PACIFICNET INC.
Date: April 4, 2007	BY: /S/ TONY TONG
	Tony Tong Chief Executive Officer (Principal Executive Officer)
Date: April 4, 2007	BY: /S/ DANIEL LUI
	Daniel Lui  Chief Financial Officer (Principal Financial Officer)

 

NAME	TITLE	DATE
/s/ TONY TONG Tony Tong	Director, Chairman and CEO	April 4, 2007
/s/ VICTOR TONG Victor Tong	Director, President and Secretary	April 4, 2007
/s/ DANIEL LUI Daniel Lui	Chief Financial Officer	April 4, 2007
/s/ PETER WANG Peter Wang	Director	April 4, 2007
/s/ MICHAEL CHUN HA Michael Chun Ha	Director	April 4, 2007
/s/ TAO JIN Tao Jin	Director	April 4, 2007
/s/ JEREMY GOODWIN Jeremy Goodwin	Director	April 4, 2007

 

	Report of Independent Registered Public Accounting Firm	F-1
	Consolidated Balance Sheets - As of December 31, 2005 and 2004	F-2
	Consolidated Statements of Operations - For the Years Ended December 31, 2005 and December 31, 2004	F-3
	Consolidated Statements of Changes in Stockholders' Equity - For the Years Ended December 31, 2005 and December 31, 2004	F-4
	Consolidated Statements of Cash Flows - For the Years Ended December 31, 2005 and December 31, 2004	F-5
	Notes to Consolidated Financial Statements	F-6

 

PACIFICNET INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands of United States dollars, except par values and share numbers)

 

		(Restated) December 31,2005			(Restated) December 31,2004
ASSETS
Current Assets:
Cash and cash equivalents		$	9,579		$	6,764
Restricted cash - pledged bank deposit			1,652			3,501
Accounts receivables ônet of allowance for doubtful accounts of $5 and $0			5,998			5,644
Inventories			1,836			1,297
Loan receivable from related parties			2,520			--
Loan receivable from third parties			1,572			--
Other current assets			7,973			4,325
Total Current Assets			31,130			21,531
Property and equipment, net			4,300			1,118
Investments in affiliated companies and subsidiaries			410			1,063
Marketable equity securities - available for sale			539			29
Goodwill			14,824			9,509
TOTAL ASSETS		$	51,203		$	33,250
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Bank line of Credit		$	1,060		$	651
Bank loans-current portion			188			1,327
Capital lease obligations - current portion			126			80
Accounts payable			3,186			3,150
Accrued expenses			4,620			128
Income tax payable			296			10
Subscription payable			775			--
Loan payable to related party			369			--
Total Current Liabilities			10,620			5,346
Long-term liabilities:
Bank loans - non current portion			6			69
Capital lease obligations - non current portion			78			129
Total long-term liabilities			84			198
Total liabilities			10,704			5,544
Minority interest in consolidated subsidiaries			8,714			2,396
Commitments and contingencies
Stockholders' Equity:
Preferred stock, par value $0.0001, Authorized - 5,000,000 shares
Issued and outstanding - none			--			--
Common stock, par value $0.0001, Authorized - 125,000,000 shares Issued and outstanding:
December 31, 2005 - 12,000,687 issued, 10,831,024 outstanding
December 31, 2004 - 10,627,737 shares issued, 9,791,583 outstanding			1			1
Treasury stock, at cost (2005: 1,169,663 shares; 2004: 836,154 shares)			(119	)		(104	)
Additional paid-in capital			57,690			53,916
Cumulative other comprehensive income (loss)			247			(24	)
Accumulated deficit			(25,990	)		(28,479	)
Less stock subscription receivable			(44	)		--
Total Stockholders' Equity			31,785			25,310
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		$	51,203		$	33,250

 

 

THE FINANCIAL STATEMENTS OF PACIFICNET AND SUBSIDIARIES FOR THE FISCAL YEARS

ENDED DECEMBER 31, 2005 AND 2004 ARE UNAUDITED

 

PACIFICNET INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS

(In thousands of United States dollars, except loss per share and share amounts)

 

		2005			(RESTATED) 2004
YEAR ENDED DECEMBER 31:
Revenues		$	44,341		$	29,709
Services			20,994			10,222
Product sales			23,347			19,487
Cost of revenues			(33,439	)		(24,074	)
Services			(12,540	)		(6,507	)
Product sales			(20,899	)		(17,567	)
Gross margin			10,902			5,635
Selling, general and administrative expenses			(5,811	)		(3,435	)
Depreciation and amortization			(293	)		(78	)
Interest expense			(229	)		(185	)
EARNINGS FROM OPERATIONS			4,569			1,937
Interest income			246			79
Sundry income			830			422
Earnings before Income Taxes, Minority Interest and Discontinued Operations			5,645			2,438
Provision for income taxes(1)			(222	)		(30	)
Share of profit of associated companies			(8	)		32
Minority interests			(2,926	)		(1,623	)
Earnings before Discontinued Operations			2,489			817
LOSS FROM DISCONTINUED OPERATIONS			--			(43	)
Net Earnings Available to Common Stockholders		$	2,489		$	774
BASIC EARNINGS PER COMMON SHARE:
Earnings from continuing operations		$	0.25		$	0.11
Earnings from discontinued operations			--			--
Net earnings		$	0.25		$	0.11
DILUTED EARNINGS PER COMMON SHARE:
Earnings from continuing operations		$	0.23		$	0.09
Earnings from discontinued operations			--			--
Net earnings		$	0.23		$	0.09

 

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

 

* Income taxes of $66,000, $110,000, $20,000 and $26,000 generated from the Company's four business units: (1) CRM Outsourcing Services, (2) Value Added Services (VAS), (3) Telecom Distribution Services and (4) Other Business.

 

 

F-3

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THE FINANCIAL STATEMENTS OF PACIFICNET AND SUBSIDIARIES FOR THE FISCAL YEARS

ENDED DECEMBER 31, 2005 AND 2004 ARE UNAUDITED

 

PACIFICNET INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

(In thousands of United States dollars)

 

		Preferred Stock			Common Stock			Additional Paid-in Capital			Stock Subscription Receivable			Cumulative Other Comprehensive Income/(loss)			Accumul- ated Deficit  (RESTATED)			Treasury Stock			Total Stockholders' Equity (RESTATED)
BALANCE AT DECEMBER 31, 2003 (5,363,977 SHARES), as originally reported			--		$	1		$	31,790		$	--			($24	)		($29,850	)		($5	)	$	1,912
Effect of Correction of an Error (Note 1)			--			--												597						597
Balance at December 31, 2003 (5,363,977 shares), as restated			--		$	1		$	31,790		$	--			($24	)		($29,253	)		($5	)	$	2509
COMPREHENSIVE EARNINGS:
Net earnings			--			--			--						--			774						774
TOTAL COMPREHENSIVE EARNINGS:																								774
Issuance of common stock for acquisition of subsidiaries (1,756,240 shares)			--			--			8,866						--			--						8,866
Proceeds from the sale of common stock, net of related costs  (2,205,697, shares)			--			--			11,773						--			--						11,773
Issuance of common stock for acquisition of Cheer Era (149,459 shares)			--			--			771						--			--						771
Repurchase of common shares (less 36,154 shares)																					(99	)		(99	)
Exercise of stock options and  warrants for cash (352,364 shares)									716															716
BALANCE AT DECEMBER 31, 2004  (9,791,583 SHARES)			--		$	1		$	53,916						($24	)		($28,479	)		($104	)	$	25,310
COMPREHENSIVE EARNINGS:
Net earnings			--			--			--						--			2,489						2,489
Cumulative Other Comprehensive gain															271									271
Total comprehensive earnings																								2,760
Issuance of common stock for acquisition of subsidiaries (515,900 shares)			--			--			3,971						--			--						3,971
Issuance of common stock (20,000 shares) for services									63															63
PIPE related Expenses			--			--			(547	)														(547	)
Repurchase of common shares for acquisition of Cheer Era (less 149,459 shares)			--			--			(771	)														(771	)
Cancellation of common shares (less 45,000 shares)			--			--			--						--			--			--			--
Repurchase of common shares  (less 2,000 shares)			--																		(15	)		(15	)
Exercise of stock options  and warrants for cash (700,000 shares)			--						1,058															1,058
Less stock subscription receivable												(44	)											(44	)
BALANCE AT DECEMBER 31, 2005 (10,831,024 SHARES)			--		$	1		$	57,690		$	(44	)	$	247			($25,990	)		($119	)	$	31,785

 

 

F-4

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THE FINANCIAL STATEMENTS OF PACIFICNET AND SUBSIDIARIES FOR THE FISCAL YEARS

ENDED DECEMBER 31, 2005 AND 2004 ARE UNAUDITED

 

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts expressed in United States dollars unless otherwise stated)

 

1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

NATURE OF OPERATIONS

 

PacificNet Inc. (referred to herein as "PacificNet" or the "Company") was originally incorporated in the State of Delaware on April 8, 1987. Through our subsidiaries we provide outsourcing services, value-added telecom services (VAS) and communication products distribution services. Our business process outsourcing (BPO) services include call centers, providing customer relationship management (CRM), and telemarketing services, and our information technology outsourcing (ITO) includes software programming and development. We are value-added resellers and providers of telecom VAS, which is comprised of interactive voice response (IVR) systems, call center management systems, and voice over Internet protocol (VOIP), as well as mobile phone VAS, such as short messaging services (SMS) and multimedia messaging services (MMS). The Company's operations are primarily targeted in the China and Hong Kong market.

