U.S. SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q


(Mark one)





[ X]
Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934





For the Quarterly Period Ended March 31, 2010


or





[  ]
Transition Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934





Commission File Number 000-50491





China Fire & Security Group, Inc.


(Name of small business issuer in its charter)





Florida

65-1193022(State or other jurisdiction

of incorporation or organization)

(I.R.S. Employer

Identification No.)B-2508 TYG Center, C2

Dongsanhuanbeilu,

Chaoyang District, Beijing 100027,

People’s Republic of China

100027(Address of principal executive offices)

(Zip Code)





Issuer’s telephone number:  (86-10) 8441 7400.





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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [  ]  No [  ]




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 [ x ]Non-accelerated filer  [  ](Do not check if smaller reporting company)

Smaller reporting company [  ]





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





As of May 10, 2011, the Registrant had 27,855,934shares of common stock outstanding.








China Fire & Security Group, Inc.





Table of Contents





PagePART I

FINANCIAL INFORMATIONItem 1.

Financial Statements (unaudited):

1Consolidated Balance Sheets as of March 31, 2011 (unaudited) and December 31, 2010

1Consolidated Statements of Income and Other Comprehensive Income

2For the Three Months Ended March 31, 2011 and 2010 (unaudited)Consolidated Statement of Changes in Equity

3Consolidated Statements of Cash Flows

4For the Three Months Ended March 31, 2011 and 2010 (unaudited)Notes to Consolidated Financial Statements (unaudited)

5Item 2.

Management’s Discussion and Analysis or Plan of Operation

34Item 3.

Quantitative and Qualitative Disclosures About Market Risk

45Item 4.

Controls and Procedures

46PART II -

OTHER INFORMATION

47Item 1.

Legal Proceedings

47Item 1A.

Risk Factors

47Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

47Item 3.

Defaults Upon Senior Securities

47Item 4.

Submission of Matters to a Vote of Security Holders.

47Item 5.

Other Information

47Item 6.

Exhibits

47





Item 1. Financial Statements




CHINA FIRE & SECURITY GROUP, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF MARCH 31, 2011 AND DECEMBER 31, 2010March 31,


December 31,2011


2010(Unaudited)ASSETSCURRENT ASSETS:Cash and cash equivalents

$
23,863,331


$
28,151,689Restricted cash


2,759,050



1,935,979Notes receivable


15,789,722



14,428,802Accounts receivable, net of allowance for doubtful accounts of $8,637,861 and$8,153,727 as of March 31, 2011 and December 31, 2010, respectively


42,279,662



41,895,129Receivables from and prepayments to related parties


2,737,957



2,448,066Other receivables


919,013



792,386Refundable bidding and system contracting project deposits


1,651,406



1,667,437Inventories


8,347,077



6,713,448Costs and estimated earnings in excess of billings


47,560,291



40,660,013Employee advances


1,705,365



1,114,080Prepayments and deferred expenses


7,416,480



10,281,292Total current assets


155,029,354



150,088,321PLANT AND EQUIPMENT, net


9,600,012



9,641,119OTHER ASSETS:Restricted cash - non current


9,603,141



7,533,407Accounts receivable - retentions


3,156,624



2,790,492Investment in joint ventures


499,440



496,834Intangible assets, net


969,842



985,643Total other assets


14,229,047



11,806,376Total assets

$
178,858,413


$
171,535,816LIABILITIES AND EQUITYCURRENT LIABILITIES:Accounts payable

$
8,121,496


$
7,666,967Customer deposits


3,886,756



3,023,329Billings in excess of costs and estimated earnings


2,317,412



2,872,706Other payables


1,305,024



838,413Accrued liabilities


20,123,301



19,737,906Taxes payable


10,278,325



9,416,829Total current liabilities


46,032,314



43,556,150COMMITMENTS AND CONTINGENCIESEQUITY:Common stock, $0.001 par value, 65,000,000 shares authorized,27,855,934 and 27,855,934 shares issued and outstanding as ofMarch 31, 2011 and December 31, 2010, respectively


27,855



27,855Additional paid-in-capital


25,806,817



24,771,143Subscriptions receivable


(27,570
)


(27,570
)Statutory reserves


7,147,795



7,147,795Retained earnings


87,828,374



84,703,984Accumulated other comprehensive income


12,020,909



11,349,619Total shareholders' equity


132,804,180



127,972,826Noncontrolling interest


21,919



6,840Total equity


132,826,099



127,979,666Total liabilities and equity

$
178,858,413


$
171,535,816







1





CHINA FIRE & SECURITY GROUP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMEAND OTHER COMPREHENSIVE INCOMEFOR THE THREE MONTHS ENDED MARCH 31, 2011 AND 2010(Unaudited)Three Months Ended March 31,2011


2010REVENUESSystem contracting projects

$
14,619,364


$
15,521,748Products


5,189,266



4,530,599Maintenance services


1,187,246



891,379Total revenues


20,995,876



20,943,726COST OF REVENUESSystem contracting projects


7,029,218



7,311,285Products


2,808,481



1,454,067Maintenance services


859,523



546,218Total cost of revenues


10,697,222



9,311,570GROSS PROFIT


10,298,654



11,632,156OPERATING EXPENSESSelling and marketing


2,356,402



1,996,198General and administrative


3,308,393



2,940,077Depreciation and amortization


246,822



200,106Research and development


517,582



396,896Total operating expenses


6,429,199



5,533,277INCOME FROM OPERATIONS


3,869,455



6,098,879OTHER INCOME (EXPENSES)Other income, net


104,652



35,263Interest income, net


108,102



83,800Total other income, net


212,754



119,063INCOME BEFORE PROVISION FOR INCOME TAXES ANDNONCONTROLING INTEREST


4,082,209



6,217,942PROVISION FOR INCOME TAXES


973,225



1,002,874NET INCOME BEFORE NONCONTROLLING INTEREST


3,108,984



5,215,068Less: Net loss attributable to noncontrolling interest


(15,406
)


(32,157
)NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST


3,124,390



5,247,225OTHER COMPREHENSIVE INCOMEForeign currency translation adjustment


671,290



(20,473
)Comprehensive (income) loss attributable to noncontrolling interest


105



(11
)COMPREHENSIVE INCOME

$
3,795,785


$
5,226,741BASIC EARNINGS PER SHAREWeighted average number of shares


27,855,934



27,595,541Earnings per share

$
0.11


$
0.19DILUTED EARNINGS PER SHAREWeighted average number of shares


29,197,961



28,397,085Earnings per share

$
0.11


$
0.18







2





CHINA FIRE & SECURITY GROUP, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTOF CHANGES IN EQUITYChina Fire & Security Group, Inc. Shareholders' EquityCommon Stock







Retained EarningsAdditional


Subscriptions


Statutory





Accumulated other

comprehensive


NoncontrollingShares


Par value


paid-in-capital


receivable


reserves


Unrestricted


income


interest


TotalsBALANCE, December 31, 2009


27,595,541


$
27,595


$
20,601,138


$
-


$
7,147,795


$
69,266,049


$
7,324,237


$
32,742


$
104,399,556Net income (loss)






















5,247,225







(32,157
)


5,215,068Options issued to employees










245,047























245,047Stock based compensation for services










790,626























790,626Foreign currency translation adjustment


























(20,473
)


(11
)


(20,484
)BALANCE, March 31, 2010, (Unaudited)


27,595,541



27,595



21,636,811



-



7,147,795



74,513,274



7,303,764



574



110,629,813Capital received from non-controlling interest



























58,440



58,440Options exercised


10,393



10



27,560



(27,570
)


















-Restricted shares issued


250,000



250



(250
)






















-Net income (loss)






















10,190,710







(53,171
)


10,137,539Options issued to employees










735,148























735,148Stock based compensation for services










2,371,874























2,371,874Foreign currency translation adjustment


























4,045,855



997



4,046,852BALANCE, December 31, 2010


27,855,934



27,855



24,771,143



(27,570
)


7,147,795



84,703,984



11,349,619



6,840



127,979,666Capital received from non-controlling interest



























30,380



30,380Net income (loss)






















3,124,390







(15,406
)


3,108,984Options issued to employees










245,049























245,049Stock based compensation for services










790,625























790,625Foreign currency translation adjustment


























671,290



105



671,395BALANCE, March 31, 2011, (Unaudited)


27,855,934


$
27,855


$
25,806,817


$
(27,570
)

$
7,147,795


$
87,828,374


$
12,020,909


$
21,919


$
132,826,099







3


CHINA FIRE & SECURITY GROUP, INC. AND SUBSIDIARIESCONSOLIDATEDSTATEMENTS OF CASH FLOWSFOR THE THREE MONTHS ENDED MARCH 31, 2011 AND 2010(Unaudited)Three Months Ended March 31,2011


2010CASH FLOWS FROM OPERATING ACTIVITIES:Net income attributable to controlling interest

$
3,124,390


$
5,247,225Net loss attributable to noncontrolling interest


(15,406
)


(32,157
)Consolidated net income


3,108,984



5,215,068Adjustments to reconcile net income to cashused in operating activities:Depreciation


244,350



196,621Amortization


18,953



18,822Provision for doubtful accounts


626,386



620,724Recovery of doubtful allowance


(186,698
)


-Option issued to employees


245,049



245,047Stock based compensation for services


790,625



790,626Provision for estimated warranty claims


32,879



-Change in operating assets and liabilitiesNotes receivable


(1,280,616
)


(1,334,580
)Accounts receivable


(976,031
)


(2,006,671
)Receivable from and prepayments to related parties


(277,850
)


(1,207,294
)Other receivables


(113,819
)


(274,691
)Refundable bidding and system contracting project deposits


16,031



235,653Inventories


(1,593,586
)


(216,429
)Costs and estimated earnings in excess of billings


(6,663,375
)


(7,148,973
)Employee advances


(583,490
)


(455,684
)Prepayments and deferred expenses


2,908,642



(233,886
)Accounts payable


433,798



(442,237
)Customer deposits


845,046



95,042Billings in excess of costs and estimated earnings


(568,574
)


(181,946
)Other payables


460,891



154,995Accrued liabilities


249,194



(969,344
)Taxes payable


809,872



(249,870
)Net cash used in operating activities


(1,453,339
)


(7,149,007
)CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of plant and equipment


(152,719
)


(340,642
)Payments for long term investments


-



(4,648
)Net cash used in investing activities


(152,719
)


(345,290
)CASH FLOWS FROM FINANCING ACTIVITIES:Change in restricted cash


(2,836,376
)


(2,321,317
)Capital contributed by noncontrolling interest shareholder


30,380



-Net cash used in financing activities


(2,805,996
)


(2,321,317
)EFFECT OF EXCHANGE RATE CHANGES ON CASH


123,696



(23,908
)DECREASE IN CASH


(4,288,358
)


(9,839,522
)CASH and CASH EQUIVALENTS, beginning of periods


28,151,689



34,976,880CASH and CASH EQUIVALENTS, end of periods

$
23,863,331


$
25,137,358SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATIONIncome taxes paid

$
839,411


$
1,125,930Interest paid

$
-


$
-







4





CHINA FIRE & SECURITY GROUP, INC. AND SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIALSTATEMENTS


March 31, 2011


(Unaudited)


Note 1 - Background





Principal activities and reorganization





China Fire & Security Group Inc.(the “Company” or “CFSG”), is a Florida corporation. The Company, through its subsidiaries, is engaged in the design, development, manufacture and sale of fire protection products and services for industrial customers in the People’s Republic of China (“PRC”) and India.





Recent developments





Investment of 5% interest in Sureland Fire & Security India Private Ltd (“Sureland India”)





Sureland India was incorporated in New Delhi, India with registered capital of $51,398 (INR2,500,000). Sureland India engages in project design, consulting and construction services for the fire protection industry in India. In January 2010, Sureland India received approval from the Indian government to accept foreign investment of 5% equity from the Company’s wholly-owned subsidiary China Fire Protection Group, Inc. ("CFPG").  CFPG completed the payment of $2,710 (INR125,000) in January 2010. After the transaction, the Company became a minority interest holder of Sureland India and the investment was recorded under the cost accounting method. The Company made advance payments to Sureland India of $ 243,639 and $450,169 as of March 31, 2011 and December 31, 2010, respectively, for future services.





Acquisition of 99% ownership interest and 1% controlling interest in Zeetech System Private Ltd. (“Zeetech”)





Zeetech was incorporated in New Delhi, India with registered capital of $2,215 (INR101,000). On February 4, 2010, CFPG signed an agreement to acquire 99% ownership and 1% controlling interest in Zeetech from the existing shareholders for $2,215 (INR101,000), approximately equal to the fair value of the net assets as of January 12, 2010. Zeetech is 100% controlled by CFPG with 99% direct holding and 1% through nominee holding where the nominee agrees to hold the shares on behalf of CFPG. Zeetech does not currently have any operations.





