For the transition period from ______________________ to _______________________
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.
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.
Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Act).
The aggregate market value of the voting
and non-voting common stock of the issuer held by non-affiliates as of June 28, 2013 was approximately $2,677,028 (12,747,754 shares
of common stock held by non-affiliates) based upon the closing price of $0.21 per share of common stock as quoted by OTCQB on June
28, 2013.
As of March 21, 2014, there are 25,689,524
shares of common stock, par value $0.00001 issued and outstanding.
PART I
Overview
We operate a chain
of 62 internet cafés in Shenzhen, Guangdong, the People’s Republic of China (“PRC”) that are generally
open 24 hours a day, seven days a week. We provide internet accesses at prices that we believe are affordable to both students
and migrant workers and we believe we are the largest internet café chain in Shenzhen. Although we sell snacks, drinks,
and game access cards, over 95% of our revenue comes from selling access time to our computers. We sell internet café memberships
to our customers. Members purchase prepaid IC cards (a pocket-sized card with embedded integrated circuits that can be used for
identification, authentication, data storage and application processing), which include stored value that will be deducted based
on time usage of a computer at the internet café. The cards are only sold at our cafés. We deduct the amount that
reflects the access time used by a customer when the customer’s IC card is inserted into the IC card slot on the computer.
Our History
China Internet Cafe
Holdings Group, Inc. (“we”, “us”, or the “Company”) is a Nevada holding company for our direct
and indirect subsidiaries in the British Virgin Islands (“BVI”) and the PRC. We own all of the issued and outstanding
capital stock of Classic Bond, a BVI corporation. Classic Bond is a holding company that owns 100% of the outstanding capital stock
of Shenzhen Zhonghefangda Network Technology Co., Limited (“Zhonghefangda”), a PRC company.
Current PRC laws and
regulations impose substantial restrictions on foreign ownership of the internet café business in the PRC. Therefore, our
principal operations and sales and marketing activities in the PRC are conducted through Shenzhen Junlong Culture Communications
Co., Ltd (“Junlong”), our variable interest entity (“VIE”), which holds the licenses and approvals for
conducting the internet café business in the PRC.
Junlong was incorporated in the
PRC in December 2003. It obtained its first licenses from the Ministry of Culture of the PRC to operate an internet café
chain in 2005 and opened its first internet café in April 2006.
Our
effective control over the VIE is contingent on a series of contractual arrangements. These contracts include a Management and
Consulting Services Agreement, an Option Agreement, an Equity Pledge Agreement, and a Voting Rights Proxy Agreement. The Management
and Consulting Services Agreement, dated June 11, 2010, is between our indirect, wholly owned subsidiary, Zhonghefangda, and our
VIE. The rest of the agreements, also dated June 11, 2010, are among Zhonghefangda, our VIE and its shareholders. The terms of
these agreements are summarized below. Please also refer to the full text of the contracts, which are filed as exhibits to this
report.
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Management and Consulting Services
Agreement.
Under the Management and Consulting Services Agreement between Junlong and Zhonghefangda, Zhonghefangda
provides management and consulting services to Junlong in exchange for service fees up to 100% of Junlong’s Aggregate Net
Profits (as defined in the agreement). In consideration for its right to receive Junlong’s aggregate net profits, Zhonghefangda
will reimburse to Junlong the full amount of Net Losses (as defined in the Agreement) incurred by Junlong. During the term of the
agreement, Junlong may not contract with any other party to provide services that are the same or similar to the services to be
provided by Zhonghefangda pursuant to the agreement. The term of this agreement is 20 years, renewable for succeeding periods of
the same duration until terminated pursuant to terms of the agreement.
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Option Agreement.
Under
the Option Agreement, Junlong’s shareholders, Mr. Dishan Guo, Mr. Jinzhou Zeng and Ms. Xiaofen Wang (the “Junlong Shareholders”),
who collectively own 100% of the equity interest in Junlong, granted Zhonghefangda an exclusive, irrevocable option to purchase
all or part of their equity interests in Junlong, exercisable at any time and from time to time, to the extent permitted under
PRC law. The purchase price of the equity interest will be equal to the original paid-in registered capital of the transferor,
adjusted proportionally if less than all of the equity interest owned by the transferor is purchased.
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Equity Pledge Agreement.
The
Junlong Shareholders have pledged their entire equity interest in Junlong to Zhonghefangda pursuant to the Equity Pledge Agreement.
The equity interests are pledged as collateral to secure the obligations of Junlong under the Management and Consulting Services
Agreement and the Junlong Shareholders’ obligations under the Option Agreement and the Proxy Agreement.
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Voting Rights Proxy Agreement.
Pursuant
to the Voting Rights Proxy Agreement, each of the Junlong Shareholders has irrevocably granted and entrusted Zhonghefangda with
all of the voting rights as a shareholder of Junlong for the maximum period of time permitted by law. Each Junlong Shareholder
has also covenanted not to transfer his or her equity interest in Junlong to any party other than Zhonghefangda or a designee of
Zhonghefangda.
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We
believe that the terms of these agreements are no less favorable than the terms that we could obtain from disinterested third parties.
According to our PRC counsel, China Commercial Law Firm, our conduct of business through these agreements complies with existing
PRC laws, rules and regulations.
As
a result of these contractual arrangements, Junlong became our controlled VIE. A variable interest represents a contractual or
ownership interest in another entity that causes the holder to absorb the changes in fair value of the other entity’s net
assets. Potential variable interests include: holding economic interests, voting rights, or obligations to an entity; issuing guarantees
on behalf of an entity; transferring assets to an entity; managing the assets of an entity; leasing assets from an entity; and
providing financing to an entity. In such cases consolidation of the VIE is required by the enterprise that controls the economic
risks and rewards of the entity, regardless of ownership. We have consolidated Junlong’s historical financial results in
our financial statements as a variable interest entity pursuant to U.S. generally accepted accounting principles (“GAAP”).
Acquisition
of Classic Bond
On
July 2, 2010, we completed a reverse acquisition transaction through a share exchange with Classic Bond and its shareholders, whereby
we acquired 100% of the issued and outstanding capital stock of Classic Bond, in exchange for 19,000,000 shares of our common stock,
which shares constituted 94% of our issued and outstanding shares on a fully-diluted basis, as of and immediately after the consummation
of the reverse acquisition. As a result of the reverse acquisition, Classic Bond became our wholly owned subsidiary and the former
shareholders of Classic Bond, became our controlling shareholders. The share exchange transaction with Classic Bond was treated
as a reverse acquisition, with Classic Bond as the acquirer and us as the acquired party. Unless the context suggests otherwise,
when we refer in this report to business and financial information for periods prior to the consummation of the reverse acquisition,
we are referring to the business and financial information of Classic Bond and its consolidated subsidiaries.
Upon
the closing of the reverse acquisition, Xuezheng Yuan, our sole director and officer, submitted a resignation letter pursuant to
which he resigned, with immediate effect, from all offices that he held and from his position as our sole director that became
effective on the August 13, 2010, ten days following the mailing by us of an information statement to our stockholders complying
with the requirements of Section 14f-1 of the Exchange Act (the “Information Statement”). Also upon the closing of
the reverse acquisition, our board of directors (the “Board”) increased its size from one to five members and appointed
Dishan Guo, Zhenquan Guo, Lei Li, Wenbin An and Lizong Wang to fill the vacancies created by the resignation of Xuezheng Yuan and
such increase. Mr. Dishan Guo’s appointment became effective upon closing of the reverse acquisition, while the remaining
appointments became effective on August 23, 2010. In addition, our executive officers were replaced by the Classic Bond executive
officers upon the closing of the reverse acquisition as indicated in more detail below.
As
a result of our acquisition of Classic Bond, we now own all of the issued and outstanding capital stock of Classic Bond. Classic
Bond was incorporated in the British Virgin Islands on November 2, 2009 to serve as an investment holding company that owns 100%
of the outstanding capital stock of Zhonghefangda.
The
following chart represents our organizational structure as of the date of this report:
On
July 2, 2010, our Board approved a change in our fiscal year end from June 30 to December 31, which was effectuated in connection
with the reverse acquisition transaction described above.
On January 20, 2011,
we filed with the Nevada Secretary of State a Certificate of Amendment to Articles of Incorporation to give effect to a name change
from “China Unitech Group, Inc.” to “China Internet Cafe Holdings Group, Inc.” The Certificate of Amendment
was approved by our Board on July 30, 2010 and was approved by a stockholder holding 59.45% of our outstanding common stock by
written consent on July 30, 2010. In connection with the name change, on January 25, 2011, we filed an Issuer Company-Related Action
Notification Form with FINRA requesting a name change from “China Unitech Group, Inc.” to “China Internet Cafe
Holdings Group, Inc.” as well as an OTC voluntary symbol change from “CUIG” to “CICC.” These changes
became effective on February 1, 2011. Our common stock began trading under the Company’s new name on the OTC Bulletin Boards
on Tuesday, February 1, 2011 under our new trading symbol “CICC.”
On February 22, 2011,
in connection with a security purchase agreement between the Company and certain investors (collectively, the “Investors”),
we closed a private placement of approximately $6.4 million from offering a total of 474,967 units (the “Units”) at
a purchase price of $13.50 per Unit, each consisting of:(i) nine shares of the Company’s 5% Series A Convertible Preferred
Stock, par value $0.00001 per share (the “Preferred Shares”), convertible on a one to one basis into nine shares of
the Company’s common stock; (ii) one share of common stock; (iii) two three-year Series A Warrants, each exercisable for
the purchase of one share of common stock, at an exercise price of $2.00 per share; and (iv) two three-year Series B Warrants,
each exercisable for the purchase of one share of common stock, to purchase one share of common stock, at an exercise price of
$3.00 per share.
Our Industry
Background on Internet
Cafés in the PRC
According
to the Survey of China Internet Café Industry by the Ministry of Culture in
2006, the PRC had 112,462
internet cafés, with more than 1,000,000 employees and contributing RMB 18,500,000,000 to China’s gross
domestic product. According to an article entitled “
China Surpasses U.S. in Number of Internet Users”
written
by David Barboza on the New York Times July 26, 2008 issue, the number of internet users in the PRC reached about 253 million in
June 2008, thereby, putting China ahead of the United States as the world’s biggest internet market. According to the research
conducted by China Internet Network Information Center (CNNIC) in January 2012, the amount of internet users in China by the end
of 2012 was 564 million, 126 million of which (22.4%) surf the internet via internet cafes.
The internet café
market in the PRC, like most places worldwide, originally started out simply as a location to access the internet. However, PRC
internet cafés have changed into full service entertainment centers where people can relax outside work and home. These
cafés provide services that are different from the internet cafés initially established in the PRC. They provide
decent facilities at a reasonable fee, with specific configuration for online games and audio visual entertainment. They are a
source of cost effective entertainment for low-income earners who cannot afford computers, game consoles or an internet connection,
such as migrant workers and students. In internet cafés, customers have access to popular online games and can either socialize
or entertain themselves. Players gather together in internet cafés for games such as World of Warcraft (WOW) and Call to
Arms, played either with their friends in the café or with users across the globe.
Due
to tightened regulations on the operations of internet cafés, there are currently around 81,000 internet cafés in
the PRC (Source: “Internet café ban call draws Chinese hacker wrath”. AFP 3 Mar, 2010. http://www.google.com/hostednews/afp/article/ALeqM5gJus4tWVAaeWI8IoS-n238PYpFjw).
There are currently 10 chains which have licenses to operate nationally. They are CY Network Home Co., Ltd, Zhong Lu Shi Kong Co.,
Ltd, Digital Library of China Co., Ltd, Asia Telecommunication Network Co., Ltd, China Relic Information Consultation Center, Capital
Net Co., Ltd, Great Wall Broadband Network Co., Ltd, China United Network Communications Group Co., Ltd, CECT-ChinaComm Communications
Co., Ltd, and Read China Investment.
Computer
Gaming Industry in China
According
to a report by Hudson Square Research dated October 2009 prepared by Scott Tilghman and Daniel Ernst, which cited Pearl Research,
a business intelligence and consulting firm, the PRC online game market rose 63% in 2008 to $2.8 billion (source: http://www.zhongman.com/games/gamehot/20090429/15485138631.htm),
rose 36% in 2009 to $3.97 billion (source http://tech.qq.com/a/20100111/000389.htm),rose 26% in 2010 to $4.8 billion, rose 21%
in 2011 to $5.8 billion (source: http://games.sina.com.cn/y/n/2011-05-05/1111495419.shtml), and rose 41% in 2012 (source: http://games.sina.com.cn/y/n/2012-09-06/1016652450.shtml).
Given the relatively low rate of computer ownership in the PRC as compared to western countries, management believes that Internet
cafés are the primary distribution point for games in the PRC. A substantial number of game players access online games
through internet cafés and these players are crucial for survival of internet cafés. (
see
: http://blog.sina.com.cn/s/blog_4aff94ef01007zei.html).
The following diagram
prepared by Morgan Stanley depicts the interdependent relations between online game developers and internet cafés. (Source:
Ji Richard and Meeker, Mary. “Creating Consumer Value in Digital China” Morgan Stanley Equity Research Global. September
12, 2005.)
Given
the popularity of internet cafés in China, it has been management’s experience that many online game companies have
been making great efforts to support internet cafés to expand their customer base (
see
: http://blog.sina.com.cn/s/blog_4aff94ef01007zei.html)
in the last few years. Many online game companies promote new products by allowing internet café customers to
sample the new products in internet cafes. In this way, online game operators are provided with an outlet to present
their new products as well as receive feedback from those individuals who sample the products in the internet cafes.
The
Company has been involved in several such promotions with the following operators:
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Giant Network who promote their product
“Titan.” As consideration for promoting their product in our internet cafes, we receive a commission based on the time
spent by customers playing the game and the level reached by customers in the game. The commissions are capped at 20,000 RMB per
month.
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Sanda Network who promote their product
“Rainbow Island.” As consideration for promoting their product in our internet cafes, we receive a commission based
on the time spent by customers playing the game and the level reached by customers in the game.
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Tencent, who promote their product “Cross
Fire.” As consideration for promoting their product in our internet cafes, we receive a commission based on the time spent
by customers playing the game and the level reached by customers in the game.
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These
promotions benefit the Company by increasing the number of customers who visit our internet cafes. Currently, we have
62 direct outlets in Shenzhen City, and we believe that the Company name has strong brand recognition in Shenzhen. As
a result, these promotions in our internet cafés are likely to increase the customer base for new online gaming products.
As
the Company continues to grow, we believes that we will have the leverage to seek more lucrative terms when partnering with game
operators who want to promote their products in our cafes.
Partnerships
between Internet Cafés and Other Online Information Providers
Besides
games, internet cafés are able to develop partnerships with other online information providers. These companies provide
games as well as other information services. As can be seen by the chart below, these providers have significant revenues and profits.
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2012 Revenue
|
|
|
|
|
|
|
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Company
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Million US$
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|
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YOY
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Net Profit
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% Net
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|
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Market Cap
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Tencent
|
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$
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6,983
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|
|
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54
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%
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$
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2,034.0
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|
|
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25.0
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%
|
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$
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60,550
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Shanda
|
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$
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744.9
|
|
|
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-11.4
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%
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$
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177.2
|
|
|
|
-12.0
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%
|
|
$
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811
|
|
Netease
|
|
$
|
1300
|
|
|
|
13.0
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%
|
|
$
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583.9
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|
|
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12.4
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%
|
|
$
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5,592
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|
ChangYou
|
|
$
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623.4
|
|
|
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29.0
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%
|
|
$
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282.4
|
|
|
|
15.0
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%
|
|
$
|
1,393
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Giant
|
|
$
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345.4
|
|
|
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20.1
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%
|
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$
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159.5
|
|
|
|
12.9
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%
|
|
$
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1,279
|
|
Perfect World
|
|
$
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444.7
|
|
|
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-7.1
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%
|
|
$
|
86.8
|
|
|
|
-45.1
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%
|
|
$
|
453
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
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|
$
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14,443
|
|
|
|
|
|
|
$
|
3,324
|
|
|
|
|
|
|
$
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69,678
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|
(Source: finance.yahoo.com, last accessed April 8, 2013)
Competitive Strengths
We believe that the
following competitive strengths enable us to compete effectively in and to capitalize on growth in the internet café market
in the PRC:
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Company-owned Cafés.
Unlike most of our competitors who franchise their internet cafés, all of our cafés are direct outlets. This model
makes it easier to carry out management decisions at each of our cafés. It also allows us to maximize operating profit and
create a consistent name brand.
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Good Scale of Operation.
We have a registered capital of RMB 10 million (approximately $1.47 million) with 62 cafés. The scale of operations allows
us to control cost and standardize store management. It is our belief that our scale of operations will not be affected as we expand
into additional provinces and obtain a national internet chain license as described in more detail below. The target companies
that we intend to acquire in the future in provinces outside of Guangdong Province will be local companies with good scale of operations.
We will identify target companies by conducting due diligence on each target company’s corporate structure, management, financials,
capitalization, and equity structure, and whether or not the target company has the proper approvals, permits, and certificates
to legally operate an internet café in the PRC. We intend to buy 51% of the target’s company, and keep the local management.
However, we will relocate an account manager and an operation manager from our headquarters in Shenzhen to any newly acquired café
to join the local management and assist in the process of the acquisition in order to make sure that the acquired café operates
in the same manner as our existing Shenzhen-based cafes. As a result, we believe that the efficient and effective operation of
the cafes will continue and the Company’s scale of operations as a whole will not be negatively affected.
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Proprietary Software.
We developed the software “SAFLASH” that provides fast and stable internet connections. Its automatic flow control
prevents users from being disconnected when there is a disruption of internet traffic. Stability is a key requirement for online
gamers. Our research and development team is working constantly to improve the software.
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Government and Industry Relations.
We have developed an excellent working relationship with the government that has assisted us to better comply with internet
café related laws and regulations and to understand regulatory trends in our industry. Our Chief Executive Officer and Chief
Financial Officer, Mr. Dishan Guo, is the executive president of Shenzhen Longgang District Internet Industry Association. This
association is an associated department of the Ministry of Culture and sets the internet café industry standards. As a result
of his involvement, Mr. Guo gains valuable insight into new standards and may also have the opportunity to influence industry standards.
Because the Ministry of Culture is responsible for culture policies and activities throughout China, and there are regional Ministry
of Culture departments in each province, Mr. Guo’s government and industry relations expand beyond the Shenzhen district,
which we believe will benefit the Company as we expand into provinces outside of Guangdong Province.
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Centralized Oversight.
All
of our café managers are trained by, and under the supervision of, our centralized operations manager, who is based at our
headquarters. As a result, our local managers are able to effectively handle operational issues at the cafés. The local
managers are trained to provide a service level that meets Junlong’s service standards, and our operations manager is able
to effectively enforce policies and procedures implemented by us.