 

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION

 

The consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America and present the financial statements of the Company and its wholly owned and majority-owned subsidiaries including variable interest entities ("VIEs") for which the Company is the primary beneficiary. All significant inter-company accounts and transactions have been eliminated. Investments in entities in which the Company can exercise significant influence, but which are less than majority owned and not otherwise controlled by the Company, are accounted for under the equity method.

 

The Company has adopted FASB Interpretation No. 46R "Consolidation of Variable Interest Entities" ("FIN 46R"), an Interpretation of Accounting Research Bulletin No. 51. FIN 46R requires a Variable Interest Entity (VIE) to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE's residual returns. VIEs are those entities in which the Company, through contractual arrangements, bears the risks of, and enjoys the rewards normally associated with ownership of the entities, and therefore the company is the primary beneficiary of these entities. Acquisitions of subsidiaries or variable interest entities are accounted for using the purchase method of accounting. The results of subsidiaries or variable interest entities acquired during the year are included in the consolidated income statements from the effective date of acquisition.

 

INITIAL MEASUREMENT OF VIE- The Company initially measures the assets, liabilities, and non-controlling interests of the VIEs at their fair values at the date of the acquisitions. Goodwill is recorded for the excess of the fair value of the newly consolidated assets and the reported amount of assets transferred by the primary beneficiary to the VIE over the sum of the fair value of the consideration paid, the reported amount of any previously held interests, and the fair value of the newly consolidated liabilities and non-controlling interests are allocated and reported as a pro rata adjustment of the amounts that would have been assigned to all of the newly consolidated assets as if the initial consolidation had resulted from a business combination.

 

ACCOUNTING AFTER INITIAL MEASUREMENT OF VIE - Subsequent accounting for the assets, liabilities, and non-controlling interest of a consolidated variable interest entity are accounted for as if the entity were consolidated based on voting interests and the usual accounting rules for which the VIE operates are applied as they would to a consolidated subsidiary as follows:

 

 

F-6

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PRC laws and regulations restrict us, as a foreign entity, from having a direct controlling interest in entities such as Guangzhou Dianxun Co., Ltd.(Dianxun-DE) and Guangzhou Sunroom Information Industry Co., Ltd.(Sunroom-DE) that hold operating licenses to engage in domestic telecom value-added services and online ecommerce in China. As a result, we conduct substantially all of our operations through Guangzhou Clickcom Digit-net Science(WOFE)and Technology Ltd. and Guangzhou 3G Information Technology Co., Ltd.(WOFE). We own 51% of the shares in each of the WOFEs and each WOFE signed Consulting and Services Agreements with Dianxun-DE and Sunroom-DE (the entities that actually carry out the operating activities). These agreements provide that all of the DE profits will flow through to the respective WOFEs. Pursuant to these agreements, the Company guarantees any obligations undertaken by these companies under their contractual agreements with third parties, and the Company is entitled to receive service fees in an amount equal to 51% of the net income of these companies. Accordingly, we bear the risks of, and enjoy the rewards associated with, the investments in the WOFEs.

 

The operations of DEs are managed by their original management teams, however, the Company has the power to appoint or change directors and senior management because it indirectly ultimately controls the voting power of the shareholders of each DE through the Power of Attorney given to PacificNet's President according to the operating agreements between the DEs and WOFEs. Pursuant to the Consulting and Service Agreements signed between each WOFE and their respective DE, the WOFE ("Party A") agrees to be the exclusive provider of telecom consulting services to the DE ("Party B"). During the term of the agreement, Party B shall not accept technical and consulting services provided by any third party. Party B agrees to pay a fee to Party A equal to 100% of its monthly net income for the services provided. Payment of the service fees has been secured through a share pledge agreement with the shareholders of each of the DEs, whereby they pledged all of their shares to the respective WOFE. Further,

 

(1) Each of the DEs, by design, is thinly capitalized because a substantial portion of PacificNet's invested amounts or consideration were paid or payable directly to previous owners of Sunroom-DE and Dianxun-DE for entering into the acquisition transactions while none of the investment consideration was injected into the DEs. Therefore, additional funding from PacificNet is needed to support the DEs' business development and working capital.

 

(2) Fees from Service Contracts are substantial, but are not commensurate with the level of service provided by the WOFEs to the DEs. The contractual and funding arrangements with the DEs evidence that PacificNet has closely participated in the majority of the DEs' economics. PacificNet is the primary beneficiary through its WOFE subsidiaries since PacificNet is the only enterprise with a sufficiently large interest in the VIEs. In compliance with PRC's foreign investment restrictions on Internet Content Provider and Value Added Telecom Services Provider's laws and regulations, the Company conducts all of its value-added services for telecom in China via the following significant domestic VIEs below. The respective management agreements between the VIE's and WOFE's create a variable interest and accordingly, these two Vies are consolidated as VIE through their respective WOFEs from the date of acquisition.

 

The following is a summary of all the VIEs of the Company:

 

o GuangZhou DianXun Company Limited (the "Dianxun-VIE"), a China company controlled through business agreement. Through Dianxun-VIE, a variable interest entity, PacificNet is able to provide indirectly to China's telecom operators, a wide variety of wireless Internet services for mobile phones, such as SMS, Wireless Application Protocol, or WAP, which allows users to access information instantly via handheld wireless devices, and Java mobile applications. The business of the VIE is managed by their original management teams Clickcom VIE is owned by Zhang Ming, CEO 60%, Lai Jinnan, COO 30%, Liu Dong, CTO 10% of the Company. The adjusted registered capital of the VIE is $125,000 (the original registered capital of Dianxun-VIE was approx. US$1.25m but was adjusted down to reflect the fair value of NAV at time of acquisition. (See Note 5) The VIE's board of directors has the power to appoint the General Manager of the VIE who in turn has the power to appoint other members of the management. PacificNet does not directly participate in the daily operation of the VIE. It however has the power to change the management, if needed, because PacificNet is directly or indirectly controlling the board of this VIE. As at the December 31, 2005, Dianxun-VIE's revenues and net earnings accounted for approximately 1.5% and 5.6% of our consolidated revenues and net earnings before minority interests respectively.

 

o Guangzhou Sunroom Information Industrial Co., Ltd. ("Sunroom-VIE"), a PRC registered domestic enterprise, controlled by PacificNet through a series of contractual agreements. It is responsible for VAS in China under its ICP and VAS licenses. It is 31% owned by Mr. Wang Yongchao (CEO), 41.4% owned by Mr. Liao Mengjiang (COO) and 27.6% owned by non-participating shareholder, Mr. Sun Zhengquan. The registered capital of the VIE Company is $4.0 million. Sunroom-VIE is required to transfer their ownership in these entities to our subsidiaries when permitted by PRC laws and regulations and all voting rights are assigned to us. As of December 31, 2005, Sunroom-VIE's revenues and net loss accounted for approximately 11% and -1.2% of our consolidated revenues and net earnings before minority interests, respectively.

 

 

F-7

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The initial capital investments in these VIEs were not funded by us but we have provided loans to these VIEs to fund their R&D and expansion plans. As of December 31, 2005, the amount of loans to Clickcom VIE and Sunroom VIE were approximately US$256,000 (low interest at 2%) and US$250,000 (interest free) respectively. None of the VIEs' assets were collateralized for our loans. Given the fact that we do not have direct ownership interests in these VIEs, the creditors of these VIEs will not have recourse to the general credit of our group being the primary beneficiary.

 

Under various contractual agreements, employee shareholders of the VIEs are required to transfer their ownership in these entities to our subsidiaries in China when permitted by PRC laws and regulations or to our designees at any time for the amount of the outstanding loans. All voting rights of the VIEs are then assigned to us. We have the power to appoint all directors and senior management personnel of the VIEs. Through our wholly owned subsidiaries in China, we have also entered into exclusive technical agreements and other service agreements with the VIEs, under which these subsidiaries provide technical services.

