.




(b)
Stock Options




In
November 2006, the Company’s stockholders approved an equity incentive plan
(“2006 EIP”) for employees, non-employee directors and other service providers
covering 1,775,148 shares of common stock. Prior to this, the Company had an
approved 2004 Equity Incentive Plan, which was replaced by the 2006 EIP. Any
options to be granted under the 2006 EIP may be either “incentive stock
options,” as defined in Section 422A of the Internal Revenue Code, or
“nonqualified stock options,” subject to Section 83 of the Internal Revenue
Code, at the discretion of the Company’s board of directors and as reflected in
the terms of the written option agreement. In the case of incentive stock
options, the option price shall not be less than 100% of the fair market value
of the optioned common stock on the date the option is granted. In the case of
incentive stock options, the option price shall not be less than 110% of the
fair market value of the optioned common stock for an optionee holding at the
time of grant, more than 10% of the total combined voting power of all classes
of its stock. Options become exercisable based on the discretion of its board of
directors and must be exercised within ten years of the date of
grant.




On
October 22, 2007, the Company’s Board of Directors adopted the 2007 Plan and the
Company received the written consent of the holders of a majority of its
outstanding common stock authorizing the 2007 Plan, which permits the grant of
share options and shares for up to 2,366,864. Immediately prior to the adoption
of the 2007 Plan, the Company cancelled and terminated its 2006 Equity Incentive
Plan (”2006 Plan''). There were no options or other securities outstanding under
the 2006 Plan at the time of termination and no future grants or issuance of
securities may be made under the 2006 Plan.




On
October 26, 2007, the Company granted each of its Chief Financial Officer and
the Executive Vice President, Corporate Development, options to purchase 600,000
shares of the Company’s common stock at $9.00 per share. Options to purchase
200,000 shares of the Company’s common stock vested immediately upon grant and
the remaining options to purchase 400,000 shares will vest in two equal annual
installments over the 24-month period following the date of the
grant.


F-28


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(12)
Stockholders’ Equity: (continued)





(b)
Stock Options (continued)





On
October 26, 2007, the Company also granted each of the Company’s four
independent director’s options to purchase 30,000 shares of the Company’s common
stock at $9.00 per share. Of the options granted to each of the directors,
options to purchase 15,000 shares of common stock vested immediately upon grant
and the remaining options to purchase 15,000 shares will vest in equal quarterly
installments over the one-year period following the date of the
grant.




Options
granted for 2007 were valued in accordance with SFAS 123R. The fair value of
these options was calculated using a Black-Scholes option pricing model using
the following assumptions: (1) risk-free interest rates of 3.8% - 4.0%,
(2) an expected life of 1 to 2 years, (3) expected volatility of 28%,
(4) expected forfeitures of 0%, and (5) a dividend yield of
0%. The Company amortized $594,204 and $701,856, respectively, for the year
ended December 31, 2008 and 2007.





The
Company entered into employment agreements with three of its executive officers
in August 2007 pursuant to which it agreed to grant stock options to acquire
shares of the Company’s common stock with a value equal to certain percentage of
the Company’s annual income before income taxes not to exceed an aggregate value
of $440,000. Options to purchase totaling 121,776 shares were granted to these
three executive officers on December 31, 2008.  The number of options
granted was computed based on the aggregate value of $440,000 dividing by the
fair value of each option measured on December 31, 2008 using the Black-Scholes
option pricing model.





The fair
value of these options was calculated using the following assumptions:
(1) risk-free interest rates of 1.55%, (2) an expected life of five
years, (3) expected volatility of 71%, (4) expected forfeitures of 0%,
and (5) a dividend yield of 0%. For the year ended December 31, 2008,
$440,000 was expensed related to the grant of these options.





The
dividend yield is 0.0% since there is no history of paying dividends and the
Company currently does not have plan to do so. Because there was no public
market or trading history at the time of the grant in October 2007 and in
accordance with SFAS 123R, the Company computed the expected volatility based on
the average historical volatilities of entities in the similar industries and
sizes. The Company computed the expected volatility on December 31, 2008 based
on the Company’s historical stock prices since its public offerings in October
2007.   The risk-free interest rate is the treasury-bill rate for
the period equal to the expected term based on the Treasury note strip principal
rates as reported in the website of U.S. Department of Treasury. The expected
term is the average of the contractual term of the option and the vesting
period. Forfeiture rate is determined based on the expected turnover rate of
officers and directors whom granted stock options during the year.