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Industry Risks
The
principal risk the company faces is the risk associated with changes in government regulations regulating the internet or internet
cafes. For example, in the year 2000, an arson killed twenty-four individuals and injured several more in an internet
café in Beijing. After this event, the government released new regulations governing the operation of internet
cafes, did not issue any new internet café operating licenses, and forced all internet cafes to temporarily close for safety
purposes (http://news.sina.com.cn/z/wangba/index.shtml). This type of action by the government could cause serious disruptions
in our operations. Additionally, the possibility of passing regulations limiting access to the internet could have a
significant negative impact on our business. Please refer to our disclosure under the “Regulation” section on page
13 for more information on the current government regulations that may have an impact on the Internet, Internet café and
online gaming industry. However, there are currently no government regulations that negatively impact our operations. On the contrary,
current government regulations promote the expansion of our operations by encouraging the growth of large-scale chain internet
cafes. Pursuant to the
Rules on Recognition and Management of Internet Café Chain Enterprises
promulgated by the
Ministry of Culture, the PRC government encourages the internet café chain enterprises to merge, acquire or control individual
internet cafés and provides simplified and convenient procedures for change of Internet Culture Operation Permit. Additionally,
the PRC government requires counterparts of Ministry of Culture at all levels to give priority to the development of internet café
chain enterprises when making the plan on the total number of internet cafés.
Our Growth Strategy
We are committed to enhancing our sales,
profitability and cash flows through the following strategies:
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We will seek to grow by business expansion.
We plan to expand in Guizhou, Sichuan, and Yunnan Provinces as well as the Chongqing Municipality principally through the acquisition
of local small chains, in order to meet the requirements of applying for a national chain license. The national chain license requires
30 internet cafés in three provinces. In the future, we plan to acquire internet cafés in Guizhou and Sichuan Provinces
to help us satisfy the requirements of obtaining a national chain license. We also want to fully develop our wholly-owned branches
through effective integration of resources. Most of our current competitors that offer franchising simply provide a franchise license
to entrepreneurs to get started in exchange for a yearly fee. Junlong, on the other hand, is deeply involved in the operational
management of its company-owned cafés. After we obtain a national chain license, we will focus on developing high-end internet
cafés in the more developed cities to create new concepts of internet café operation such as operating cafes that
provide food and beverage service as well as overnight accommodation. The high-end internet cafes that we plan to open in the future
will house the most up to date computers and have private rooms for movie viewing and game play with surround sound capability.
These high-end cafes will cater to individuals with disposable income exceeding that of our general customers, young low-income
males and migrant workers. We expect to spread to the less developed cities in three years in order to gain competitive market
shares. We plan to put 20% of our resources to the less developed cities for market integration after we are granted a national
license, which will effectively lay the foundation for us in those cities.
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We will seek to grow by improving our
company structure. To optimize our resources and operations, we plan to improve our company structure so that 20% of our internet
cafés will be large stores, each with 300 or more computers mainly focusing on movies, high-end games and entertainment;
50% of cafés will be medium stores with 150 to 300 computers and a few movie suites focusing on high-end games; 10% of cafés
will be small stores in the developed cities to spread our reputation with 100 to 150 computers. In order to penetrate the less
developed cities, we want to open 20% of our stores in those cities. Our mission is to set up internet cafés all over the
PRC to become a real internet cafés chain and the industry leader, and we will start to implement these plans in the second
half of 2014
.
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We will seek to grow by location selection.
Running internet cafés is a retail business. Internet cafés are located in highly populated areas so as to attract
customers. Junlong’s internet cafés are located at busy and well attended areas such as industrial zones and business
quarters. We kept conducting market research in Hunan, Hubei, and Beijing in 2013.
As a result of this market research, we have identified the university areas in Sichuan and Chongqing, the residential areas and
business quarters in Yunan and Guizhou as prime areas for the establishment of internet cafés. As such, our future expansion
in the south-western region will focus on the establishment of internet cafes in these locations.
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Use of Prepaid IC Cards
Our internet café
members purchase prepaid IC cards which include stored value that is deducted based on time usage of a computer at our internet
cafés. The cards are only sold at our cafés. We deduct from the stored value amount to reflect customer usage when
the customers’ IC cards are inserted into the IC card slot on the computer. Revenues derived from the prepaid IC cards at
the internet café are recognized when services are provided. Below is our IC card sample.
Outstanding customer
balances on the IC cards are included in deferred revenue on the balance sheets. We do not charge any service fees that cause a
decrease in customer balances.
The basic
membership comes with the IC card and costs RMB 10 (approximately $1.52) on top of the initial credits deposited. Members receive
a discount (e.g. RMB 50 (approximately $7.94) deposit gets RMB 60 (approximately $9.52) credit in the IC card). There is no expiration
date for IC cards, but money deposited into the IC cards is not refundable.
Software on the Computers
We
have on average 250 computers in each location and a total of over 15,433 computers serving all 62 internet cafés. We install
more than 1,000 online games on each of our computers. We also provide movies, music and online chatting software. We use Microsoft
Word compatible software called “WPS,” which is a freeware provided by Kingsoft, a Chinese software company, so that
we do not pay for the higher priced Microsoft Office license.
Third Party Gaming Cards, Snacks and Drinks
We also sell third
party on-line gaming cards, snacks and drinks. The commission for the sale of gaming cards is generally 20% of the value of the
cards. Concessions (snacks and drinks) are also sold to customers.
On January 27, 2014,
we entered into a health products distribution agreement (the “Distribution Agreement”) with Beijing Eastern Union
Medical Biotechnology, Ltd. and its subsidiary Ningxia Eastern Outai Medicine, Ltd. (collectively, “Eastern Union”)
to distribute and sell Eastern Union’s Yiyou Series of nutriceutical products including melatonin tablets, Vitamin B tablets,
calcium and zinc chewable tablets and multi-vitamin tablets (the “Products”). Pursuant to the agreement, the Company
will purchase the Products on consignment and sell them to customers on the non-medical entity market in Guangdong Province, China,
including the Company’s 62 internet cafés in Shenzhen, China. The agreement is valid from January 27, 2014 to January
30, 2015. The Company has the priority to renew the agreement upon termination.
New products or services
We
are considering opening more “luxury” cafés in the future to meet the needs of high income groups. This strategy
is only in the planning stage. Further, although this is potentially a very interesting marketing and branding tool, we do not
expect these locations to significantly increase our overall revenues.
Our
Customers
Our
customers are individuals who come into the location to surf the internet and/or play online games with their friends locally and
remotely with individuals around the world.
Internet
café users are mainly young males with low incomes, mainly migrant workers. At our cafés, migrant workers are provided
a convenient channel at low cost to communicate with their families and friends. For example, VOIP (Voice over IP) service at the
café is much cheaper than any other telecommunications method. Low income earners can arrange a time to chat online with
their friends and families in their home cities.
We
estimate that at our internet café approximately 50% of computer time is spent on gaming, 30% for other entertainment (e.g.
online chatting, online movies, or online music); and 20% for other purposes (e.g. work).
In
the last few years there has been a decrease in the number of internet café users as a result of increased availability
of internet connections at home (
see
: http://blog.sina.com.cn/s/blog_4aff94ef01007zei.html). However, we believe that
we will be able to maintain organic growth by providing quality services to our core customers. Even if someone has internet access
in their home or dormitory, these locations do not provide the atmosphere and services provided by internet cafés. For example,
if a computer is set up in the limited space of a dormitory, an additional internet connection would need to be purchased. A computer
suitable for online gaming costs RMB 5,000 (approximately $760.47) or more. The monthly rent for an ADSL connection costs an additional
RMB 100 (approximately $15.21) and even this may not be good enough for some online games such as WOW. In these types of games,
there is a very important play mode called RAID, where, for example, 40 people are needed on a team to kill some monster in the
dungeon. This requires all players to have very stable internet connections. A typical low-end computer and ADSL connection would
suffer significant lags and cause performance issues. Internet cafés, on the other hand, can provide high speed computers
and internet connections at much lower cost to the players.
In the year of 2014
we plan to open internet cafés around university areas in the first-class provinces and cities. Students spend more time
in internet cafés because their time is very flexible. We believe that major users of internet cafés in the future
will be young game players.
Competition
The
following describes some of our local, regional and national competitors.
Local Competitors
in Shenzhen
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Shenzhen Bian Internet Co. Ltd.
Although
the company entered into the internet café industry in 2003, its current structure was founded on February 22, 2007 and
obtained its regional internet café chain license in 2007. The company operates mostly as a franchise model with 30 registered
café, only 3 of which are directly owned by the company. Each café has 80-150 computers. It also has a few large
cafés with more than 200 computers. The estimated total number of computers owned by the company is 4,500. There is a significant
turnover in franchise ownership with around one third of the franchise cafés transferring their licenses to other internet
café owners.
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Quansu Internet Café Chain Company.
Quansu
was founded in 1998 as a subsidiary investment project of the Shenzhen Commercial Bank Investment Co. Ltd. The company owns 37
cafés, 8 of which are directly owned and 27 of which are franchises. Each café has 80-150 computers. The total number
of computers is approximately 6,000. The cafés are located in Baoan District, Futian District and Luohu District. In May
2009, Quansu switched its major business towards its internet cable connection business and public telephone business.
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National Competitors
Currently there are
ten national internet café chains:
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Zhongqing Network Home Co., Ltd.
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Beijing Cultural Development Co., Ltd.
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China Digital Library Co., Ltd.
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Yalian Telecommunication Network Co.,
Ltd.
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China Heritage Information Center
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Capital Networks Limited
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Great Wall Broadband Network Service Co.,
Ltd.
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China United Telecommunications Co., Ltd.
(China Unicom)
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CLP Chinese Tong Communication Co., Ltd.
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Reid Investment Holding Company
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The
ten national chains generally have strong financial support. However, to our knowledge these chains have not been successful in
expanding their operations.
Intellectual Property
Trademark
Junlong
owns the trademark Junlong, as specified in the Registration Certificate No. 4723040 issued by the Trademark Office under the State
Administration of Industry and Commerce of the PRC. The registration is valid from January 28, 2009 to January 27, 2019.
Domain
Name
We
own and currently utilize the domain name,
www.cncicc.com
.
Software
The
main piece of intellectual property for Junlong is the SAFLASH software. This software, developed on a Microsoft Windows platform,
increases internet connection stability. Its automatic flow control prevents users from being disconnected when there is a disruption
in internet traffic. The stability is a key requirement for online gamers.
Although
there are no patents or copyrights for this software, it is only used internally on our computer systems and is not available for
download. We also entered into a confidentiality agreement with the IT manager Zhenfan Li whose team developed this software. Our
competitive advantage lies in continually updating SAFLASH to assure internet connection stability. We estimate the
research and development costs associated with updating SAFLASH to be approximately RMB100,000 (approximately $ 15,870) per year. This
cost includes the salaries of software engineers and costs associated with testing any updates. The costs associated with
research and development activities are borne by our customers in the form of increased prices.
Regulation
Because
our VIE is located in the PRC, we are regulated by the national and local laws of the PRC.
In
2001, the PRC government imposed a minimum capital requirement of RMB 10 million (approximately $1.47 million) for regional café
chains and RMB 50 million (approximately $7.35 million) for national café chains. On September 29, 2002, Ministry of Information
Industry, Ministry of Public Security, Ministry of Culture and State Administration for Commerce and Industry issued “Regulations
on the Administration of Business Sites of Internet Access Services.” The regulations require a license to operate internet
cafés which may not be assigned or leased to any third parties. The regulations also have detailed provisions regarding
internet cafes’ business operations and security control.
We
have been in compliance of these regulations. In August 2004, we increased our registered capital to RMB 10 million (approximately
$1.46 million). In 2005, Junlong obtained internet café licenses of operating internet café chain in Shenzhen from
the local counterpart of Ministry of Culture.
The
Ministry of Culture of China is in charge of regulating national internet café chains. To obtain a license to operate a
national internet café chain, an applicant must, among other things, (i) have a minimum registered capital of RMB 50 million,
(ii) own or control at least 30 internet cafés, which shall cover at least three provinces or municipalities under direct
administration of the State Council, and (iii) have been in full compliance with administrative regulations with respect to internet
cafés for at least one year before submitting the application. Other requirements include having appropriate computer and
ancillary facilities, necessary and qualified personnel and sound internal policy. Application for a national internet café
chain shall be first made to the provincial counterpart of the Ministry of Culture. After preliminary approval, the provincial
authority will submit the application to the Ministry of Culture for final approval. In rendering its approval, the authorities
consider such factors as the then existing number of the internet café chains. We believe that obtaining a national
license will provide many advantages to the Company including increasing brand awareness throughout China and increasing access
to profitable markets throughout China. Obtaining the national chain license will not have an impact on any other government
regulations to which we are subject and there are currently no government regulations that negatively impact our operations. On
the contrary, current government regulations promote the expansion of our operations by encouraging the growth of large-scale chain
Internet Cafes. Pursuant to the
Rules on Recognition and Management of Internet Café Chain Enterprises promulgated by
the Ministry of Culture
(http://www.ccnt.gov.cn/xxfb/zwxx/ggtz/200909/t20090917_73276.html), the PRC government encourages
internet café chain enterprises to merge, acquire or control individual internet cafés and provides simplified and
convenient procedures for change of Internet Culture Operation Permit. Additionally, the PRC government requires counterparts of
Ministry of Culture at all levels to give priority to the development of internet café chain enterprises when making the
plan on the total number of internet cafés.
In
contrast, we are also aware that obtaining a national license may also negatively affect us in the future in that there is the
possibility of future government regulation of Internet cafes in provinces outside of Guangdong Province, where we are located.
Such additional regulations could affect our operations or cause our management standard to adapt to new regulatory environment
and may consequently be a strain on our resources and abilities.
Although
the Ministry of Culture suspended the issuance of new internet café licenses to individual operators in 2007, the government
is encouraging presently licensed internet café chain companies to acquire and merge with smaller cafes and café
chains. The government supports the growth of large internet café chains because regulation of the industry will become
significantly easier with fewer large chains as opposed to hundreds of individually operated cafes. We do not view this suspension
as an impediment to our plans to open new internet cafes and obtain a license to operate a national Internet café chain.
We
are subject to PRC foreign currency regulations. The PRC government has controlled Renminbi reserves primarily through direct regulation
of the conversion of Renminbi into other foreign currencies. Although foreign currencies, which are required for “current
account” transactions, can be bought at authorized PRC banks, the proper procedural requirements prescribed by PRC law must
be met. At the same time, PRC companies are also required to sell their foreign exchange earnings to authorized PRC banks, and
the purchase of foreign currencies for capital account transactions still requires prior approval of the PRC government.
Under
current PRC laws and regulations, Foreign Invested Entities, or FIEs, may pay dividends only out of their accumulated after-tax
profits, if any, determined in accordance with PRC accounting standards and regulations. In addition, FIEs in China are required
to set aside at least 10% of their after-tax profit based on PRC accounting standards each year to their general reserves until
the cumulative amount of such reserves reaches 50% of their registered capital. These reserves are not distributable as cash dividends.
The Board of Directors of an FIE has the discretion to allocate a portion of the FIEs’ after-tax profits to staff welfare
and bonus funds, which may not be distributed to equity owners except in the event of liquidation.
Our Employees
As
of March 21, 2014, we had 560 full time employees. The following table sets forth the number of employees by function:
Function
|
|
Number of
Employees
|
|
Senior Management
|
|
|
64
|
|
Accounting
|
|
|
4
|
|
Staff employees
|
|
|
492
|
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Total
|
|
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560
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|
As
required by applicable PRC law, we have entered into employment contracts with most of our officers, managers and employees. We
are working towards entering employment contracts with those employees who do not currently have employment contracts with us.
We believe that we maintain a satisfactory working relationship with our employees, and we have not experienced any significant
disputes or any difficulty in recruiting staff for our operations.
An
investment in our Common Stock involves a high degree of risk. You should carefully consider the risks described below, together
with all of the other information included in this report, before making an investment decision. If any of the following risks
actually occurs, our business, financial condition or results of operations could suffer. In that case, the trading price of our
Common Stock could decline, and you may lose all or part of your investment.
Risks Related to Our
Business
Our limited operating
history makes evaluating our business and prospects difficult.
Our
VIE, Junlong, was established in December 2003 and obtained the license to operate internet cafés in Shenzhen in 2005. Our
limited operating history may not provide a meaningful basis for you to evaluate our business and prospects. Our business strategy
has not been proven over time and we cannot be certain that we will be able to successfully expand our business.
Fluctuations
in operating results or the failure of operating results to meet the expectations of public market analysts and investors may negatively
impact the market price of our securities. Operating results may fluctuate in the future due to a variety of factors that
could affect revenues or expenses in any particular quarter. Fluctuations in operating results could cause the value of our
securities to decline. Investors should not rely on comparisons of results of operations as an indication of future performance.
As a result of the factors listed below, it is possible that in future periods results of operations may be below the expectations
of public market analysts and investors. This could cause the market price of our securities to decline. Factors that may
affect our quarterly results include:
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vulnerability of our business to a general economic downturn in the PRC;
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changes in the laws of the PRC that affect our operations;
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competition from other similar service providers; and
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our ability to obtain necessary government certifications and/or licenses to conduct our business.
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We are dependent
on our management team and the loss of any key member of that team could have a material adverse effect on our operations and financial
condition.
We
attribute our success to the leadership and contributions of our managing team comprising executive directors and key executives,
in particular, Dishan Guo, our Chief Executive Officer and Chief Financial Officer.
Our
continued success is therefore dependent to a large extent on our ability to retain the services of these key management personnel.
The loss of their services without timely and qualified replacement, will adversely affect our operations and hence, our revenue
and profits.
We have limited internal controls due to our lack of sufficient
personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP.
During the year ended December 31, 2013,
we lacked personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of
GAAP commensurate with our complexity and our financial accounting and reporting requirements. Due to this lack of qualified personnel,
there is a reasonable possibility that material misstatements of the financial statements including disclosures will not be prevented
or detected on a timely basis.
We have not obtained
social insurance benefits for all of our employees and could incur administrative fines and penalties that could materially affect
our financial condition and reputation.
We
have obtained social benefits coverage for employees who work at the headquarters of Junlong. For other employees, because of the
high mobility of their work, they usually work on a probationary basis and will not enter into a long employment relationship with
us. We are subject to administrative fines and penalties as a result of our failure to obtain social insurance for these employees.
The amount of these fines and penalties, in the aggregate, may adversely affect our financial condition and our public image.
Tightened regulations
on internet cafés may adversely affect our operations and revenues.
The
PRC government has been tough on internet café regulations. In 2003, the PRC government imposed a minimum capital requirement
of RMB 10 million (approximately $1.47 million) for regional café chains and RMB 50 million (approximately $7.32 million)
for national café chains. On September 29, 2002, the State Council issued “Regulations on the Administration of Business
Sites of Internet Access Services.” The regulations require a license to operate internet cafés which may not be assigned
or leased to any third parties. The regulations also have detailed provisions regarding internet cafes’ business operations
and security control. The number of internet cafés in China was reduced after these regulations went effective.
If
the PRC government decided to impose more stringent regulations on internet cafés and their operations, our business may
be adversely affected and our revenues may decrease as a result.
There may be reduced
use of internet cafés with the increase in computer ownership and internet connections at home and any such reduction would
negatively affect our financial performance.