 

BUSINESS COMBINATIONS

 

The Company accounts for its business combinations using the purchase method of accounting. This method requires that the acquisition cost to be allocated to the assets and liabilities the Company acquired based on their fair values. The Company makes estimates and judgments in determining the fair value of the acquired assets and liabilities, based on valuations using management's estimates and assumptions including its experience with similar assets and liabilities in similar industries. If different judgments or assumptions were used, the amounts assigned to the individual acquired assets or liabilities could be materially different.

 

GOODWILL AND PURCHASED INTANGIBLE ASSETS (Correction of an error)

 

Goodwill represents the excess of the purchase price over the fair value of the identifiable assets and liabilities acquired as a result of the Company's acquisitions of interests in its subsidiaries and VIEs. Under Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets ("SFAS 142")," goodwill is no longer amortized, but tested for impairment upon first adoption and annually, thereafter, or more frequently if events or changes in circumstances indicate that it might be impaired. The Company assesses goodwill for impairment periodically in accordance with SFAS 142.

 

The Company applies the criteria specified in SFAS No. 141, "Business Combinations" to determine whether an intangible asset should be recognized separately from goodwill. Intangible assets acquired through business acquisitions are recognized as assets separate from goodwill if they satisfy either the "contractual-legal" or "separability" criterion. Per SFAS 142, intangible assets with definite lives are amortized over their estimated useful life and reviewed for impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets." Intangible assets, such as purchased technology, trademark, customer list, user base and non-compete agreements, arising from the acquisitions of subsidiaries and variable interest entities are recognized and measured at fair value upon acquisition. Intangible assets are amortized over their estimated useful lives from one to ten years The Company reviews the amortization methods and estimated useful lives of intangible assets at least annually or when events or changes in circumstances indicate that it might be impaired. The recoverability of an intangible asset to be held and used is evaluated by comparing the carrying amount of the intangible asset to its future net undiscounted cash flows. If the intangible asset is considered to be impaired, the impairment loss is measured as the amount by which the carrying amount of the intangible asset exceeds the fair value of the intangible asset, calculated using a discounted future cash flow analysis. The Company uses estimates and judgments in its impairment tests, and if different estimates or judgments had been utilized, the timing or the amount of the impairment charges could be different.

 

 

F-8

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We currently have seven reporting units: Lion Zone, Linkhead, EPRO, Shanghai Classic, Smartime/Soluteck, Clickcom-WOFE, and Guangzhou 3G-WOFE for the purpose of goodwill assessment. We determined our reporting units if the entity constituted a business, financial information was available, and segment management can regularly review the operating results of that component. Excluding investment holding vehicles and self-developed units, reporting units only include those operating units that PacificNet holds 50% or more through acquisition and maintain effective control. Units such as PacificNet Solution, PacificNet Limited, and PacificNet Communication are 100% owned by PacificNet through self development and not through acquisition. Therefore, there is no goodwill allocation to these self-developed units.

 

We allocated goodwill amongst the reporting units based on the consideration paid in shares and cash minus the proportional share of the fair value of net assets and liabilities at the time of acquisition specific to each reporting unit. The fair value of each reporting unit represents the amount at which the unit as a whole could be bought or sold in a current transaction between willing parties in an open marketplace. At the time of acquisition, the fair value of assets and liabilities was determined based on book value minus any potential write-down, if any, to reflect the fair value of the assets and liabilities acquired in the transaction. The Company has one class of goodwill arising from business combination resulting from the acquisitions of our subsidiaries.  Goodwill has been revised to reflect certain expenses that should have been written off prior to certain acquisitions, not subsequent to the acquisitions, to better reflect the assets acquired and liabilities assumed in certain business combinations during 2003 in accordance with SFAS No. 141, "Business Combinations”. Originally, the Company had acquired certain intangible assets such as research and development costs and related party receivables that were considered as part of the purchase price allocation, then subsequently expensed them at year end. As of and for the year ended December 31, 2003, the correction of the error resulted in an approximate $597,000 increase in goodwill with an offsetting decrease in net loss, accumulated deficit, and and total stockholders’ equity.  Net loss per share decreased from $0.36 to $0.24. Notes 4, 15 and Note 16 have been revised to reflect the corresponding correction of an error.

 

 

(US$000s)	Group 1. Outsourcing Services Products	Group 2. Value-Added Services	Group 3. Distribution of Communications	Total
Balance as of December 31, 2003, as originally reported	$567	$(147)	$--	$420
Effect of correction of an error	393	204		597
Balance as of December 31,2003, as restated	960	57		1,017
Goodwill acquired during the year	2,976	4,416	1,100	8,492
Impairment losses	--	--	--	--
Goodwill written off related to sale of business unit	--	--	--	--
Balance as of December 31, 2004	3,936	4,473	1,100	9,509
Goodwill acquired during the year	--	5,315	--	5,315
Impairment losses	--	--	--	--
Goodwill written off related to sale of business unit	--	--	--	--
Balance as of December 31, 2005	$3,936	$9,788	$1,100	$14,824

 

The Company assesses the need to record impairment losses on our goodwill assets at least annually or when an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment includes using a combination of qualitative and quantitative analyses such as DCF/PE multiples based on 5 year profit forecasts, and published comparables, where applicable. The Company concluded that there have been no material adverse changes on the operating environments during the reporting periods that would have otherwise affected the carrying value of the goodwill. In addition, there has been no disposal of any reporting subsidiaries and, as a result, no gain or loss is recognized during those reporting periods.

 

The following table summarizes goodwill from the Company's acquisitions during 2005 and 2004:

 

(USD000s)	December 31, 2005	December 31, 2004
Epro	$3,703	$3,703
Linkhead	4,473	4,473
Shanghai Classic (Yueshen)	1,100	1,100
Smartime (Soluteck)	233	233
Clickcom	391	-
GZ3G (Sunroom)	4,042	-
Lion Zone (ChinaGoHi)	882	-
Total	$ 14,824	$ 9,509

 

 

 

F-9

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The effect of post-shipment/delivery obligations, such as customer acceptance, product returns, etc. on our revenue recognition policy is as follows: (a) there is no effect on outsourcing services as revenue is recognized as the services are performed; however product sale revenue is recognized when contracts are approximately 80% completed for revenue recognition and fully when the customer signs the UAT, (i.e., "User Acceptance Form"); (b) there is no effect on value-added services revenue as the product sales mainly involve IVR hardware that are from mature and stable products of multi-national vendors and there have been minimal returns historically; and (c) there is no effect on communication products distribution since the transactions are conducted on cash basis and revenue is recognized at the time the sale is transacted.

 

ALLOWANCE FOR DOUBTFUL ACCOUNTS

 

The Company presents accounts receivable, net of allowances for doubtful accounts and returns. The allowances are calculated based on a detailed review of certain individual customer accounts, historical rates and an estimate of the overall economic conditions affecting the Company's customer base. The Company frequently monitors its customers' financial condition and credit worthiness and only sells products, licenses or services to customers where, at the time of the sale, collection is reasonably assured. If the financial condition of its customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company also records reserves for bad debt for all other customers based on a variety of factors including the length of time the receivables are past due, the financial health of the customer, macroeconomic considerations and historical experience. If circumstances related to specific customers change, the Company's estimates of the recoverability of receivables could be further adjusted. Allowance for doubtful accounts at December 31, 2005 was approximately $5,000 (2004: $0).

 

PROPERTY AND EQUIPMENT

 

Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term, ranging from three to five years. Significant improvements and betterments are capitalized. Routine repairs and maintenance are expensed when incurred. When property and equipment is sold or otherwise disposed of, the asset account and related accumulated depreciation account are relieved, and any gain or loss is included in operations.

 

INVENTORIES

 

Inventories consist of finished goods and are stated at the lower of cost or market value. Cost is computed using the first-in, first-out method and includes all costs of purchase and other costs incurred in bringing the inventories to their present location and condition. Market value is determined by reference to the sales proceeds of items sold in the ordinary course of business after the balance sheet date or management estimates based on prevailing market conditions. The inventories consist of finished goods and represent telecommunication products such as mobile phone, rechargeable phone cards, smart chip, and interactive voice response cards.

 

 

F-11

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INCOME TAXES

 

Income taxes are accounted for using an asset and liability approach, which requires the recognition of income taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company's consolidated financial statements or tax returns. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax laws; the effects of future changes in tax laws or rates are not anticipated. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence assessed using the criteria in SFAS No. 109, "Accounting for Income Taxes," will not more-likely-than-not be realized.

 

The Company records a valuation allowance for deferred tax assets, if any, based on estimates of its future taxable income as well as its tax planning strategies when it is more likely than not that a portion or all of its deferred tax assets will not be realized. If the Company is able to utilize more of its deferred tax assets than the net amount previously recorded when unanticipated events occur, an adjustment to deferred tax assets would be reflected in income when those events occur.