A summary
of stock option activity and related information for the years ended December
31, 2008 and 2007 is as follows:








Shares
                
                Weightedaverage
                  exerciseprice
                
                Weightedaverage
                  remaining
                  contractuallife
                  (inyears)
                
                Aggregate
                  IntrinsicValueOutstanding, January 1, 2007
                —
                
                
                —Granted
                1,320,000
                
                $
                9.00
                
                3.64Forfeited
      or Expired
                —
                
                
                —
                
                —Exercised
                —
                
                
                —
                
                —Outstanding,
      December 31, 2007
                1,320,000
                
                $
                9.00
                
                3.46
                
                $
                —Granted
                121,776
                
                $
                6.55
                
                10.00Forfeited
      or Expired
                —
                
                
                —
                
                —Exercised
                —
                
                
                —
                
                —Outstanding,
      December 31, 2008
                1,441,776
                
                $
                8.79
                
                3.09
                
                $
                —Option
      exercisable, December 31, 2008
                1,041,776
                
                $
                8.71
                
                3.58
                
                $
                —


F-29


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(12)
Stockholders’ Equity: (continued)





(b)
Stock Options (continued)





A summary
of the status of the Company’s nonvested shares as of December 31, 2008 and 2007
and changes during the years ended December 31, 2008 and 2007, is presented as
below:





Non-vestedshares
                  
                  Shares
                  
                  
                  Weighted-average
                    grant-datefairvalueNon-vested
      at January 1, 2007
                  
                  
                  —
                  
                  
                  
                  
                  
                  
                  —Granted
                  
                  
                  1,320,000
                  
                  
                  $
                  
                  
                  
                  
                  1.33Vested
                  
                  
                  (460,000
                  )
                  
                  
                  
                  
                  
                  
                  1.33Forfeited
                  
                  
                  —
                  
                  
                  
                  
                  
                  
                  
                  —Non-vested
      at December 31, 2007
                  
                  
                  860,000
                  
                  
                  $
                  
                  
                  
                  $
                  1.33




Granted
                  
                  
                  —
                  
                  
                  
                  
                  
                  
                  —Vested
                  
                  
                  (460,000
                  )
                  
                  $
                  
                  
                  
                  
                  1.33Forfeited
                  
                  
                  —
                  
                  
                  
                  
                  
                  
                  
                  —Non-vested
      at December 31, 2008
                  
                  
                  400,000
                  
                  
                  $
                  
                  
                  
                  $
                  1.33





For the
years ended December 31, 2008 and 2007, the Company recognized expenses of
approximately $1,034,000 and $702,000, respectively, representing the total fair
value of shares vested.  As of December 31, 2008 and 2007, there
was approximately $459,000 and $1.1 million, respectively, of total unrecognized
compensation cost related to nonvested share-based compensation arrangements
granted under the Plan. The cost is expected to be recognized over a
weighted-average period of 0.82 year and 1.2 years in 2008 and 2007,
respectively.





(c)
Stock Purchase Warrants




In
accordance with the Visitalk Plan, the Company issued six series of common stock
purchase warrants allowing holders to purchase additional shares of common stock
(“Plan Warrants”). Each Plan Warrant provides for the purchase of one share of
common stock and is callable by the Company for a price of $.0001 per warrant at
any time. The Plan Warrants are governed by a Warrant Agreement. Currently, the
Company is acting as the Warrant Agent but has the right to appoint an
alternative Warrant Agent in accordance with the Visitalk Plan. The board of
directors can extend the expiration date of the Plan Warrants or reduce the
exercise price of any warrant on a temporary or permanent basis. The Company has
actually issued 4,014,801 Plan Warrants in each series to 240 claimants under
the Visitalk Plan. In connection with the execution of the Share Exchange
Agreement on November 20, 2006 referred to in Note (1), four series of the Plan
Warrants (series A, B, D and F) were called and expired. In substance, three of
Visitalk Plan’s warrants were exchanged for each of the Company’s warrants. As
of December 31, 2006, a total of 9,968,628 series C and series E warrants
remained outstanding.




In May
2007, the Company delivered a notice of redemption to the warrant holders
pursuant to the terms of the Warrant Agreement and the Visitalk Plan. Upon
expiration of the call period on June 8, 2007, series C warrants had been
exercised for 578,177 shares of the Company’s common stock, for total gross
proceeds from conversion of $2,931,360. The remaining unexercised warrants were
redeemed at $0.0001 per share by the Company. No warrants remained outstanding
after the closing of the call.


F-30




FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(12)
Stockholders’ Equity: (continued)





(c)
Stock Purchase Warrants (continued)




The
Company issued a total of 578,177 shares of common stock to existing warrant
holders upon the exercise of warrants under the registration exemption offered
under Section 1145(a)(1) of the United States Bankruptcy Code, as
amended.