With
the rapid economic development and growing disposable income, computer ownership and internet connections at home will gradually
increase as the price for computer hardware, software and internet access decreases. The increase in computer ownership and internet
connections at home may result in decreased demand for our services. Such decrease in demand may adversely affect our business
and our revenues may decrease as a result.
Negative media coverage
of internet cafés may reduce the number of customers that visit our internet cafés and result in lower revenues.
In
the last few years there have been several negative stories in the media about internet cafés. A fatal fire in Beijing's
Lanjisu Internet café in June 2002 raised nationwide concern about the country’s burgeoning internet café business.
In 2006, a report from the China National Children's Center, a government think-tank, said that 13 percent of the PRC's 18 million
internet users under 18 were internet addicts. Responding to the problems associated with internet cafés, the PRC imposed
more stringent laws and regulations on internet cafés. In 2007, fearful of soaring internet addiction and juvenile crime,
the PRC banned the opening of new internet cafés for a year. Such negative media coverage may result in stricter government
regulations and reduced number of customers.
Interruption or
failure of our own information technology and communications systems or those of third-party service providers we rely
upon could impair our ability to effectively provide our services, which could damage our reputation and harm our operating results.
Our
ability to provide our services depends on the continuing operation of our information technology and communications systems. Any
damage to or failure of our systems could interrupt our service. Service interruptions could reduce our revenues and profits, and
damage our brand if our system is perceived to be unreliable. Our systems are vulnerable to damage or interruption as a result
of terrorist attacks, wars, earthquakes, floods, fires, power loss, telecommunications failures, undetected errors or “bugs”
in our software, and computer viruses.
Our
servers are vulnerable to break-ins, sabotage and vandalism. The occurrence of a natural disaster or a closure of an Internet data
center by a third-party provider without adequate notice could result in lengthy service interruptions.
The
steps we take to increase the reliability and redundancy of our systems are expensive, reduce our operating margin and may not
be successful in reducing the frequency or duration of service interruptions.
Our business may
be adversely affected by third-party software applications or practices that interfere with our receipt of information from, or
provision of information to, our customers, which may impair our customers’ experience.
Our
business may be adversely affected by third-party malicious or unintentional software applications that make changes to our computers
and interfere with our services. These software applications may be difficult or impossible to remove or disable, may reinstall
themselves and may circumvent other applications’ efforts to block or remove them. The ability to provide a superior user
experience is critical to our success. If we are unable to successfully combat third-party software applications that interfere
with our products and services, our reputation may be harmed.
The successful operation
of our business depends upon the performance and reliability of the Internet infrastructure and fixed telecommunications networks
in China.
Our
business depends on the performance and reliability of the Internet infrastructure in China. Almost all access to the Internet
is maintained through state-owned telecommunication operators under the administrative control and regulatory supervision of the
Ministry of Industry and Information Technology (or its predecessor, the Ministry of Information Industry, before its formal establishment
in 2008), or the MIIT. In addition, the national networks in China are connected to the Internet through international gateways
controlled by the PRC government. These international gateways are the only channels through which a domestic user can connect
to the Internet. We cannot assure you that a more sophisticated Internet infrastructure will be developed in China. We may not
have access to alternative networks in the event of disruptions, failures or other problems with China’s Internet infrastructure.
In addition, the Internet infrastructure in China may not support the demands associated with continued growth in Internet usage.
Any
unscheduled service interruption could damage our reputation and result in a decrease in our revenues. Furthermore, if the prices
that we pay for telecommunications and Internet services rise significantly, our gross margins could be adversely affected.
Concerns about the
security of electronic commerce transactions and confidentiality of information on the Internet may reduce use of our internet
cafes and impede our growth.
A
significant barrier to electronic commerce and communications over the Internet in general has been a public concern over security
and privacy, including the transmission of confidential information. If these concerns are not adequately addressed, they may inhibit
the growth of the Internet and other online services generally, especially as a means of conducting commercial transactions. If
a well-publicized Internet breach of security were to occur, general Internet usage could decline, which could cause our operations
to be adversely affected.
Regulation and censorship
of information disseminated over the Internet in China may adversely affect our business.
The
PRC government has adopted regulations governing Internet access and the distribution of news and other information over the Internet.
Under these regulations, Internet content providers and Internet publishers are prohibited from posting or displaying over the
Internet content that, among other things, violates PRC laws and regulations, impairs the national dignity of China, or is reactionary,
obscene, superstitious, fraudulent or defamatory. Failure to comply with these requirements may result in the revocation of licenses
to provide Internet content and other licenses and the closure of the concerned websites.
The
Ministry of Public Security has the authority to order any local Internet service provider to block any Internet website at its
sole discretion. From time to time, the Ministry of Public Security has stopped the dissemination over the Internet of information
which it believes to be socially destabilizing. The State Secrecy Bureau is also authorized to block any website it deems to be
leaking state secrets or failing to meet the relevant regulations relating to the protection of State secrets in the dissemination
of online information.
Such
regulation and censorship could lead to a decrease in our customers’ interest in utilizing our internet cafes which would
cause our operations to be adversely affected.
Intensified government
regulation of Internet cafes could cause our operations to be adversely affected.
The
PRC government has tightened its regulation of Internet cafes in recent years. In particular, a large number of unlicensed Internet
cafes have been closed. In addition, the PRC government has imposed higher capital and facility requirements for the establishment
of Internet cafes. Furthermore, the PRC government’s policy, which encourages the development of a limited number of national
and regional Internet cafe chains and discourages the establishment of independent Internet cafes, may slow down the growth of
Internet cafes. In June 2002, the Ministry of Culture, together with other government authorities, issued a joint notice, and in
February 2004, the State Administration for Industry and Commerce issued another notice, suspending the issuance of new Internet
cafe licenses. In May 2007, the State Administration for Industry and Commerce reiterated its position not to register any new
Internet cafes in 2007. In 2008 and 2009, the Ministry of Culture, the State Administration for Industry and Commerce and other
relevant government authorities, individually or jointly, issued several notices that provide various ways to strengthen the regulation
of Internet cafes, including investigating and punishing Internet cafes that accept minors, cracking down on Internet cafes without
sufficient and valid licenses, limiting the total number of Internet cafes and approving Internet cafes within the planning made
by relevant authorities, screening unlawful and adverse games and websites, and improving the coordination of regulation over Internet
cafes and online games. Such intensified government regulation of Internet cafes and any additional government regulation that
may arise in the future could adversely affect our operations by limiting the services currently provided by our cafes, which in
turn could decrease our customer base or have similar negative effect on our operations.
If we fail to successfully
update our computer hardware, software, and systems to customer requirements or emerging industry standards, our business, prospects
and financial results may be materially and adversely affected.
To
remain competitive, we must continue to update the computer hardware, software and systems in our internet cafes. The computer
industry is characterized by rapid technological evolution, changes in user requirements and preferences, frequent introductions
of new products and services embodying new technologies and the emergence of new industry standards and practices that could render
our existing proprietary technologies and systems obsolete. If we are unable to adapt in a cost-effective and timely manner in
response to changing market conditions or customer requirements, whether for technical, legal, financial or other reasons, our
business, prospects, financial condition and results of operations would be materially adversely affected.
We may be unable
to adequately safeguard our intellectual property or we may face claims that may be costly to resolve or that limit our ability
to use such intellectual property in the future.
Our
business is reliant on our intellectual property. Our software SAFLASH is the result of our research and development efforts, which
we believe to be proprietary and unique. However, we are unable to assure you that third parties will not assert infringement claims
against us in respect of our intellectual property or that such claims will not be successful. It may be difficult for us to establish
or protect our intellectual property against such third parties and we could incur substantial costs and diversion of management
resources in defending any claims relating to proprietary rights. If any party succeeds in asserting a claim against us relating
to the disputed intellectual property, we may need to obtain licenses to continue to use the same. We cannot assure you that we
will be able to obtain these licenses on commercially reasonable terms, if at all. The failure to obtain the necessary licenses
or other rights could cause our business results to suffer.
Further,
we rely upon a combination of trade secrets, non-disclosure and other contractual agreements with our employees as well as limitation
of access to and distribution of our intellectual property in our efforts to protect intellectual property. However, our efforts
in this regard may be inadequate to deter misappropriation of our proprietary information or we may be unable to detect unauthorized
use and take appropriate steps to enforce our rights. Policing unauthorized use of our intellectual property is difficult and there
can be no assurance that the steps taken by us will prevent misappropriation of our intellectual property.
Where
litigation is necessary to safeguard our intellectual property, or to determine the validity and scope of the proprietary rights
of others, this could result in substantial costs and diversion of our resources and could have a material adverse effect on our
business, financial condition, operating results or future prospects.
We may not have
sufficient insurance coverage and an interruption of our business or loss of a significant amount of property could have a material
adverse effect on our financial condition and operations.
We
currently do not maintain any insurance policies against loss of key personnel and business interruption as well as product liability
claims. If such events were to occur, our business, financial performance and financial position may be materially and adversely
affected.
Inability to maintain
our competitiveness would adversely affect our financial performance.
We
operate in a competitive environment and face competition from existing competitors and new market entrants. Some of these existing
competitors, especially the national chains of internet cafés have more resources than us and may provide better services
to customers.
There
is no assurance that we will be able to compete successfully in the future. Any failure by us to remain competitive would adversely
affect our financial performance.
We may be adversely
affected by a significant or prolonged economic downturn in the level of consumer spending in the industries and markets served
by our customers.
We
rely on the spending of our customers in our cafés for our revenues, which may in turn depend on the customers’ level
of disposable income, perceived future earning capabilities and willingness to spend. Any significant or prolonged decline of the
PRC economy or economy of such markets served by our customers will affect consumers’ disposable income and consumer spending
in these markets, and lead to a decrease in demand for consumer products.
To
the extent that such decrease in demand for consumer products translates into a decline in the demand for internet café
services, our performance will be adversely affected.
Revocation of the
license for operating internet café chain will adversely affect our business.
We
hold a license for operating a regional internet café chain in Shenzhen and each of our internet cafés obtains a
license for the internet access services. These licenses are currently valid, and will continue to be valid within the term of
the corresponding business licenses. These licenses do not need to be renewed unless there is change of information thereon. But
the competent authorities are entitled to examine and reevaluate our internet cafés any time upon their initiatives or following
orders of the higher-level authorities, and we must comply with the then prevailing standards and regulations which may change
from time to time. Failure to comply with these changing standards and regulations could result in our licenses being revoked
or suspended, which could have a material adverse effect on our operations. Furthermore, if escalating compliance costs associated
with governmental standards and regulations restrict or prohibit any part of our operations, it may adversely affect our operations
and profitability.
We may be unable
to effectively manage our expansion.
We
have identified several growth plans. These expansion plans may strain our financial resources. In addition, any significant growth
into new markets may require an expansion of our employee base for managerial, operational, financial, and other purposes.
During any growth, we may face problems related to our operational and financial systems and controls. We would also need
to continue to expand, train and manage our employee base. Continued future growth will impose significant added responsibilities
upon the members of management to identify, recruit, maintain, integrate, and motivate new employees.
If
we are unable to successfully manage our expansion, we may encounter operational and financial difficulties which would in turn
adversely affect our business and financial results.
We may require additional
funding for our growth plans, and such funding may result in a dilution of your investment.
We
attempted to estimate our funding requirements in order to implement our growth plans.
If
the costs of implementing such plans should exceed these estimates significantly or if we come across opportunities to grow through
expansion plans which cannot be predicted at this time, and our funds generated from our operations prove insufficient for such
purposes, we may need to raise additional funds to meet these funding requirements.
These
additional funds may be raised by issuing equity or debt securities or by borrowing from banks or other resources. We cannot assure
you that we will be able to obtain any additional financing on terms that are acceptable to us, or at all. If we fail to obtain
additional financing on terms that are acceptable to us, we will not be able to implement such plans fully. Such financing even
if obtained, may be accompanied by conditions that limit our ability to pay dividends or require us to seek lenders’ consent
for payment of dividends, or restrict our freedom to operate our business by requiring lender’s consent for certain corporate
actions.
Further,
if we raise additional funds by way of a rights offering or through the issuance of new shares, any shareholders who are unable
or unwilling to participate in such an additional round of fund raising may suffer dilution in their investment.
Our strategy to
acquire companies may result in unsuitable acquisitions or failure to successfully integrate acquired companies, which could lead
to reduced profitability
.
We
intend to expand our business through acquisitions of companies or operations similar to our own. We may be unsuccessful
in identifying suitable acquisition candidates, or may be unable to consummate a desired acquisition. To the extent any future
acquisitions are completed, we may be unsuccessful in integrating acquired companies or their operations, or if integration is
more difficult than anticipated, we may experience disruptions that could have a material adverse impact on future profitability.
Some of the risks that may affect our ability to integrate, or realize any anticipated benefits from, acquisitions include:
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unexpected losses of key employees or
customer of the acquired company;
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difficulties integrating the acquired
company's standards, processes, procedures and controls;
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difficulties hiring additional management
and other critical personnel;
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difficulties increasing the scope, geographic
diversity and complexity of our operations;
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difficulties consolidating facilities,
transferring processes and know-how;
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difficulties reducing costs of the acquired
company's business; and
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diversion of management's attention from
our management.
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We may be exposed
to potential risks relating to our internal controls over financial reporting.
The
Company’s management is responsible for establishing and maintaining adequate internal control over our financial reporting
as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act. The Company’s management is also required
to assess and report on the effectiveness of the Company’s internal control over financial reporting in accordance with Section
404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). Internal control over financial reporting is a process
to provide reasonable assurance regarding the reliability of the Company’s financial reporting for external purposes
in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures
that: (i) pertain to maintaining records that in reasonable detail accurately and fairly reflect the Company’s transactions;
(ii) provide reasonable assurance that transactions are recorded as necessary for preparation of the Company’s financial
statements and that receipts and expenditures of company assets are made in accordance with management authorization; and (iii)
provide reasonable assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect
on our financial statements would be prevented or detected on a timely basis.
Because
of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of
any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes
in conditions, or that the degree of compliance with the policies and procedures may deteriorate.
Our holding company
structure may limit the payment of dividends.
We
have no direct business operations, other than our ownership of our subsidiaries and contractual relationship with Junlong. Should
we decide in the future to pay dividends, as a holding company, our ability to pay dividends and meet other obligations depends
upon the receipt of dividends or other payments from our operating subsidiaries and other holdings and investments. In addition,
our operating subsidiaries, from time to time, may be subject to restrictions on their ability to make distributions to us, including
as a result of restrictive covenants in loan agreements, restrictions on the conversion of local currency into U.S. dollars or
other hard currency and other regulatory restrictions as discussed below. If future dividends are paid in RMB, fluctuations in
the exchange rate for the conversion of RMB into U.S. dollars may reduce the amount received by U.S. stockholders upon conversion
of the dividend payment into U.S. dollars. Further, dividends paid to non-PRC stockholders may be subject to a 10% withholding,
as further discussed in a later section. Under the EIT Law, we may be classified as a ‘resident enterprise’ of the
PRC. Such classification will likely result in unfavorable tax consequences to us and our non-PRC shareholders.”
Relevant
PRC statutory laws and regulation permit payments of dividends by the Company’s subsidiaries in the PRC only out of their
accumulated profits, if any, as determined in accordance with the PRC accounting standards and regulations.
Our
subsidiary in the PRC is also required to set aside a portion of its after tax profits according to PRC accounting standards and
regulations to fund certain reserve funds. Currently, our subsidiary in the PRC is the only sources of revenues or investment holdings
for the payment of dividends. If it does not accumulate sufficient profits under PRC accounting standards and regulations to first
fund certain reserve funds as required by PRC accounting standards, we will be unable to pay any dividends.
As
of December 31, 2013 and 2012, $718,744 was appropriated from retained earnings and set aside for the statutory reserve by the
Company’s subsidiaries in the PRC. As a result of these PRC laws and regulations, the Company’s subsidiaries in the
PRC are restricted in their ability to transfer a portion of their net assets to either in the form of dividends, loans or advances,
which consisted of paid-up capital and statutory reserves, amounting to
$2,085,967 a
s
of December 31, 2013 and 2012.
Risks Relating to Our
Commercial Relationship with Junlong
All of our revenues
are generated through our VIE, and we rely on payments made by our VIE to Zhonghefangda, our subsidiary, pursuant to contractual
arrangements to transfer any such revenues to Zhonghefangda. Any restriction on such payments and any increase in the amount of
PRC taxes applicable to such payments may materially and adversely affect our business and our ability to pay dividends to our
shareholders.
We
conduct substantially all of our operations through Junlong, our VIE, which generates all of our revenues. As Junlong is not owned
by our subsidiary, it is not able to make dividend payments to our subsidiary. Instead, Zhonghefangda, our subsidiary in China,
entered into a number of contracts with Junlong, including a Management and Consulting Services Agreement, an Equity Pledge Agreement,
an Option Agreement and a Voting Rights Proxy Agreement, pursuant to which Junlong pays Zhonghefangda for certain services that
Zhonghefangda provides to Junlong. However, depending on the nature of services provided, certain of these payments are subject
to PRC taxes at different rates, including business taxes and VATs, which effectively reduce the amount that Zhonghefangda receives
from Junlong. We cannot assure you that the PRC government will not impose restrictions on such payments or change the tax rates
applicable to such payments. Any such restrictions on such payment or increases in the applicable tax rates may materially and
adversely affect our ability to receive payments from Junlong or the amount of such payments, and may in turn materially and adversely
affect our business, our net income and our ability to pay dividends to our shareholders.
Dishan Guo, Jinzhou Zeng, and Xiaofen
Wang’s association with Junlong could pose a conflict of interest which may result in Junlong decisions that are adverse
to our business.
Dishan
Guo, Jinzhou Zeng and Xiaofen Wang, who hold controlling interest in Classic Bond are also controlling shareholders of our VIE.
Conflicts of interests between their dual roles as owners of both Junlong and our company may arise. We cannot assure you that
when conflicts of interest arise, any or all of these individuals will act in the best interests of our company or that any conflict
of interest will be resolved in our favor. In addition, these individuals may breach or cause Junlong to breach or refuse to renew
the existing contractual arrangements, which will have a material adverse effect on our ability to effectively control Junlong
and receive economic benefits from it. If we cannot resolve any conflicts of interest or disputes between us and the beneficial
owners of Junlong, we would have to rely on legal proceedings, the outcome of which is uncertain and which could be disruptive
to our business.
Messrs
Guo, Zeng and Wang do not have a formalized dispute resolution agreement. However, it is anticipated that parties will resolve
any conflict through mutual consultation and negotiations as is typical in China. Should such conflict endure, the parties will
subject their dispute to be adjudicated before a court of competent jurisdiction in China. The Company does not have a policy pursuant
to which its directors, such as Messrs. Guo, Zeng and Wang must resolve any conflict of interest that arise as a result of their
ownership interests in or management of other companies, such as Classic Bond.
If Junlong or the
VIE Shareholders violate our contractual arrangements with it, our business could be disrupted and we may have to resort to litigation
to enforce our rights which may be time consuming and expensive.