5


Restructuring of Sureland Industrial





During the first quarter of 2010, CFPG entered into an agreement with Zeetech, our 100% controlled subsidiary, to transfer CFPG's entire interest (75%) in Sureland Industrial to Zeetech. On March 12, 2010, the restructuring transaction was approved by the Chinese Ministry of Commerce.  During the fourth quarter of 2010, CFPG entered into an agreement with Zeetech, pursuant to which Zeetech’s entire interest (75%) in Sureland Industrial Fire Safety Limited (“Sureland Industrial”) shall revert back to CFPG.  On December 9, 2010, the reverse transaction was approved by the Chinese Ministry of Commence. Subsequent to the transaction, CFSG still holds 100% of the interests in Sureland Industrial through its subsidiaries.




Formation of Shenyang Hongshida Electronics Co., Ltd (“Shenyang Hongshida”)





Shenyang Hongshida was incorporated in Shenyang, Liaoning Province, China with registered capital of $1,525,000 (RMB10,000,000). Pursuant to Shengyang Hongshida’s by-laws dated June 1, 2009, the registered capital is required to be injected over the subsequent two years. Shenyang Hongshida is 80% owned by our wholly-owned subsidiary, Beijing Hua An, with a 20% noncontrolling interest owned by an unrelated party. Shenyang Hongshida, which is in the pre-operating stage, will engage in the production and sale of fire equipment, electronic products, instrumentation, and computer parts and provision of technical advisory services. Shenyang Hongshida will focus on the low- to middle-end segment of the fire products market. As of March 31, 2011, $915,000 (RMB 6,000,000) of the registered capital of Shenyang Hongshida has been received, including $152,500 (RMB 1,000,000) in February 2011, of which $30,500 (RMB 200,000) was received from the non-controlling interest investor.





Receipt of “Going Private” Proposal




On March 7, 2011, the Special Committee of its Board of Directors (the "Special Committee") has received a non-binding letter from a leading global private equity firm (the "PE"), pursuant to which the PE proposes to acquire all of the outstanding shares of common stock of China Fire in cash at a price which represents a premium over the current stock price (the "Proposal"). According to the Proposal, the PE is willing to structure the proposed acquisition to allow the existing members of the Company's management to exchange all or part of their equity interests in the Company into equity securities in the post-acquisition company. The Proposal is subject to certain conditions, including, among other things, successful completion of due diligence to the satisfaction of the PE.




The Special Committee was formed to consider certain potential transactions involving the Company (including the Proposal). The Board cautions the Company's shareholders and others considering trading in its securities that no decision has been made by the Special Committee with respect to the Company's response to the Proposal. There can be no assurance that any definitive offer will be made, that any agreement will be executed or that this or any other transaction will be approved or consummated.




6


Note 2 - Summary of significant accounting policies





The reporting entity





The consolidated financial statements of China Fire & Security Group Inc. and Subsidiaries reflect the activities of the parent and the following subsidiaries:





Subsidiaries

Incorporated in

Ownership

PercentageChina Fire Protection Group Inc. (“CFPG”)

British Virgin Islands


100
%Zeetech System Private Limited (“Zeetech”)

India


99
%
(1)Sureland Industrial Fire Safety Limited (“Sureland Industrial”)

PRC


100
%Sureland Industrial Fire Equipment Co. Ltd. (“Sureland Equipment”)

PRC


100
%Beijing Hua An Times Fire Safety Technology Co., Ltd. (“Beijing Hua An”)

PRC


100
%Beijing Shian Kexin Technology Co., Ltd

PRC


100
%Shenyang Hongshida Electronics Co., Ltd

PRC


80
%





(1)
CFPG has 1% controlling interest in Zeetech through nominee holding where the nominee agrees to hold the shares on behalf of CFPG





Basis of presentation





The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. All material intercompany transactions and balances have been eliminated in consolidation.





While management has included all normal recurring adjustments considered necessary to give a fair presentation of the operating results for the periods presented, interim results are not necessarily indicative of results for a full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K.




7


Use of estimates





The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Management believes that the estimates utilized in preparing the consolidated financial statements are reasonable and prudent. Actual results could differ from these estimates.





Certain of the Company’s accounting policies require higher degrees of judgment than others in their application. These include the recognition of revenue and earnings from system contracting projects under the percentage-of-completion method, determining the fair value of stock based compensation and the allowance for doubtful accounts and warranty expenses. Management evaluates all of its estimates and judgments on an on-going basis.





Revenue recognition





Revenue is recognized when it is probable that the economic benefits will flow to the Company as follows:





1.
Revenues from system contracting projects are recognized using the percentage-of-completion method of accounting, and therefore, take into account the costs, estimated earnings and revenue to date on contracts not yet completed. Revenue recognized is that percentage of the total contract price that costs expended to date bear to anticipated final total costs, based on current estimates of costs to complete. Contract costs include all direct material and labor costs and those indirect costs related to contract performance, such as indirect labor, supplies, tools, repairs, and depreciation costs. Adjustments to the original estimates of the total contract revenue, total contract costs, or the extent of progress toward completion are often required as work progresses. Such changes and refinements in estimation are reflected in reported results of operations as they occur; if material, the effects of changes in estimates are disclosed in the notes to the consolidated financial statements.



The key assumptions used in the estimate of costs to complete relate to the unit material cost, the quantity of materials to be used, the installation cost and those indirect costs related to contract performance. The estimate of unit material cost is reviewed and updated on a quarterly basis, based on the updated information available in the supply markets. The estimate of material quantity to be used for completion and the installation cost is also reviewed and updated on a quarterly basis, based on the updated information on the progress of project execution. If the supply market conditions or the progress of project execution were different, it is likely that materially different amounts of contract costs would be used in the percentage of completion method of accounting. Thus the uncertainty associated with those estimates may impact our consolidated financial statements.  Selling, general, and administrative costs are




8




charged to expense as incurred. At the time a loss on a contract becomes known, the entire amount of the estimated ultimate loss is recognized in the consolidated financial statements. Claims for additional contract costs are recognized upon a signed change order from the customer.




2.
Revenue from product sales is recognized when the goods are delivered and title has passed. Product sales revenue is presented net of a value-added tax (“VAT”). All of the Company’s products that are sold in the People’s Republic of China (“PRC”) are subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing the finished product.





3.
Revenue from the rendering of maintenance services is recognized over the service period on a straight-line basis.





In accordance with ASC 605-15, “Revenue Recognition when Right of Return Exists,” revenue is recorded net of an estimate of markdowns, price concessions and warranty costs. Such reserve is based on management’s evaluation of historical experience, current industry trends and estimated costs.





Enterprise wide disclosure





Almost all of the Company’s products (fire detecting products, fire alarm control device, and water mist/sprinkler systems) are sold via system contracting projects or as part of the integrated product sales. The composition of these three types of products varies significantly from project to project, both in quantity and in dollar amounts. Although the Company could provide a breakdown of sales contribution for the Company’s own products for each project, it is almost impossible to provide revenues for each of the products when the revenue from each project is recognized based on a percentage of completion.  More importantly, the revenues from the Company’s own products do not accurately reflect the Company’s overall financial performance. The Company is a system contracting projects provider rather than a product vendor that sells their own products directly or through channels.  Therefore, it is not practical to separately disclose the revenues from external customers for each of the products.





The Company’s chief operating decision-makers (i.e. chief executive officer and his direct reports) review financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by business lines for purposes of allocating resources and evaluating financial performance. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the consolidated unit level. Based on qualitative and quantitative criteria established by ASC 280-10, “Disclosures about Segments of an





9


Enterprise and Related Information,” the Company considers itself to be operating within one reportable segment.





Shipping and handling





Costs related to shipping and handling are included in cost of revenue pursuant to ASC 605-45 “Accounting for Shipping and Handling Fees and Costs.”





Foreign currency translation





The reporting currency of the Company is the US dollar. The Company’s operating subsidiaries use their local currency, Renminbi (RMB) and Indian Rupee (INR), as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People’s Bank of China at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the consolidated statement of changes in equity.





Asset and liability accounts at March 31, 2011 were translated at 6.56 RMB to $1.00 and 45.25 INR to $1.00 as compared with 6.59 RMB to $1.00 and 45.45 INR to $1.00 at December 31, 2010, respectively.  Equity accounts were stated at their historical rate.  The average translation rates of RMB applied to income statement accounts for the three months ended March 31, 2011 and 2010 were 6.58 RMB, to $1.00 and 6.82 RMB to $1.00, respectively. The average translation rate of INR applied to income statement accounts for the three months ended March 31, 2011 and 2010 were 45.66 INR to $1.00 and 45.91 INR to $1.00, respectively. Cash flows are also translated at average translation rates for the period; therefore, amounts reported in the statement of cash flows will not necessarily agree with changes in the corresponding balances in the balance sheets.





Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.  Historically, the Company has not entered into any currency trading or hedging transactions, although there is no assurance that the Company will not enter into such transactions in the future.





Concentration of risk





Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC, Hong Kong and India. The Company maintains balances at financial institutions which, from time to time, may exceed Hong Kong Deposit Protection Board insured limits for the banks located in Hong Kong. Balances at financial institutions or state owned banks within the PRC are not





10


covered by insurance.  The balances maintained in India are deposited in the branch of DBS Bank (Singapore) Limited, which are fully insured by the Government of Singapore as of March 31, 2011. As of March 31, 2011 and December 31, 2010, the Company had deposits (including restricted cash balances) totaling $36,069,397 and $37,596,887, respectively, that are not covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.





The Company's operations are mainly carried out in the PRC. The revenue recognized from operations in India is immaterial to the Company’s consolidated financial statements. Accordingly, the Company's business, financial condition and results of operations may be influenced primarily by the political, economic and legal environments in the PRC, and by the general state of the PRC's economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittances abroad, and rates and methods of taxation, among other things.





The Company has one major customer who represented approximately 45% of the Company’s revenues for the three months ended March 31, 2011. Accounts receivable from this customer were $2,364,545 as of March 31, 2011. The Company has one major customer who represented approximately 60% of the Company’s revenues for the three months ended March 31, 2010. Accounts receivable from this customer were $0 as of March 31, 2010.





For the three months ended March 31, 2011, one supplier accounted for approximately 16.3% of the Company’s purchases. This supplier represented 0.1% of the Company’s total accounts payable as of March 31, 2011. For the three months ended March 31, 2010, two suppliers accounted for approximately 65% of the Company’s purchases. These suppliers represented 3% of the Company’s total accounts payable as of March 31, 2010.





Cash and cash equivalents





The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.  Cash and cash equivalents also include unrestricted time deposits.


11


Restricted cash





Restricted cash represents cash required to be deposited in a separate bank account subject to withdrawal restrictions related to its system contracting projects and product sales customers to guarantee contracts performance. The deposits cannot be drawn or transferred by the Company until the restriction period has expired.





Restricted cash consists of the following:


March 31,

2011


December 31,

2010(Unaudited)Restricted cashProduct sales

$
8,313,022


$
4,803,276System contracting projects


4,049,169



4,666,110Total restricted cash


12,362,191



9,469,386Restricted cash - non current


(9,603,141)



(7,533,407
)Restricted cash - current

$
2,759,050


$
1,935,979





Inventories





Inventories are stated at the lower of cost or market, using the weighted average method.





Inventories consist of the following:


March 31,

2011


December 31,

2010(Unaudited)Raw materials

$
373,094


$
192,978Finished goods


6,696,923



5,054,289Work in progress


1,277,060



1,466,181Total

$
8,347,077


$
6,713,448





12


Raw materials consist primarily of materials used in production. Finished goods consist primarily of equipment used in product sales and system contracting projects. The costs of finished goods include direct costs of raw materials as well as direct labor used in production. Indirect production costs such as utilities and indirect labor related to production such as assembling, shipping and handling costs are also included in the cost of inventory.  The Company reviews its inventories periodically to determine if any reserves are necessary for potential obsolescence. As of March 31, 2011 and December 31, 2010, the Company determined no reserves were necessary.





Accounts receivable





Accounts receivable represents amounts due from customers for products sales, maintenance services and system contracting projects. Overdue balances are reviewed regularly by senior management.





We establish an allowance for doubtful accounts based on management’s assessment of the collectability of our accounts receivable. A considerable amount of judgment is required in assessing the amount of the allowance. We consider the historical level of credit losses, apply percentages to aged receivable categories, make judgments about the creditworthiness of each customer based on ongoing credit evaluations, and monitor current economic trends that might impact the level of credit losses in the future. If the financial condition of the customers were to deteriorate, resulting in their inability to make payments, a larger allowance may be required.