A summary
of the Plan Warrants is as follows:





A&B
                        Warrants
                      
                      
                      C&D
                        Warrants
                      
                      
                      E&F
                        WarrantsWarrants
      outstanding,
                        December
      31, 2006
                      
                      
                      —
                      
                      
                      
                      4,984,314
                      
                      
                      
                      4,984,314Granted
      (unaudited)
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Exercised
      (unaudited)
                      
                      
                      —
                      
                      
                      
                      (578,177
                      )
                      
                      
                      —Expired
      or Forfeited or redeemed
                        (unaudited)
                      
                      
                      —
                      
                      
                      
                      (4,406,137
                      )
                      
                      
                      (4,984,314
                      )Warrants
      outstanding,
                        December
      31, 2007 and 2008
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —Exercise
      Price
                      
                      
                      N/A
                      
                      
                      $
                      5.07
                      
                      
                      $
                      6.76Expiration
      Date
                      
                      
                      N/A
                      
                      
                      August
      31, 2007
                      
                      
                      August
      31, 2007




(d) Dividend
Payment Restrictions




Substantially
all of the Company’s retained earnings as well as net assets are attributable to
the PRC wholly subsidiary, Shenzhen Fuqi. Payment of dividends by Shenzhen Fuqi
is not permitted and restricted by the Maximum Banking Facility Agreement
executed with Agricultural Bank as disclosed in Note 8. Total restricted
net assets of Shenzhen Fuqi were approximately $50 million and $18 million as of
December 31, 2008 and 2007, respectively. As a result of the above restrictions
which prevent Shenzhen Fuqi from distributing all of their profit, the
restricted net assets held by the Company’s consolidated subsidiaries exceeded
25% of the consolidated net assets as of December 31, 2008. As such, the
Company has included Schedule I in accordance with Regulation S-X
promulgated by the United States Securities and Exchange
Commission.


F-31


FUQI INTERNATIONAL,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(13)
Income Taxes:





The
Company’s income tax provision amounted to $6,861,353, $2,097,050 and $995,462,
respectively, for the years ended December 31, 2008, 2007 and 2006 (an effective
rate of  19.8% for 2008, 13.4% for 2007, and 14.7% for 2006).





A
reconciliation of the provision for income taxes, with amounts determined by
applying the statutory U.S. federal income tax rate to income before income
taxes, is as follows:




YearEndedDecember31,2008
                  
                  
                  2007
                  
                  
                  2006Computed
      tax at federal statutory rate of 34%
                  
                  $
                  11,811,752
                  
                  
                  $
                  5,308,408
                  
                  
                  $
                  2,308,496Tax
      rate difference between US and PRC on foreign earnings
                  
                  
                  (5,765,336
                  )
                  
                  
                  (3,305,659
                  )
                  
                  
                  (1,290,042
                  )Effect
      of statutory rate change
                  
                  
                  (14,396
                  )
                  
                  
                  (13,751
                  )
                  
                  
                  (22,992
                  )Exemption
      of business tax liabilities and estimated penalty payable
                  
                  
                  —
                  
                  
                  
                  (456,867
                  )
                  
                  
                  —Other
                  
                  
                  384,704
                  
                  
                  
                  (112,893
                  )
                  
                  
                  —Change
      in Valuation Allowance
                  
                  
                  444,629
                  
                  
                  
                  677,812
                  
                  
                  
                  —$
                  6,861,353
                  
                  
                  $
                  2,097,050
                  
                  
                  $
                  995,462





YearEndedDecember31,2008
                
                2007
                
                2006Current
                
                $
                6,940,533
                
                
                $
                2,147,254
                
                
                $
                1,001,782Deferred
                
                
                (79,180
                )
                
                
                (50,204
                )
                
                
                (6,320
                )$
                6,861,353
                
                
                $
                2,097,050
                
                
                $
                995,462





YearEndedDecember31,2008
                
                2007
                
                2006Domestic
                
                $
                800
                
                
                $
                800
                
                
                $
                —Foreign
                
                
                6,860,553
                
                
                
                2,096,250
                
                
                
                995,462$
                6,861,353
                
                
                $
                2,097,050
                
                
                $
                995,462




Effective
January 1, 2008, the National People’s Congress of China enacted a new PRC
Enterprise Income Tax Law, under which foreign invested enterprises and domestic
companies is subject to enterprise income tax at a uniform rate of 25%. During
the transition period, the tax rate is gradually increased to coincide with the
new tax rate within five years starting from 2008 and reaching the uniform rate
of 25% in 2012.





The
regular enterprise income tax rates in Shenzhen, China, were 18%, 15% and 15% in
2008, 2007 and 2006, respectively. As a new business, the Company was exempted
from paying any income taxes for the first two years of its operations (2 years
from the inception of the business, years ended December 31, 2001 and 2002), and
enjoyed a discounted income tax rate of 7.5% of pretax income during the third,
fourth and fifth years of its operations (the three years ended December 31,
2003, 2004 and 2005). Beginning January 1, 2006, the Company became subject to
the regular rate of 15% on its pretax income.