 

RESEARCH AND DEVELOPMENT COSTS AND CAPITALIZED SOFTWARE COSTS

 

Expenditures related to the research and development of new products and processes, including significant improvements and refinements to existing products are expensed as incurred, unless they are required to be capitalized.

 

Software development costs are required to be capitalized when a product's technological feasibility has been established by completion of a detailed program design or working model of the product, and ending when a product is available for release to customers. For the years ended December 31, 2005 and 2004, the Company did not capitalize any costs related to the purchase of software and related technologies and content. Research and development costs charged to operations for 2005 were approximately 182,400 (2004: $161,000).

 

EARNINGS PER SHARE (EPS)

 

Basic and diluted earnings or loss per share (EPS) amounts in the financial statements are computed in accordance with SFAS No. 128, "Earnings Per Share." Basic EPS is based on the weighted average number of common shares outstanding Diluted EPS is based on the weighted average number of common shares outstanding and dilutive common stock equivalents. Basic EPS is computed by dividing net income/loss available to common stockholders (numerator) by the weighted average number of common shares outstanding (denominator) during the period. Dilutive earnings per share for 2005 exclude the potential dilutive effect of 473,456 warrants because their impact would be anti-dilutive based on current market prices. All per share and per share information are adjusted retroactively to reflect stock splits and changes in par value.

 

 

	FY2005	FY 2004
Numerator: earnings	$2,489	$774
Denominator:
Weighted-average shares used to compute basic EPS	10,154,271	7,268,374
Dilutive potential from assumed exercise of stock options	489,552	157,585
Dilutive potential from assumed exercise of stock warrants	57,388	816,037
Weighted-average shares used to compute diluted EPS	10,701,211	8,241,996
Basic earnings per common share:	$0.25	$0.11
Diluted earnings per common share:	$0.23	$0.09

 

 

F-12

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STOCK-BASED COMPENSATION PLANS

 

The Company has adopted SFAS No. 123, "Accounting for Stock Based Compensation". As permitted by SFAS No. 123, the Company measures compensation cost in accordance with Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees" and related interpretations. Compensation cost for stock options, if any, is measured as the excess of the quoted market price of the Company's stock at the date of grant over the amount an employee must pay to acquire the stock. Accordingly, no accounting recognition is given to stock option granted at fair market value until they are exercised. Upon exercise, net proceeds including tax benefits realized, are credited to equity. Details regarding a description and status of the Company's stock option plans can be found in Note 12.

 

 

	FY2005	FY2004
Net earnings/ (loss):
As reported	$2,489	$774
Stock-based compensation cost, net of tax	(3,300)	(1,188)
Pro forma	(811)	(414)
Basic earnings/ (loss) per share:
As reported	$0.25	$0.11
Pro forma	(0.08)	(0.06)
Diluted profit/ (loss) per share:
As reported	$0.23	$(0.09)
Pro forma	$(0.08)	$(0.05)

 

The fair value of options granted during 2005 and 2004, respectively was approximately $4.82 and $1.88 per option respectively based on the Black-Scholes option pricing model using valuation assumptions of: a) average remaining contractual life of four and two years; b) expected volatility of 43.18% and 153.68%, c) dividend yield of 0% for both years; and d) a risk free interest rate of 5% and 3%.

 

ADVERTISING EXPENSES

 

Advertising expenses consist primarily of costs of promotion for corporate image and product marketing and costs of direct advertising. The Company expenses all advertising costs as incurred and classify these costs under selling, general and administrative expenses, which amounted to $150,047 in 2005 (2004: $9,908).

 

CASH EQUIVALENTS

 

Cash and cash equivalents comprise cash at bank and on hand, demand deposits with banks and other financial institutions, and short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Bank overdrafts that are repayable on demand and form an integral part of the PacificNet's cash management are also included as a component of cash and cash equivalents for the purpose of the cash flow statement. Highly liquid investments with original maturities of three months or less are considered cash equivalents.

 

RELATED PARTY TRANSACTIONS

 

A related party is generally defined as (i) any person that holds 10% or more of the Company's securities including such person's immediate families, (ii) the Company's management, (iii) someone that directly or indirectly controls, is controlled by or is under common control with the Company, or (iv) anyone who can significantly influence the financial and operating decisions of the Company. A transaction is considered to be a related party transaction when there is a transfer of resources or obligations between related parties. (See Note 12)

 

 

F-13

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RECLASSIFICATION

 

Certain prior period amounts have been reclassified to conform to the current year presentation. These changes had no effect on previously reported results of operations or total stockholders' equity.

 

FAIR VALUE OF FINANCIAL INSTRUMENTS

 

Fair value is described as the amount at which the instrument could be exchanged in a current transaction between informed willing parties, other than a forced liquidation. Cash and cash equivalents, accounts receivable and payable, accrued expenses and other current liabilities are reported on the consolidated balance sheets at carrying value which approximates fair value due to the short-term maturities of these instruments. The Company does not have any off balance sheet financial instruments.

 

CONCENTRATION OF CREDIT RISK

 

CASH HELD IN BANKS. For those financial institutions that the Company maintains cash balances in the United States, the amounts are insured by the Federal Deposit Insurance Corporation up to $100,000.

 

GEOGRAPHIC RISK. All of the Company's revenues are derived in Asia and Greater China and its operations are governed by Chinese laws and regulations. The operations in China are carried out by the subsidiaries and VIEs. If the Company was unable to derive any revenue from Asia and Greater China, it would have a significant, financially disruptive effect on the normal operations of the Company.

 

SIGNIFICANT RELATIONSHIPS. A. substantial portion of the operations of the Company's VIEs (Dianxun-DE and Sunroom-DE) business operations depend on mobile telecommunications operators (operators) in China and any loss or deterioration of such relationship may result in severe disruptions to their business operations and the loss of a significant portion of the Company's revenue. The VIEs rely entirely on the networks and gateways of these operators to provide its wireless value-added services. Specifically these operators are the only entities in China that have platforms for wireless value-added services. The Company's agreements with these operators are generally for a period of less than one year and generally do not have automatic renewal provisions. If neither of them is willing to continue to cooperate with the Company, it would severely affect the Company's ability to conduct its existing wireless value-added services business.

 

MARKETABLE EQUITY SECURITIES

 

Marketable equity securities are classified as available-for-sale and are recorded at fair value in other assets on the balance sheet, with the change in fair value during the period excluded from earnings and recorded net of tax as a component of other comprehensive income. Realized gains or losses are charged to the income statement during the period in which the gain or loss is realized Investments classified as available-for-sale securities include marketable equity securities of Unit Trust Funds and are based primarily on quoted market prices at December 31, 2005. The component costs of these securities are summarized as follows: cost of $567,000, gross unrealized losses of $28,000 and estimated fair value of $539,000. The acquisition of marketable securities and unrealized losses on marketable equity securities are recorded on consolidated statements of cash flows.

 

FOREIGN CURRENCY

 

The Company's reporting currency is the U.S. dollar. The Company's operations in China and Hong Kong use their respective currencies as their functional currencies. The financial statements of these subsidiaries are translated into U.S. dollars using period-end rates of exchange for assets and liabilities and average rates of exchange in the period for revenue and expenses. Translation gains and losses are recorded in accumulated other comprehensive income or loss as a component of shareholders' equity. Net gains and losses resulting from foreign exchange transactions are included in General and Administrative Expenses an amount of US$76,000. During the year ended December 31, 2005, the foreign currency translation adjustments to the Company's comprehensive income was $271,000 and the currency translation gain was approximately $29,000, primarily as a result of the Chinese Renminbi appreciating against the U.S. dollar.

 

 

F-14

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SEGMENT INFORMATION

 

The Company determines and classified its operating segments in accordance with SFAS No. 131 "DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION" based on the following considerations: (a) each of the Company's operating segments is a discrete business unit that earns revenues and incurs expenses; (b) the operating results are regularly reviewed by PacificNet's chief operating decision makers for the purposes of fine-tuning its strategies going forward, making resource allocation decisions such as whether further working capital advances are required and assessing individual performance; and (c) discrete financial information for each subsidiary within each operating segment is available. The chief operating decision makers are the Company's President and CEO and its Chairman, and their decisions are based on discussions with each segment's senior management and financial controllers regarding non-financial indicators such as customer satisfaction, loyalty and new marketplace competition as well as financial indicators such as internally generated financial statements, to assess overall financial performance.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

The Financial Accounting Standards Board issued the following recent accounting pronouncements:

 

In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections". SFAS No. 154 replaces APB Opinion No. 20 "Accounting Changes" and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". SFAS No. 154 requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The adoption of SFAS No. 154 did impact the Company's consolidated financial statements.