Additional specific provision is made against accounts receivable to the extent that they are considered to be doubtful. Bad debts are written off against the allowance for doubtful accounts when identified. We do not accrue any interest on accounts receivable. Historically, losses from uncollectible accounts have not deviated from the general allowance estimated by management and no bad debts have been written off directly to the statements of operations. This general provisioning policy has not changed since establishment and management considers that the aforementioned general provisioning policy is adequate and does not expect to change this established policy in the near future. Any changes in the estimates of our general provision policy could have a material effect on our results of operations.





Accounts receivable consist of the following:


March 31,

2011


December 31,

2010(Unaudited)Accounts receivable:System contracting projects

$
31,125,980


$
31,930,814Maintenance services


4,247,522



3,817,251Product sales


18,700,645



17,091,283Total accounts receivable


54,074,147



52,839,348Allowance for bad debts


(8,637,861
)


(8,153,727
)Accounts receivable, net


45,436,286



44,685,621Accounts receivable - non-current retentions


(3,156,624
)


(2,790,492
)Accounts receivable - current

$
42,279,662


$
41,895,129


13


The activity in the allowance for doubtful accounts for trade accounts receivable for the three months ended March 31, 2011 and year ended December 31, 2010 is as follows:





March 31,

2011

December 31,

2010(Unaudited)Beginning allowance for doubtful accounts
$
8,153,727

$
6,539,787Additions charged to bad debt expense

626,386


1,894,361Recovery of doubtful allowance

(186,698)


(540,913)Foreign currency translation adjustment

44,446


260,492Ending allowance for doubtful accounts
$
8,637,861

$
8,153,727





Retentions held by customers for system contracting projects included in the Company’s accounts receivable are as follows:


March 31,

2011


December 31,

2010(Unaudited)RetentionsCurrent

$
5,108,513


$
6,130,574Non-current


3,156,624



2,790,492Total retentions

$
8,265,137


$
8,921,066





These balances represent portions of billings made by the Company but held for payment by the customer, pending satisfactory completion of the project. Retention payments are generally collected within one year of the completion of the project.





As of March 31, 2011, the Company believes that  9.1% of accounts receivable would be collected in more than one year, based on our historical collection pattern.





14


Costs and estimated earnings in excess of billings





The current asset “Costs and estimated earnings in excess of billings” on contracts, represents revenues recognized in excess of amounts billed.





Costs and estimated earnings in excess of billings consist of the following:


March 31,

2011


December 31,

2010(Unaudited)Contract costs incurred plus recognized profits less recognized losses to date

$
144,593,675


$
130,434,619Less: progress billings


(97,033,384
)


(89,774,606
)Costs and estimated earnings in excess of billings

$
47,560,291


$
40,660,013





The Company believes that some portion of costs and estimated earnings in excess of billings would be collected in more than one year, based on our historical billing and collection pattern. Currently, we are actively evaluating all the possible estimation methods in order to best estimate the amount to be collected in more than one year.





Billings in excess of costs and estimated earnings





The current liability “Billings in excess of costs and estimated earnings” on contracts, represents billings in excess of revenues recognized.





Billings in excess of costs and estimated earnings consists of the following:





March 31,

2011


December 31,

2010(Unaudited)Progress billings

$
11,040,846


$
16,126,195Less: contract costs incurred plus recognized profits less recognized losses to date


(8,723,434
)


(13,253,489
)Billings in excess of costs and estimated earnings

$
2,317,412


$
2,872,706





15


Plant and equipment





Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets with a 5% residual value. Depreciation expense amounted to $244,350 and $196,621 for the three months ended March 31, 2011 and 2010, respectively.





Estimated useful lives of the assets are as follows:





Useful

LifeBuildings and improvements

40 yearsTransportation equipment

5 yearsMachinery

10 yearsOffice equipment

5 yearsFurniture

5 years





Construction in progress represents the costs incurred in connection with the construction of buildings or additions to the Company’s plant facilities. No depreciation is provided for construction in progress until such time as the assets are completed and placed into service. Interest incurred during construction is capitalized into construction in progress. All other interest is expensed as incurred.





The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the consolidated statements of income. Maintenance, repairs and minor renewals are charged directly to expense as incurred. Major additions and betterments to buildings and equipment are capitalized.





Plant and equipment consists of the following:


March 31,

2011


December 31,

2010(Unaudited)Buildings and improvements

$
7,296,743


$
7,258,465Transportation equipment


4,074,948



3,963,302Machinery


922,400



901,655Office equipment


1,122,335



1,083,512Furniture


126,697



126,032Total depreciable assets


13,543,123



13,332,966Less accumulated depreciation


(4,254,507
)


(3,988,332
)Construction in progress


311,396



296,485Plant and equipment, net

$
9,600,012


$
9,641,119





16


Intangible assets





Land use rights - All land in the PRC is owned by the government. However, the government grants the user “land use rights”. The Company acquired land use rights in 2001 and the land use rights expire in 2051. The costs of these rights are being amortized over fifty years using the straight-line method.





Technology rights - In May 2007, the Company acquired the rights to manufacture two fire protection products and the costs of these rights are being amortized over ten years using the straight-line method.





Intangible assets consist of the following:





March 31,

2011


December 31,

2010(Unaudited)Land use rights
$
770,789


$
770,789Technology rights

608,745



608,745Accumulated amortization

(409,692
)


(393,891
)Balance
$
969,842


$
985,643





Amortization expense amounted to $18,953 and $18,822 for the three months ended March 31, 2011 and 2010, respectively.





Impairment of long-lived assets





The Company assesses the impairment of long-lived assets, which include identifiable intangible assets, and property and equipment, at least annually or more often whenever events or changes in circumstances indicate that the carrying value of the long lived assets may not be recoverable. Changes in the underlying business could adversely affect the fair value and recoverability of these assets. Important factors which could require an impairment review include: (i) underperformance relative to expected historical or projected future operating results; (ii) changes in the manner of use of the assets or the strategy for our overall business; (iii) negative industry or economic trends; and (iv) our enterprise fair value relative to net book value.





Our impairment evaluation of identifiable intangible assets and property and equipment includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remainingestimated useful lives, the





17


Company records an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. The Company determines fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued. Major factors that influence our cash flow analysis are our estimates for future revenue and expenses associated with the use of the asset. Different estimates could have a significant impact on the results of our evaluation. If, as a result of our analysis, the Company determines that our amortizable intangible assets or other long-lived assets have been impaired, the Company will recognize an impairment loss in the period in which the impairment is determined. Any such impairment charge could be significant and could have a material negative effect on our results of operations.  As of March 31, 2011, the Company expects these assets to be fully recoverable.





Backlog





System Contracting Projects





The following schedule shows a reconciliation of backlog representing the amount of revenue the company expects to realize from work to be performed on uncompleted contracts in progress at March 31, 2011, and from contractual agreements on which work has not yet begun.





Backlog at December 31, 2010

$
106,990,673Less:  Bids awarded and pending execution of contracts as of December 31, 2010


(32,450,706
)Contract revenue on uncompleted contracts at December 31, 2010

$
74,539,967Contract adjustments (change orders)


(564,890)Contract revenue for new contracts for the three months ended March 31, 2011


13,922,209Bids awarded and pending execution of contracts as of March 31, 2011


43,628,190Less: Contract revenue earned for the three months ended March 31, 2011 excluded the effect of miscellaneous sales tax of $433,449


(15,052,813
)Effect of exchange rate changes


(83,586
)Backlog at March 31, 2011

$
116,389,077





In addition, the Company entered into additional system contracting project contracts with revenues of $3,399,574 between April 1, 2011 and May 16, 2011.





18


Products





As of March 31, 2011, the backlog of unshipped and uninspected orders was $40,941,899. In addition, the Company entered into additional product sales contracts with revenues of $146,061 between April 1, 2011 and May 16, 2011.





Maintenance Service





As of March 31, 2011, the future revenue under existing service agreements amounted to $2,341,724.





Research and development





Research and development expenses include salaries, consultant fees, supplies and materials, as well as costs related to other overheads such as depreciation, facilities, utilities and other departmental expenses. The costs that the Company incurs with respect to internally developed technology and engineering services are included in research and development expenses as incurred as they do not directly relate to any particular licensee, license agreement or licenses fee.





Warranty





Generally, the Company’s products are not covered by specific warranty terms. However, it is the Company’s policy to replace parts if they become defective within one year after deployment at no additional charge to the customer.  The Company maintains a provision for potential warranty costs on these products for one year.  This provision represents management’s assessment of the Company’s history of warranty costs while incorporating estimates by the quality review staff of the potential product failure rates.  The Company records a warranty obligation in selling expense at the time revenue is recognized.    For the three months ended March 31, 2011 and 2010, the company accrued $32,879 and $0, respectively, warranty expense. As of March 31, 2011 and December 31, 2010, the Company recorded $429,471 and $383,744, respectively, as a provision for estimated warranty claims, which is included in the caption of accrued liabilities on the consolidated balance sheet.





Fair value of financial instruments





ASC 825-10-50, "Disclosures about Fair Value of Financial Instruments," defines financial instruments and requires fair value disclosures for those instruments. ASC 820-10, "Fair Value Measurements," defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value





19


measurement and enhances disclosure requirements for fair value measures. The three levels are defined as follow:





·
Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.





·
Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.





·
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value.





The carrying amounts reported in the balance sheets for receivables and payables qualify as financial instruments and are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and their current market rate of interest.





Investments in joint ventures are also a financial instrument.  The Company invested $173,850 (RMB 1,140,000) in Hubei Shou An Changjiang Fire Protection Co., Ltd for a 19% equity interest, invested $322,880 (RMB 2,117,246) in Tianxiao Fire Safety Equipment Co., Ltd. for 16.7% equity interest and $2,710 (INR 125,000) in Sureland India for a 5% equity interest. Total investments as of March 31, 2011 amounted to $499,440.  There is no quoted or observable market price for the fair value of similar long term investments in joint ventures.  The Company believes that the cost of the capital contributed to these joint ventures is a reasonable approximation of their fair values.





The Company did not identify any other assets and liabilities that are required to be presented on the balance sheet at fair value in accordance with ASC 820-10.





Income taxes





The Company reports income taxes pursuant to ASC 740, “Accounting for Income Taxes” and ASC 740-10, “Accounting for Uncertainty in Income Taxes” (formerly “FIN 48”). ASC 740 requires the recognition of deferred income tax liabilities and assets for the expected future tax consequences of temporary differences between the income tax basis and financial reporting basis of assets and liabilities. Provision for income taxes consists of taxes currently due plus deferred taxes. Deferred tax assets amounted to $99,350 and $85,678 as of March 31, 2011 and December 31, 2010, respectively, and are included in prepayment and deferred expenses in the accompanying consolidated balance sheets.





20


Under ASC 740-10, a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely to be realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. ASC 740-10 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. Penalties and interest incurred related to underpayment of income tax are classified as income tax expense in the year incurred.  No significant penalties or interest relating to income taxes have been incurred during the three months ended March 31, 2011 and 2010.





The Company’s operations are subject to income and transaction taxes in the United States, the PRC and the India jurisdictions. Significant estimates and judgments are required in determining the Company’s worldwide provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations. The ultimate amount of tax liability may be uncertain as a result. The Company does not anticipate any events which could cause change to these uncertainties.





The charge for taxation is based on the results for the year as adjusted for items which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.





Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit.





In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probable that taxable profit will be available against which deductible temporary differences can be utilized. Deferred tax is calculated using enacted tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it is related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity. Deferred tax assets and liabilities are offset when they relate to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis.





Value Added Tax





Enterprises or individuals who sell products, engage in repair and maintenance or import and export goods in the PRC are subject to a value added tax in accordance with Chinese laws. The value added





21


tax standard rate is 17% of the gross sales price. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the contract and production of the Company’s finished products can be used to offset the VAT due on sales of the finished product.  All of our PRC subsidiaries’ VAT is subject to a 17% rate.





VAT on sales and VAT on purchases amounted to $1,716,319 and $948,581 for the three months ended March 31, 2011 and $1,467,891 and $844,159 for the three months ended March 31, 2010, respectively. Sales and purchases are recorded net of VAT collected and paid as the Company acts as an agent for the government. VAT taxes are not impacted by the income tax holiday.





Stock-based compensation





The Company follows ASC 718, “Accounting for Stock-Based Compensation,” which defines a fair-value-based method of accounting for stock-based employee compensation and transactions in which an entity issues its equity instruments to acquire goods and services from non-employees. Stock compensation granted to non-employees has been determined in accordance with ASC 718 and ASC 505-50, “Accounting for Equity Instruments that are issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.