F-32


FUQI INTERNATIONAL,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(13)
Income Taxes: (continued)





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes. Significant components of the
Company’s deferred tax assets and liabilities are as follows:





YearEndedDecember31,2008
                
                
                2007Deferred
      tax assets:Allowance
      for doubtful accounts
                
                $
                309,675
                
                
                $
                84,582Net
      operating loss
                
                
                461,120
                
                
                
                419,823Stock-based
      payment
                
                
                743,728
                
                
                
                300,675Accrual
      expense
                
                
                15,648
                
                
                
                -Other
                
                
                28,533
                
                
                
                6,892Total
      deferred tax assets
                
                
                1,558,704
                
                
                
                811,972Deferred
      tax liabilities:State
      deferred taxes
                
                
                (95,752
                )
                
                
                (49,577
                )Gain
      from derivative instrument
                
                
                (171,648
                )
                
                
                -Other
                
                
                (26,255
                )
                
                
                (5,181
                )Total
      deferred tax liabilities
                
                
                (293,655
                )
                
                
                (54,758
                )Net
      deferred tax assets before valuation allowance
                
                
                1,265,049
                
                
                
                757,214Valuation
      allowance
                
                
                (1,122,441
                )
                
                
                (677,812
                )$
                142,608
                
                
                $
                79,402




The
Company has established a valuation allowance against its net deferred tax
assets, due to uncertainty regarding their future realization. In assessing the
realizability of its deferred tax assets, management considers the scheduled
reversal of deferred tax liabilities, projected future taxable income, and tax
planning strategies. Based on the projections for future taxable income over the
periods in which the deferred tax assets are realizable and the full utilization
of the Company’s loss carryback potential, management concluded that a full
valuation allowance on the deferred tax assets and liabilities of the
Company’s US holding entity since the Company does not expect any net profits
generated from this entity in the near future.




Realization
of deferred tax assets is dependent on future earnings, if any, the timing and
amount of which is uncertain.





The
Company intends to permanently reinvest the earnings of its foreign
subsidiaries, as such no deferred taxes have been provided on such amounts under
APB 23.  The Company made investments in its foreign
subsidiaries.  The amount of the unrecognized deferred tax liability
for temporary differences related to investments in foreign subsidiaries that
are essentially permanent in duration cannot be practically
determined.





At
December 31, 2008 and 2007, the Company has available federal unused net
operating losses carryforwards of  $977,000 and $469,000,
respectively, related to loss incurred after the reverse merger with Fuqi BVI in
November 2006 that may be applied against future taxable income and will begin
to expire in 2028 for federal and 2013 for California. Section 382 of the
Internal Revenue Code limits the use of net operating loss and tax credit
carryforwards in certain situations where changes occur in the stock ownership
of a company. In the event such ownership changes of the Company have occurred,
the utilization of the carryforwards could be restricted.


F-33


FUQI INTERNATIONAL,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(13)
Income Taxes: (continued)





The
Company recorded the interest on underpayment of income taxes as interest
expense under the Other Income (Expenses) and estimated penalties on
underpayment of income taxes as penalty expenses under general and
administrative expenses in the consolidated statements of income and
comprehensive Income.  There was no interest and penalty being accrued
for the years ended December 31, 2008, 2007 and 2006.  The estimated
penalties payable of $1,119,201 on the balance sheet as of December 31, 2006
were accrued for the periods up to December 31, 2004.  As disclosed in
the following paragraphs, in April 2006, the Shenzhen local tax department made
the determination not to impose any penalties on the unpaid
taxes.  Accordingly, the Company did not accrue additional penalties
for the year ended December 31, 2005 and all the subsequent years.




The
recognition of the estimated penalty payable was reversed in October 2007 when
the condition set forth by the Shenzhen local tax department was fulfilled and
the assessment and settlement became final.





The
Company files U.S. and foreign income tax returns in jurisdictions with varying
statutes of limitations. The fiscal 2003 through 2008 tax years generally remain
subject to examination by federal and foreign tax
authorities.





The
Company adopted the provisions of FASB Interpretation No. 48,Accounting for Uncertainty in Income
Taxes—an Interpretation of FASB Statement
No. 109, or FIN 48, on January 1, 2007. This interpretation requires
companies to determine whether it is more likely than not that a tax position
will be sustained upon examination by the appropriate taxing authorities before
any part of the benefit can be recorded in the financial
statements.




Management,
in conjunction with input from its U.S. and Chinese tax advisors, has performed
an analysis of its tax positions, in accordance with FIN 48, and has determined
that the Company has no material uncertain tax positions which are less than
more-likely-than-not of being sustained for the full amount claimed, or to be
claimed, on its applicable tax returns for the year ended December 31, 2008 and
2007.




The
Company did not report certain cash revenues related to fees charged to its
customers for product design. Such fee revenues are subject to business tax and
service charges in China at an aggregate rate of 5.2%. The Company has not
reported such revenues since the inception of its operations in 2001 through
2006. The Company has recorded in its consolidated financial statements the tax
liabilities representing business tax and fees of 5.2% and income tax on the
unreported design revenues since the inception of its business in 2001. During
the years ended December 31, 2006, 2005, and 2004, the Company recorded
$312,002, $302,409 and $234,261, respectively, for business tax and fees and
$900,118, $393,806, and $337,877, respectively, for income tax related to
these revenues. In addition, per advice of a registered tax agent in China in
2004, the Company accrued 100% of the unpaid tax amounts as the maximum
penalties which could be assessed by the local tax department through the
periods ended December 31, 2004.