Our
operations are currently dependent upon our commercial relationship with Junlong. If Junlong or their shareholders are unwilling
or unable to perform their obligations under our commercial arrangements with them, including payment of revenues under the Management
and Consulting Service Agreement, we will not be able to conduct our operations in the manner currently planned.
If the PRC government
determines that the agreements establishing the structure for operating our China business do not comply with applicable PRC laws,
rules and regulations, we could be subject to severe penalties including being prohibited from continuing our operations in the
PRC.
On
August 8, 2006, six PRC regulatory agencies, including Ministry of Commerce (the
“MOFCOM
”), the China
Securities Regulatory Commission (the “
CSRC
”), the State Asset Supervision and Administration Commission
(the “
SASAC
”), the State Administration of Taxation (the “
SAT
”), the State
Administration for Industry and Commerce (the “
SAIC
”) and the State Administration of Foreign Exchange
(the “
SAFE
”), jointly adopted the
Regulations on Mergers and Acquisitions of Domestic Enterprises
by Foreign Investors, or the M&A Rule
(the “
M&A Rule
”), which became effective
on September 8, 2006. This new regulation, among other things, governs the approval process by which a PRC company may participate
in an acquisition of assets or equity interests. In the opinion of our PRC counsel, China Commercial Law Firm, this approval process
was not required in our case because we have not acquired either the equity or assets of a company located in the PRC, and that
the VIE agreements do not constitute such an acquisition. If the PRC government were to take a contrary view, we might be subject
to fines or other enforcement action, and might be forced to amend or terminate our contractual arrangements with Junlong, which
could have an adverse effect on our business.
Uncertainties in
the PRC legal system may impede our ability to enforce the commercial agreements that we have entered into with Junlong or any
arbitral award thereunder and any inability to enforce these agreements could materially and adversely affect our business and
operation.
While
disputes under the Consulting Agreement with Junlong are subject to binding arbitration before the China International Economic
and Trade Arbitration Commission, or CIETAC, in accordance with CIETAC Arbitration Rules, the agreements are governed by PRC law
and an arbitration award may be challenged in accordance with PRC law. For example, a claim that the enforcement of an award in
our favor will be detrimental to the public interest, or that an issue does not fall within the scope of the arbitration would
require us to engage in administrative and judicial proceedings to defend an award. PRC legal system is a civil law system based
on written statutes and unlike common law systems, it is a system in which decided legal cases have little value as precedent.
As a result, PRC administrative and judicial authorities have significant discretion in interpreting and implementing statutory
and contractual terms, and it may be more difficult to evaluate the outcome of administrative and judicial proceedings and the
level of legal protection available than in more developed legal systems. These uncertainties may impede our ability to enforce
the terms of the Consulting Agreement and the other contracts that we may enter into with Junlong. Any inability to enforce the
Consulting Agreement or an award thereunder could materially and adversely affect our business and operation.
Our arrangements
with Junlong and the VIE Shareholders may be subject to a transfer pricing adjustment by the PRC tax authorities which could have
an adverse effect on our income and expenses.
We
could face material and adverse tax consequences if the PRC tax authorities determine that our contracts with Junlong and the VIE
Shareholders were not entered into based on arm’s length negotiations. If the PRC tax authorities determine that these contracts
were not entered into on an arm’s length basis, they may adjust our income and expenses for PRC tax purposes in the form
of a transfer pricing adjustment. Such an adjustment may require that we pay additional PRC taxes plus applicable penalties and
interest, if any.
Risks Related to Doing
Business in the PRC
New labor law in
the PRC may adversely affect our results of operations.
On
June 29, 2007, the National People’s Congress promulgated the Labor Contract Law of PRC, or the Labor Law, which became
effective as of January 1, 2008. On September 18, 2008, the PRC State Council issued the PRC Labor Contract Law Implementation
Rules, which became effective as of the date of issuance. The Labor Law and its implementation rules are intended to give employees
long-term job security by, among other things, requiring employers to enter into written contracts with their employees and restricting
the use of temporary workers. The Labor Law and its implementation rules impose greater liabilities on employers, require certain
terminations to be based upon seniority rather than merit and significantly affect the cost of an employer’s decision to
reduce its workforce. Employment contracts lawfully entered into prior to the implementation of the Labor Law and continuing after
the date of its implementation remain legally binding and the parties to such contracts are required to continue to perform their
respective obligations thereunder. However, employment relationships established prior to the implementation of the Labor Law without
a written employment agreement were required to be memorialized by a written employment agreement that satisfies the requirements
of the Labor Law within one month after it became effective on January 1, 2008. In the event we decide to significantly
change or decrease our workforce, the New Labor Contract Law could adversely affect our ability to enact such changes in a manner
that is most advantageous to our business or in a timely and cost effective manner, thus materially and adversely affecting our
financial condition and results of operations.
We may be exposed
to liabilities under the Foreign Corrupt Practices Act and Chinese anti-corruption law, and any determination that we violated
such laws could hurt our business.
We
are subject to the Foreign Corrupt Practice Act, or FCPA, and other laws that prohibit improper payments or offers of payments
to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute for the
purpose of obtaining or retaining business. We are also subject to Chinese anti-corruption laws, which strictly prohibit bribery.
We have operations, agreements with third parties and make sales in the PRC, which may experience corruption. Our activities in
the PRC create the risk of unauthorized payments or offers of payments by one of the employees, consultants, sales agents or distributors
of our Company, even though these parties are not always subject to our control. It is our policy to implement safeguards to discourage
these practices by our employees. However, our existing safeguards and any future improvements may prove to be less than effective,
and our employees, consultants, sales agents or distributors may engage in conduct for which we might be held responsible. Violations
of the FCPA or Chinese anti-corruption law may result in severe criminal or civil sanctions, and we may be subject to other liabilities,
which could negatively affect our business, operating results and financial condition. In addition, the United States government
may seek to hold us liable for successor liability FCPA violations committed by companies in which we invest or that we acquire.
Changes in PRC political
or economic situation could harm us and our operating results.
Some
of the changes in PRC political or economic situation that could harm us and our operating results are the:
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level of government involvement in the economy;
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control of foreign exchange;
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methods of allocating resources;
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balance of payments position;
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international trade restrictions; and
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international conflict.
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The
PRC economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development,
or OECD, in many ways. For example, state-owned enterprises still constitute a large portion of the PRC economy and weak corporate
governance and a lack of flexible currency exchange policy still prevail in the PRC. As a result of these differences, we may not
develop in the same way or at the same rate as might be expected if the PRC economy was similar to those of the OECD member countries.
Our business is
largely subject to the uncertain legal environment in China and your legal protection could be limited.
The
PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which precedents
set in earlier legal cases are not generally used. The overall effect of legislation enacted over the past 20 years has been to
enhance the legal protections afforded to foreign invested enterprises in the PRC. However, these laws, regulations and legal requirements
are relatively recent and are evolving rapidly, and their interpretation and enforcement involve uncertainties. These uncertainties
could limit the legal protections available to foreign investors, such as the right of foreign invested enterprises to hold licenses
and permits such as requisite business licenses. In addition, all of our executive officers and our directors are residents of
the PRC and not of the U.S., and substantially all the assets of these persons are located outside the U.S. As a result, it could
be difficult for investors to effect service of process in the U.S., or to enforce a judgment obtained in the U.S. against our
PRC operations and our controlled VIE.
The PRC government
exerts substantial influence over the manner in which we must conduct our business activities.
The
PRC only recently has permitted provincial and local economic autonomy and private economic activities. The PRC government has
exercised and continues to exercise substantial control over virtually every sector of the PRC economy through regulation and state
ownership. Our ability to operate in the PRC may be harmed by changes in its laws and regulations, including those relating to
taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our
operations in the PRC are in material compliance with all applicable legal and regulatory requirements. However, the central or
local governments of the jurisdictions in which we operate may impose new, stricter regulations or interpretations of existing
regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or
interpretations.
Accordingly,
government actions in the future, including any decision not to continue to support recent economic reforms and to return to a
more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant
effect on economic conditions in the PRC or particular regions thereof, and could require us to divest ourselves of any interest
we then hold in PRC properties or joint ventures.
Future inflation
in the PRC may inhibit our ability to conduct business in the PRC.
In
recent years, the PRC economy has experienced periods of rapid expansion and highly fluctuating rates of inflation. During the
past ten years, the rate of inflation in the PRC has been as high as 20.7% and as low as -2.2%. These factors
have led to the adoption by the PRC government, from time to time, of various corrective measures designed to restrict the availability
of credit or regulate growth and contain inflation. High inflation may in the future cause the PRC government to impose controls
on credit and/or prices, or to take other action, which could inhibit economic activity in the PRC, and thereby harm the market
for our products and our company.
Restrictions on
currency exchange may limit our ability to receive and use our revenues effectively.
The
majority of our revenues will be settled in Renminbi and any future restrictions on currency exchanges may limit our ability to
use revenue generated in Renminbi to fund any future business activities outside the PRC or to make dividend or other payments
in U.S. dollars. Current significant currency exchange restrictions include the restriction that foreign-invested enterprises may
only buy, sell or remit foreign currencies after providing valid commercial documents, at those banks in the PRC authorized to
conduct foreign exchange business. In addition, conversion of Renminbi for capital account items, including direct investment and
loans, is subject to governmental approval in the PRC, and companies are required to open and maintain separate foreign exchange
accounts for capital account items. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions
on the convertibility of the Renminbi.
Failure to comply
with PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident
stockholders to personal liability, limit our ability to acquire PRC companies or to inject capital into our PRC controlled VIEs,
limit our PRC controlled VIEs’ ability to distribute profits to us or otherwise materially adversely affect us.
On
October 21, 2005, the State Administration for Foreign Exchange of the PRC (“
SAFE
”) issued a
Circular
on Relevant Issues Concerning Foreign Exchange Administration on the Financing and Return Investment by Chinese Domestic Residents
through Overseas Special Purpose Companies
(“
Circular 75
”), which became effective on November 1,
2005. Circular 75 and its relevant implementing rules issued thereafter regulate the foreign exchange matters in relation
to the use of a “special purpose vehicle” by PRC residents to seek offshore equity financing and conduct “round
trip investment” in China. Under Circular 75, a ‘special purpose vehicle” or ‘SPV” refers to
an offshore entity established or controlled, directly or indirectly, by PRC residents or PRC entities for the purpose of seeking
offshore equity financing using assets or interests owned by such PRC residents or PRC entities in onshore companies, while “round
trip investment” refers to the direct investment in China by PRC residents through the “
SPV
”, including
without limitation establishing foreign invested enterprises and using such foreign invested enterprises to purchase or control
(by way of contractual arrangements) onshore assets. Pursuant to Circular 75, (i) a PRC resident shall register with a local
branch of the SAFE before he or she establishes or controls an overseas SPV, for the purpose of overseas equity financing (including
convertible debt financing); (ii) when a PRC resident contributes the assets of or his or her equity interests in a domestic enterprise
to an SPV, or engages in overseas financing after contributing assets or equity interests to an SPV, such PRC resident must register
his or her interest in the SPV and any subsequent changes in such interest with a local branch of the SAFE; and (iii) when the
SPV undergoes a material change outside of China, such as a change in share capital or merger or acquisition, the PRC resident
shall, within 30 days from the occurrence of the event that triggers the change, register such change with a local branch of the
SAFE. In addition, the PRC subsidiary of the offshore SPV are prohibited from distributing their profits and proceeds from
any reduction in capital, share transfer or liquidation to their offshore special purpose vehicle parent companies if the SPV shareholders
who are PRC residents have not completed foreign exchange registration pursuant to Circular 75. If any PRC resident stockholder
of a SPV fails to make the required SAFE registration and amended registration, the onshore PRC subsidiaries of that offshore company
may be prohibited from distributing their profits and the proceeds from any reduction in capital, share transfer or liquidation
to the offshore entity. Failure to comply with the SAFE registration and amendment requirements described above could result
in liability under PRC laws for evasion of applicable foreign exchange restrictions.
Our
current shareholders, who are PRC residents as defined in Circular 75, (the “
PRC
Shareholders”) have not completed
the necessary registrations as required under Circular 75. We have already asked our PRC Shareholders to make up the necessary
applications and registrations as required under Circular 75 and related regulations, and our PRC Shareholders have agreed to do
so immediately. However, we cannot assure you that our PRC Shareholders will be able to make up the necessary approval and registration
procedures required by the Circular 75 and related regulations. Failure by the PRC Shareholders to register as required with
the relevant local branch of SAFE could subject them to fines and legal sanctions and may also limit our ability to contribute
additional capital into or provide loans to (including using the proceeds from this offering) our PRC subsidiary, limit our PRC
subsidiary’s ability to pay dividends or otherwise distribute profits to us, or otherwise adversely affect us.
The approval of
the China Securities Regulatory Commission, or the CSRC, may be required in connection with this offering under PRC regulations.
The regulation also establishes more complex procedures for acquisitions conducted by foreign investors that could make it more
difficult for us to grow through acquisitions.
On
August 8, 2006, six PRC regulatory agencies, including the CSRC, promulgated the
Regulation on Mergers and Acquisitions
of Domestic Companies by Foreign Investors
, which became effective on September 8, 2006 (the “
M&A Rules
”).
The M&A Rules requires offshore special purpose vehicles that are controlled by PRC companies or residents and that have been
formed for the purpose of seeking a public listing on an overseas stock exchange through acquisitions of PRC domestic companies
or assets to obtain CSRC approval prior to publicly listing their securities on an overseas stock exchange. On September 21,
2006, the CSRC published a notice on its website specifying the documents and materials that special purpose vehicles are required
to submit when seeking CSRC approval for their listings outside of China. The interpretation and application of the M&A Rules
remain unclear, and this offering may ultimately require approval from the CSRC, and if it does, it is uncertain how long it will
take us to obtain the approval. If CSRC approval is required for this offering, our failure to obtain or delay in obtaining the
CSRC approval for this offering would subject us to sanctions imposed by the CSRC and other PRC regulatory agencies, which could
include fines and penalties on our operations in China, restrictions or limitations on our ability to pay dividends outside of
China, and other forms of sanctions that may materially and adversely affect our business, results of operations and financial
condition. The CSRC or other PRC regulatory agencies may also take actions requiring us, or making it advisable for us, to halt
this offering before settlement and delivery of the offering.
Our
PRC counsel, China Commercial Law Firm, has advised us that, based on their understanding of the current PRC laws, regulations
and rules and the procedures announced on September 21, 2006, because (i) we established our PRC subsidiary by means
of direct investment other than by merger or acquisition of the equity or assets of Junlong, and (ii) our VIE between our
PRC subsidiary and Junlong does not constitute the acquisition of our PRC subsidiary, we are not required to apply with the CSRC
for the approval of the listing and offering on the OTCBB market.
The
M&A Rules also established additional procedures and requirements that are expected to make merger and acquisition activities
in China by foreign investors more time-consuming and complex, including requirements in some instances that the MOFCOM be notified
in advance of any change-of-control transaction in which a foreign investor takes control of a PRC domestic enterprise, or that
the approval from the MOFCOM be obtained in circumstances where overseas companies established or controlled by PRC enterprises
or residents acquire affiliated domestic companies. We may grow our business in part by acquiring other companies operating in
our industry. Complying with the requirements of the M&A Rules to complete such transactions could be time-consuming, and any
required approval processes, including approval from Ministry of Commerce, may delay or inhibit our ability to complete such transactions,
which could affect our ability to expand our business or maintain our market share.
The
M&A Rules, along with foreign exchange regulations discussed in the above subsection, will be interpreted or implemented by
the relevant government authorities in connection with our future offshore financings or acquisitions, and we cannot predict how
they will affect our business development strategy.
Under the EIT Law,
we may be classified as a “resident enterprise” of China. Such classification will likely result in unfavorable tax
consequences to us and our non-PRC shareholders.
Under
the new PRC Enterprise Income Tax Law, or the EIT Law, and its implementing rules, both of which became effective on January 1,
2008, an enterprise established outside of the PRC with “de facto management bodies” within the PRC is considered a
“resident enterprise,” meaning that it can be treated in a manner similar to a PRC enterprise for enterprise income
tax purposes. The implementing rules of the EIT Law define de facto management as “substantial and overall management and
control over the production and operations, personnel, accounting, and properties” of the enterprise.
On
April 22, 2009, the State Administration of Taxation issued the Notice Concerning Relevant Issues Regarding Cognizance of Chinese
Investment Controlled Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria of de facto Management Bodies,
or the Notice, further interpreting the application of the EIT Law and its implementation non-PRC enterprise or group controlled
offshore entities. Pursuant to the Notice, an enterprise incorporated in an offshore jurisdiction and controlled by a PRC enterprise
or group will be classified as a “non-domestically incorporated resident enterprise” if (i) its senior management in
charge of daily operation reside or perform their duties mainly in the PRC; (ii) its financial or personnel decisions are made
or approved by bodies or persons in the PRC; (iii) its substantial properties, accounting books, corporate chops, board and shareholder
minutes are kept in the PRC; and (iv) half of the directors with voting rights or senior management often resident in the PRC.
Such resident enterprise would be subject to an enterprise income tax rate of 25% on its worldwide income and must pay a withholding
tax at a rate of 10% when paying dividends to its non-PRC shareholders. However, it remains unclear as to whether the Notice is
applicable to an offshore enterprise incorporated by a PRC natural person. Nor are detailed measures on imposition of tax from
non-domestically incorporated resident enterprises available. Therefore, it is unclear how tax authorities will determine tax residency
based on the facts of each case.
However,
as our case substantially meets the foregoing criteria, there is a likelihood that we are deemed to be a resident enterprise by
PRC tax authorities. If the PRC tax authorities determine that we are a “resident enterprise” for PRC enterprise income
tax purposes, a number of unfavorable PRC tax consequences could follow. First, we may be subject to the enterprise income tax
at a rate of 25% on our worldwide taxable income as well as PRC enterprise income tax reporting obligations. In our case, this
would mean that income such as interest on financing proceeds and non-PRC source income would be subject to PRC enterprise income
tax at a rate of 25%. Second, although under the EIT Law and its implementing rules dividends paid to us from our PRC subsidiaries
would qualify as “tax-exempt income,” we cannot guarantee that such dividends will not be subject to a 10% withholding
tax, as the PRC foreign exchange control authorities, which enforce the withholding tax, have not yet issued guidance with respect
to the processing of outbound remittances to entities that are treated as resident enterprises for PRC enterprise income tax purposes.
Finally, it is possible that future guidance issued with respect to the new “resident enterprise” classification could
result in a situation in which a 10% withholding tax is imposed on dividends we pay to our non-PRC shareholders and with respect
to gains derived by our non-PRC shareholders from transferring our shares. We are actively monitoring the possibility of “resident
enterprise” treatment for the
2010
tax year and are evaluating appropriate organizational
changes to avoid this treatment, to the extent possible.
If
we were treated as a “resident enterprise” by PRC tax authorities, we would be subject to taxation in both the U.S.
and the PRC, and our PRC tax may not be creditable against our U.S. tax.
The value of our
securities will be affected by the currency exchange rate between U.S. dollars and RMB.