ASC 718 requires that all share-based compensation be recognized as an expense in the consolidated financial statements and that such cost be measured at the fair value of the award and requires compensation cost to reflect estimated forfeitures. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including our expected stock price volatility over the term of the awards, actual and projected share option exercise behaviors, risk-free interest rates and expected dividends. The volatility of the Company’s common stock was estimated by management based on the historical volatility of our common stock, the risk free interest rate was based on Treasury Constant Maturity Rates published by the U.S. Federal Reserve for periods applicable to the expected life of the share option, the expected dividend yield was based on the Company’s current and expected dividend policy, and the projected share option exercise behaviors is based on one-half of the sum of the vesting period and the contractual life of each share option. This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date.





22


Recently issued accounting pronouncements




In January 2010, FASB issued ASU No. 2010-01- “Accounting for Distributions to Shareholders with Components of Stock and Cash.” The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.
  In January 2010, FASB issued ASU No. 2010-02 – “Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification.” The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity.  The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.
  In January 2010, FASB issued ASU No. 2010-06 – “Improving Disclosures about Fair Value Measurements.” This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2.  A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers.  2)  Activity in Level 3 fair value measurements.  In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarifies existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.
  In February 2010, the FASB issued Accounting Standards Update 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements,” or ASU 2010-09. ASU 2010-09 primarily rescinds the requirement that, for listed companies, financial statements clearly disclose the date through which subsequent events have been evaluated. Subsequent events must still be evaluated through the date of financial statement issuance; however, the disclosure requirement has been removed to avoid conflicts with other SEC guidelines. ASU 2010-09 was effective immediately upon issuance and was adopted in February 2010.


In April 2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” or ASU 2010-13. This Update provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In April 2010, the FASB issued Accounting Standard Update 2010-17, “Revenue Recognition—Milestone Method (Topic 605): Milestone Method of Revenue Recognition” or ASU 2010-17. This Update provides guidance on the recognition of revenue under the milestone method, which allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a substantive milestone (milestone consideration) in the period the milestone is achieved. The pronouncement is effective on a prospective basis for milestones achieved in fiscal years and interim periods within those years, beginning on or after June 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In July 2010, FASB issued Accounting Standard Update 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” or ASU 2010-20. This Update provides enhanced disclosures which are designed to assist financial statement users in assessing an entity’s credit risk exposure and in evaluating the adequacy of an entity’s allowance for credit losses. Public entities must apply the disclosure requirements applicable to period-end balances beginning with the first interim or annual reporting period ending on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In September 2010, FASB issued Accounting Standard Update 2010-25, “Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans” or ASU 2010-25. The ASU clarifies how loans to participants should be classified and measured by defined contribution plans and how IFRS compare to these provisions. The amendments in this update are effective for fiscal years ending after December 15 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This ASU modifiedStep 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entityis required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill





23


impairment exists. For publicentities, the amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-29, Business Combinations(Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that, if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective prospectively for business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





Reclassifications





Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.





Note 3 - Earnings per share





The Company reports earnings per share in accordance with the provisions of ASC 260-10, “Earnings per Share.” ASC260-10 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share.  Basic earnings per share are computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock.





The following is a reconciliation of the basic and diluted earnings per share computation for the three months ended March 31:





2011

(Unaudited)


2010

(Unaudited)Net income for earnings per share

$
3,124,390


$
5,247,225Weighted average shares used in basic computation


27,855,934



27,595,541Dilutive effect of stock options and restricted stock


1,342,027



801,544Weighted average shares used in diluted computation


29,197,961



28,397,085Earnings per share:Basic

$
0.11


$
0.19Diluted

$
0.11


$
0.18





24


As of March 31, 2011, 1,014,878 shares of options were excluded in the calculation of diluted earnings per share due to their anti-diluted effect. All other outstanding stock options and restricted stocks were included in the calculation of diluted earnings per share because of their dilutive nature.As of March 31, 2010, all outstanding stock options and restricted stocks were included in the calculation of diluted earnings per share.





Note 4 - Related party transactions





The Company has receivables from Hubei Shou An Changjiang Fire Protection Co., Ltd. (“Hubei Shou An”), in which the Company has a 19% ownership interest. The accounts receivable due from Hubei Shou An was $161,579 and $160,731 as of March 31, 2011 and December 31, 2010, respectively, which resulted from product sales of $57,016 and $41,045 for the years ended December 31, 2010 and 2009, respectively. This amount is expected to be repaid by December 31, 2011 in cash.





In addition, the Company has other receivables from Hubei Shou An in the amounts of $235,277 and $234,042 as of March 31, 2011 and December 31, 2010, respectively. This balance was for operating capital in Hubei Shou An and is expected to be repaid by December 31, 2011 in cash.





The Company has prepayments to Tianjin Tianxiao Fire Safety Equipment Co., Ltd., in which the Company has a 16.7% ownership interest. The prepayment to Tianjin Tianxiao Fire Safety Equipment Co., Ltd. was $2,097,462 and $1,603,123 as of March 31, 2011 and December 31, 2010. Total product purchases amounted to $325,970 and $1,407,126 for the three months ended March 31, 2011 and 2010, respectively.





Advance payments to Sureland India, in which the Company has a 5.0% ownership interest, were $243,639 and $450,170 as of March 31, 2011 and December 31, 2010, respectively. This balance was for the advance payment to Sureland India for the delivery of future services.





Note 5 - Notes receivable





Notes receivable represents trade accounts receivable due from various customers where the customers’ bank or a customer with a AAA rating has guaranteed the payment of the receivable. These amount are non-interest bearing and are normally paid within three to six months. The Company has





25


the ability to submit a request for payment to the customer’s bank earlier than the scheduled payment date. However, the Company will incur an interest charge and a processing fee when they submit the payment request early. The Company‘s notes receivable totaled $15,789,722 and $14,428,802 as of March 31, 2011 and December 31, 2010, respectively, of which $7,853,750 and $6,826,500 as of March 31, 2011 and December 31, 2010, respectively, are corporate notes receivable that are guaranteed by a customer with a AAA rating.





Note 6 - Prepayments and deferred expenses





Prepayments and deferred expenses are monies deposited with or advanced to subcontractors to perform services on system contracting projects. Some subcontractors require a certain amount of money to be deposited as a guarantee payment in order for them to start performing the services.  Prepayments and deferred expenses also include monies deposited or advanced to vendors on future inventory purchases to ensure timely delivery. The total outstanding amount was $7,416,480 and $10,281,292 as of March 31, 2011 and December 31, 2010, respectively.





Note 7 - Investment in joint ventures





During the second quarter of 2007, the Company invested $173,850 (RMB1,140,000) for a 19% interest in Hubei Shou An Changjiang Fire Protection Co., Ltd., located in China Hubei, PRC.  The investment is recorded under the cost accounting method.





As of  March 31, 2011, the Company held an investment of $322,880 (RMB2,117,246) for a 16.7% interest in Tianjin Tianxiao Fire Safety Equipment Co., Ltd. as a non-controlling interest holder. The investment is recorded under the cost accounting method at fair value at the deconsolidation date.





In January 2010, the company invested $2,710 (INR125,000) for a 5% interest in Sureland India as a non-controlling interest holder. The investment is recorded under the cost accounting method.





Note 8 - Customer deposits





Customer deposits represent amounts advanced by customers on product orders, maintenance services deposits and system contracting projects deposits. The product or service normally is shipped or performed within nine months after receipt of the advance payment and the related sale is recognized in accordance with the Company’s revenue recognition policy.  These advance payments are applied to the invoices when the Company bills the customer based on the progression of the projects. As of





26


March 31, 2011 and December 31, 2010, customer deposits amounted to $3,886,756 and $3,023,329, respectively.





Note 9 - Accrued liabilities





Accrued liabilities represent subcontractors’ expenses incurred as of the balance sheet date for system contracting projects. Accrued liabilities also represent an accrued estimation of warranty expenses.  As of March 31, 2011 and December 31, 2010, accrued liabilities amounted to $20,123,301 and $19,737,906, respectively.





Note 10 - Income taxes





Local PRC Income Tax





Starting from January 1, 2008, all of the Company’s Chinese subsidiaries are subject to a 25% income tax rate according to the Income Tax Laws of the PRC. According to the PRC’s central government policy, certain new technologies and/or high technology companies will enjoy a preferential tax rate of 15%, instead of 25%. Beijing Hua An qualifies for the preferential tax treatment in the year 2009 and 2010. Sureland Industrial receives a 50% income tax reduction for three years beginning in January 2009, Sureland Equipment receives a 50% income tax reduction for three years beginning in January 2008, and Beijing Hua An receives a 50% income tax reduction for the years of 2009 and 2010 due to the fact that they are located in a specially designated region.





India Project Office Income Tax





The Company’s operation in India is managed on a project basis and projects are conducted under the name of CFPG or Sureland Industrial as a foreign enterprise. Under the India Income Tax Act, the Company’s projects are generally subject to an income tax at an effective rate of 40% on income reported in the statutory financial statements after appropriate tax adjustments in accordance with Indian tax regulations.





The Company’s subsidiaries are paying the following tax rate for the three months ended March 31, 2010:





27


Subsidiaries

Income tax

exemption

Effective

income tax

rateSureland Industrial


12.5
%


12.5
%Sureland Equipment


12.5
%


12.5
%Beijing Hua An


17.5
%


7.5
%Shian Kexin


-
%


25.0
%Zeetech


-
%


40.0
%India Project Office


-
%


40.0
%Shanyang Hongshida


-
%


25.0
%





The Company’s subsidiaries are paying the following tax rate for the three months ended March 31, 2011:


Subsidiaries

Income tax

exemption

Effective

income tax

rateSureland Industrial


12.5
%


12.5
%Sureland Equipment


-
%


25.0
%Beijing Hua An


-
%


25.0
%Shian Kexin


-
%


25.0
%Zeetech


-
%


40.0
%India Project Offices


-
%


40.0
%Shanyang Hongshida


-
%


25.0
%





The provision for income taxes amounted to $973,225 and $1,002,874 for the three months ended March 31, 2011 and 2010, respectively.





The following table reconciles the U.S. statutory rate to the Company’s effective tax rate for the three months ended March 31:


2011


2010U.S. Statutory rates


34.0
%


34.0
%Foreign income not recognized in USA


(34.0
)


(34.0
)China income taxes


25.0



25.0China income tax exemption


(11.0
)


(18.3
)Permanent Differences (China)(1)


2.4



1.4Other item (2)


7.4



8.0Effective income tax rates


23.8
%


16.1
%





(1) The 2.4% represents $529,402 of bad debt provisions and $150,286 of meals and entertainment expenses incurred by Sureland Industrial, Sureland Equipment, and Beijing Hua An that are not deductible in PRC for the three months ended March 31, 2011. These non-deductible expenses were offset by $258,791, which is a 50% additional deduction allowed in PRC for Research and Development expenses at Sureland Industrial. The 1.4% represents $620,724 of bad debt provisions and $148,350 of meals and entertainment expenses incurred by Sureland Industrial, Sureland Equipment, and Beijing Hua An that are not deductible in PRC for the three months ended March 31,





28


2010. These non-deductible expenses were offset by $198,448 which is a 50% additional deduction allowed by PRC for Research and Development expenses at Sureland Industrial.





(2)  The 7.4% and 8.0% represents $1,520,803 and $1,387,159 in expenses incurred by CFSG and CFPG that are not deductible in PRC for the three months ended March 31, 2011 and 2010, respectively.





The estimated tax savings as a result of PRC income tax exemption for the three months ended March 31, 2011 and 2010 amounted to $620,161 and $1,139,778, respectively. The net effect on basic and diluted earnings per share if the income tax had been applied would decrease basic and diluted earnings per share for the three months ended March 31, 2011 and 2010 by $0.02 and $0.04, respectively.




China Fire & Security Group, Inc., the parent company, is incorporated in the United States and incurred net operating losses of $0 for income tax purposes for the three months ended March 31, 2011.  The estimated net operating loss carry forwards at March 31, 2011 for United States income taxes amounted to $1,079,324 which may be available to reduce future years’ taxable income.  These carry forwards will expire, if not utilized, from 2024 through 2030.  Management believes that the realization of the benefits from these losses appears uncertain due to the Company’s limited operating history and continuing losses for United States income tax purposes.  Accordingly, the Company has provided a 100% valuation allowance on the deferred tax asset benefit to reduce the asset to zero.  The net change in the valuation allowance for the three months ended March 31, 2011 and 2010 was $0, respectively, and the accumulated valuation allowance as of March 31, 2011 amounted to $366,970. Management reviews this valuation allowance periodically and makes adjustments as warranted.