In April
2006, the Shenzhen local tax department made an assessment of the total tax
liabilities related to the cash revenues. Per the tax assessment notice dated
April 24, 2006, the Company is obligated to pay a total of $1,754,802
(RMB14,161,249) including business tax, fees and income taxes related to these
cash revenues through December 31, 2005. If the Company did not pay off these
tax liabilities by April 30, 2006, the Company would be subject to 0.05% per day
of interest and penalties of the unpaid tax and fee liability amount from the
due date (April 30, 2006).




On April
28, 2006, the Company filed an extension to remit these outstanding tax
liabilities to December 20, 2006 and was approved by the tax department in July
2006.




On
December 28, 2006, the Shenzhen local tax department granted a further extension
to the Company to remit the tax liabilities from December 20, 2006 to April 25,
2007. The Company would not be subject to any penalties and interest if all the
outstanding taxes are remitted to the Tax Department prior to the revised due
date on April 25, 2007.


F-34


FUQI INTERNATIONAL,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(13)
Income Taxes: (continued)





On
April 25, 2007, the Company appointed its registered tax agent to apply on
behalf of the Company for a special reduction or exemption for the unpaid tax
liabilities for the period from inception to December 31, 2006. On May 14, 2007,
the Company received a notice from the Shenzhen local tax department to accept
the Company’s application for a tax reduction or exemption and was granted an
additional period to remit its outstanding tax liabilities until August 9, 2007.
The tax department agreed not to assess any interest and penalties during this
review process until August 9, 2007. Accordingly, the Company did not accrue any
interest and penalties related to these outstanding tax liabilities in the
accompanying condensed consolidated financial statements.




On August
10, 2007, the Company received a notice from the tax department conditionally
agreeing to exempt the Company’s tax liabilities in the amount of approximately
$3 million on unreported design fee income for the period from the inception of
the Company’s operations in 2001 to December 31, 2006, provided that the
Company’s common stock is successfully listed on a major overseas stock exchange
within 180 days from the date of the tax notice. Due to such condition being
fulfilled in October 2007 and acknowledged by the Shenzhen tax department in
November 2007, the accrued business and income tax liabilities, and the accrued
estimated and penalties totaling $4.2 million was fully reversed and recorded as
non-operating income in the consolidated statement of income for the year ended
December 31, 2007.  All the income has been fully reported to the
tax department and all the prior unreported revenues have been settled as of
December 31, 2007.





(14)
Commitments:




Employment
Agreements




In
October 2007, the Company entered into three-year employment contracts with the
Company’s five executive officers each of which includes a fixed amount of
annual salary and stock options to purchase the Company’s common stock. Details
of each executive officer are summarized as follows:





·
            Yu
      Kwai Chong, the Company’s Chief Executive Officer, receives an annual
      salary of $200,000 and an automobile allowance of approximately $52,000 as
      well as stock options to be granted on an annual basis to acquire shares
      of the common stock with a market value of 2% of the Company’s annual
      profit, approximately, before tax, not exceeding $200,000. The stock
      options have a life of 10 years and its exercise price shall be equal to
      110% of the fair market value of the Company’s common stock on the date of
      the grant.




·
            Ching
      Wan Wong, the Company’s Chief Financial Officer, receives an annual salary
      of $160,000 and is granted, on the effective date of the employment
      agreement, stock options with three-year terms to acquire 600,000 shares
      of common stock at a per share exercise price of
  $9.00.




·
            Each
      of Lie Xi Zhang, the Company’s Chief Operating Officer, and Xi Zhou Zhuo,
      its Marketing Director, receives an annual salary of $120,000 and stock
      options to be granted on an annual basis to acquire shares of common stock
      with a market value of 1% of its annual profit before tax, not exceeding
      $120,000. The stock options have a life of 10 years and its exercise price
      shall be equal to 100% of the fair market value of the Company’s common
      stock on the date of the grant.




·
            Heung
      Sang Fong, the Company’s Vice President of Corporate Development, receives
      an annual salary of $120,000 and stock options with three-year terms to
      acquire 600,000 shares of common stock at
$9.00.




On
August 7, 2008, in conjunction with the Temix acquisition (Note 2), the Company
entered into an employment agreement with Mr. Chujian Huang as the General
Manager of Temix subsidiary for a term of three years. Under the terms of the
agreement, Mr. Huang is compensated an annual salary of $66,900, and is eligible
for a discretionary bonus determined by the Company’s compensation
committee.





Pursuant
to the employment contracts, either the Company or employee can terminate the
employment with 60 to 90 days advance notice.


F-35


FUQI INTERNATIONAL,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(14) Commitments:
(continued)





Facility and Office
Operating Leases




The
Company leases certain facilities under various long-term noncancellable and
month-to-month leases and certain offices under noncancellable operating lease.
These leases are accounted for as operating leases. Rent expense amounted to
$375,103, $171,160, and $158,399 for the years ended 2008, 2007 and 2006,
respectively.