 

In December 2004, the FASB issued SFAS No. 123R (revised 2004) "Share-Based Payment" which amends FASB Statement No. 123 and will be effective for public companies (small business issuers) for interim or annual periods beginning after December 15, 2005. SFAS 123R requires that compensation cost related to share-based payment transactions be recognized in the financial statements. Share-based payment transactions within the scope of SFAS 123R include stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee share purchase plans. The Company adopted the new standard as of January 1, 2006. Based on the Company's evaluation of the adoption of the new standard, the Company believes that it could have a significant impact to the Company's financial position and overall results of operations depending on the number of stock options granted in a given year.

 

2. BUSINESS ACQUISITIONS

 

During 2005 and 2004, PacificNet acquired various entities in accordance with the Company's strategy to grow via mergers and acquisitions. The entities acquired met various PacificNet acquisition criteria, which include reasonable expectations for positive earnings and cash flow within two years of acquisition and reputation for high quality and performance in the customer relationship management, brand name recognition, and well-established relationships with clients. Several factors contributed to the determination of the negotiated purchase price and deal structure. Among them were the value of assets acquired and liabilities assumed, historical EBITDA and projected EBITDA. The assets acquired and liabilities assumed were recorded at estimated fair values as determined by the Company's management based on information currently available and on current assumptions as to future operations

 

A summary of business acquisitions for the periods presented follows:

 

SHANGHAI CLASSIC GROUP LIMITED ("YUESHEN")

 

On April 12, 2004, the Company, through its subsidiary PacificNet Strategic Investment Holdings Limited, consummated the acquisition of a 100% controlling interest (the "Acquisition") in Shanghai Classic Group Limited, which owns 51% of Guangzhou YueShen TaiYang Technology Limited, a newly formed telecommunication company located and incorporated in the People's Republic of China ("Yueshen"). The Company acquired the 100% controlling interest in Shanghai Classic through the purchase of 85 shares (representing 100% of the issued and outstanding shares, the "Shanghai Shares") of Shanghai Classic Group Limited, which is also the beneficial owner of the 51% controlling interest in Yueshen. The consideration for the Acquisition was an aggregate value of approximately USD$1,196,143, which was paid in cash and shares of common stock of the Company (the "Common Stock"), and a warrant to purchase up to 50,000 shares of Common Stock. The consideration was paid as follows:

 

(i) approximately USD$616,195 by delivery of 106,240 shares of Common Stock as consideration for the purchase of 51 of the Shanghai Shares from Yan Kuan Li ("Ms. Li") within thirty (30) days of the signing of the agreement for the Acquisition. All of the Common Stock deliverable to Ms. Li is being held in escrow pursuant to the terms of an escrow agreement, which provides that the Common Stock will be released in installments over the twelve month period following the consummation of the Acquisition, provided, that Yueshen attains certain net income milestones during such period. In the event there is a shortfall in the net income during the period Ms. Li shall return to the Company shares of Common Stock equivalent to the dollar amount of such shortfall divided by $5.80; and

 

 

F-15

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(ii) approximately USD$338,303 in cash as consideration for the purchase of 34 of the Shanghai Shares from Avatar Trading, Ltd. ("Avatar") within thirty (30) days of the closing of the Acquisition; and

 

(iii) approximately USD$241,645 in cash directly to Yueshen within thirty (30) days of the closing of the Acquisition, as consideration for the purchase of the Yueshen shares by Shanghai Classic.

 

(iv) A common stock purchase warrant to purchase 50,000 shares of PacificNet common stock, par value $0.0001 per share. The exercise price under this warrant shall be the 5-Day volume weighted average price of the common stock of PacificNet before the signing date of this Agreement, exercisable within 3 years from the date of issuance. The warrants are considered contingent consideration and have not been valued as the contingency has not been met.(See Note 5)

 

The cash portion of the purchase price for the Acquisition was paid from working capital of the Company. The value of the common shares issued was determined based on the average market price of PacificNet's common shares over a reasonable period before and after the terms of the acquisition were agreed to and announced.

 

 

Estimated fair values:
Current Assets	$211,886
Property Plant and equipment	38,917
Goodwill	1,100,585
Total Assets Acquired	1,351,388
Current Liabilities assumed	(155,245)
Net assets acquired	$1,196,143

 

As of December 31, 2004 and 2005, Goodwill of $1,100,585 represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired and is not deductible for tax purposes The total amount of goodwill by reportable segment Communications Distribution Business was $1,100,585 (see Note 15).

 

In accordance with SFAS 142, goodwill is not amortized but is tested for impairment at least annually. The purchase price allocation for the Shanghai Classic acquisition was based on management's estimates and its overall industry experience. Immediately after the signing of the definitive agreement, the Company obtained effective control over Shanghai Classic. Accordingly, the operating results of Shanghai Classic have been consolidated with those of the Company starting April 12, 2004.

 

UNAUDITED PROFORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE YEAR ENDED DECEMBER 31, 2005 AND 2004

 

 

	Year ended December 31
	2005	2004
	(UN-AUDITED AND IN THOUSANDS OF U.S. DOLLARS)
Revenues	Fully	$12,547
Net earnings attributable to shareholders	consolidated	182
Earnings per share - basic (cents)		0.02
Earnings per share - diluted (cents)	In 2005	0.02

 

PacificNet included the financial results of the subsidiary in its consolidated 2005 financial results and from the date of the acquisition, April 12, 2004 through December 31, 2004.

 

 

F-16

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PACIFIC SMARTIME SOLUTIONS LIMITED ("SMARTIME")

 

On September 15, 2004, the Company, through its subsidiary PacificNet Strategic Investment Holdings Limited, consummated the acquisition of a 51% controlling interest (the "Acquisition") in Soluteck Technology (Shenzhen) Company Limited, a corporation incorporated in Shenzhen, China ("Soluteck"). The Company acquired the controlling interest in Soluteck through the purchase of 630 shares (the "Shares") of Pacific Smartime Solutions Limited ("Smartime"), the beneficial owner of an 81% controlling interest in Soluteck, from the shareholders of Smartime. The consideration for the Acquisition was payable as follows:

 

(i) USD$500,000, payable in shares of common stock of the Company (the "Common Stock"), equivalent to 100,000 restricted shares (the "Shares") of Common Stock, based on a fair market value of $5.00, deliverable within 30 days of signing the Agreement. All of the Shares deliverable to the Shareholders are being held in escrow pursuant to the terms of an escrow agreement, which provides that the Common Stock will be released in installments over the twelve month period ending on September 30, 2005; provided that Soluteck meets certain net income milestones during such period. If at the end of the second twelve month period ending on September 30, 2006, there is a shortfall in Soluteck's net income, the Shareholders shall return to the Company Shares equivalent to the dollar amount of such shortfall divided by $5.00; and

 

(ii) warrants to purchase up to 50,000 shares of common stock at an exercise price equal to the 5 day volume weighted average price of the Company's common stock before the signing of the Agreement. The warrants are exercisable for a period of 3 years from the date of issuance. The warrants are considered contingent consideration and have not been valued as the contingency has not been met. (See Note 5)

 

In connection with the Acquisition, the Company's subsidiary has agreed to provide Soluteck with an operating loan of RMB 3,000,000; provided that Soluteck secures certain contracts with Huawei. The loan would mature within 3 years with interest at a rate of 4% per year.

 

The Shares are restricted shares issued under an exemption from registration of the Securities Act of 1933, as amended. If at the time the Shareholders are eligible to sell the Shares under Rule 144, the fair market value of the Common Stock is less than USD$3.50, the Company shall issue additional shares of Common Stock for an aggregate amount of USD$100,000, up to a maximum of 60,000 shares of Common Stock. If at such time the fair market value of the Common Stock is more than USD$8.00 per share, the Shareholders and the Company will share on an equal basis any excess over USD$8.00 per share.

 

The value of the common shares issued was determined based on the average market price of PacificNet's common shares over a reasonable period before and after the terms of the acquisition were agreed to and announced.

 

 

Estimated fair values:
Current Assets	$460,957
Property Plant and equipment	60,505
Intangible Assets	562
Goodwill	233,000
Total Assets Acquired	755,024
Current Liabilities assumed	(255,024)
Net assets acquired	$ 500,000

 

As of December 31, 2004 and 2005, goodwill of $233,000 represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired and is not deductible for tax purposes and the total amount of goodwill by reportable segment for Business Process Outsourcing was $3,936,000 in both years (see Note 15).

 

In accordance with SFAS 142, goodwill is not amortized but is tested for impairment at least annually. The purchase price allocation for Smartime acquisition is based on a management's estimates and overall industry experience Immediately after the signing of the definitive agreement, the Company obtained effective control over Smartime. Accordingly, the operating results of Smartime have been consolidated with those of the Company starting September 15, 2004.