The Company has cumulative undistributed earnings of foreign subsidiaries of approximately $95.7 million as of March 31, 2011, which is included in the consolidated retained earnings and will continue to be indefinitely reinvested in international operations.  Accordingly, no provision has been made for U.S. deferred taxes related to future repatriation of these earnings, nor is it practicable to estimate the amount of income taxes that would have to be provided if the Company concluded that such earnings will be remitted in the future.





Taxes payable





Taxes payable consisted of the following:


March 31,

2011


December 31,

2010(Unaudited)VAT taxes payable

$
7,387,464


$
6,887,213Income taxes payable


1,394,744



1,284,469Sales taxes


1,369,103



1,120,446Other taxes payable


127,014



124,701Total

$
10,278,325


$
9,416,829





29


Note 11 - Retirement plan





The Company and its subsidiaries are required to participate in a central pension scheme operated by the local municipal government. The Company is required to contribute 20% of its payroll costs to the central pension scheme in 2011 and 2010. The contributions are charged to the consolidated income statement of the Company as they become payable in accordance with the rules of the scheme. The aggregate contributions of the Company to retirement benefit schemes amounted to $115,939 and $100,429 for the three months ended March 31, 2011 and 2010, respectively.





Note 12 - Statutory reserves





The laws and regulations of the PRC require that before an enterprise distributes profits to its partners, it must first satisfy all tax liabilities, provide for losses in previous years, and make allocations, in proportions determined at the discretion of the board of directors, after the statutory reserve. The statutory reserves include a surplus reserve fund and the enterprise fund. These statutory reserves represent restricted retained earnings.





Surplus reserve fund





The Company is required to transfer 10% of its net income, as determined in accordance with PRC accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the Company’s registered capital.





The transfer to this reserve must be made before distribution of any dividend to shareholders. The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them, provided that the remaining reserve balance after such issue is not less than 25% of the registered capital.





Because the surplus reserve fund already totals 50% of Sureland Industrial, Sureland Equipment, and Beijing Hua An’s registered capital, the Company did not reserve any surplus reserve fund at the end of





30


March 31, 2011 for these subsidiaries.  As of March 31, 2011, the remaining reserve required for Shian Kexin and Shenyang Hongshida to fulfill the 50% registered capital requirement totaled $838,750.





Enterprise fund





The enterprise fund may be used to acquire plant and equipment or to increase the working capital to expend on production and operation of the business. No minimum contribution is required and the Company did not make any contribution to this fund for the three months ended March 31, 2011 and 2010.





Note 13 - Options issued to employees





On December 31, 2008, pursuant to the Company's 2008 Omnibus Long-term Incentive Plan, the Company's Board of Directors authorized the issuance of 1,000,000 share options for its employees, including 800,000 options issued to executive officers. The options vest evenly each quarter over the following four years, starting from the first quarter of 2009. The Company used the Black Scholes Model to value the options at the time they were issued, based on the exercise price of $6.81, which was the closing price of the Company’s stock on December 31, 2008 and using risk-free rates of 0.875%, 1.125%, 1.313% and 1.5% and volatility of 86% that was estimated by analyzing the trading history of the Company’s stock. Because the Company did not have historical exercise history, the Company used the simplified method to estimate the expected life of the options, which is equal to the midpoint between the vesting date and expiration date of the options. The 1,000,000 employee options had a grant date fair value of $3,863,606. The related compensation expense is recognized on a straight-line basis over the four year vesting period.





The total stock option compensation expense recognized for the three months ended March 31, 2011 and 2010 was $245,049 and $245,047, respectively. As of March 31, 2011, approximately $1.69 million of estimated expense related to un-vested stock-based awards has yet to be recognized and will be recognized over the employee’s remaining service period of approximately 1.73 years.





There were 1,765,607 options outstanding as of March 31, 2011.





31


The Company has stock options as follows:


WeightedAverage


AggregateOptions


Exercise


IntrinsicOutstanding


Price


ValueOutstanding, December 31, 2009


1,776,000


$
4.45


$
16,120,860GrantedForfeitedExercisedOutstanding, March 31, 2010


1,776,000


$
4.45


$
15,126,300GrantedForfeitedExercised


(10,393
)


2.65Outstanding, December 31, 2010


1,765,607


$
4.46


$
3,719,188GrantedForfeitedExercisedOutstanding, March 31, 2011


1,765,607


$
4.46


$
3,012,917





Following is a summary of the status of options outstanding at March 31, 2011:





Outstanding Options

Exercisable OptionsAverage







AverageRemaining







RemainingNumber of


Exercise

Contractual

Number of


Exercise


ContractualOptions


Price

Life

Options


Price


Life742,229


$
1.25

5.25


742,229


$
1.25



5.256,000


$
4.51

1.08


6,000


$
4.51



1.0820,000


$
6.70

1.25


18,750


$
6.70



1.25997,378


$
6.81

2.75


559,878


$
6.81



2.751,765,607








1,326,857





32


Note 14 - Restricted stock issued to employees





On December 1, 2009, pursuant to the Company's 2008 Omnibus Long-term Incentive Plan, the Company's Board of Directors authorized the issuance of 1,000,000 shares of restricted stock for its employee, including 285,000 shares of restricted stock issued to executive officers. The restricted stocks will vest evenly each year over the following four years, starting from December 1, 2009. The Company used the closing price of the Company’s common stock at the time the restricted stock grants were made, based on the closing price of $12.65, which was the closing price of the Company’s stock on November 30, 2009.





The 1,000,000 shares of employee restricted stock had a fair value of $12,650,000. The related compensation expense is recognized on a straight-line basis over the four year vesting period.





The total restricted stock compensation expense recognized for the three months ended March 31, 2011 and 2010 was $790,625 and $790,626, respectively.





On December 1, 2010, 250,000 shares of the restricted stock are vested and issued to the employees and executive officers accordingly.





Note 15 - Commitments and Contingencies





Commitments





As described in Note 1, Shenyang Hongshida has a registered capital of $1,525,000, of which $915,000 has been invested as of March 31, 2011. The remaining $610,000 is scheduled to be injected within two years of June 1, 2009, the date of the Company’s by-laws.





Contingencies




As previously disclosed, on March 7, 2011, the Company issued a press release announcing that the Special Committee of its Board of Directors (the "Special Committee") had received a non-binding letter from a leading global private equity firm (the "PE"), pursuant to which the PE proposes to acquire all of the outstanding shares of common stock of the Company in cash at a price which represents a premium over the current stock price (the "Proposal").  The press release further announced that the Board cautioned the Company's shareholders and others considering trading in its securities that no decision has been made by the Special Committee with respect to the Company's response to the Proposal and that there can be no assurance that any definitive offer will be made, that any agreement will be executed or that this or any other transaction will be approved or consummated.  For the full details of this press release, please see the Company’s Form 8-K, filed with the SEC on March 7, 2011.
 
 In response to this announcement, on April 1, 2011, a purported class action lawsuit captionedIra Brown v. China Fire & Security Group, Inc., et al., was filed in the Broward County Circuit Court of the State of Florida against the Company and its individual directors.  The complaint purports to allege breaches of fiduciary duties by the individual directors relating to the disclosure of information concerning the Proposal.  The complaint seeks compensatory damages and injunctive relief, including to enjoin any transactions related to the Proposal and any related going private transaction, and an award of attorneys’ and other fees and costs, in addition to other relief.  The Company believes the plaintiff’s allegations lack merit, and will contest them vigorously. However, based upon information that is presently available to it, the Company’s management does not believe this class action could have a material adverse effect on the Company’s financial position, results of operations, or cash flows.




33


Item 2. Management’s Discussion and Analysis or Plan of Operation





Forward-Looking Statements


Some of the statements contained in this Form 10-Q are not historical facts and are forward-looking statements, which can be identified by the use of terminology such as estimates, projects, plans, believes, expects, anticipates, intends, or the negative or other variations, or by discussions of strategy that involve risks and uncertainties. We urge you to be cautious of the forward-looking statements, that such statements, which are contained in this Form 10-Q reflect our current beliefs with respect to future events and involve known and unknown risks, uncertainties, and other factors affecting our operations, market growth, services, products, and licenses. No assurances can be given regarding the achievement of future results, as actual results may differ materially as a result of the risks we face, and actual events and conditions that may differ from the assumptions underlying the statements that have been made regarding anticipated events. Factors that may cause actual results, our performance or achievements, or industry results, to differ materially from those contemplated by such forward-looking statements include without limitation: our ability to attract and retain management to integrate and maintain technical information and management information systems; our ability to raise capital when needed and on acceptable terms and conditions; the intensity of competition; and general economic conditions.
 
 All written and oral forward-looking statements made in connection with this Form 10-Q that are attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Given the uncertainties that surround such statements, you are cautioned not to place undue reliance on such forward-looking statements.


General





The following discussion and analysis provides information which the management of China Fire & Security Group, Inc., (“we,” “our,” “us,” the “Company” or “CFSG”) believes to be relevant to an assessment and understanding of the Company’s results of operations and financial condition. This discussion should be read together with the Company’s financial statements and the notes to financial statements, which are included in this report.





Overview





We are engaged in the design, development, manufacturing and sale of fire protection products and services for large industrial firms in China and international markets. We have developed a proprietary product line that addresses all aspects of industrial fire safety from fire detection to fire system control and extinguishing. The Company is one of the first companies in China to leverage high technology for fire protection and safety on behalf of its clients including iron and steel companies, power plants, petrochemical plants, as well as, special purpose construction companies in China and other international markets.





Reorganization





We were organized as a Florida corporation on June 17, 2003.





On September 1, 2006, we entered into a share exchange agreement, pursuant to which we acquired all of the outstanding capital shares of China Fire Protection Group Inc. in exchange for a controlling interest in our common shares. The transaction was completed on Oct 27, 2006.





China Fire Protection Group was organized on June 2, 2006 for the purpose of acquiring all of the capital shares of Sureland Industrial Fire Safety Limited (Sureland Industrial), a Chinese corporation, and, Sureland Industrial Fire Equipment Co., Ltd. (Sureland Equipment), a Chinese corporation, which collectively engage in the design, development, manufacturing and sale of fire protection products and services for large industrial firms in China. As a result of the transactions described above, both Sureland Industrial Fire Safety Limited and Sureland Industrial Fire Equipment Co., Ltd became wholly-owned subsidiaries of China Fire Protection Group Limited, and China Fire Protection Group Limited is a wholly-owned subsidiary of Unipro.





On February 9, 2007, Unipro changed its name to China Fire & Security Group, Inc. (CFSG) and started trading on the OTC Bulletin Board under its new ticker symbol CFSG. On July 16, 2007, China Fire & Security Group, Inc. began trading on the Nasdaq Capital Market and retained the ticker symbol CFSG.





CFSG owns, through its wholly owned subsidiary China Fire Protection Group, Inc., Sureland Industrial and Sureland Equipment (jointly “Sureland”). Sureland is engaged primarily in the design, development, manufacture and sale in China of a variety of fire safety products for the industrial fire safety market as well as the design and installation of industrial fire safety systems in which it uses a combination of fire safety products including its own fire safety products. To a minor extent, it provides maintenance services for customers of its industrial fire safety systems. Its business is primarily in China, but it has recently begun contract manufacturing products for the export market and it has begun to provide a fire safety system for a Chinese company operating abroad.





Sureland markets its industrial fire safety products and systems primarily to major companies in the iron and steel, power and petrochemical industries in China. It has also completed projects for highway and railway tunnels, wine distilleries and a nuclear reactor. It is expanding its business in the transportation, wine, vessels, nuclear energy, and public space markets. Its products can be readily adapted for use on vessels and in exhibition halls and theatres. It plans to expand its marketing efforts to secure business in these industries.





Sureland has internal research and development facilities engaged primarily in furthering fire safety technologies. It believes that its technologies allow it to offer cost-effective and high-quality fire safety products and systems. It has developed products for industrial fire detecting and extinguishing. It believes that it is the largest manufacturer in China that has successfully developed a comprehensive line of linear heat detectors.





In May 2009, Beijing Shian Kexin Technology Co., Ltd. (“Shian Kexin”) was incorporated in Beijing, China under the laws of the PRC with registered capital of RMB5,000,000 or approximately $748,500. Shian Kexin is 100% owned by Sureland Industrial.





34


In May 2009, Shenyang Hongshida Electronics Co., Ltd. (“Hongshida”) was incorporated in Shenyang, Liaoning Province, China under the laws of the PRC with registered capital of RMB10,000,000 or approximately  $1,497,000. Hongshida is 80% owned by Beijing Hua An Times Fire Safety Technology Co., Ltd. (“Beijing Hua An”) with a 20% non-controlling interest owned by an unrelated party. Beijing Hua An is 100% owned by Sureland Industrial.