A summary
of the future minimum annual rental commitments under the operating leases is as
follows:





Year Ending December 31,2009
                
                $
                239,1642010
                
                
                68,7862011
      and thereafter
                
                
                -$
                307,950




(15)
Segment Information:





With its
acquisition of Temix in August 2008, the Company has determined that there are
two reportable segments: (i) wholesale and distribution and
(ii) retail. The segment data for the years ended December 31, 2008,
2007 and 2006 are shown below. Net sales represent sales to unaffiliated
customers as reported in the consolidated condensed statements of
income.




YearendedDecember31,2008
                      
                      
                      2007
                      
                      
                      2006Net
      Sales:Wholesale
      and distribution
                      
                      $
                      356,471,362
                      
                      
                      $
                      144,313,478
                      
                      
                      $
                      92,408,539Retail
                      
                      
                      11,134,243
                      
                      
                      
                      1,245,189
                      
                      
                      
                      -$
                      367,605,605
                      
                      
                      $
                      145,558,667
                      
                      
                      $
                      92,408,539Income
      before provision for income taxes:Wholesale
      and distribution
                      
                      $
                      37,894,193
                      
                      
                      $
                      13,932,303
                      
                      
                      $
                      7,506,369Retail
                      
                      
                      (971,840
                      )
                      
                      
                      218,712
                      
                      
                      
                      -36,922,353
                      
                      
                      
                      14,151,015
                      
                      
                      
                      7,506,369Unallocated
      corporate expenses
                      
                      
                      (3,563,360
                      )
                      
                      
                      (1,661,533
                      )
                      
                      
                      -Other
      income (expense), net
                      
                      
                      1,381,453
                      
                      
                      
                      3,123,482
                      
                      
                      
                      (716,676
                      )$
                      34,740,446
                      
                      
                      $
                      15,612,964
                      
                      
                      $
                      6,789,693




F-36


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





(15) Segment Information:
(continued)





The table
below provides a summary of the Company’s assets as it relates to the Company’s
operation segments as of the dates shown:





December31,2008
                  
                  2007Assets:Wholesale
      and distribution
                  
                  $
                  163,502,662
                  
                  
                  $
                  117,134,853Retail
                  
                  
                  30,296,113
                  
                  
                  
                  3,339,195Corporate
                  
                  
                  1,050,639
                  
                  
                  
                  2,240,542Totals
                  
                  $
                  194,849,414
                  
                  
                  $
                  122,714,590




(16)
Subsequent Event:




On
January 23, 2009, the Company announced that its Executive Vice President of
Corporate Development, Heung Sang Fong, would be resigning effective January 31,
2009 to pursue other business opportunities.  After the effective date
of his resignation, Mr. Fong will serve as a consultant to the Company through
May, 2009.


F-37


FUQI INTERNATIONAL,
INC.




SCHEDULE
I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT




CONDENSED
BALANCE SHEETS





December 31,2008
                                      
                                      
                                      2007ASSETSCurrent
      assets:Cash
                                      
                                      $
                                      16,065
                                      
                                      
                                      $
                                      358,218Prepaid
      expenses and other current assets
                                      
                                      
                                      235,063
                                      
                                      
                                      
                                      215,566Total
      current assets
                                      
                                      
                                      251,128
                                      
                                      
                                      
                                      573,784Investment
      in subsidiaries
                                      
                                      
                                      137,216,823
                                      
                                      
                                      
                                      96,913,495Total
      Assets
                                      
                                      $
                                      137,467,951
                                      
                                      
                                      $
                                      97,487,279LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable and accrued liabilities
                                      
                                      $
                                      638,350
                                      
                                      
                                      $
                                      226,824Income
      tax payable
                                      
                                      
                                      -
                                      
                                      
                                      
                                      800Total
      current liabilities
                                      
                                      
                                      638,350
                                      
                                      
                                      
                                      227,624STOCKHOLDERS'
      EQUITYPreferred
      stock, $0.001 par value, 5,000,000 shares authorized, none issued and
      outstanding
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Common
      stock, $0.001 par value, 100,000,000 shares authorized shares issued and
      outstanding – 22,005,509 shares for 2008 and 20,924,843 shares for
      2007
                                      
                                      
                                      22,006
                                      
                                      
                                      
                                      20,925Additional
      paid in capital
                                      
                                      
                                      82,503,638
                                      
                                      
                                      
                                      77,449,355Accumulated
      foreign currency translation adjustments
                                      
                                      
                                      9,620,524
                                      
                                      
                                      
                                      2,985,035Retained
      earnings
                                      
                                      
                                      44,683,433
                                      
                                      
                                      
                                      16,804,340Total
      stockholders' equity
                                      
                                      
                                      136,829,601
                                      
                                      
                                      
                                      97,259,655Total
      Liabilities and Stockholders’ Equity
                                      
                                      $
                                      137,467,951
                                      
                                      
                                      $
                                      97,487,279




F-38


FUQI
INTERNATIONAL, INC.