 

 

 

F-17

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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE YEAR ENDED DECEMBER 31, 2005 AND 2004

 

 

	2005	2004
	(UN-AUDITED AND IN THOUSANDS OF U.S. DOLLARS)
Revenues	Fully	$1,830
Operating income	--
Net earnings attributable to shareholders	Consolidated	$269
Earnings per share - basic (cents)		$0.037
Earnings per share - diluted (cents)	In 2005	$0.037

 

PacificNet included the financial results of Smartime in its consolidated 2005 financial results and from the date of the purchase, September 15, 2004 through December 31, 2004.

 

PACIFICNET CLICKOM LIMITED

 

On December 16, 2004, we entered into an agreement to acquire a controlling interest in Guangzhou Clickcom Digit-net Science and Technology Ltd. ("Clickcom-WOFE") through the purchase of a 51% interest of Clickcom-WOFE's parent company, PacificNet Clickcom Limited, a British Virgin Islands Company ("Clickcom-BVI") from three shareholders, Mr. Jinnan Lai, Mr. Ming Zhang and Mr. Dong Liu who are majority shareholders of GuangZhou DianXun Company Limited ("Dianxun-DE"), a PRC registered Domestic Enterprise (DE) either. The acquisition was completed on March 28, 2005 upon receipt of the required business license and approval from the local government.

 

The total purchase consideration for 51% of Clickcom is approximately one million, which is payable 30% in cash and 70% in restricted shares of PACT. The purchase price is payable upon achievement of certain quarterly earn-out targets based on net profits, through the issuance of 130,000 restricted shares of common stock of PacificNet. As of December 31, 2005, cash consideration of $267,826 and stock consideration of $260,000, representing 52,000 restricted shares of PACT common stock valued at $5.00 per share, was recorded as the cost of the acquisition. Total unearned purchase consideration in the form of common stock to be distributed based on the achievement of earnings was 78,000 restricted shares (See Note 12). PacificNet will also issue warrants to purchase 50,000 shares of PacificNet's common stock. The warrants are considered contingent consideration and have not been valued as the contingency has not been met. (See Note 5)

 

The cash portion of the purchase price for the Acquisition was paid from working capital of the Company. The value of the common shares issued was determined based on the average market price of PacificNet's common shares over a reasonable period before and after the terms of the acquisition were agreed to and announced.

 

 

Estimated fair values:
Current Assets	$136,474
Goodwill	391,352
Total Assets Acquired	527,826
Liabilities assumed	-
Net assets acquired	$527,826

 

At December 31, 2005, goodwill of $391,352 represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired and is not deductible for tax purposes and the total amount of goodwill by reportable segment for VAS Business was $9,788,000 in the same year (see Note 15)

 

In accordance with SFAS 142, goodwill is not amortized but is tested for impairment at least annually. The purchase price allocation for the Clickcom acquisition was based on a management's estimates and overall industry experience. Immediately after the signing of the definitive agreement, the Company obtained effective control over Clickcom. Accordingly, the operating results of Clickcom have been consolidated with those of the Company starting March 28, 2005. Pursuant to SFAS 141 "Business Combinations", the earn-out consideration is considered contingent consideration, which will not become certain until the audited combined after-tax profit of US$600,000 for 12 months ended December 31, 2005 is available. Accordingly, the contingent consideration of 78,000 restricted shares has not been reflected in the consolidated financial statements of the Company as of December 31, 2005 due to the performance target not being met.

 

 

F-18

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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE YEAR ENDED DECEMBER 31, 2005 AND 2004

 

 

	Year ended December 31
	2005	2004
	(UN-AUDITED AND IN THOUSANDS OF U.S. DOLLARS)
Revenues	$44,481	$29,878
Operating income	$4,737	$1,958
Net profit	$2,620	$784
Earnings per share - basic (cents)	$0.26	$0.11
Earnings per share - diluted (cents)	$0.24	$0.10

 

PacificNet included the financial results of Clickcom in its consolidated 2005 financial results from the date of the purchase, March 28, 2005 through December 31, 2005.

 

GUANGZHOU 3G INFORMATION TECHNOLOGY CO. LTD

 

On March 30, 2005 we entered into an agreement to acquire a controlling interest in Guangzhou 3G Information Technology Co. Ltd. ("Guangzhou3G-WOFE"), a PRC registered wholly owned foreign enterprise (WOFE), through the purchase of a 51% interest of Guangzhou 3G's parent company, Pacific 3G Information & Technology Co. Limited, a British Virgin Islands Company ("Guangzhou3G-BVI") from three shareholders, ASIAFAME INTERNATIONAL LIMITED, STARGAIN INTERNATIONAL LIMITED, and TRILOGIC INVESTMENTS LIMITED. All of above three shareholders are incorporated in BVI. Guangzhou3G-WOFE conducts it VAS operations with Guangzhou Sunroom Information Industrial Co., Ltd. ("Sunroom-DE"), a PRC registered Domestic Enterprise (DE), through a series of contractual agreements.

 

The details of the acquisition are as follows:

 

The purchase price for 51% controlling interest is approximately $5.9 million which is payable 29% in cash and 71% in restricted shares of PacificNet The purchase price includes $500,000 cash payable to Guangzhou 3G, and the remaining amount payable to the selling shareholders through the issuance of 522,750 restricted shares of common stock of PacificNet plus $1.18 million cash payable to the sellers upon achievement by Guangzhou 3G of certain quarterly earn-out targets based on net profits. As of December 31, 2005, cash consideration of $1,683,000 and stock consideration of $2,611,200, representing 326,400 restricted shares of PACT common stock valued at $8.00 per share, was recorded as the cost of the acquisition. Total unearned purchase consideration in the form of common stock to be distributed based on the achievement of earnings was 196,350 restricted shares (See Note 12). PacificNet also issue warrants to purchase 100,000 shares of PacificNet's common stock. The warrants have never been issued since it is contingent upon a certain earning milestone which has not been met.

 

The cash portion of the purchase consideration was paid from working capital of the Company. The value of the common shares issued was determined based on the average market price of PacificNet's common shares over a reasonable period before and after the terms of the acquisition were agreed to and announced.

 

 

F-19

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Estimated fair values:
Current Assets	$253,000
Goodwill	$4,041,200
Total Assets Acquired	$4,294,200
Liabilities assumed	--
Net assets acquired	$4,294,200

 

At December 31, 2005, goodwill of $4,041,200 represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired and is not deductible for tax purposes and the total amount of goodwill by reportable segment for VAS Business was $9,788,000. (See Note 15).

 

In accordance with SFAS 142, goodwill is not amortized but is tested for impairment at least annually. The purchase price allocation for Guangzhou3G acquisition is based on a management's estimates and overall industry experience Immediately after the signing of the definitive agreement, the Company obtained effective control over Guangzhou3G. Accordingly, the operating results of Guangzhou 3G have been consolidated with those of the Company starting March 30, 2005. Pursuant to SFAS 141 "Business Combinations", the earn-out consideration is considered contingent consideration, which will not become certain until the audited combined after-tax profit of US$2,000,000 for the 12 months ended December 31, 2005 is available. Accordingly, the contingent consideration of 196,350 shares has not been reflected in the consolidated financial statements of the Company as of December 31, 2005.

 

 

F-20

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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE YEAR ENDED DECEMBER 31, 2005 AND 2004

 

 

	Year ended December 31
GZ3G	2005	2004
	(UN-AUDITED AND IN THOUSANDS OF U.S. DOLLARS)
Revenues	$45,312	$32,690
Operating income	$4,910	$1,374
Net profit	$2,734	$458
Earnings per share - basic (cents)	$027	$006
Earnings per share - diluted (cents)	$026	$006

 

PacificNet included the financial results of 3G in its consolidated 2005 financial results from the date of the purchase, March 30, 2005 through December 31, 2005.

 

SHENZHEN GUHAIGUANCHAO INVESTMENT CONSULTANT COMPANY LIMITED ("CHINAGOHI")

 

On December 19, 2005, we closed an agreement to purchase a 51% interest in Shenzhen GuHaiGuanChao Investment Consultant Company Limited ("ChinaGoHi"), a wholly owned foreign enterprise (WOFE) registered in China and a provider of DRTV infomercial marketing company for financial advisory services in China. On October 3, 2005 we announced that we had signed an agreement dated as of September 30, 2005 to acquire 51% of the outstanding shares of ChinaGoHi from Hitching International Corporation ("HIC"), the former majority owner of ChinaGoHi to be closed upon the completion of due diligence and the approval of the WOFE structure by China's Industry and Commerce Department.

 

As a result of the due diligence process and receipt of the Chinese government's WOFE approval, we and HIC agreed to amend the Sale and Purchase Agreement and entered into a Supplementary Agreement dated as of December 1, 2005 (the "Supplementary Sale and Purchase Agreement") and permitted us to have direct ownership of ChinaGoHi through the acquisition of 51% of the outstanding shares from Lion Zone Holdings Limited instead of HIC.