The
value of our Common Stock will be affected by the foreign exchange rate between U.S. dollars and RMB, and between those currencies
and other currencies in which our sales may be denominated. For example, if we need to convert U.S. dollars into RMB for our operational
needs and the RMB appreciates against the U.S. dollar at that time, our financial position, our business, and the price of our
Common Stock may be harmed. Conversely, if we decide to convert our RMB into U.S. dollars for the purpose of declaring dividends
on our Common Stock or for other business purposes and the U.S. dollar appreciates against the RMB, the U.S. dollar equivalent
of our earnings from our subsidiaries in the PRC would be reduced.
Risks Related to the
Market for Our Common Stock
Our Common Stock
is quoted on the OTC Bulletin Board which may have an unfavorable impact on our stock price and liquidity.
Our
Common Stock is quoted on the OTCQB. The OTCQB is a significantly more limited market than the New York Stock Exchange or NASDAQ
stock markets. The quotation of our shares on the OTCQB means there is a less liquid market available for existing and potential
stockholders to trade shares of our Common Stock. The limited liquidity could depress the trading price of our Common Stock and
could have a long-term adverse impact on our ability to raise capital in the future.
You
may have difficulty trading and obtaining quotations for our Common Stock.
Our
Common Stock does not trade, and the bid and asked prices for our Common Stock on the OTCQB may fluctuate widely in the future.
As a result, investors may find it difficult to dispose of, or to obtain accurate quotations of the price of, our securities. This
severely limits the liquidity of the Common Stock, and would likely reduce the market price of our Common Stock and hamper our
ability to raise additional capital.
The market price
of our Common Stock is likely to be highly volatile and subject to wide fluctuations.
Dramatic
fluctuations in the price of our Common Stock may make it difficult to sell our Common Stock. The market price of our Common Stock
is likely to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our
control, including:
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dilution caused by our issuance of additional shares of Common Stock and other forms of equity securities, which we expect
to make in the Offering and in connection with future capital financings to fund our operations and growth, to attract and retain
valuable personnel and in connection with future strategic partnerships with other companies;
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variations in our quarterly operating results;
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announcements that our revenue or income are below or that costs or losses are greater than analysts’ expectations;
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the general economic slowdown;
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sales of large blocks of our Common Stock;
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announcements by us or our competitors of significant contracts, acquisitions, strategic partnerships, joint ventures or capital
commitments; and
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fluctuations in stock market prices and volumes;
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These
and other factors are largely beyond our control, and the impact of these risks, singly or in the aggregate, may result in material
adverse changes to the market price of our Common Stock and/or our results of operations and financial condition.
We do not expect
to pay cash dividends on our Common Stock in the future.
We
have paid no cash dividends on our Common Stock in the past and do not intend to pay any cash dividends on our Common Stock in
the foreseeable future. We anticipate that we will reinvest profits from our operations, if any, into our business. We cannot
assure you that we will ever pay cash dividends to holders of our Common Stock. Therefore, investors will not receive any funds
unless they sell their Common Stock, and stockholders may be unable to sell their shares on favorable terms or at all. Investors
cannot be assured of a positive return on investment or that they will not lose the entire amount of their investment in the Common
Stock.
We are subject to
penny stock regulations and restrictions.
The
SEC has adopted regulations which generally define so-called “penny stocks” to be an equity security that has a market
price less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exemptions. If our Common
Stock becomes a “penny stock,” we may become subject to Rule 15g-9 under the Exchange Act, or the Penny Stock Rule.
This rule imposes additional sales practice requirements on broker-dealers that sell such securities to persons other than established
customers and “accredited investors” (generally, individuals with a net worth in excess of $1,000,000 or annual incomes
exceeding $200,000, or $300,000 together with their spouses). For transactions covered by Rule 15g-9, a broker-dealer must make
a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior
to sale. As a result, this rule may affect the ability of broker-dealers to sell our securities and may affect the ability of purchasers
to sell any of our securities in the secondary market.
For
any transaction involving a penny stock, unless exempt, the rules require delivery, prior to any transaction in a penny stock,
of a disclosure schedule prepared by the SEC relating to the penny stock market. Disclosure is also required to be made about sales
commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Finally,
monthly statements are required to be sent disclosing recent price information for the penny stock held in the account and information
on the limited market in penny stock.
There
can be no assurance that our Common Stock will qualify for exemption from the Penny Stock Rule. In any event, even if our Common
Stock were exempt from the Penny Stock Rule, we would remain subject to Section 15(b)(6) of the Exchange Act, which gives the SEC
the authority to restrict any person from participating in a distribution of penny stock, if the SEC finds that such a restriction
would be in the public interest.
Compliance with
changing regulation of corporate governance and public disclosure will result in additional expenses.
Changing
laws, regulations and standards relating to corporate governance and public disclosure, including SOX and related SEC regulations,
have created uncertainty for public companies and significantly increased the costs and risks associated with accessing the public
markets and public reporting. Our management team will need to invest significant management time and financial resources
to comply with both existing and evolving standards for public companies, which will lead to increased general and administrative
expenses and a diversion of management time and attention from revenue generating activities to compliance activities.
Certain provisions
of our Articles of Incorporation may make it more difficult for a third party to effect a change-in-control.
Our
Articles of Incorporation authorizes the Board of Directors to issue up to 50 million shares of preferred stock. The preferred
stock may be issued in one or more series, the terms of which may be determined at the time of issuance by the Board of Directors
without further action by the stockholders. These terms may include voting rights including the right to vote as a series on particular
matters, preferences as to dividends and liquidation, conversion rights and redemption rights provisions. The issuance of any preferred
stock could diminish the rights of holders of our Common Stock, and therefore could reduce the value of such Common Stock. In addition,
specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with, or sell assets
to, a third party. The ability of the Board of Directors to issue preferred stock could make it more difficult, delay, discourage,
prevent or make it more costly to acquire or effect a change-in-control, which in turn could prevent the stockholders from recognizing
a gain in the event that a favorable offer is extended and could materially and negatively affect the market price of our Common
Stock.
|
Item 1B.
|
Unresolved Staff Comments.
|
Not applicable.
There
is no private land ownership in the PRC. Individuals and companies are permitted to acquire land use rights for specific purposes.
We currently do not have any land use rights. Instead we lease most of the property that we need to operate our business from third
parties.
Junlong
currently leases an office space of approximately 411.14 square meters for its headquarters located at #1707, Block A, Genzon Times
Square, Longcheng Blvd, Centre City, Longgang District, Shenzhen. The term of the lease is from March 15, 2012 to March 14, 2015.
Junlong
also leases spaces from different entities or individuals for its 62 internet cafés. The rent we paid for leased spaces
in the fiscal year ended December 31, 2013 was approximately $2,747,167 in total.
|
Item 3.
|
Legal Proceedings.
|
From time to time,
we may become involved in various lawsuits and legal proceedings that arise in the ordinary course of business. However, litigation
is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm
our business. We are currently not aware of any such legal proceedings or claims that we believe will have a material adverse effect
on our business, financial condition or operating results.
|
Item 4.
|
Mine Safety Disclosures.
|
Not applicable.
The accompanying notes are an integral part of the condensed consolidated financial statements
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
|
1.
|
Organization, Recapitalization and Nature of Business
|
China Internet Cafe
Holdings Group, Inc. (“China Internet Cafe”)
China
Internet Cafe Holdings Group, Inc. (formerly known as China Unitech Group, Inc.) (“China Internet Café”, “the
Company”, “we”, “us”, “our”) was incorporated in the State of Nevada on March 14, 2006.
The Company was a development company from incorporation until the quarter ended June 30, 2010. On July 2, 2010, the Company successfully
closed a share exchange transaction with the shareholders of Classic Bond Development Limited, a British Virgin Islands corporation
(" Classic Bond"). The Company will operate through its variable interest entities in China to execute the current business
plan of those affiliates which involves the operation of a chain of China-based internet cafes. The “Business”, on
February 1, 2011, the Company changed its name from China Unitech Group, Inc. to China Internet Cafe Holdings Group, Inc.
Recapitalization
of Classic Bond Development Limited
On
July 2, 2010, the Company entered into a share exchange transaction with Classic Bond Development Limited, a British Virgin Islands
corporation (“Classic Bond”), and the shareholders of Classic Bond. Pursuant to the Share Exchange Agreement, China
Internet Cafe acquired 100% of the issued and outstanding capital stock of Classic Bond in exchange for 19,000,000 newly issued
shares of the Company’s common stock, which represented approximately 94% of the 20,200,000 issued and outstanding shares
of common stock after the transaction and after the coincident cancellation of 4,973,600 shares of common stock held by the Company’s
former majority stockholder. The business, assets and liabilities did not change as a result of the reverse acquisition.
This
share exchange transaction resulted in the shareholders of Classic Bond obtaining a majority voting interest in the Company. Generally
accepted accounting principles require that the Company whose shareholders retain the majority interest in a combined business
be treated as the acquirer for accounting purposes, resulting in a reverse acquisition with Classic Bond as the accounting acquirer
and China Internet Cafe as the acquired party. Accordingly, the share exchange transaction has been accounted for as a recapitalization
of Classic Bond whereby Classic Bond is deemed to be the continuing, surviving entity for accounting purposes, but through reorganization,
has deemed to have adopted the capital structure of China Internet Cafe. The equity section of the accompanying financial statements
has been restated to reflect the recapitalization of the Company due to the reverse acquisition as of the first day of the first
period presented.
Accordingly,
all references to common shares of Classic Bond’s common stock have been restated to reflect the equivalent number of China
Internet Cafe‘s common shares. In other words, the 2,000,000 Classic Bond shares outstanding are restated as 20,200,000 common
shares, as of July 2, 2010. Each share of Classic Bond is restated to 10.10 shares of China Internet Cafe.
The
book value of the net assets that for accounting purposes, were deemed to have been acquired by Classic Bond from China Internet
Cafe, as of the date of acquisition (July 2, 2010) were $3,333.
During
the recapitalization, the Company incurred restructuring expenses of $300,000, related legal and professional fee of $ 129,033
and the interest expenses of $6,053 related to the short term loan for paying restructuring expenses. All of these expenses amounting
to $435,086 in total were recorded as reorganizational expenses in statement of income.
Classic Bond Development
Limited (“Classic Bond”)
Classic
Bond Development Limited was incorporated on November 2, 2009 in the British Virgins Islands (“BVI”) with 50,000 authorized
common stock with no par value. On November 2, 2009, 50,000 common stock at $0.129 (HK$1) each were issued for cash at $6,452 (HK$50,000)
to several shareholders including Mr. Guo Dishan who is the 65% equity interest shareholder and the sole director of the Company.
On
June 23, 2010, the Company further issued 1,950,000 shares of common stock of classic bond to 42 individuals to raise fund of
$84,093 (HK$651,721) for 641,046 shares and 1,308,954 shares associated with the reorganization of the Company at a value of $167,519
(HK$1,308,954) which is reflected as contributed capital by existing shareholders of Junlong and the total amount was $251,612.
As of June 30, 2010, 2,000,000 shares of Common Stock were issued and outstanding.
Classic
Bond is in the business of operating internet cafés, throughout the Longang District of Shenzhen in Province of Guangdong
of People's Republic of China ("PRC"). The Company conducts its operations through the following subsidiaries: (a) a
wholly-owned subsidiary of the Company located in the PRC: Shenzhen Zhonghefangda Network Technology Co., Ltd. (“Zhonghefangda”)
and (b) an entity located in the PRC: Shenzhen Junlong Culture Communication Co., Ltd. (“Junlong’), which is controlled
by the Company through contractual arrangements between Zhonghefangda and Junlong, as if Junlong were a wholly-owned subsidiary
of Classic Bond.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
1.
|
Organization, Recapitalization and Nature of Business (Continued)
|
Shenzhen Zhonghefangda
Network Technology Co., Ltd. (“Zhonghefangda”)
Zhonghefangda
, Classic Bond’s wholly-owned subsidiary, was incorporated in People’s Republic of China (“PRC”) on June
10, 2010 with registered capital of $129,032 (HK$1 million). Zhonghefangda is engaged in provision of management and consulting
services and Mr. Guo Dishan is the legal representative of Zhonghefangda.
On
June 11, 2010, to protect the Company’s shareholders from possible future foreign ownership restrictions, Zhonghefangda and
Junlong entered into a series of agreements. Under these agreements Zhonghefangda obtained the ability to direct the operations
of Junlong and to receive a majority of the residual returns. Therefore, management determined that Junlong became a variable interest
entity (“VIE”) under the provisions of Financial Accounting Standards Board (“FASB”) ASC 810-10 and Zhonghefangda
was determined to be the primary beneficiary of Junlong. Accordingly, beginning June 11, 2010, Zhonghefangda is able to consolidate
the assets, liabilities, results of operations and cash flows of Junlong in its financial statements. Because the legal representatives
and ultimate major stockholder of Zhonghefangda and Junlong is the same person, Mr. Guo Dishan, Zhonghefangda and Junlong were
deemed, until June 11, 2010, to be under common control.
Exclusive Management
and Consulting Agreement
On
June 11, 2010, Zhonghefangda signed an exclusive management and consulting services agreement with Junlong. Pursuant to the agreement,
Zhonghefangda agreed to provide management and consulting services to Junlong, upon request, in connection with the operation of
the Business. The agreement provides that Junlong will compensate Zhonghefangda by paying an amount equal to the aggregate net
profit of Junlong for a period of twenty (20) years and for succeeding periods of the same duration until the agreement is terminated
by both parties under agreed conditions. Zhonghefangda will reimburse Junlong the full amount of any net losses incurred by Junlong
during the term of this agreement. As a result of entering into the exclusive management and consulting agreement, Zhonghefangda
should be deemed to control Junlong as a Variable Interest Entity and Junlong is consolidated in the accompanying financial statements.
Shenzhen Jun Long
Culture Communication Co., Ltd. (“Junlong”)
Junlong
is a Chinese enterprise organized in the People’s Republic of China (“PRC”) on December 26, 2003 in accordance
with the Laws of the People’s Republic of China with the registered capital of $0.136 million (equivalent to RMB 1 million).
In 2001, the Chinese government imposed higher capital (RMB10 million for regional internet café chain and RMB50 million
for national internet café chain) and facility requirements for the establishment of internet cafes. On August 19, 2004,
Junlong was granted approval from Shenzhen Municipal People’s Government to increase its registered capital by $1,230,500
from $136,722 to $1,367,222 million (increased by RMB 9 million, from RMB 1 million to RMB 10 million) The capital verification
process has been completed. In April and July of 2010, Junlong acquired three internet cafes in Shenzhen.
In
2005, Junlong obtained internet cafe licenses to operate an internet café chain from the Ministry of Culture, and opened
its first internet cafe in April, 2006 and our members can access the internet at our venues. We opened 7 internet cafes in 2006,
5 internet cafes opened in 2007, 11 internet cafes opened in 2008, 5 internet cafes opened in 2009, 16 internet cafes opened in
2010, 15 internet cafes opened in 2011, and 3 internet cafes opened during the year 2012. In total, as of December 31, 2013, we
owned 62 internet cafes within Shenzhen, Guangdong.
2.
|
Summary of Significant Accounting Policies
|
|
(a)
|
Basis of presentation
|
The
Company’s accounting policies used in the preparation of the accompanying financial statements conform to accounting principles
generally accepted in the United States of America ("US GAAP") and have been consistently applied.
|
(b)
|
Principle of consolidation
|
The
consolidated financial statements include the accounts of China Internet Cafe Holdings Group, Inc., Classic Bond Development Limited,
Zhonghefangda and the VIE-Junlong. All significant intercompany balances and transactions have been eliminated in the consolidation.
The consolidated financial statements included herein, presented in accordance with United States generally accepted accounting
principles and stated in US dollars, have been prepared by the Company, pursuant to the rules and regulations of the Securities
and Exchange Commission.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
In
preparing financial statements in conformity with accounting principles generally accepted in the United states of America, management
makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets
and liabilities at the dates of the financial statements, as well as the reported amounts of revenues and expenses during the reporting
periods. These accounts and estimates include, but are not limited to, the valuation of receivables due from related parties, inventories
and the estimation of useful lives of plant and machinery and intangibles assets. Actual results could differ from those estimates.
Warrants that could require cash settlement
or have anti-dilution price protection provisions are recorded as liabilities at their estimated fair value at the date of issuance,
with subsequent changes in estimated fair vale recorded in other income (expense) in our statement of loss and comprehensive loss
in each subsequent period. In general, warrants with anti-dilution provisions are measured using the binomial valuation model.
The methodology based, in part, upon inputs for which there is little or no observable market data requiries the Group to develop
its own assumptions. The assumptions used in calculating the estimated fair value of the warrants represent our best estimates,
however these estimates involve inherent uncertainties and the application of judgment. As a result, if factors change and different
assumptions are used, the warrant liability and the change in estimated fair value could be materially different. Also see Note
16.
Internet
café members purchase prepaid IC cards which include stored value that will be deducted based on time usage of computers
at the internet cafe. Revenues derived from the prepaid IC cards at the internet café are recognized when services are provided.
This is based upon the usage of computer time at the internet cafe. Outstanding customer balances in the IC cards are included
in deferred revenue on the balance sheets. The Company does not charge any service fees that cause a decrease to customer balances.
There is no expiration date for IC cards.
The
Company also records revenue from commissions received from the sale of third parties on-line gaming cards, snacks and drinks.
Commission revenue amounting to 20% of the value of the on-line gaming cards, snacks and drinks is recognized at the time the gaming
cards, etc. are sold to customers. During the years ended December 31, 2013 and 2012, the commission income was $452,837 and $373,285,
less than 1% of total revenue.
Cost
of revenue consists primarily of depreciation of each internet café’s computer equipment and hardware and overhead
associated with the internet cafes including rental payments, utilities, business taxes, value added taxes, and surcharges. Our
internet surfing business tax is 20% on gross revenue generated from our internet cafes. Our other surcharges are an education
surcharge of 3%, city development surcharge of 1%, a culture development surcharge of 3%, and a snacks and drinks business tax
of 5%. All surcharges are calculated on the basis of business tax amount. Our value added taxes is 3% on gross revenue generated
from selling time of internet surfing in our internet cafes. Since November 2012, the Company has paid value added taxes instead
of business taxes.
The
Company may be exposed to credit risk from its cash at banks. An allowance has been considered for estimated irrecoverable amounts
determined by reference to past default experience and the current economic environment. No allowance is considered necessary for
the period.
|
(g)
|
Cash and cash equivalents
|
Cash
and cash equivalents include cash on hand, cash accounts, interest bearing savings accounts and time certificates of deposit with
a maturity of three months or less when purchased.
Inventory
represented the IC cards we purchased from IC cards manufacturer. Inventories are stated at the lower of cost or market value.
Cost is determined using the first-in, first-out (FIFO) method.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
|
(i)
|
Fair Value of Financial Instruments
|
The Company applies the provisions of accounting
guidance, FASB Topic ASC 820 that requires all entities to disclose the fair value of financial instruments, both assets and liabilities
recognized and not recognized on the balance sheet, for which it is practicable to estimate fair value, and defines fair value
of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties.