SCHEDULE
I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT




CONDENSED
STATEMENTS OF INCOME





Years Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Operating
      expenses:General
      and administrative
                  
                  $
                  2,827,840
                  
                  
                  $
                  1,661,533
                  
                  
                  $
                  -Total
      operating expenses
                  
                  
                  2,827,840
                  
                  
                  
                  1,661,533
                  
                  
                  
                  -Loss
      from operations
                  
                  
                  (2,827,840
                  )
                  
                  
                  (1,661,533
                  )
                  
                  
                  -Other
      income (expenses):Interest
      expense
                  
                  
                  -
                  
                  
                  
                  (110
                  )
                  
                  
                  -Interest
      income
                  
                  
                  966
                  
                  
                  
                  6,393
                  
                  
                  
                  -Miscellaneous
                  
                  
                  -
                  
                  
                  
                  5,744
                  
                  
                  
                  -Total
      other income (expenses)
                  
                  
                  966
                  
                  
                  
                  12,027
                  
                  
                  
                  -Loss
      before provision for income taxes
                  
                  
                  (2,826,874
                  )
                  
                  
                  (1,649,506
                  )
                  
                  
                  -Provision
      for income taxes
                  
                  
                  800
                  
                  
                  
                  800
                  
                  
                  
                  -Loss
      from operations before equity in earnings of subsidiaries
                  
                  
                  (2,827,674
                  )
                  
                  
                  (1,650,306
                  )
                  
                  
                  -Equity
      in earnings of subsidiaries
                  
                  
                  30,706,767
                  
                  
                  
                  15,166,220
                  
                  
                  
                  5,794,231Net
      income
                  
                  $
                  27,879,093
                  
                  
                  $
                  13,515,914
                  
                  
                  $
                  5,794,231Earnings
      per share – basic
                  
                  $
                  1.32
                  
                  
                  $
                  0.96
                  
                  
                  $
                  0.51Earnings
      per share - diluted
                  
                  $
                  1.32
                  
                  
                  $
                  0.86
                  
                  
                  $
                  0.50Weighted
      average number of common shares - basic
                  
                  
                  21,142,457
                  
                  
                  
                  14,105,791
                  
                  
                  
                  11,260,544Weighted
      average number of common shares- diluted
                  
                  
                  21,142,457
                  
                  
                  
                  15,627,494
                  
                  
                  
                  11,631,549





F-39


FUQI
INTERNATIONAL, INC.




SCHEDULE
I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)




CONDENSED
STATEMENTS OF STOCKHOLDERS’ EQUITY





Common StockShares
                        
                        
                        Amount
                        
                        
                        Additional Paid
                          in Capital
                        
                        
                        Other
                          Comprehensive
                          Income
                        
                        
                        Retained
                          Earnings
                        
                        
                        Total
                          Stockholders'
                          EquityBalance,
      December 31, 2005
                        
                        
                        11,175,543
                        
                        
                        $
                        11,176
                        
                        
                        $
                        7,217,740
                        
                        
                        $
                        143,706
                        
                        
                        $
                        233,921
                        
                        
                        $
                        7,606,543Reverse
      acquisition of Fuqi BVI
                        
                        
                        1,082,081
                        
                        
                        
                        1,082
                        
                        
                        
                        (5,610
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (4,528
                        )Dividend
      paid
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (2,739,726
                        )
                        
                        
                        (2,739,726
                        )Foreign
      currency translation adjustments
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        288,419
                        
                        
                        
                        -
                        
                        
                        
                        288,419Net
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        5,794,231
                        
                        
                        
                        5,794,231Balance,
      December 31, 2006
                        
                        
                        12,257,624
                        
                        
                        
                        12,258
                        
                        
                        
                        7,212,130
                        
                        
                        
                        432,125
                        
                        
                        
                        3,288,426
                        
                        
                        
                        10,944,939Issuance
      of common stock related to initial public offering, net of financing
      cost
                        
                        
                        8,088,888
                        
                        
                        
                        8,089
                        
                        
                        
                        66,780,438
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        66,788,527Issuance
      of common stock for exercise of stock warrants
                        
                        
                        578,331
                        
                        
                        
                        578
                        
                        
                        
                        2,754,931
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        2,755,509Fair
      value of stock options granted to executives and directors
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        701,856
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        701,856Foreign
      currency translation adjustments
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        2,552,910
                        
                        
                        
                        -
                        
                        
                        
                        2,552,910Net
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        13,515,914
                        
                        
                        
                        13,515,914Balance,
      December 31, 2007
                        
                        
                        20,924,843
                        
                        
                        
                        20,925
                        
                        
                        
                        77,449,355
                        
                        
                        
                        2,985,035
                        
                        
                        
                        16,804,340
                        
                        
                        
                        97,259,655Issuance
      of common stock on acquisition of a business, net of financing
      cost
                        
                        
                        1,080,666
                        
                        
                        
                        1,081
                        
                        
                        
                        4,020,079
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        4,021,160Issuance
      of common stock for exercise of stock warrants
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Fair
      value of stock options granted to executives and directors
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,034,204
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,034,204Foreign
      currency translation adjustments
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        6,635,489
                        
                        
                        
                        -
                        
                        
                        
                        6,635,489Net
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        27,879,093
                        
                        
                        
                        27,879,093Balance,
      December 31, 2008
                        
                        
                        22,005,509
                        
                        
                        $
                        22,006
                        
                        
                        $
                        82,503,638
                        
                        
                        $
                        9,620,524
                        
                        
                        $
                        44,683,433
                        
                        
                        $
                        136,829,601




F-40


FUQI
INTERNATIONAL, INC.