 

We agreed to purchase 12,850 existing ordinary shares (the "Sale Shares") of ChinaGoHi from Lion Zone Holdings Limited (the "Seller") and to subscribe 5,000 newly issued ordinary shares (the "Subscription Shares") from the Seller, which together with the Sale Shares, being 17,850 or 51% of the 35,000 entire outstanding shares of ChinaGoHi. The purchase price for 51% of the outstanding shares of ChinaGoHi is an aggregate of US$10.2 million: US$2.1 million payable in cash to the Seller and US$6.6 million in shares (approximately 825,000 shares) of our common stock valued at $8 per share. The purchase price is payable upon achievement of certain quarterly earn-out targets based on net profits, through the issuance of our 825,000 shares. In addition, we has agreed to issue our restricted shares, a number to be based on 51% of the net cash divided by the 60-day volume weighted average price of PacificNet, upon auditor's certification of ChinaGoHi's US$7 million accumulated net cash profit for the fiscal years ended 2003, 2004 and 2005 (subject to completion of 2005 annual USGAAP audit).

 

The cash portion of the acquisition consideration was for the working capital of the Company. The value of the common shares issued was determined based on the average market price of PacificNet's common shares over a reasonable period before and after the terms of the acquisition were agreed to and announced.

 

 

F-21

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Estimated fair values:
Current Assets	$4,785,924
Property Plant and equipment	157,376
Goodwill	881,681
Total Assets Acquired	$ 5,824,981
Current Liabilities assumed	(2,449,981)
Long Term Liabilities assumed	--
Net assets acquired	$ 3,375,000

 

As of December 31, 2005, the total amount of cash and stock consideration was $2,275,000 and $1,100,000 respectively.

 

At December 31, 2005, goodwill of $881,681 represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired and is not deductible for tax purposes and the total amount of goodwill by reportable segment for VAS Business was $9,788,000 (see Note 15).

 

In accordance with SFAS 142, goodwill is not amortized but is tested for impairment at least annually. The purchase price allocation for ChinaGohi acquisition is based on management's estimates and overall industry experience. Immediately after the signing of the definitive agreement, the Company obtained effective control over ChinaGohi. Accordingly, the operating results of ChinaGohi have been consolidated with those of the Company starting December 19, 2005. Pursuant to SFAS 141 "Business Combinations", the earn-out consideration is considered contingent consideration, which will not become certain until the audited combined after-tax profit of US$4,500,000 for 15 months ending December 31, 2006 is available. Accordingly, the contingent consideration of 687,500 restricted shares and cash of US$1,325,000 have not been reflected in the consolidated financial statements of the Company as of December 31, 2005.

 

 

F-22

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UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION DISCLOSURE FOR THE YEAR ENDED DECEMBER 31, 2005 AND 2004

 

 

	Year ended December 31
	2005	2004
	(UN-AUDITED AND IN THOUSANDS OF U.S. DOLLARS)
Revenues	$55,209	$39,164
Operating income	$7,332	$4,267
Net profit	$3,354	$1,688
Earnings per share - basic (cents)	$0.33	$0.23
Earnings per share - diluted (cents)	$0.31	$0.20

 

 

3. INVESTMENT IN AFFILIATED COMPANIES

 

Investments in affiliated companies and goodwill consist of the following as of December 31, 2005 (in thousands):

 

	COLLATERAL/OWNERSHIP % AND BUSINESS DESCRIPTION
	AMOUNT	DESCRIPTION
INVESTMENTS IN AFFILIATED COMPANIES:
Take1 (Cheer Era Limited) [1]	$ 386	20% ownership interest; trader of vending machine located in Hong Kong
Xmedia Holdings Inc	95	25% ownership; provides new media business development and marketing to advertisers.
Less: Provision for Impairment	(95)
Total	$ 386

 

TAKE 1 TECHNOLOGIES GROUP LIMITED (FORMERLY KNOWN AS: CHEER ERA LIMITED "CHEERERA")

 

The investment in 30% of Take 1 Technologies Group Limited ("Take 1"), a trader of vending machine located in Hong Kong, was originally made in April 2004 with details as follows:

 

In April 2004 the Company, through its subsidiary PacificNet Strategic Investment Holdings Limited, acquired 30% equity interest in Take 1. The aggregate consideration was $1,156,812, of which $385,604 was paid in cash and $771,208 was paid in 149,459 PacificNet shares at $5.16, and warrants within a duration of three years to purchase up to 80,000 PacificNet shares at 5-Day volume weighted average price immediately prior to the transaction. The warrants have been cancelled in the year 2005 because the warranted profit was not met. (See Note 5)

 

 

F-23

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In 2005 both the Company and Take 1 have mutually agreed to a change to the original investment structure pursuant to the Securities Repurchase Agreements entered. Summarized below are the effects of these repurchase arrangements:

 

(i)	PacificNet 's interest in Take 1 was reduced to 20% in the year 2005 from 30% in the prior year;

(ii)	PacificNet repurchased 149,459 shares in PacificNet previously issued to the majority owner of Take 1 at nominal value;

(iii)

In addition to PacificNet 's existing loan of $769,000 (or HKD$6,000,000), PacificNet will advance a new loan of $256,000 (or HKD$2,000,000) to Take 1 (collectively called `Convertible Loan'). The Convertible Loan is guaranteed personally and jointly by the two majority owners of Take 1. The term of the Convertible Loan shall be three years expiring on October 17, 2008 (referred as "Term") with 8% interest per annum or HK Six-Month Prime Rate, whichever is higher.

(iv)

Conversion terms of the Convertible Loan provide PacificNet an option at any time during the Term to convert in part or in whole of the then outstanding loan principal up toS$1,794,000 (or HKD$8,000,000) into shares of Take 1 to reach 51% ownership of Take 1. The conversion rate will be based on a valuation of SIX (6) times the average annual net profits of 3 years ending December 31, 2007 audited by PacificNet 's auditors.

 

 

4. PROPERTY AND EQUIPMENT, NET

 

Property and equipment consists of the following as of December 31 (in thousands):

 

	2005	2004
Office furniture, fixtures and leasehold improvements	$531	$16
Computers and office equipment	1054	624
Motor Vehicles	220	69
Software	568	235
Electronic Equipment	3520	13
Other	77	468
Less: Accumulated depreciation	(1,670)	(307)
Net Property and Equipment	$4,300	$1,118

 

For the years ended December 31, 2005 and 2004, the total depreciation and amortization expenses were $1,126,000, of which $833,000 was included in the cost of revenue, and $78,000, respectively.

 

5. COMMITMENTS AND CONTINGENCIES

 

OPERATING LEASES -The Company leases warehouse and office space under operating leases for two years with fixed monthly rentals that expire through 2005. None of the leases included contingent rentals. Lease expense charged to operations for 2005 amounted to $653,000 (2004: $397,854). Future minimum lease payments under non-cancelable operating leases are 2006: $870,000 and 2007: $806,000.

 

RESTRICTED CASH - The Company has a $163,000 pledged bank deposit for Epro which represents overdraft protections with certain financial institutions and a fixed deposit of $1,489,000 for Lion Zone utilized to provide guarantee for related party.

 

 

F-24

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BANK LINE OF CREDIT (2005): As of December 31, 2005, the Company utilized $1,060,000 of the banking facility including $945,000 from Epro and $112,000 from Smartime, and the differences of the exchange rate of $3,000. Epro has an overdraft banking facility with certain major financial institutions in the aggregate amount of $1,218,000, which is secured by a pledge of its fixed deposits of $163,000, pursuant to the following terms: interest will be charged at the Hong Kong Prime Rate per annum and payable at the end of each calendar month or the date of settlement, whichever is earlier. For Smartime, there is no due date payment stipulated by Hong Kong Hang Seng Bank because its overdraft banking facility was borrowed directly from one of its directors personal fixed deposit account as a mortgage. The detailed payment period is based on its funding condition.

 

BANK LINE OF CREDIT (2004): The Company has an overdraft banking facility with certain major bankers in the aggregate amount of $1,309,000, which is secured by a pledge of the Company's fixed deposits in the amount of $212,000, pursuant to the following terms: interest will be charged at the Hong Kong Prime Rate per annum and payable at the end of each calendar month or the date of settlement, which ever is earlier. As of December 31, 2004, the Company utilized $651,000 of the above-mentioned banking facility.