During the first quarter of 2010, our wholly-owned subsidiary, China Fire Protection Group, Inc. entered into an agreement with Zeetech System Private Limited (“Zeetech”), our subsidiary in which we control 100% (99% direct holding, 1% through nominee holding where the nominee agrees to hold the shares on behalf of CFPG), pursuant to which China Fire Protection Group Inc.’s entire interest (75%) in Sureland Industrial shall be transferred to Zeetech. On March 12, 2010, the restructuring transaction was approved by the Chinese Ministry of Commence. Subsequent to the transfer, China Fire & Security Group, Inc. still holds 100% of the interest in Sureland Industrial through its subsidiaries.





During the fourth quarter of 2010, our wholly-owned subsidiary, China Fire Protection Group, Inc. entered into an agreement with Zeetech System Private Limited (“Zeetech”) pursuant to which Zeetech’s entire interest (75%) in Sureland Industrial shall be reverted back to China Fire Protection Group, Inc.  On December 9, 2010, the reverse transaction was approved by the Chinese Ministry of Commence. Subsequent to the transaction, China Fire & Security Group, Inc. still holds 100% of the interest in Sureland Industrial through its subsidiaries.





As of March 31, 2011, Sureland operates more than 20 sales and liaison offices in China. Sureland has been ranked as the leading Chinese industrial fire safety company and the largest contractor by the China Association for Fire Prevention based on six major factors including total revenue, growth rate, net profit, return on assets, investment in research and development and intellectual property. Its key products include linear heat detectors and water mist extinguishers, whose sales volumes are the largest in China. Its products have been used by its customers in more than 20 provinces throughout China.





Critical Accounting Policies and Estimates





While our significant accounting policies are more fully described in Note 2 to our consolidated financial statements appearing at the end of this report, we believe that the following accounting policies are the most critical to aid you in fully understanding and evaluating our reported financial results.





Certain of the Company’s accounting policies require higher degree of judgment than others in their application. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our financial statements:





Revenue recognition





Revenue is recognized when it is probable that the economic benefits will flow to the Company as follows:





1.
Revenue recognition of total solution contracts: Historically more than 70% of our revenues are derived from long-term, fixed price total solution contracts for which revenues and estimated profits are recognized using the percentage of completion method of accounting. Under this method revenue recognized based upon the ratio that incurred costs to date bear to total estimated contract costs at completion with related cost of sales recorded as costs are incurred. Contract costs include all direct material and labor costs and those indirect costs related to contract performance. Selling and administrative costs are charged to expense as incurred. Risks and uncertainties inherent in the estimation process could affect the amounts reported in our financial statements. The key assumptions used in the estimate of costs to complete relate to the unit material cost, the quantity of materials to be used, the installation cost and those indirect costs related to contract performance. The estimate of unit material cost is reviewed and updated on a quarterly basis, based on the updated information available on the supply markets. The estimate of material quantity to be used for completion and the installation cost is also reviewed and updated on a quarterly basis, based on the updated information on the progress of projection execution. If the supply market conditions or the progress of projection execution were different, it is likely that materially different amounts of contract costs would be used in the percentage of completion method of accounting. Thus the uncertainty associated with those estimates may impact our consolidated financial statements.





2.
Revenue from product sales is recognized when the goods are delivered and title has passed. Product sales revenue is presented net of a value-added tax (“VAT”). All of the Company’s products that are sold in the PRC are subject to a Chinese value-added




35


tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on raw materials and other materials included in the cost of producing their finished product.


3.
Revenue from the rendering of Maintenance Services is recognized over the service period on a straight-line basis.




In accordance with ASC 605-15, “Revenue Recognition when Right of Return Exists,” revenue is recorded net of an estimate of markdowns, price concessions and warranty costs. Such reserve is based on management’s evaluation of historical experience, current industry trends and estimated costs.





Foreign currency translation





The reporting currency of the Company is the U.S. dollar. The Company uses their local currency, Renminbi and Indian Rupee (“INR”), as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate as quoted by the People’s Bank of China at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the consolidated statement of changes in equity.





Asset and liability accounts at March 31, 2011 were translated at 6.56 RMB to $1.00 and 45.25 INR to $1.00 as compared to 6.59 RMB to $1.00 and 45.45 INR to $1.00 at December 31, 2010  respectively.  Equity accounts were stated at their historical rate.  The average translation rates of RMB applied to income statements accounts for the three months ended March 31, 2011 and 2010 were 6.58 RMB and 6.82 RMB respectively. The average translation rates of INR applied to income statements accounts for the three months ended March 31, 2011 and 2010 were 45.66 INR and 45.91 INR. Cash flows are also translated at average translation rates for the period, therefore, amounts reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the balance sheets.




Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred. Historically, the Company has not engaged in any currency trading or hedging transactions, although there is no assurance that the Company will not enter into such transactions in the future.





Use of estimates





The preparation of financial statements in conformity with generally accepted accounting principles of the United States of America requires management to make estimates and assumptions that affect the amounts reported in the combined financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates.





Certain of the Company’s accounting policies require higher degrees of judgment than others in their application. These include the recognition of revenue and earnings from system contracting projects under the percentage of completion method, impairment of long-lived assets and the allowance for doubtful accounts. Management evaluates all of its estimates and judgments on an on-going basis.





Accounts receivable





Accounts receivable represents amounts due from customers for products sales, maintenance services and system contracting projects. The credit term is generally for a period of three months for major customers. Each customer has a maximum credit limit. The Company seeks to maintain strict control over its outstanding receivables. Overdue balances are reviewed regularly by senior management.  In order to mitigate the adverse liquidity impact of the delays in customer payments, we can negotiate with our suppliers for a better payment term, in order to slow down our payments to our suppliers in the future. However, due to the limited number of qualified suppliers available in the market, the potential delay in our payments to suppliers cannot significantly offset the adverse liquidity impact of the delays from our customer payments.





Allowance for doubtful accounts





We establish an allowance for doubtful accounts based on management’s assessment of the collectability of our account receivables. A considerable amount of judgment is required in assessing the amount of the allowance. We consider the historical level of credit losses, apply percentages to aged receivable categories, make judgments about the creditworthiness of each customer based on





36


ongoing credit evaluations, and monitor current economic trends that might impact the level of credit losses in the future. If the financial condition of the customers were to deteriorate, resulting in their inability to make payments, a larger allowance may be required.





Based on the above assessment, during the reporting years, the management establishes the general provision policy to make allowance equivalent to the sum of 3% of amount of account receivables less than 1 year, 15% of amount of account receivable between 1 year to 2 years, 40% of amount of account receivable between 2 years to 3 years and 100% of amount of account receivable above 3 years. Additional specific provision is made against account receivables to the extent which they are considered to be doubtful.





Bad debts are written off against allowance for doubtful accounts when identified. We do not accrue any interest on accounts receivable. Historically, losses from uncollectible accounts have not deviated from the general allowance estimated by the management and no bad debts have been written off against allowance for doubtful accounts directly to the profit and loss. This general provisioning policy has not changed in the past since establishment and the management considers that the aforementioned general provisioning policy is adequate and does not expect to change this established policy in the near future. Any changes on the estimates on our general provision policy could have a material effect on our results of operations.




Valuation of Long-Lived Assets





We assess the impairment of long-lived assets, which include goodwill, identifiable intangible assets, and property and equipment (“P&E”), at least annually for goodwill or whenever events or changes in circumstances indicate that the carrying value may not be recoverable for all long-lived assets. Changes in the underlying business could adversely affect the fair value of the enterprise and intangible asset and P&E asset groups. Important factors which could require an impairment review include: (i) underperformance relative to expected historical or projected future operating results; (ii) changes in the manner of use of the assets or the strategy for our overall business; (iii) negative industry or economic trends; (iv) our enterprise fair value relative to net book value.





Our impairment evaluation of identifiable intangible assets and P&E includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remaining estimated useful lives, we record an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. We determine fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued. Major factors that influence our cash flow analysis are our estimates for future revenue and expenses associated with the use of the asset. Different estimates could have a significant impact on the results of our evaluation. If, as a result of our analysis, we determine that our amortizable intangible assets or other long-lived assets have been impaired, we will recognize an impairment loss in the period in which the impairment is determined. Any such impairment charge could be significant and could have a material negative effect on our results of operations.





Share-based Compensation





We applied ASC 718, Compensation - Stock Compensation (formerly SFAS No. 123R, Share-Based Payment). ASC 718 requires that all share-based compensation be recognized as an expense in the consolidated financial statements and that such cost be measured at the fair value of the award and requires compensation cost to reflect estimated forfeitures. The determination of the fair value of share-based compensation awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including our expected stock price volatility over the term of the awards, actual and projected share option exercise behaviors, risk-free interest rate and expected dividends. The volatility of the Company’s common stock was estimated by management based on the historical volatility of our common stock, the risk free interest rate was based on Treasury Constant Maturity Rates published by the U.S. Federal Reserve for periods applicable to the expected life of the share option, the expected dividend yield was based on the Company’s current and expected dividend policy, and the projected share option exercise behaviors is based on one-half of the sum of the vesting period and the contractual life of each share option.  This is the same as assuming that the options are exercised at the mid-point between the vesting date and expiration date.





Any uncertainty associated with these assumptions may impact our consolidated financial statements might affect our valuation when the options are granted.





37


Inventories





Inventories are stated at the lower of cost or market, using the weighted average method. Raw materials consist primarily of materials used in production. Finished goods consist primarily of equipment used in product sales and system contracting projects. The costs of finished goods include direct costs of raw materials as well as direct labor used in production. Indirect production costs such as utilities and indirect labor related to production such as assembling, shipping and handling costs are also included in the cost of inventory. The Company reviews its inventory periodically to determine if any reserves are necessary for potential obsolescence.





Costs and estimated earnings in excess of billings





The current asset, “Costs and estimated earnings in excess of billings” on contracts, represents revenues recognized in excess of amounts billed.





Billings in excess of costs and estimated earnings





The current liability, “Billings in excess of costs and estimated earnings” on contracts, represents billings in excess of revenues recognized.





Plant and equipment





Plant and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets with a 5% residual value.





Recently issued accounting pronouncements





In January 2010, FASB issued ASU No. 2010-01- “Accounting for Distributions to Shareholders with Components of Stock and Cash.” The amendments in this Update clarify that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in EPS prospectively and is not a stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings Per Share). The amendments in this update are effective for interim and annual periods ending on or after December 15, 2009, and should be applied on a retrospective basis. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In January 2010, FASB issued ASU No. 2010-02 – “Accounting and Reporting for Decreases in Ownership of a Subsidiary – a Scope Clarification.” The amendments in this Update affect accounting and reporting by an entity that experiences a decrease in ownership in a subsidiary that is a business or nonprofit activity. The amendments also affect accounting and reporting by an entity that exchanges a group of assets that constitutes a business or nonprofit activity for an equity interest in another entity.  The amendments in this update are effective beginning in the period that an entity adopts SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date the amendments in this update are included in the Accounting Standards Codification, the amendments in this update are effective beginning in the first interim or annual reporting period ending on or after December 15, 2009. The amendments in this update should be applied retrospectively to the first period that an entity adopted SFAS No. 160. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In January 2010, FASB issued ASU No. 2010-06 – “Improving Disclosures about Fair Value Measurements.” This update provides amendments to Subtopic 820-10 that requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2.  A reporting entity should disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers.  2)  Activity in Level 3 fair value measurements.  In the reconciliation for fair value measurements using significant unobservable inputs (Level 3), a reporting entity should present separately information about purchases, sales, issuances, and settlements (that is, on a gross basis rather than as one net number). This update provides amendments to Subtopic 820-10 that clarifies existing disclosures as follows: 1) Level of disaggregation. A reporting entity should provide fair value measurement disclosures for each class of assets and liabilities. A class is often a subset of assets or liabilities within a line item in the statement of financial position. A reporting entity needs to use judgment in determining the appropriate classes of assets and liabilities. 2) Disclosures about inputs and valuation techniques. A reporting entity should provide disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements. Those disclosures are required for fair value measurements that fall in either Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal





38


years beginning after December 15, 2010, and for interim periods within those fiscal years. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In February 2010, the FASB issued Accounting Standards Update 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements,” or ASU 2010-09. ASU 2010-09 primarily rescinds the requirement that, for listed companies, financial statements clearly disclose the date through which subsequent events have been evaluated. Subsequent events must still be evaluated through the date of financial statement issuance; however, the disclosure requirement has been removed to avoid conflicts with other SEC guidelines. ASU 2010-09 was effective immediately upon issuance and was adopted in February 2010.