As of December 31, 2013, the fair value of cash and cash equivalents, accounts payable, short-term loans, and accrued expenses
approximated carrying value due to the short maturity of the instruments, or are based on quoted market prices or interest rates
which fluctuate with market rates except for related party debt or receivables for which it is not practicable to estimate fair
value.
The Company adopted the provisions of Accounting
Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures. ASC 820 clarifies the definition of fair
value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring
fair value as follows:
Level 1
– Inputs
are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.
Level 2
– Inputs
are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets
and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or
corroborated by observable market data.
Level 3
– Inputs
are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants
would use in pricing the asset or liability based on the best available information.
The availability of inputs observable in
the market varies from instrument to instrument and depends on a variety of factors including the type of instrument, whether the
instrument is actively traded, and other characteristics particular to the transaction. For many financial instruments, pricing
inputs are readily observable in the market, the valuation methodology used is widely accepted by market participants, and the
valuation does not require significant management discretion. For other financial instruments, pricing inputs are less observable
in the market and may require management judgment.
|
(j)
|
Stock-Based Compensation
|
Our
advisor assists the Company for ongoing corporate compliance and development are accounted for under ASC 505-50. ASC 505-50-30-11
(previously EITF 96-18) further provides that an issuer measure the fair value of the equity instruments in these transactions
using the stock price and other measurement assumptions as of the earlier of the following dates, referred to as the measurement
date:
i.
The date at which a commitment for performance by the counterparty to earn the equity instruments is reached (a performance commitment);
and
ii.
The date at which the counterparty’s performance is complete.
The
Company prepaid equipment deposits to computer suppliers for the purchase of computers and equipment for new internet cafes.
|
(l)
|
Property, plant and equipment
|
Property,
plant and equipment, comprising computer equipment and hardware, leasehold improvements, office furniture and vehicles are stated
at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives
listed below.
|
|
Estimated Useful Lives
|
Leasehold improvements
|
|
5 years
|
Cafe computer equipment and hardware
|
|
5 years
|
Cafe furniture and fixtures
|
|
5 years
|
Office furniture, fixtures and equipments
|
|
5 years
|
Motor vehicles
|
|
5 years
|
Leasehold
improvements mainly result from decoration expense. All of the Company’s lease contracts state lease terms of 5 years and
leasehold improvements are amortized over 5 years, which represents the shorter of useful life and lease term.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
Our
intangible assets consist of definite-lived assets subject to amortization such as Business License and Customer Lists. The useful
lives of the Business License are 9 to 15 years and we amortized the customer lists over 5 years. We calculate amortization of
the definite-lived intangible assets on a straight-line basis over the useful lives of the related intangible assets. Development
cost of internal-use software is insignificant and is recorded as expense in the period such cost occurs.
Deferred
revenue represents unused balances of the prepaid amounts from the IC cards that are unused balance. The Outstanding customer balances
are $2,293,794 and $1,505,699 as of December 31, 2013 and 2012, respectively, and are included in deferred revenue on the balance
sheets. Management has evaluated the deferred revenue balance and has determined any potential revenue from the unused balance
to be immaterial at the year ended December 31, 2013.
The
Company follows the FASB’s accounting standard. Comprehensive income is defined as the change in equity of a company during
a period from transactions and other events and circumstances excluding transactions resulting from investments from owners and
distributions to owners. For the Company, comprehensive income for the periods presented includes net income and foreign currency
translation adjustments.
Income
taxes are provided on an asset and liability approach for financial accounting and reporting of income taxes. Current tax is based
on the profit or loss from ordinary activities adjusted for items that are non-assessable or disallowable for income tax purpose
and is calculated using tax rates that have been enacted or substantively enacted at the balance sheet date. Financial Accounting
Standards Board ("FASB") Accounting Standards Codification ("ASC") 740-10-50-2 requires deferred tax assets
and liabilities be recognized for future tax consequence attributable to differences between the financial statement carrying amounts
of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted
tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to reverse. The
effect on deferred tax assets and liabilities of a change in tax rates is recognized in the statement of income in the period that
includes the enactment date. A valuation allowance is provided for deferred tax assets if it is more likely than not these items
will either expire before the Company is able to realize their benefits, or that future deductibility is uncertain. Losses incurred
by the Company in prior years provide for a net operating loss carry-forward. However, due to the fact that all net operating losses
are from the U.S. shell company which we currently anticipate insufficient income to utilize in the future, the assets balance
has been fully reserved for.
|
(q)
|
Consolidation of Variable Interest Entities
|
According
to the requirements of Statement of Financial Accounting Standards No. 810-10, “Variable interest Entities”, the Company
has evaluated the economic relationships of its wholly owned subsidiary, Shenzhen Zhonghefangda Network Technology Co., Ltd. (“Zhonghefangda”)
with Junlong and has determined that it is required to consolidate Zhonghefangda and Junlong pursuant to the rules of FASB ASC
Topic 810-10. Therefore Junlong is considered to be a VIE, as defined by FASB ASC Topic 810-10 of which Classic Bond is the primary
beneficiary as a result of its wholly owned subsidiary Zhonghefangda. Classic Bond, as mentioned above, will absorb a majority
of the economic risks and rewards of the VIE that are being consolidated in the accompanying financial statements.
The
carrying amount of the VIE’s’ assets and liabilities are as follows:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
Current assets and Long term rental deposit
|
|
$
|
40,805,688
|
|
|
$
|
26,392,390
|
|
Property, plant and equipment
|
|
|
9,463,574
|
|
|
|
12,730,766
|
|
Intangible assets
|
|
|
62,008
|
|
|
|
124,275
|
|
Total assets
|
|
|
50,331,270
|
|
|
|
39,247,431
|
|
Total liabilities
|
|
|
(11,793,939
|
)
|
|
|
(10,129,831
|
)
|
Net assets
|
|
$
|
38,537,331
|
|
|
$
|
29,117,600
|
|
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
|
(r)
|
Foreign currency translation
|
Assets
and liabilities of the Company with a functional currency other than US$ are translated into US$ using period end exchange rates.
Income and expense items are translated at the average exchange rates in effect during the period. Foreign currency translation
differences are included as a component of Accumulated Other Comprehensive Income in Stockholders’ Equity.
The
exchange rates used to translate amounts in RMB into USD for the purposes of preparing the financial statements were as follows:
|
|
December 31, 2013
|
|
|
December 31, 2012
|
|
Year-end RMB : USD exchange rate
|
|
|
6.1104
|
|
|
|
6.3011
|
|
Average yearly RMB : USD exchange rate
|
|
|
6.1905
|
|
|
|
6.3034
|
|
The
RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions.
No representation is made that the RMB amounts could have been, or could be, converted into USD at the rates used in translation.
|
(s)
|
Post-retirement and post-employment benefits
|
The
Company contributes to a state pension plan in respect of its PRC employees. Other than the above, neither the Company nor its
subsidiary or the consolidated VIE’s provides any other post-retirement or post-employment benefits.
|
(t)
|
Earnings per share (EPS)
|
Earnings
per share is calculated in accordance with ASC 260-10 which requires the Company to calculate net income (loss) per share based
on basic and diluted net income (loss) per share, as defined. Basic EPS excludes dilution and is computed by dividing net income
(loss) by the weighted average number of shares outstanding for the period.
Diluted EPS is similar to basic EPS but presents
the dilutive effect on a per share basis of potential common shares (e.g., convertible securities, preferred stock and warrants)
as if they had been converted at the beginning of the periods presented, or issuance date, if later. Potential common shares that
have an anti-dilutive effect (i.e., those that increase income per share or decrease loss per share) are excluded from the calculation
of diluted EPS.
See Note 13 for details.
|
(u)
|
Retained earnings-appropriated
|
In
accordance with the relevant PRC regulations and Zhonghefangda and Junlong’s articles of association, Junlong is required
to allocate their respective net income to statutory surplus reserve.
|
(v)
|
Statutory surplus reserves
|
In
accordance with the relevant laws and regulations of the PRC and the articles of associations of the Company, Junlong is required
to allocate 10% of their net income reported in the PRC statutory accounts, after offsetting any prior years’ losses, to
the statutory surplus reserve, on an annual basis. When the balance of such reserve reaches 50% of the respective registered capital
of the subsidiaries, any further allocation is optional.
As
of December 31, 2013 and 2012, the statutory surplus reserves of the subsidiary already reached 50% of the registered capital of
the subsidiary and the Company was not required to allocate any further amount to it.
The
statutory surplus reserves can be used to offset prior years’ losses, if any, and may be converted into registered capital,
provided that the remaining balances of the reserve after such conversion is not less than 25% of registered capital. The statutory
surplus reserve is non-distributable.
Certain reclassifications have been made to the prior year financial
statements to conform to the current year presentation.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
|
(x)
|
Recent Accounting Pronouncements
|
In
January 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of
Disclosures about Offsetting Assets and Liabilities. This ASU clarifies that ordinary trade receivables and receivables are not
in the scope of ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities. Specifically,
ASU 2011-11 applies only to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities
lending transactions that are either offset in accordance with specific criteria contained in the FASB Accounting Standards Codification™
(Codification) or subject to a master netting arrangement or similar agreement. The FASB undertook this clarification project in
response to concerns expressed by U.S. stakeholders about the standard’s broad definition of financial instruments. After
the standard was finalized, companies realized that many contracts have standard commercial provisions that would equate to a master
netting arrangement, significantly increasing the cost of compliance at minimal value to financial statement users. An entity is
required to apply the amendments in ASU 2013-01 for fiscal years beginning on or after January 1, 2013, and interim periods within
those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented.
The effective date is the same as the effective date of ASU 2011-11. The adoption of ASU 2013-01 is not expected to have a material
impact on the Company’s financial position or results of operations.
In
February 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts
Reclassified out of Accumulated Other Comprehensive Income. This ASU improves the transparency of reporting these reclassifications.
Other comprehensive income includes gains and losses that are initially excluded from net income for an accounting period. Those
gains and losses are later reclassified out of accumulated other comprehensive income into net income. The amendments in this ASU
do not change the current requirements for reporting net income or other comprehensive income in financial statements. All of the
information that this ASU requires already is required to be disclosed elsewhere in the financial statements under U.S. GAAP. The
new amendments will require an organization to:
|
(1)
|
Present (either on the face of the statement where net income is presented or in the notes) the
effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income - but
only if the item reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting
period.
|
|
(2)
|
Cross-reference to other disclosures currently required under U.S. GAAP for other reclassification
items (that are not required under U.S. GAAP) to be reclassified directly to net income in their entirety in the same reporting
period. This would be the case when a portion of the amount reclassified out of accumulated other comprehensive income is initially
transferred to a balance sheet account (e.g., inventory for pension-related amounts) instead of directly to income or expense.
|
The
amendments apply to all public and private companies that report items of other comprehensive income. Public companies are required
to comply with these amendments for all reporting periods (interim and annual). A private company is required to meet the reporting
requirements of the amended paragraphs about the roll forward of accumulated other comprehensive income for both interim and annual
reporting periods. However, private companies are only required to provide the information about the effect of reclassifications
on line items of net income for annual reporting periods, not for interim reporting periods. The amendments are effective for reporting
periods beginning after December 15, 2012, for public companies and are effective for reporting periods beginning after December
15, 2013, for private companies. Early adoption is permitted. The adoption of ASU 2013-02 is not expected to have a material impact
on the Company’s financial position or results of operations.
In
February 2013, FASB issued Accounting Standards Update (ASU) No. 2013-03, Financial Instruments (Topic 825). This ASU clarifies
the scope and applicability of a disclosure exemption that resulted from the issuance of Accounting Standards Update No. 2011-04,
Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP
and IFRSs. The amendment clarifies that the requirement to disclose "the level of the fair value hierarchy within which the
fair value measurements are categorized in their entirety (Level 1, 2, or 3)" does not apply to nonpublic entities for items
that are not measured at fair value in the statement of financial position, but for which fair value is disclosed. This ASU is
the final version of Proposed Accounting Standards Update 2013-200—Financial Instruments (Topic 825) which has been deleted.
The amendments are effective upon issuance. The adoption of ASU 2013-03 is not expected to have a material impact on the Company’s
financial position or results of operations.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
In
February 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-04, Liabilities (Topic 405): Obligations Resulting from
Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date. This ASU
provides guidance for the recognition, measurement, and disclosure of obligations resulting from joint and several liability arrangements
for which the total amount of the obligation within the scope of this ASU is fixed at the reporting date, except for obligations
addressed within existing guidance in U.S. GAAP. The guidance requires an entity to measure those obligations as the sum of the
amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting
entity expects to pay on behalf of its co-obligors. The guidance in this ASU also requires an entity to disclose the nature and
amount of the obligation as well as other information about those obligations. The amendments in this ASU are effective for fiscal
years, and interim periods within those years, beginning after December 15, 2013. For nonpublic entities, the amendments are effective
for fiscal years ending after December 15, 2014, and interim periods and annual periods thereafter. The amendments in this ASU
should be applied retrospectively to all prior periods presented for those obligations resulting from joint and several liability
arrangements within the ASU’s scope that exist at the beginning of an entity’s fiscal year of adoption. An entity may
elect to use hindsight for the comparative periods (if it changed its accounting as a result of adopting the amendments in this
ASU) and should disclose that fact. Early adoption is permitted. The adoption of ASU 2013-04 is not expected to have a material
impact on the Company’s financial position or results of operations.
In
March 2013, FASB has issued Accounting Standards Update (ASU) No. 2013-05, Foreign Currency Matters (Topic 830). This ASU resolve
the diversity in practice about whether Subtopic 810-10, Consolidation—Overall, or Subtopic 830-30, Foreign Currency Matters—Translation
of Financial Statements, applies to the release of the cumulative translation adjustment into net income when a parent either sells
a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group
of assets that is a nonprofit activity or a business (other than a sale of in substance real estate or conveyance of oil and gas
mineral rights)within a foreign entity. In addition, the amendments in this Update resolve the diversity in practice for the treatment
of business combinations achieved in stages (sometimes also referred to as step acquisitions) involving a foreign entity. This
ASU is the final version of Proposed Accounting Standards Update EITF11Ar—Foreign Currency Matters (Topic 830), which has
been deleted. The amendments in this Update are effective prospectively for fiscal years (and interim reporting periods within
those years) beginning after December 15, 2013. For nonpublic entities the amendments in this Update are effective prospectively
for the first annual period beginning after December 15, 2014, and interim and annual periods thereafter. The amendments should
be applied prospectively to derecognition events occurring after the effective date. Prior periods should not be adjusted. Early
adoption is permitted. If an entity elects to early adopt the amendments, it should apply them as of the beginning of the entity’s
fiscal year of adoption. The adoption of ASU 2013-05 is not expected to have a material impact on the Company’s financial
position or results of operations.
In
April 2013, FASB Accounting Standards Update 2013-07, Presentation of Financial Statements (Topic 205): Liquidation Basis of Accounting.
This ASU clarifies when an entity should apply the liquidation basis of accounting. In addition, the guidance provides principles
for the recognition and measurement of assets and liabilities and requirements for financial statements prepared using the liquidation
basis of accounting. Liquidation is the process by which a company converts its assets to cash or other assets and settles its
obligations with creditors in anticipation of ceasing all of its activities. An organization in liquidation must prepare its financial
statements using a basis of accounting that communicates information to users of those financial statements to enable those users
to develop expectations about how much the organization will have available for distribution to investors after disposing of its
assets and settling its obligations. The ASU requires organization to prepare its financial statements using the liquidation basis
of accounting when liquidation is “imminent.” Liquidation is considered imminent when the likelihood is remote that
the organization will return from liquidation and either: (a) a plan for liquidation is approved by the person or persons with
the authority to make such a plan effective and the likelihood is remote that the execution of the plan will be blocked by other
parties; or (b) a plan for liquidation is being imposed by other forces (e.g., involuntary bankruptcy). In cases where a plan for
liquidation was specified in the organization’s governing documents at inception (e.g., limited-life entities), the organization
should apply the liquidation basis of accounting only if the approved plan for liquidation differs from the plan for liquidation
that was specified in the organization’s governing documents. The ASU requires financial statements prepared using the liquidation
basis to present relevant information about a company’s resources and obligations in liquidation, including the following:
|
(1)
|
The organization’s assets measured at the amount of the expected cash proceeds from liquidation,
including any items it had not previously recognized under U.S. GAAP that it expects to either sell in liquidation or use in settling
liabilities (e.g., trademarks).
|
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
|
(2)
|
The organization’s liabilities as recognized and measured in accordance with existing guidance
that applies to those liabilities.
|
|
(3)
|
Accrual of the costs it expects to incur and the income it expects to earn during liquidation,
including any anticipated disposal costs.
|
This
ASU is effective for interim and annual reporting periods beginning after December 15, 2013, with early adoption permitted. The
adoption of ASU 2013-07 is not expected to have a material impact on the Company’s financial position or results of operations.
In
June 2013, FASB Accounting Standards Update 2013-08, Financial Services—Investment Companies (Topic 946): Amendments to the
Scope, Measurement, and Disclosure Requirements. This ASU sets forth a new approach for determining whether a public or private
company is an investment company. The ASU also clarifies the characteristics and sets measurement and disclosure requirements for
an investment company. The ASU is effective for fiscal years beginning after December 15, 2013. Early adoption is not allowed.
This
guidance is a result of the efforts of the FASB and the IASB to develop a consistent approach for determining whether a company
is an investment company, for which fair value of investments is the most relevant measurement for the company’s financial
statement users. The ASU affects the scope, measurement, and disclosure requirements for investment companies under U.S. GAAP.
Under
the ASU, a company regulated under the Investment Company Act of 1940 is considered an investment company for accounting purposes.
All other companies must assess whether they have the following characteristics to be considered an investment company:
|
(a)
|
The company obtains funds from investor(s) and provides the
investor(s) with investment management services;
|
|
(b)
|
The company commits to its investor(s) that its business
purpose and only substantive activities are investing the funds for returns solely from capital appreciation, investment income,
or both;
|
|
(c)
|
The company or its affiliates do not obtain or have the objective
of obtaining returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests or
that are other than capital appreciation or investment income;
|
|
(d)
|
The company has multiple investments;
|
|
(e)
|
The company has multiple investors;
|
|
(f)
|
The company has investors that are not related to the parent
or investment manager;
|
|
(g)
|
The company’s ownership interests are in the form of
equity or partnership interests; and
|
|
(h)
|
The company manages substantially all of its investments
on a fair value basis.
|
To
be considered an investment company, a company must have all the fundamental characteristics of (a) through (c) above. Typically,
an investment company also has characteristics (d) through (h). However, if a company does not possess one or more of the typical
characteristics, it must apply judgment and determine, considering all facts and circumstances, how its activities continue to
be consistent (or are not consistent) with those of an investment company.
An
investment company also will be required to measure noncontrolling ownership interests in other investment companies at fair value
rather than using the equity method of accounting. In addition, an investment company will be required to make the following additional
disclosures: (a) the fact that the company is an investment company and is applying specialized guidance; (b) information about
changes, if any, in a company’s status as an investment company; and (c) information about financial support provided or
contractually required to be provided by an investment company to any of its investees.