SCHEDULE
I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)




CONDENSED
STATEMENTS OF CASH FLOWS





Year Ended December 31,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006Cash
      flows provided by operating activities:Net
      income
                                      
                                      $
                                      27,879,093
                                      
                                      
                                      $
                                      13,515,914
                                      
                                      
                                      $
                                      5,794,231Adjustments
      to reconcile net income to net cashprovided
      by (used for) operating activities:Equity
      in earnings of subsidiaries
                                      
                                      
                                      (30,706,767
                                      )
                                      
                                      
                                      (15,166,220
                                      )
                                      
                                      
                                      (5,794,231
                                      )Stock
      based compensation expense
                                      
                                      
                                      1,034,204
                                      
                                      
                                      
                                      701,856
                                      
                                      
                                      
                                      -Changes
      in operating assets and liabilities:Prepaid
      expenses and other current assets
                                      
                                      
                                      (19,497
                                      )
                                      
                                      
                                      (215,566
                                      )
                                      
                                      
                                      -Amount
      due from subsidiaries
                                      
                                      
                                      1,060,088
                                      
                                      
                                      
                                      (68,249,396
                                      )
                                      
                                      
                                      -Accounts
      payable and accrued liabilities
                                      
                                      
                                      411,526
                                      
                                      
                                      
                                      226,824
                                      
                                      
                                      
                                      -Income
      tax payable
                                      
                                      
                                      (800
                                      )
                                      
                                      
                                      800
                                      
                                      
                                      
                                      -Net
      cash used for operating activities
                                      
                                      
                                      (342,153
                                      )
                                      
                                      
                                      (69,185,788
                                      )
                                      
                                      
                                      -Cash
      flows provided by financing activities:Proceeds
      from exercise of warrants, net of financing cost
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      2,755,479
                                      
                                      
                                      $Issuance
      of common stock related to initial public offering, net of financing
      cost
                                      
                                      
                                      -
                                      
                                      
                                      
                                      66,788,527
                                      
                                      
                                      
                                      -Net
      cash provided by financing activities
                                      
                                      
                                      -
                                      
                                      
                                      
                                      69,544,006
                                      
                                      
                                      
                                      -Net
      (decrease) increase in cash
                                      
                                      
                                      (342,153
                                      )
                                      
                                      
                                      358,218
                                      
                                      
                                      
                                      -Cash,beginning of
      year
                                      
                                      
                                      358,218
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Cash,end of
      year
                                      
                                      $
                                      16,065
                                      
                                      
                                      $
                                      358,218
                                      
                                      
                                      $
                                      -


F-41


FUQI
INTERNATIONAL, INC.


SCHEDULE
I—CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)


NOTES
TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT






1.
Basis for preparation




The
condensed financial information of Fuqi International, Inc. (“Fuqi”) has been
prepared using the same accounting policies as set out in the Company’s
consolidated financial statements except that Fuqi used the equity method to
account for investments in its subsidiaries.




2.
Investments in subsidiaries




Fuqi and
its subsidiaries are included in the consolidated financial statements where the
inter-company balances and transactions are eliminated upon consolidation. For
the purpose of Fuqi’s stand-alone financial statements, its investments in
subsidiaries are reported using the equity method of accounting. Fuqi’s share of
income and losses from its subsidiaries is reported as earnings from
subsidiaries in the accompanying condensed financial information of parent
company.




3.
Income taxes




Fuqi is
incorporated in the State of Delaware, in the US and is subject to US federal
and state income taxes.


F-42


FUQI
INTERNATIONAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




SCHEDULE
II




FUQI
INTERNATIONAL, INC.


Valuation
and Qualifying Accounts and Reserves


Years
Ended December 31, 2008, 2007 and 2006





Balance at the
                  Beginning of the
                  Year
                
                
                Provision for
                  bad debts
                
                
                Write off and
                  other deductions
                
                
                Balance atthe
                  End of the YearAllowance
      for Doubtful Accounts:Year
      ended December 31, 2006
                
                $
                302,000
                
                
                $
                —
                
                
                $
                (107,000
                )
                
                $
                195,000Year
      ended December 31, 2007
                
                
                195,000
                
                
                
                275,000
                
                
                
                —
                
                
                
                470,000Year
      ended December 31, 2008
                
                
                470,000
                
                
                
                1,150,000
                
                
                
                —
                
                
                
                1,620,000




F-43