In April 2010, the FASB issued Accounting Standards Update 2010-13, “Compensation—Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” or ASU 2010-13. This Update provides amendments to Topic 718 to clarify that an employee share-based payment award with an exercise price denominated in currency of a market in which a substantial porting of the entity’s equity securities trades should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. The amendments in this Update are effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In April 2010, the FASB issued Accounting Standard Update 2010-17, “Revenue Recognition—Milestone Method (Topic 605): Milestone Method of Revenue Recognition” or ASU 2010-17. This Update provides guidance on the recognition of revenue under the milestone method, which allows a vendor to adopt an accounting policy to recognize all of the arrangement consideration that is contingent on the achievement of a substantive milestone (milestone consideration) in the period the milestone is achieved. The pronouncement is effective on a prospective basis for milestones achieved in fiscal years and interim periods within those years, beginning on or after June 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In July 2010, FASB issued Accounting Standard Update 2010-20, “Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses” or ASU 2010-20. This Update provides enhanced disclosures which are designed to assist financial statement users in assessing an entity’s credit risk exposure and in evaluating the adequacy of an entity’s allowance for credit losses. Public entities must apply the disclosure requirements applicable to period-end balances beginning with the first interim or annual reporting period ending on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements





In September 2010, FASB issued Accounting Standard Update 2010-25, “Plan Accounting—Defined Contribution Pension Plans (Topic 962): Reporting Loans to Participants by Defined Contribution Pension Plans” or ASU 2010-25. The ASU clarifies how loans to participants should be classified and measured by defined contribution plans and how IFRS compare to these provisions. The amendments in this update are effective for fiscal years ending after December 15 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-28, Intangibles—Goodwill and Other (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts. This ASU modifiedStep 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entityis required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. For publicentities, the amendments in the ASU are effective for fiscal years, and interim periods within those years, beginning after December15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





In December 2010, the FASB issued Accounting Standard Update 2010-29, Business Combinations(Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations. This ASU specifies that, if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 is effective prospectively for business combinations where the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Adoption of this ASU did not have material impact on the Company’s consolidated financial statements.





39


Results of Operations





Comparison of the There Months Ended March 31, 2011 and 2010:





For the There Months Ended March 31, 20112011


2010


Y/Y ChangeAmount

($)


% of Total

Revenue


Amount

($)


% of Total

Revenue


Amount

($)


%RevenueSystem contracting projects


14,619,364



69.6
%


15,521,748



74.1
%


-902,384



-5.8
%Products


5,189,266



24.7
%


4,530,599



21.6
%


658,667



14.5
%Maintenance Services


1,187,246



5.7
%


891,379



4.3
%


295,867



33.2
%Total Revenue


20,995,876



100.0
%


20,943,726



100.0
%


52,150



0.2
%





Total revenues were approximately $21.0 million for the three months ended March 31, 2011 as compared to approximately $20.9 million for the three months ended March 31, 2010, an increase of $52,150 or 0.2%. This slight increase in our total revenue was primarily due to the increase in revenue from both products sales and maintenance services, offset by the decrease in revenue from system contracting projects during the period. The Company recognized revenues from 223 total solution, product sales and maintenance contracts for the three months ended March 31, 2011 as compared to 197 contracts for the three months ended March 31, 2010.





Revenues from our total solution system contracting projects decreased by $0.9 million to $14.6 million derived from 100 contracts for the three months ended March 31, 2011, compared to $15.5 million derived from 85 contracts for the three months ended March 31, 2010. This decrease in revenues from our system contracting projects was mainly attributable to slower progress in projects from the iron and steel industry during the period, which has experienced significant weakness during recent quarters. Revenues from product sales were $5.2 million with 58 contracts executed for the three months ended March 31, 2011, compared to $4.5 million with 61 contracts executed for the three months ended March 31, 2010. The increase in revenues from product sales was mainly due to the increase in value of product sales contracts executed both from the nuclear industry and the international market in India during the period. Revenues from maintenance services increased by 33.2% to $1.2 million derived from 65 contracts for the three months ended March 31, 2011, compared to $0.9 million derived from 51 contracts for the three months ended March 31, 2010. The increase in revenues from maintenance services was mainly attributable to the increase in the number of maintenance service contracts executed as a result of the expansion of our customer base during the period.





In particular, our three largest clients were Wuhan Iron and Steel Group, China Guangdong Nuclear Power group and Anshan Iron and Steel Group, which collectively contributed approximately $10.8 million of revenues, representing 51.6% of total revenues for the three months ended March 31, 2011.





Out of the system contracting revenue of $14.6 million for the three months ended March 31, 2011, the iron and steel industry contributed approximately $13.2 million or 90.5% of the revenue from system contracting projects, while traditional power generation contributed approximately $1.2 million or 7.9%. Petrochemical, nuclear and other verticals together represented the remaining $0.2 million or 1.5% of revenue.





For the three months ended March 31, 2011, the significant increase in reliance on one client for our operating results was due to the significant size of the total solution contract executed with Wuhan Iron and Steel. The value of this contract was approximately $92 million, compared to our historical average of $1 million for the iron and steel industry. Therefore, with the successful implementation of this project, for the three months ended March 31, 2011, Wuhan Iron and Steel contributed $9.4 million, the largest portion of our sales during the period. By  March 31, 2011, the $92 million contract with Wuhan Iron and Steel was 47.1% completed; as a result, we expect that a large portion of our revenue in future reporting periods will rely on the execution of this contract.





40





For the There Months Ended March 31, 20112011


2010


Y/Y ChangeAmount

($)


% of

Revenue


Amount

($)


% of

Revenue


Amount

($)


%Cost of RevenuesSystem contracting projects


7,029,218



48.1
%


7,311,285



47.1
%


-282,067



-3.9
%Products


2,808,481



54.1
%


1,454,067



32.1
%


1,354,414



93.1
%Maintenance Services


859,523



72.4
%


546,218



61.3
%


313,305



57.4
%Total Cost of Revenues


10,697,222



50.9
%


9,311,570



44.5
%


1,385,652



14.9
%Gross ProfitSystem contracting projects


7,590,146



51.9
%


8,210,463



52.9
%


-620,317



-7.6
%Products


2,380,785



45.9
%


3,076,532



67.9
%


-695,747



-22.6
%Maintenance Services


327,723



27.6
%


345,161



38.7
%


-17,438



-5.1
%Total Gross Profit


10,298,654



49.1
%


11,632,156



55.5
%


-1,333,502



-11.5
%





Cost of revenues for the three months ended March 31, 2011 was approximately $10.7 million, as compared to $9.3 million for the three months ended March 31, 2010, representing an increase of approximately $1.4 million or 14.9%. The increase in cost of revenues was mainly driven by the increase in material costs and subcontractor costs related to the execution of total solution, product sales and maintenance contracts during the period. Gross profit for the three months ended March 31, 2011 was approximately $10.3 million, as compared to $11.6 million for the three months ended March 31, 2010, a decrease of approximately $1.3 million or 11.5%. Gross margin for the three months ended March 31, 2011 was 49.1%, which is lower than the gross margin of 55.5% for the three months ended March 31, 2010. The decrease in overall gross margin was mainly due to the decrease in the gross margin of system contracting projects and the gross margin of product sales during the period.





Gross margin of system contracting projects was 51.9% for the three months ended March 31, 2011, compared to 52.9% for the three months ended March 31, 2010. The decrease in gross margin of system contracting projects was mainly attributable to the contract mix during the period, as the gross margin of system contracting projects represents the average value of the gross margins of different system contracting projects executed during the period. Since gross margins during each quarter are determined by the revenue-weighted average of gross margins which are comprised of the gross margins of different system contracting projects executed during the period, the decrease in  gross margins of system contracting projects were primarily due to the different contract mix during the three months ended March 31, 2011. In a given period, if more revenues are recognized from contracts with higher gross margins, this will result in a higher gross margin for the period. During the three months ended March 31, 2011, the iron and steel industry contributed 90.5 percent of the revenue from system contracting projects, which was lower than 98.4 percent in the three months ended March 31, 2010. The decrease in the percentage of revenue contribution from the iron and steel industry resulted in lower gross margins during the period. We attributed the decrease in the average project gross margins from the iron and steel industry during the three months ended March 31, 2011 due to the different contract mix during the period as the gross margin of individual iron and steel contracts during certain period is determined by various factors including the complexity of project itself, competition during the bidding process as well as the variation in the project’s gross margins due to the change from clients’ requirement. However, from the aspect of overall iron and steel contracts, the gross margins of iron and steel contracts were maintained at similar levels to those of last year. Furthermore, we did not observe any trends or factors which could negatively impact gross margins from the iron and steel industry in the long run.





The gross margin of product sales was 45.9% for the three months ended March 31, 2011, compared to 67.9% for the three months ended March 31, 2010. The decrease in the gross margin of product sales was mainly attributable to a lower percentage of self-manufactured proprietary products sold through our product sales contracts during the period, contributing to lower gross margin. Of the products sales in the three months ended March 31, 2011, the percentage of self-manufactured proprietary products decreased to 21.0%, compared to 41.3% in the three months ended March 31 2010. The main reason for the shift in sales from self-manufactured products to third-party manufactured products is the percentage of product sales from the nuclear industry and international market from India increased significantly to 51.9% in the three months ended March 31, 2011, compared to 20.6% for the same period of last year. Since product sales contracts from both the nuclear industry and international market from India typically use fewer self-manufactured proprietary products than  other industries, the higher sales contribution from the nuclear industry and international market in India resulted in a lower percentage of self-manufactured proprietary products during the period.





41


Gross margin of maintenance services was 27.6% for the three months ended March 31, 2011, compared to 38.7% for the three months ended March 31, 2010.  This decrease in the gross margin of maintenance services was primarily due to the increase in labor costs associated with the maintenance contracts during the period.





For the Three Months Ended March 31, 20112011





2010






Y/Y ChangeAmount

($)


% ofTotal

Revenue


Amount

($)



% ofTotal

Revenue


Amount

($)


%Operating ExpensesSelling Expense


2,356,402



11.2
%


1,996,198




9.5
%


360,204



18.0
%General Administrative


3,308,393



15.8
%


2,940,077




14.0
%


368,316



12.5
%Depreciation and Amortization


246,822



1.2
%


200,106




1.0
%


46,716



23.3
%R&D


517,582



2.5
%


396,896




1.9
%


120,686



30.4
%Total Operating Expenses


6,429,199



30.6
%


5,533,277




26.4
%


895,922



16.2
%Income From Operations


3,869,455



18.4
%


6,098,879




29.1
%


-2,229,424



-36.6
%





Operating expenses were approximately $6.4 million for the three months ended March 31, 2011 as compared to approximately $5.5 million for the three months ended March 31, 2010, an increase of approximately $0.9 million or 16.2%.  This increase in operating expenses was mainly attributable to the increase in selling, general administrative and R&D expenses during the period.





Selling expenses were approximately $2.4 million for the three months ended March 31, 2011 as compared to approximately $2.0 million for the three months ended March 31, 2010, an increase of approximately $0.4 million or 18.0%. The increase in selling expenses was mainly attributable to the increase in the compensation to our sales team and the increase in the expense related to our warranty expenses during the period. General administrative expenses were approximately $3.3 million for the three months ended March 31, 2011, as compared to approximately $2.9 million for the three months ended March 31, 2010, an increase of approximately $0.4 million or 12.5%. The significant increase in general administrative expenses was mainly attributable to increases in the overall compensation to our employees during the period. Depreciation and amortization expenses were approximately $0.2 million for the three months ended March 31, 2011 as compared to approximately $0.2 million for the three months ended March 31, 2010, an increase of $46,716 or 23.3%. The increase in depreciation and amortization expenses was mainly due to the increase in plant and equipment related to business operations. R&D expenses were approximately $0.5 million for the three months ended March 31, 2011 as compared to approximately $0.4 million for the three months ended March 31, 2010, an increase of approximately $0.1 million or 30.4%. The increase in R&D expenses was mainly attributable to the variance in expenditures required in different new product development cycles.





Operating income was approximately $3.9 million for the three months ended March 31, 2011 as compared to approximately $6.1 million for the three months ended March 31, 2010, a decrease of approximately $2.2 million or 36.6%.  The decrease in operating income was mainly attributable to the   lower gross margin and higher operating expenses during this period. Total other income was approximately $0.2 million for the three months ended March 31, 2011 as compared to approximately $0.1 million for the three months ended March 31, 2010, an increase of $0.1 million or 78.7%.