The
adoption of ASU 2013-08 is not expected to have a material impact on the Company’s financial position or results of operations.
In
July 2013, The FASB has published Accounting Standards Update 2013-09, Fair Value Measurement (Topic 820): Deferral of the Effective
Date of Certain Disclosures for Nonpublic Employee Benefit Plans in Update No. 2011-04. This ASU defers indefinitely certain disclosures
about investments held by nonpublic employee benefit plans in their plan sponsors’ own nonpublic equity securities. The ASU
was approved by the FASB on June 12, 2013. ASU No. 2013-09, Fair Value Measurement (Topic 820): Deferral of the Effective Date
of Certain Disclosures for Nonpublic Employee Benefit Plans in Update No. 2011-04, applies to disclosures of certain quantitative
information about the significant unobservable inputs used in Level 3 fair value measurement for investments held by certain employee
benefit plans. The adoption of ASU 2013-09 is not expected to have a material impact on the Company’s financial position
or results of operations.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
2.
|
Summary of Significant Accounting Policies (Continued)
|
In
July 2013, The FASB has issued Accounting Standards Update (ASU) No. 2013-10, Derivatives and Hedging (Topic 815): Inclusion of
the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (a
consensus of the FASB Emerging Issues Task Force). The amendments in this ASU permit the Fed Funds Effective Swap Rate (OIS) to
be used as a U.S. benchmark interest rate for hedge accounting purposes, in addition to UST and LIBOR. The amendments also remove
the restriction on using different benchmark rates for similar hedges.
Before
the amendments in this ASU, only UST and, for practical reasons, the LIBOR swap rate, were considered benchmark interest rates.
Including the Fed Funds Effective Swap Rate (OIS) as an acceptable U.S. benchmark interest rate in addition to UST and LIBOR will
provide risk managers with a more comprehensive spectrum of interest rate resets to utilize as the designated benchmark interest
rate risk component under the hedge accounting guidance.
The
amendments apply to all entities that elect to apply hedge accounting of the benchmark interest rate. The amendments are effective
prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. The adoption of
ASU 2013-10 is not expected to have a material impact on the Company’s financial position or results of operations.
In
July 2013, The FASB has issued ASU No. 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net
Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task
Force).
U.S.
GAAP does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating
loss carryforward, a similar tax loss, or a tax credit carryforward exists. The amendments in this ASU state that an unrecognized
tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred
tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except as follows. To the extent
a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under
the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax
position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use,
the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability
and should not be combined with deferred tax assets.
This
ASU applies to all entities that have unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or
a tax credit carryforward exists at the reporting date. The amendments in this ASU are effective for fiscal years, and interim
periods within those years, beginning after December 15, 2013. For nonpublic entities, the amendments are effective for fiscal
years, and interim periods within those years, beginning after December 15, 2014. Early adoption is permitted. The amendments should
be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted.
The adoption of ASU 2013-11 is not expected to have a material impact on the Company’s financial position or results of operations.
3. Cash and cash equivalents
Cash and cash equivalents
are summarized as follows:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
Cash and cash equivalents at bank
|
|
$
|
40,217,223
|
|
|
$
|
25,800,930
|
|
Cash in hand
|
|
|
24,236
|
|
|
|
17,111
|
|
|
|
$
|
40,241,459
|
|
|
$
|
25,818,041
|
|
Financial
instruments that potentially subject the Company to significant concentration of credit risk consist primarily of cash and cash
equivalents (Note 2). As of December 31, 2013 and 2012, $40,204,156 and $25,794,334 of the Company’s cash and cash equivalents
were held by major banks located in the PRC, which management believes are of high credit quality, and $2,534 and $1,951 of the
Company's cash and cash equivalents were held by Chase bank and JP Morgan Chase bank in USA, respectively.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
4. Equipment Deposits
Equipment deposits consist
of:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
|
|
$
|
3,240
|
|
|
$
|
7,427
|
|
|
|
|
|
|
|
|
|
|
As of December 31, 2012, equipment deposits
are for the purchase of an air-conditioner and fire protection systems for the new headquarters in Shenzhen. As of December 31,
2013, equipment deposit is for the purchase of fire protection systems for the new headquarters in Shenzhen. The deposit was paid
in 2012 and remains in place.
5. Inventory
Inventory consists of:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
|
|
|
|
|
|
|
|
|
Purchased IC cards
|
|
$
|
36,200
|
|
|
$
|
49,681
|
|
There
was no allowance made for obsolete or slow moving inventory as of December 31, 2013 and 2012.
6. Property, Plant
and Equipment, net
Property, plant and equipment,
net, consist of the following:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
Leasehold improvement
|
|
$
|
4,234,152
|
|
|
$
|
4,394,136
|
|
Cafe computers equipment and hardware
|
|
|
17,307,427
|
|
|
|
16,939,215
|
|
Cafe furniture and fixtures
|
|
|
2,176,149
|
|
|
|
1,963,143
|
|
Office furniture, fixtures and equipment
|
|
|
355,974
|
|
|
|
303,271
|
|
Motor vehicles
|
|
|
486,703
|
|
|
|
471,973
|
|
|
|
$
|
24,560,405
|
|
|
$
|
24,071,738
|
|
Less: Accumulated depreciation
|
|
|
(15,096,832
|
)
|
|
|
(11,340,972
|
)
|
Property, plant and equipment, net
|
|
$
|
9,463,573
|
|
|
$
|
12,730,766
|
|
During
the year ended December 31, 2013, depreciation expenses amounted to $3,357,900, of which $3,250,521 and $107,379 were recorded
as cost of sales and general and administrative expense, respectively.
During
the year ended December 31, 2012, depreciation expenses amounted to $3,090,100, of which $2,985,548 and $104,552 were recorded
as cost of sales and general and administrative expense, respectively.
7. Intangible Assets
Intangible assets are
summarized as follows:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
Business License
|
|
$
|
102,723
|
|
|
$
|
99,614
|
|
Customer Lists
|
|
|
130,158
|
|
|
|
126,219
|
|
|
|
|
232,881
|
|
|
|
225,833
|
|
Less: Accumulated Amortization
|
|
|
(170,874
|
)
|
|
|
(101,559
|
)
|
Total
|
|
$
|
62,007
|
|
|
$
|
124,274
|
|
During
the years ended December 31, 2013 and 2012, amortization expenses amounted to $66,145 and $38,103 respectively which was recorded
under cost of sales.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
7. Intangible Assets (Continued)
Estimated
amortization for the next five years and thereafter are as follows:
Years ending December 31,
|
|
|
|
2014
|
|
$
|
46,576
|
|
2015
|
|
|
15,431
|
|
2016
|
|
|
-
|
|
Thereafter
|
|
|
-
|
|
Total
|
|
$
|
62,007
|
|
8. Short Term Loan
The
short term loan due within one year as of December 31, 2013 and 2012 consist of the following:
|
|
|
|
Interest
|
|
|
December 31,
|
|
December 31,
|
|
Bank
|
|
Loan Period
|
|
rate
|
|
|
2013
|
|
2012
|
|
China Construction Bank
|
|
April 1, 2012 to March 26, 2013
|
|
|
12.46
|
%
|
|
$
|
-
|
|
$
|
158,702
|
|
China Construction Bank
|
|
June 13, 2013 to June 12, 2014
|
|
|
9
|
%
|
|
$
|
163,655
|
|
$
|
-
|
|
On March 27, 2012, the Company entered
into a loan agreement with China Construction Bank for $158,702 (RMB 1,000,000), which was secured by a director’s guarantee.
The annual interest rate was approximately 12.46% and the loan was due on March 26, 2013. The loan has been paid in full on March
26, 2013.
On June 13, 2013, the Company entered into
a loan agreement with China Construction Bank for $163,655 (RMB 1,000,000), which was secured by a director’s guarantee.
The annual interest rate is approximately 9% and the loan is due on June 12, 2014.
For the years ended December 31, 2013 and
2012, interest expense on these loans was $12,825 and $14,501, respectively.
9. Income and Other
Taxes Payable
Income and other tax payables
consist of the following:
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
|
|
|
|
|
|
|
|
|
Value added taxes
|
|
$
|
218,231
|
|
|
$
|
78,013
|
|
Income tax
|
|
|
567,419
|
|
|
|
586,908
|
|
Withhold individual income tax payable
|
|
|
4,064
|
|
|
|
2,208
|
|
Other tax payable
|
|
|
222,100
|
|
|
|
87,580
|
|
Total
|
|
$
|
1,011,814
|
|
|
$
|
754,709
|
|
10. Due To A Shareholder
|
|
December 31,
2013
|
|
|
December 31,
2012
|
|
Mr. Guo Di Shan, a shareholder of the Company
|
|
$
|
3,063,633
|
|
|
$
|
2,634,163
|
|
|
|
|
|
|
|
|
|
|
The amount due to Mr.
Di Shan Guo is unsecured with no stated interest and is payable on demand. The amount due as of December 31, 2013, represents amounts
accumulated since 2007 and used to pay daily operating expenses and professional fees.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
11. Cost of Revenue
Cost of revenue consists
of the following:
|
|
For The Years Ended
December 31,
|
|
|
|
2013
|
|
|
2012
|
|
|
|
|
|
|
|
|
|
|
Depreciation and amortization
|
|
$
|
3,607,119
|
|
|
$
|
3,023,651
|
|
Salary
|
|
|
3,458,182
|
|
|
|
3,250,516
|
|
Rent
|
|
|
2,752,109
|
|
|
|
2,326,337
|
|
Utility
|
|
|
2,107,666
|
|
|
|
2,221,137
|
|
Business tax and surcharge
|
|
|
1,807,787
|
|
|
|
6,138,096
|
|
Others
|
|
|
3,092,473
|
|
|
|
3,892,024
|
|
|
|
$
|
16,825,336
|
|
|
$
|
20,851,761
|
|
12. Income Tax
The components of income
before income taxes from continuing operations consisted of the following:
|
|
2013
|
|
|
2012
|
|
|
|
US$
|
|
|
US$
|
|
Income (loss) subject to domestic income taxes only
|
|
|
(59,098
|
)
|
|
|
(759,539
|
)
|
Income (loss) subject to foreign income taxes only
|
|
|
11,201,163
|
|
|
|
7,429,365
|
|
|
|
|
11,142,065
|
|
|
|
6,633,826
|
|
The
Company is subject to U.S. federal and state income taxes. The Company’s subsidiaries incorporated in the PRC are subject
to enterprise income taxes in China. The provision for income taxes from continuing operations consisted of the following:
|
|
2013
|
|
|
2012
|
|
|
|
US$
|
|
|
US$
|
|
Current:
|
|
|
|
|
|
|
Federal
|
|
|
-
|
|
|
|
-
|
|
State
|
|
|
-
|
|
|
|
-
|
|
PRC
|
|
|
2,877,937
|
|
|
|
1,934,323
|
|
|
|
|
2,877,937
|
|
|
|
1,934,323
|
|
Deferred:
|
|
|
|
|
|
|
|
|
Federal
|
|
|
-
|
|
|
|
-
|
|
State
|
|
|
-
|
|
|
|
-
|
|
PRC
|
|
|
(77,646
|
)
|
|
|
(76,982
|
)
|
Total provision for income taxes
|
|
|
2,800,291
|
|
|
|
1,857,341
|
|
The
following is a reconciliation of the difference between the actual provision for income taxes and the provision computed by applying
the federal statutory rate on income from continuing operations before income taxes:
|
|
2013
|
|
|
2012
|
|
|
|
US$
|
|
|
US$
|
|
Tax at federal statutory rate
|
|
|
2,785,516
|
|
|
|
1,658,456
|
|
Permanent differences
|
|
|
(98,384
|
)
|
|
|
29,804
|
|
Loss not benefited
|
|
|
113,159
|
|
|
|
169,081
|
|
|
|
|
2,800,291
|
|
|
|
1,857,341
|
|
Deferred
tax assets and liabilities are recognized for the expected future tax consequences of differences between the carrying amounts
of assets and liabilities and their respective tax bases using enacted tax rates in effect for the year in which the differences
are expected to reverse. Deferred taxes are comprised of the following:
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
12. Income Tax (Continued)
|
|
2013
|
|
|
2012
|
|
|
|
US$
|
|
|
US$
|
|
DTA:
|
|
|
|
|
|
|
|
|
Deferred assets - others
|
|
|
77,646
|
|
|
|
76,982
|
|
Deferred assets - NOL
|
|
|
681,290
|
|
|
|
865,401
|
|
Total Deferred assets
|
|
|
758,936
|
|
|
|
942,383
|
|
Total Gross DTA
|
|
|
758,936
|
|
|
|
942,383
|
|
Valuation allowance
|
|
|
(681,290
|
)
|
|
|
(865,401
|
)
|
Net deferred assets
|
|
|
77,646
|
|
|
|
76,982
|
|
The
Company has recorded a valuation allowance against all of its US deferred tax assets at December 31, 2013 and 2012. In accordance
with ASC 740 Accounting for Income Taxes, based on all available evidence, including the Company’s historical results and
the forecast of its future income, it is more likely than not that its US entity will not be able to realize its deferred tax assets,
and that all of its PRC entities will be able to realize the deferred tax assets.
For
U.S. federal income tax purposes, the Company has net operating loss, or NOL carry forwards of approximately $0.68 million and
$0.87 million, at December 31, 2013 and 2012, respectively. The 2013 net operating loss carry forwards will expire after 20 years
beginning 2031 and the 2012 net operating loss carry forwards will expire after 20 years beginning 2030, if not utilized. The Company
has no net operating loss carry forwards for PRC enterprise income tax purposes, at December 31, 2013 and 2012, respectively.
Undistributed
earnings of the Company’s PRC subsidiary amounted to approximately $34 million as of December 31, 2013. Those earnings are
considered to be permanently reinvested and accordingly, no deferred tax expense is recorded for U.S. federal and state income
tax or applicable withholding taxes. The PRC tax authorities have clarified that dividend distributions made out of pre-January
1, 2008 retained earnings will not be subject to withholding taxes.
The
Company and its subsidiaries are subject to taxation in the U.S. and the PRC. Our U.S. federal and state income tax returns are
generally not subject to examination by the tax authorities for tax years before 2008. The tax authorities in the PRC may examine
the tax returns of the Company three years after its fiscal year ended.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
13. Earnings per Share
Basic earnings per share is computed by
dividing net income attributable to common shareholders by the weighted average number of common shares outstanding during the
period. Diluted earnings per share reflects the potential dilution of securities by including other potential common stock, including
convertible preferred stock, stock options and warrants, in the weighted average number of common shares outstanding for the period,
if dilutive. The numerators and denominators used in the computations of basic and dilutive earnings per share are presented in
the following table:
|
|
For The Years Ended
December 31,
|
|
|
|
2013
|
|
|
2012
|
|
BASIC
|
|
|
|
|
|
|
Numerator for basic earnings per share attributable to the Company’s common stockholders:
|
|
|
|
|
|
|
Net income
|
|
$
|
8,341,774
|
|
|
$
|
4,776,485
|
|
Dividend on preferred stock
|
|
|
(113,836
|
)
|
|
|
(216,605
|
)
|
Net income used in computing basic earnings per share
|
|
$
|
8,227,938
|
|
|
$
|
4,559,880
|
|
|
|
|
|
|
|
|
|
|
Basic weighted average shares outstanding
|
|
|
25,080,525
|
|
|
|
21,335,038
|
|
Basic earnings per share
|
|
$
|
0.33
|
|
|
$
|
0.21
|
|
|
|
For The Years Ended
December 31,
|
|
|
|
2013
|
|
|
2012
|
|
DILUTED
|
|
|
|
|
|
|
|
|
Numerator for diluted earnings per share attributable to the Company’s common stockholders:
|
|
|
|
|
|
|
|
|
Net income
|
|
$
|
8,227,938
|
|
|
$
|
4,559,880
|
|
Dividend on preferred stock
|
|
|
113,836
|
|
|
|
216,605
|
|
Net income used in computing diluted earnings per share
|
|
$
|
8,341,774
|
|
|
$
|
4,776,485
|
|
|
|
|
|
|
|
|
|
|
Weighted average outstanding shares of common stock
|
|
|
25,080,525
|
|
|
|
21,335,038
|
|
Weighted average preferred stock
|
|
|
811,258
|
|
|
|
4,294,703
|
|
Diluted weighted average shares outstanding
|
|
|
25,891,783
|
|
|
|
25,629,741
|
|
Diluted earnings per share
|
|
$
|
0.32
|
|
|
$
|
0.19
|
|
|
|
|
|
|
|
|
|
|
Potential common shares outstanding as of December 31:
|
|
|
|
|
|
|
|
|
Series A preferred stock
|
|
|
-
|
|
|
|
4,274,703
|
|
Warrants
|
|
|
2,498,326
|
|
|
|
2,498,326
|
|
|
|
|
2,498,326
|
|
|
|
6,773,029
|
|
As of December 31, 2013, the average market
price of the common stock during the year was less than the exercise price of the Warrants. Accordingly, the Warrants were anti-dilutive
and have not been included in the calculation of diluted earnings per share.
14. Employee Benefits
The
Company contributes to a state pension scheme organized by municipal and provincial governments in respect of its employees in
PRC. The pension expense related to this plan is calculated at a range of 8% of the average monthly salary. The pension expense
was $12,851 and $11,658 for the years ended December 31, 2013 and 2012, respectively.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
15. Stockholders’
Equity
Common Stock
On
July 2, 2010, China Internet Cafe entered into a share exchange transaction with Classic Bond and the shareholders of Classic Bond.
Pursuant to the Share Exchange Agreement, China Internet Cafe acquired 100% of the issued and outstanding capital stock of Classic
Bond in exchange for 19,000,000 newly issued shares of the Company’s common stock, which represented approximately 94% of
the 20,200,000 issued and outstanding shares of common stock after the transaction and after the coincident cancellation of 4,973,600
shares of common stock held by the Company’s former majority stockholder The business, assets and liabilities did not change
as a result of the reverse acquisition.
As
of December 31, 2013 and 2012, there are 25,689,524 and 21,414,821 shares of Common Stock issued and outstanding respectively.
Series A Preferred Stock
On February 16, 2011, the Company filed
with the Secretary of State of Nevada, as an amendment to its Articles of Incorporation, a Certificate of Designation, Preferences
and Rights for the 5% Series A Convertible Preferred Stock, par value $0.00001 per share (the “Series A Preferred Stock”).
On February 22, 2011, the Company issued 4,274,703 shares of its Series A Preferred Stock.
For each outstanding share of Series A
Preferred Stock, dividends are payable quarterly, at the rate of 5% per annum ($0.675 per share), on or before each date that is
thirty days following the last day of March, June, September, and December of each year, commencing September 30, 2011. Dividends
on the Series A Preferred Stock accrue and are cumulative from and after the date of initial issuance. For the quarter ended September
30 and December 31 of 2012 and from January 1, 2013 to February 22, 2012, dividends have been accrued as dividends payable and
are not paid as of December 31, 2013.
The Series A Preferred Stock was not subject
to mandatory redemption (except on liquidation) but was redeemable in certain circumstances. Because of the possible redemption
conditions, the Series A Preferred Stock was classified as mezzanine equity.