 

CONTINGENT CONSIDERATION: Warrants have not been included as part of the acquisition price of various S&P Agreements (Note 2) and are no longer considered as part of the purchase consideration due to (i) the ambiguity of the S&P Agreements with respect to the issuance of the warrants and (ii) the lack of actual instruments to transfer the warrants, such as a warrant agreement that is signed and sealed by the Company and property registered at the Company Registrar of securities in Hong Kong, and accordingly, there is no irrevocable obligation by the Company to issue the warrants. Furthermore, the net income milestones were not achieved as required under the S&P Agreements according to Hong Kong law. Based on the opinion of the Company's legal counsel in Hong Kong, the Company does not have an irrevocable obligation to issue the warrants and therefore the warrants are not considered issued and outstanding. The offer to issue the warrants is no longer part of the purchase price in the S&P Agreements due to the failure by the Sellers to satisfy their warranties in the S&P Agreements. Accordingly, the warrants have not been valued.

 

MINIMUM STATED CAPITAL REQUIREMENTS. Guangzhou Dianxun Co, Limited (DE) ("Dianxun"), a subsidiary of the Group, is carrying on business as a telecommunication value added service provider in the People's Republic of China ("PRC"). Initially, Dianxun obtained a certificate (the "Certificate") from the PRC authority to transact business and according to the PRC Telecommunication Rules, all telecommunication value added service providers can only carry on business if the Certificate is granted and if the Company maintains a minimum capital requirement of at least RMB10,000,000.

 

In order to satisfy the capital requirement of RMB 10,000,000, the shareholders of Dianxun had contributed relevant asset equivalent to RMB9,000,000 on behalf of Dianxun and such assets were verified by an independent professional accountant. Subsequently, such assets were returned back to the shareholders. In the opinion of the directors, even though the capital requirement is not fulfilled, Dianxun can continue to carry on business. No provision for any loss arising from the consequential actions that may be taken by the authority in the PRC and any potential penalties or claims for the Company not maintaining the minimum stated capital requirements of the PRC have been made in these financial statements.

 

 

6. OTHER CURRENT ASSETS

 

Other current assets is represented in Consolidated Balance Sheets which include the following at December 31 (in thousands):

 

	2005	2004
Deposit	$707	$870
Prepayment	1,294	354
Other receivables	5,972	3,101
Total	$7,973	$4,325

 

 

F-25

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	2005	2004
Total minimum lease payments	$216	$225
Interest expense relating to future periods	(12)	(16)
Present value of the minimum lease payments	204	209
Less: current portion	(126)	(80)
Non current portion	$78	$129

 

 

	2005	2004
Computers and office equipment	$441	$268
Less: accumulated depreciation	(286)	(246)
	$155	$22

 

 

10. SUBSCRIPTION PAYABLE

 

In December 2005, the Company executed agreements and acquired controlling interests in Shenzhen GuHaiGuanChao Investment Consultant Company Limited ("ChinaGoHi"), a wholly owned foreign enterprise (WOFE) registered in China and a provider of DRTV infomercial marketing company for financial advisory services in China.

 

According to the agreement for the acquisition of ChinaGoHi, the total purchase consideration at the acquisition date approximated $10,200,000, which included the following:

 

(1)	Cash for original shareholders of ChinaGoHi: $2,100,000 (payable in installments based on the terms and conditions; the payable amount is $775,000 at December 31, 2005);

(2)	PACT common stock for original shareholders of ChinaGoHi: $6,600,000 (825,000 x $8 per share); and

(3)	Cash for registered capital of ChinaGoHi: $1,500,000.

 

Accordingly, subscription payable of $775,000 represents the installment payment in cash due under the terms and conditions of the Sale and Purchase Agreement at December 31, 2005.

 

 

11. SUNDRY INCOME

 

Sundry income for the years ended December 31, 2005 and 2004, consists of the following on the consolidated income statements (in thousands):

 

	2005	2004
Consulting service income	$116	$380
Investment income	113	--
Leasehold income	75	--
Software service income	375	--
Others	151	42
TOTAL	$830	$422

 

12. STOCKHOLDERS' EQUITY

 

a) COMMON STOCK

 

For the year ended December 31, 2005, the Company had the following equity transactions (i) 700,000 shares as a result of exercise of stock options and warrants with cash consideration of $1,014,000; (ii) 515,900 shares for acquisition of subsidiaries valued at $3,971,000;(iii) 20,000 shares at $3.10 per share, or $63,000 for investor relations services rendered based on the fair market value of the services rendered; and (iv) cancellation of 149,459 shares with a market value of $771,000 related to affiliated company (see Note 3 for details).

 

For the year ended December 31, 2004, the Company had the following equity transactions (i) 352,364 shares as a result of exercise of stock options and warrants with cash consideration of $716,000; (ii) 1,756,240 shares for acquisition of subsidiaries valued at $8,866,000; and (iii) 2,205,697 shares for cash proceeds of $11,773,000 (net of offering costs); and (iv) 149,459 shares with a market value of $771,000 for acquisition of affiliated company (see Note 3 for details).

 

b) STOCK OPTION PLAN

 

On December 23, 2003, stockholders of the Company adopted an amendment to the Stock Option Plan (the "Plan") to increase the number of shares reserved under the Plan from 1,666,667 to 2,000,000. On December 30, 2004, stockholders of the Company approved the new 2005 Stock Option Plan (the "2005 Option Plan"). The 2005 Option Plan provide for the grant to directors, officers, employees and consultants of the Company (including its subsidiaries) of options to purchase up to an aggregate of 2,000,000 shares of Common Stock. The 2005 Plan is administered by the Board of Directors or a committee of the Board of Directors (in either case, the "Committee"), which has complete discretion to select the optionees and to establish the terms and conditions of each option, subject to the provisions of the 2005 Option Plan. Options granted under the 2005 Plan are "incentive stock options" as defined in Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), or nonqualified options.

 

The purpose of the Plan is to attract and retain the best available personnel for positions of responsibility and to provide incentives to such personnel to promote the success of the business. The Plan provides for the grant to directors, officers, employees and consultants of the Company (including its subsidiaries) of options to purchase shares of common stock. Options granted under the Plan may be "incentive stock options" as defined in Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), or non-qualified options. To date, all options granted have been nonqualified options. The exercise price of incentive stock options may not be less than 100% of the fair market value of the common stock as of the date of grant. The number of options outstanding and the exercise price thereof are subject to adjustment in the case of certain transactions such as mergers, recapitalizations, stock splits or stock dividends. Options granted under the Plan fully vest through June 2005.

 

 

F-27

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	OPTIONS	WEIGHTED AVERAGE EXERCISE PRICE
OUTSTANDING, DECEMBER 31, 2002	312,600	$1.13
Granted	963,000	$2.97
Exercised	(350,000)	$1.13
OUTSTANDING, DECEMBER 31, 2003	925,600	$2.87
Granted	600,000	$ 2.00
Cancelled	(400,000)	$4.25
Exercised	(321,500)	$ 2.11
OUTSTANDING, DECEMBER 31, 2004	804,100	$ 1.90
Granted	680,000	$ 6.57
Cancelled	--	--
Exercised	(100,000)	$ 1.99
OUTSTANDING, DECEMBER 31, 2005	1,384,100	$3.99

 

 

Shares of common stock	EXERCISE PRICE PER SHARE	EXPIRATION DATE OF WARRANTS
123,456	$7.15	January 15, 2009
117,682	$3.89	November 15, 2009
350,000	$12.21	December 9, 2009
---------------------
591,138

 

The Company believes 330,000 warrants issued in connection with certain acquisition agreements (Note 2) with the following subsidiaries, Yueshen: 50,000, Cheer Era: 80,000, Smartime: 50,000, Clickcom: 50,000, and Guangzhou3G:100,000 are no longer part of the purchase consideration as more fully described in Note 5 and therefore are not considered outstanding.

 

During 2005, 200,000 unexercised warrants (Excel Harbour warrants) expired, and 600,000 warrants were exercised by Sino Mart Management Ltd, a related party, at an exercise price of $1.45 per share for total proceeds of $870,000. For the year ended December 31, 2004, 30,864 warrants were exercised at an exercise price of $7.15 per share for total proceeds of $220,678.

 

 

F-28

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d) TREASURY STOCK

 

The following is a summary of the movement of the Company's shares held as treasury stock for the years ended December 31:

 

	Number of Remarks shares
Balance, December 31, 2003	800,000
Repurchase in the open market	36,154
Balance, December 31, 2004	836,154
Repurchase in the open market	2,000
Repurchase of shares from Take 1	149,459	See note 3 to the F/S
Cancellation of former employee shares	45,000
Holdback shares as contingent consideration due to performance targets not yet met	298,550	Including 24,200 shares relating to Yueshen, 196,350 hares to 3G and 78,000 shares to Clickcom
Share consideration for acquisition of ChinaGoHi deemed issued under Sale and Purchase Agreement	(137,500)	Due to share issuance in progress; actual share certificate delivered after the year end
Options exercised but shares deemed issued	(24,000)	Share issuance in progress prior to year end
Balance, December 31, 2005:	1,169,663
Shares outstanding at December 31, 2005	10,831,024
Shares issued at December 31, 2005	12,000,687