Income before income tax was approximately $4.1 million for the three months ended March 31, 2011 as compared to approximately $6.2 million for the three months ended March 31, 2010, a decrease of $2.1 million or 34.3%.  The main reason for the decrease in income before income tax was mainly due to the decrease in gross margin and increase in operating expenses during the period. Provision for income tax was approximately $1.0 million for the three months ended March 31, 2011 with an effective tax rate of approximately 23.8%, as compared to a $1.0 million provision for income tax for the there months ended on March 31, 2010, a decrease of $0.03 million.  The slightly decrease in provision for income tax was mainly due to a decrease in income before income tax and offsetting by the increase of effective tax rate from 16.1% to 23.8% caused by the expiration of 50% tax deduction in two Chinese entities - Sureland Equipment and Beijing Hua’an during current  quarter compared with the same period in prior year.





Our net income was approximately $3.1 million for the three months ended March 31, 2011 as compared to approximately $5.2 million net income for the three months ended March 31, 2010, a decrease of $2.1 million or 40.5%. The reason for this decrease in net income was mainly due to the decrease in revenue and gross margin, and the increase in operating expenses during the period.





Currency translation adjustments resulting from RMB appreciation amounted to $0.7 million and $20,473 for the three months ended on March 31, 2011 and 2010, respectively.





42


Comprehensive income, which adds the currency adjustment to net income, was approximately $3.8 million for the three months ended March 31, 2011 as compared to approximately $5.2 million for the three months ended March 31, 2010, a decrease of $1.4 million or 27.4%.





Liquidity and Capital Resources





As of March 31, 2011, we had working capital of $109.0 million, including cash and cash equivalents of $23.9 million. The following table sets forth a summary of our cash flow for the periods indicated:





Statements of Cash Flow





For the Three months Ended March 31,2011

2010Net cash used in operating activities

$
(1,453,339
)

$
(7,149,007
)Net cash used in investing activities


(152,719
)


(345,290
)Net cash used in financing activities


(2,805,996
)


(2,321,317
)Effect of foreign currency translation


123,696



(23,908
)Net cash flow

$
(4,288,358
)

$
(9,839,522
)





Operating Activities





Comparison of the three months ended March 31, 2011 and 2010:





Net cash used in operating activities was approximately $1.5 million for the three months ended March 31, 2011 as compared to approximately $7.1 million used for the same period in 2010. The decrease in net cash provided by operating activities was mainly due to the slower cash payments collected from our customers during the weakness experienced in the iron and steel industry in recent quarters. Net cash used by operating activities in the three months ended March 31, 2011 was mainly due to net income of $3.1 million, a $1.0 million add-back of non cash stock based compensation, a $0.7 million add-back of other non cash expenses, a $2.9 million decrease in prepayments and deferred expenses, offset by a $1.3 million increase in notes receivable, $1.6 million increase in inventory, and an $6.7 million increase in costs and estimated earnings in excess of billing.





The increase of $6.7 million in costs and estimated earnings in excess of billings for the three months ended March 31, 2011 was mainly due to the increase in aggregate value of projects where we have recognized revenues more than we have billed our customers for these projects, while the decrease in billings in excess of costs and estimated earnings was mainly due to the decrease in the aggregate value of projects where we have billed our customers less than we have recognized revenues for these projects.





As of March 31, 2011, approximately 7.9% of accounts receivable related to revenue recognized for maintenance service contracts  were due from clients in China’s iron and steel industry. Most of these clients are leading, large-size State-Owned Enterprises (“SOEs”), and include Anshan Iron and Steel, Wuhan Iron and Steel and Capital Iron and Steel. Since China’s government is the majority shareholder of these companies, the creditworthiness of these companies is generally perceived to be much higher than that of private companies in the market. Moreover, we have not observed nor do we expect to observe any bankruptcies amongst these leading SOEs in the foreseeable future. Therefore, we believe that the accounts receivable for maintenance service contracts are highly collectible. Also, given that accounts receivable from such SOEs are highly collectible overall, it is customary in the interest of maintaining client relationships and securing recurring maintenance contracts not to aggressively enforce the collection of receivables.





During the past three months, we did not change or extend our standard contract payment terms. Primarily, fundamental weaknesses in the iron and steel industry resulted in the delay of customers’ payments related to the revenue recognized for maintenance service contracts beyond one-year. These delays also are a side effect of the industry practice to not aggressively enforce collection of SOE receivables in the interest of maintaining client relationships. These late payments were the result of our goodwill to maintain client relationships rather than the result of payment extensions.





According to our standard contract terms, the prerequisite that must be met in order to have the legal right to bill our customers for the amounts recognized as unbilled costs and earnings is the customer’s acceptance of the completion of different stages throughout the project. This is accomplished through the customer’s inspection process upon completion of certain stages of a project’s





43


implementation including (but not limited to): the completion of a project’s design, the delivery of certain equipment to a project’s location, the completion of a certain stage of a project’s construction, the completion of a system adjustment and final acceptance by the customer and the fire safety department. For a standard system contracting project, there are multiple stages of construction, customer inspection and billing. These processes are on-going throughout the term of the contract, which can be for an extended period of time. In our operating history, we have never been unable to bill our customers or receive payments for the amounts recognized as unbilled costs and earnings as a result of the customer’s inspection process upon achieving a certain stage. Therefore, the collectability of the amounts recognized as unbilled costs and earnings is reasonably assured.





The main reason for the recent delays or prolonged customer inspection processes is the weakness in the iron and steel industry. These delays or prolonged inspection processes can slow the customers’ payments to their suppliers including our company. The recent delays in our customer’s inspection process did not relate to any performance issues raised by our customers. We have not experienced any inability to bill and/or experienced non-payment for a receivable and/or customer’s claim because of a contract dispute. In recent quarters, we have not made any material changes in the standard contract payment provisions as compared to prior periods. In the future, we will disclose any material contract changes to our standard contractual terms and also provide investors with an explanation of such changes, along with an explanation of any material impact such changes are having or may have on our operating results and liquidity.





There are a number of factors and/or circumstances that could adversely impact our ability to collect the receivables from and/or bill the Costs and estimated earnings in excess billings (“CIEB”) to the SOEs. First, a significant decline in the overall demand for iron and steel products in China could adversely impact our ability to collect the receivables from and/or bill the CIEB to the SOEs. The iron and steel industry is one of the core industries in China’s economy. Thus, the Chinese government has a vested interest in maintaining the health of this sector and consequently maintains shareholdings in key players in the industry. However, if there was a significant decrease in the overall demand for iron and steel products in China, the Chinese government could be forced to close certain companies, even SOEs, whose iron and steel production capacities are outdated. Second prolonged monetary losses amongst SOEs could adversely impact our ability to collect the receivables from and/or bill the CIEB to the SOEs. If the iron and steel SOEs sustained long-term losses with no prospects for improvement, there exists the possibility that the Chinese government could force these SOEs to be acquired or even shutdown. Even though the possibility exists, we have never observed these circumstances nor do we expect them to occur in the foreseeable future.





As the Chinese government is only a shareholder in these SOEs, we do not have any direct recourse against the Chinese government and there is not any requirement for the Chinese government to settle and/or act on the payment of the receivables.





However, there are a few mechanisms available to us to collect the receivables from the SOEs, including the following:





1) In order to improve the collection of our accounts receivable, during the third quarter of 2010 we formed a special accounts receivable collection team to enhance communication with our clients. Not only do we assign accounts receivable quotas to each individual sales person, we also hold a weekly accounts receivable team call to ensure full execution and effectiveness of our accounts receivable collection process.





2) If the enhanced collection effort does not lead to a successful collection of receivables, we can have our counsel send an opinion letter to our delinquent clients to express our serious concern over the collection of the outstanding receivables and highlighting the importance we attach to the collection of receivables.





3) If the two mechanisms discussed above do not produce positive results in the collection of our receivables, the last mechanism available to us is to initiate a legal proceeding in a Chinese court against any clients unwilling to pay us. However, it is difficult to predict how long a lawsuit can take or its final adjudication. In the history of the Company’s operation, we have never initiated a legal proceeding against our SOE clients over payment matters.





Account Receivable Aging Analysis, as of March 31, 20111-180 days


181-360 days


361-720 days


720-1080 days


over 1080 days


TotalBalance

$
29,906,253


$
5,907,309


$
9,255,845


$
4,254,783


$
4,749,958


$
54,074,147





As of March 31, 2011, the Company believes that 9.1 percent of accounts receivable would be collected in more than one year, based on our historical collection pattern.





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CIEB is the net difference between the aggregate values of recognized revenue versus the aggregate value of invoices billed.  This account reflects the timing difference between the date that we recognize revenue and the date that we bill to our customers. Revenue recognized from total solution projects is based on the percentage of project’s completion, which most properly reflects the progress of total solution service we render to our clients, while the billing to our customers was based on the contract’s payment schedule of our clients.





As of March 31, 2011, the balance of CIEB was $47.6 million. There was a material portion of CIEB that was not yet billed in  March, 2011. The reason for the increase in CIEB in recent quarters is mainly due to the clients’ prolonged inspection and approval period for the project completion in their administrative process, as China’s iron and steel industry experienced industry-wide weakness during recent quarters. However, we believe that this industry-wide weakness is short-term. The ratio of CIEB relative to our total current will revert back to historical level when the iron and steel industry recovers.





Investing Activities





Net cash used in investing activities in the three months ended March 31, 2011 was $152,719 as compared to net cash used in investing activities of $345,290 in the same period of 2010. The cash used in investing activities in the three months ended March 31, 2011 was mainly attributable to the capital expenditure in the purchase of new equipment.





Financing Activities





Net cash used in financing activities in the three months ended March 31, 2011 totaled $2.8 million as compared to $2.3 million used in financing activities in the same period of 2010. The cash used in financing activities in the three months ended March 31, 2011 was mainly attributable to the increase in restricted cash during the period.





As a result of the total cash activities, net cash decreased $4.3 million from December 31, 2010. We believe that our currently available working capital of $109.0 million, including cash and cash equivalents of $23.9 million, is adequate to sustain our operations at our current level and our anticipated expansion.




Item 3. Quantitative and Qualitative Disclosures about Market Risk





Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, exchange rates, commodity prices, equity prices and other market changes. Cash and cash equivalents are held for working capital purposes and consist primarily of bank deposits. We do not enter into investments for trading or speculative purposes.





Interest Rate Risk





We currently do not have any long-term debt. Exposure to interest rate risk primarily relates to the interest income generated by excess cash invested in demand deposits. We have not used derivative financial instruments in our investment portfolio in order to reduce interest rate risk. Interest earning instruments carry a degree of interest rate risk and our future interest income may change, depending on market interest rate movement.





Foreign Currency Risk





Our business is operated in the PRC and India, and its value is effectively denominated in Renminbi and Indian Rupees. The fluctuation of foreign exchange rate between U.S. dollars and Renminbi and U.S. dollars and Indian Rupees could affect the value of our common stock. Our revenues and expenses are primarily denominated in Renminbi and Indian Rupees, so our exposure to foreign exchange risks should generally be limited. We do not have material monetary assets and liabilities denominated in U.S. dollars, although to the extent that we do in the future, the fluctuation of foreign exchange rate would affect the value of these monetary assets and liabilities denominated in U.S. dollars. Generally, appreciation of Renminbi and Indian Rupees against U.S. dollars will devalue the assets and liabilities denominated in U.S. dollars, while devaluation of Renminbi and the Indian Rupee again U.S. dollars will appreciate the assets and liabilities denominated in U.S. dollar. In China and India, very limited hedging transactions are available to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure.





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Item 4. Controls and Procedures.





(a)   Evaluation of Disclosure Controls. As required by Exchange Act Rule 13a-15(b), our management has carried out an evaluation, under the supervision of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2011.





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.





Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective at March 31, 2011.





(b)   Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred in the first quarter of 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





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PART II - OTHER INFORMATION








Item 1. Legal Proceedings





For a description of our material legal proceedings, see the section captioned “Contingencies” included in Note 15 — “Commitments and Contingencies” in the Notes to the condensed consolidated financial statements, which is incorporated by reference herein.





Item 1A. Risk Factors





We have no material changes to the risk factors previously disclosed in our Form 10-K for the year ended December 31, 2010.





Item 2. Unregistered Sales of Equity Securities and Use of Proceeds





None.





Item 3. Defaults Upon Senior Securities





None.





Item 4. Submission of Matters to a Vote of Security Holders





None.





Item 5. Other Information





None.





Item 6.  Exhibits





The following exhibits are hereby filed as part of this Quarterly Report on Form 10-Q.





Exhibit

Number:

Description31.1

Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.31.2

Certification of Principal Accounting Officer under Section 302 of the Sarbanes-Oxley Act of 2002.32.1

Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350





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SIGNATURES





Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant certifies that it has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized.





CHINA FIRE & SECURITY GROUP, INC.Dated: May 16, 2011
By:
/s/ Brian LinBrian LinChief Executive Officer(Principal Executive Officer)Dated: May 16, 2011
By:
/s/ Tongzhou QinTongzhou QinChief Financial Officer(Principal Financial Officer)





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