Each share of Series A Preferred Stock
may be converted at any time, at the option of the holder, into a number of fully paid and non-assessable shares of Common Stock
equal to the quotient of (i) the Series A Liquidation Preference of $1.35 per share divided by (ii) the conversion price in effect
as of the date of the Conversion Notice. The initial conversion price of the Series A Preferred Stock was $1.35 per share.
In addition to the holder’s right
to convert the Series A Preferred Stock at any time, provided that the Common Stock underlying the Series A Preferred Stock is
registered under an effective registration statement or is available for resale under Rule 144, without limitation, all outstanding
shares of the Series A Preferred Stock automatically converted into shares of Common Stock at the earlier to occur of (i) February
22, 2013, the 24 month anniversary of the Closing Date of the issuance of the Series A Preferred Stock, or (ii) at such time that
the volume-weighted average price of the Company’s Common Stock is equal to or greater than $3.00 (as may be adjusted for
any stock splits or combinations of the Common Stock) for a period of ten consecutive trading days and such Common Stock has an
average daily trading volume, for ten consecutive trading days, equal to or greater than 50,000 shares.
On
February 22, 2013, in accordance with its terms, all 4,274,703 shares of Series A Preferred Stock outstanding automatically converted
into 4,274,703 shares of common stock.
Securities Purchase Agreement
On February 22, 2011 (the “Closing
Date”), the Company completed a private placement (the “Offering”) of 474,967 units at a purchase price of $13.50
per unit, each unit consisting
of:(i) nine shares of the Company’s Series A Preferred
Stock, convertible on a one to one basis into nine shares of the Company’s common stock; (ii) one share of Common Stock;
(iii) two three-year Series A Warrants (the “Series A Warrants”), each exercisable for the purchase of one share of
Common Stock, at an exercise price of $2.00 per share; and (iv) two three-year Series B Warrants (the “Series B Warrants”),
each exercisable for the purchase of one share of Common Stock, at an exercise price of $3.00 per share.
The Company received
aggregate gross proceeds of $6,412,055. The Offering was conducted pursuant to a Securities Purchase Agreement (the “Agreement”)
between the Company and various accredited investors (the “Investors).
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
16. Sale of Common Stock, Series A Preferred Stock and Warrants
Because certain of the instruments issued
in the Offering are derivative instruments which will be initially and continuously carried at fair value, we believe the aggregate
proceeds received should be allocated following the principles implicit in the guidance at ASC 815-15-30-2. The proceeds are first
allocated to those derivative instruments that will initially and continuously be carried at fair value. The remaining proceeds,
if any, are then allocated between the non-derivative host contract and other non-derivative instruments on a relative fair value
basis.
The Company reviewed the features of the
Series A Preferred Stock, other than the conversion feature, and concluded that, on balance, the terms and features of the host
contract should be considered to be more akin to a debt instrument. Accordingly, the embedded conversion option may be required
to be bifurcated and accounted for as a derivative instrument unless it meets the exemption provided by ASC 815-10-15-74a.
The conversion price of the Series A Preferred
Stock is subject to adjustment if the Company subsequently sells Common Stock at a lower price. Also, as described below for the
Warrants, the conversion option is denominated in U.S. dollars, a currency other than the Company’s functional currency.
Accordingly, the embedded conversion option is not considered to be indexed only to the Company’s common stock. In addition,
the Company may be required to redeem the Series A Preferred Stock for cash if, on receipt of a conversion request, it is unable
to issue shares registered for resale for any reason. In addition, the conversion price of the Series A Preferred Stock is subject
to adjustment if the Company subsequently sells Common Stock at a lower price but there is no explicit limit on the number of shares
that the Company may be required to issue. As a result of the foregoing, the exemption provided by ASC 815-10-15-74a is not available
and the embedded conversion option has been bifurcated and accounted for as a derivative liability. Because the embedded conversion
option has been bifurcated and accounted for as a derivative liability, no beneficial conversion option was required to be recognized.
Warrants
The Series A and Series B Warrants are
exercisable at any time and from time to time at an exercise price of $2.00 and $3.00 per share, respectively, and expired on February
22, 2014. The holder may elect a cashless exercise of the Warrants beginning 12 months after the issuance date but only if the
shares underlying the Warrants are not registered for sale.
The Warrants contain standard anti-dilution
adjustments for stock splits and similar events but the exercise price is not otherwise subject to adjustment.
The Company may call the Series A and Series
B Warrants for redemption at a redemption price of $0.01 per Warrant share if the shares underlying the Warrants are registered
for sale and the volume-weighted average price of the Company’s Common Stock is equal to or greater than $6.00 per share
or $9.00 per share, respectively, for a period of ten consecutive trading days and such Common Stock has an average daily trading
volume, for ten consecutive trading days, equal to or greater than 75,000 shares per day.
The Warrants are free-standing derivative
instruments. Although the Company is a U.S. entity, the Company has no U.S. operations and all of its operations are conducted,
through its subsidiaries, in the People’s Republic of China. Accordingly, because the Company is fully invested in China
and those operations in China represent the Company’s only source of future revenues or income, the Company concluded that
its functional currency should be considered to be the RMB. As a result, because the Warrants are denominated in U.S. dollars,
they are denominated in a currency different from the Company’s functional currency and therefore, in accordance with the
guidance at ASC 815-40-15-7I, the Warrants are not considered to be indexed only to the Company’s common stock. As a result,
the exemption provided by ASC 815-10-15-74a is not available and the Warrants are recorded as a derivative liability.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
16. Sale of Common Stock, Series A Preferred Stock and Warrants
(Continued)
Registration Rights Agreement
In connection with the Offering, the Company
entered into a Registration Rights Agreement with the Investors, in which the Company agreed to file a registration statement to
register for resale the Common Stock and the Common Stock issuable upon conversion of the Series A Preferred Stock and exercise
of the Series A and Series B Warrants, within 45 calendar days of the Closing Date, and to have the registration statement declared
effective within 150 calendar days of the Closing Date or within 180 calendar days of the Closing Date in the event of a full review
of the registration statement by the Securities and Exchange Commission. If the Company does not comply with the foregoing obligations
under the Registration Rights Agreement, the Company will be required to pay cash liquidated damages to each Investor, at the rate
of 1% of the applicable subscription amount for each 30 day period or part thereof in which we are not in compliance; provided,
that such liquidated damages will be capped at 10% of the subscription amount of each Investor and will not apply to any securities
that may be sold pursuant to Rule 144 under the Securities Act, or which are subject to an SEC restriction with respect to Rule
415 under the Securities Act.
The required registration statement was
filed by the required due date. However, the Company did not meet the deadline to render its S-1 registration statement effective.
At December 31, 2012, the Company has accrued $641,200 for the estimated liquidated damages it expects to pay.
Placement Agent Fees
In connection with the Offering, the Company
paid its placement agents (i) a cash fee of 7% of the gross proceeds from sale of the Units, (ii) a cash management fee of 1% and
(iii) a 0.5% non-accountable expense allowance. In addition to these placement agent cash fees aggregating $545,025, the Company
paid $181,415 in legal fees and other expense related to the Offering. After payment of the placement agent cash fees and legal
and other expenses, the Company received net proceeds of $5,675,614.
In addition, the placement agents received
warrants to purchase such number of securities equal to 9% of the aggregate number of shares of common stock issuable in connection
with the Units (the “Placement Agent Warrants”). The Placement Agent Warrants expire after three years and are exercisable
at the following prices: (i) 427,740 Warrants - $1.35 per share (ii) 85,494 Series A Warrants - $2.00 per share and (iii) 85,494
Series B Warrants - $3.00 per share. The terms of the Warrants, including anti-dilution protection for stock splits and similar
events, are similar to the Warrants issued to the Investors, except that the 427,740 Warrants do not permit the Company to call
the Warrants.
Securities Escrow Agreement
In connection with the Offering, we also
entered into a Securities Escrow Agreement with the Investors and Mr. Dishan Guo (the “Stockholder”), the Company’s
chairman and principal stockholder, pursuant to which the Stockholder placed in escrow one share of our Common Stock for each $10
of Units sold to the Investors, equal to 641,205 shares of Common Stock (the “Escrow Shares”). The escrow agreement
establishes a performance threshold for the Company based on net income (as defined and subject to certain non-cash adjustments)
for the year ending December 31, 2011 of $10,000,000. If the Company achieves 95% or more of the performance threshold, the shares
will be returned to the Stockholder. If the Company’s net income is less than $9,500,000, then the shares will be delivered
to the Investors in the amount of 10% of the escrow shares for each full percentage point by which such performance threshold was
not achieved, up to a maximum of the 641,205 shares placed in escrow.
The Stockholder’s agreement to place
the shares in escrow was undertaken in his capacity as a major stockholder of the Company. In accordance with the guidance at ASC
718-10-S99-2, the Company does not believe the potential return of the shares to the Stockholder is compensatory because such return
is not contingent on his continued employment with the Company. The Investors who may receive shares under the escrow arrangement
have no relationship with the Company other than in their capacity as shareholders.
The shares are outstanding and are included
in the weighted average shares outstanding for purposes of computing basic earnings per share.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
16. Sale of Common Stock, Series A Preferred Stock and Warrants
(Continued)
Lock-up Agreement
On the Closing Date, the Company entered
into a lock-up agreement (the “Lock-Up Agreement”) with the Stockholder whereby the Stockholder is prohibited from
selling our securities that they directly or indirectly own (the “Lock-Up Shares”) until nine months after the Registration
Statement is declared effective (the “Lock-Up Period”). In addition, the Stockholder further agreed that during the
12 months immediately following the Lock-Up Period, the Stockholder will not offer, sell, contract to sell, assign or transfer
more than 0.833% of the Lock-Up Shares during each calendar month following the Lock-Up Period, other than engaging in a transfer
in a private sale of the Lock-Up Shares if the transferee agrees in writing to be bound by and subject to the terms of the Lock-Up
Agreement.
Accounting for Derivative Instruments
The Warrants and Placement Agent Warrants
are derivative instruments as defined in ASC 815-10-15-83. ASC 815-10-15-74 provides that a contract that would otherwise meet
the definition of a derivative instrument but that is both (a) indexed to a company’s own stock and (b) classified in stockholders’
equity in the statement of financial position would not be considered a derivative financial instrument. FASB ASC 815-40-15 and
815-40-25 provide guidance for determining whether those two criteria are met. For purposes of this evaluation, the Company has
concluded that the Company’s functional currency is the Renminbi. Because the Warrants are denominated in U.S. Dollars, FASB
ASC 815-40-15-7I provides that they are not considered to be indexed only to the Company’s Common Stock. Accordingly, the
exemption in FASB ASC 815-10-15-74 is not available and the Warrants are classified as a derivative instrument liability.
The Series A Preferred Stock is a hybrid
financial instrument that embodies the risks and rewards typically associated with both equity and debt instruments. Accordingly,
we are required to evaluate the features of this contract to determine its nature as either an equity-type contract or a debt-type
contract. We determined that the Series A Preferred Stock is generally more akin to a debt-type contract, principally due to its
potential redemption requirements, its fixed rate quarterly dividend requirement and its lack of voting rights. This determination
is subjective. However, in complying with the guidance provided in FASB ASC 815, we concluded, based upon the preponderance and
weight of all terms, conditions and features of the host contract, that the Series A Preferred Stock was more akin to a debt instrument
for purposes of considering the clear and close relationship of the embedded derivative features to the host contract. ASC 815
requires bifurcation when the embedded derivative features and the host contract have risks that are not clearly and closely related.
Certain exemptions to this rule, such as that for conventional convertible instruments that are convertible into a fixed number
of shares, were not available to us because the conversion price of the Series A Preferred Stock is not fixed and will be adjusted
if the Company sells shares of Common Stock at a price lower than the conversion price. Also, because the conversion price of the
Series A Preferred Stock is denominated in U.S. Dollars, as for the warrants discussed above, the embedded conversion option is
not considered to be indexed only to the Company’s Common Stock. In addition, the Company may be required to redeem the Series
A Preferred Stock if it is unable to deliver registered shares on conversion. Accordingly, the exemption in FASB ASC 815-10-15-74
is not available and the embedded conversion option, along with certain other features of the Series A Preferred Stock that have
risks of equity, required bifurcation and classification in liabilities as a compound embedded derivative financial instrument.
Derivative financial instruments are initially measured at their
fair value and are then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income.
Valuation of Derivative Instruments
The Warrants and the Placement Agent Warrants
were initially valued, using a binomial model, at $649,821 and $262,966, respectively, based on the quoted market price of the
Common Stock of $1.00 per share, a term equal to the remaining life of the Warrants, an expected dividend yield of 0%, a risk-free
interest rate of 1.32% based on constant maturity rates published by the U.S. Federal Reserve applicable to the remaining life
of the Warrants and estimated volatility of 85%, based on a review of the historical volatility of publicly-traded companies considered
by management to be comparable to the Company.
The compound embedded derivative financial
instrument related to the Series A Preferred Stock, consisting primarily of the embedded conversion option, was initially valued,
using a binomial model, at $1,604,794, based on the quoted market price of the Common Stock of $1.00, a term equal to the expected
life of the conversion option, an expected dividend yield of 0%, a risk-free interest rate of 0.78% based on constant maturity
rates published by the U.S. Federal Reserve applicable to the expected life and estimated volatility of 85%.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
16. Sale of Common Stock, Series A Preferred Stock and Warrants
(Continued)
After allocating a portion of the proceeds
received to the fair value of the Warrants and the embedded derivative instrument in the Series A Preferred Stock, the remaining
proceeds were allocated to the Common Stock component of the Units and the carrying value of the Series A Preferred Stock host
contract.
On February 22, 2013, all outstanding shares
of the Series A Preferred Stock were converted to common stock. As of that date, the conversion feature of the Series A Preferred
Stock was out-of-the-money and accordingly had no value. The aggregate change in the fair value of the embedded derivative instrument
related to the Series A Preferred Stock between December 31, 2012 and February 22, 2013 of $64,280 has been credited to income.
At December 31, 2013, the Warrants, the
Placement Agent Warrants and the embedded derivative instrument related to the Series A Preferred Stock were re-valued at $-0-,
$-0- and $-0-, respectively, because of their short remaining life with expiration date on February 14, 2014 and the recent low
volatility of the stock price. The aggregate change in the fair value of the derivative liabilities between December 31, 2012 and
December 31, 2013 of $393,534 has been credited to income.
Accounting for Series A Preferred Stock
$3,682,473 of the proceeds received was
allocated to the carrying value of the Series A Preferred Stock host contract. The 4,274,703 shares of Series A Preferred Stock
have a liquidation value of $5,770,849. Because the Series A Preferred Stock has conditions for its redemption that are outside
our control, it is classified outside of Stockholders’ Equity, in the mezzanine section of our balance sheet, in accordance
with ASC 480-10-S99-3A. Because the Series A Preferred Stock is not currently redeemable and the Company currently believes that
it is not probable that it will become redeemable, no adjustment of the carrying value of the Series A Preferred Stock has been
recognized. If it becomes probable that the Series A Preferred Stock will be redeemed, it will be adjusted to its redemption value.
Placement Agent Fees
The placement agent cash fees of $545,025,
other expenses related to the sale of the Units of $181,415 and the initial fair value of the Placement Agent Warrants of $262,966,
aggregating $989,406, have been charged to additional paid-in capital.
Advisory Fees
On November 22, 2010, the Company entered
into a 12 month Advisory Agreement with an affiliate of its placement agent, under which the affiliate agreed to render on-going
financial advisory and investment banking services to the Company. As compensation for its services, the Company agreed to pay
a monthly fee of $10,000, payable on the first day of each month after the completion of a Transaction, as defined in the agreement
between the Company and its placement agent. Payment of these fees commenced on March 1, 2011, following completion of the sale
of the Units.
The Company also agreed to place in escrow
for issuance to the affiliate a total of 400,000 shares of Common Stock, with 200,000 shares to be released following the completion
of a Transaction, 100,000 shares to be released six months after the completion of a Transaction and 100,000 shares to be released
12 months after the completion of a Transaction. In accordance with ASC 505-50-25-7, the Company concluded that the value of the
shares should be measured at the date the Transaction was completed because the shares are effectively fully vested as of that
date and non-forfeitable and the agreement does not provide for any further specific performance criteria to be met. The Company
valued the shares issued at $1.00 per share (based on the quoted market price), resulting in compensation expense for the services
rendered and to be rendered of $400,000. The expense related to the services provided and to be provided was recognized over the
period from November 22, 2010, the date from which services commenced under the agreement, to the one year anniversary, when the
agreement expired. At December 31, 2011, the expense has been fully recognized.
In addition to the above fees, the Company
issued 50,000 shares to its legal counsel, in consideration for their introducing the Company to the placement agent. The cost
of these shares, which were valued at $1.00 per share (determined as described above) were expensed during the year ended December
31, 2011.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
16. Sale of Common Stock, Series A Preferred Stock and Warrants
(Continued)
Fair Value Considerations
As required by FASB ASC 820, assets and
liabilities measured at fair value are classified in their entirety based on the lowest level of input that is significant to their
fair value measurement. Our derivative financial instruments that are measured at fair value on a recurring basis under FASB ASC
815 are all measured at fair value using Level 3 inputs. Level 3 inputs are unobservable inputs that are supported by little or
no market activity and that are significant to the fair value of the assets or liabilities.
The following represents a reconciliation
of the changes in fair value of financial instruments measured at fair value using Level 3 inputs during the year ended December
31, 2013:
|
|
Preferred –
Embedded
Derivative
|
|
|
Warrants
|
|
|
Total
|
|
Beginning balance, December 31, 2012
|
|
$
|
64,280
|
|
|
$
|
329,254
|
|
|
$
|
393,534
|
|
Fair value adjustments
|
|
|
(64,280
|
)
|
|
|
(329,254
|
)
|
|
|
(393,534
|
)
|
Ending balance, December 31, 2013
|
|
$
|
-
|
|
|
$
|
-
|
|
|
$
|
-
|
|
Estimating fair values of derivative financial
instruments requires the development of significant and subjective estimates that may, and are likely to, change over the duration
of the instrument with related changes in internal and external market factors. In addition, valuation techniques are sensitive
to changes in the estimated fair value of our common stock and our estimates of its volatility. Because derivative financial instruments
are initially and subsequently carried at fair values, our income will reflect the volatility in these estimate and assumption
changes.
17. Commitments and
Contingencies
Operating Leases
In
the normal course of business, the Company leases office space and internet cafes under operating leases agreements, which expire
through 2017. The Company rents internet cafes venues and office space, primarily for regional sales administration offices that
are conducive to administrative operations. The operating leases agreements generally contain renewal options that may be exercised
in the Company's discretion after the completion of the base rental terms. In addition, many of the leases provide for regular
increases to the base rental rate at specified intervals, which usually occur on an annual basis.
As
of December 31, 2013, the Company was obligated under operating leases requiring minimum rentals as follows:
Fiscal year
|
|
|
|
2014
|
|
$
|
2,555,828
|
|
2015
|
|
|
1,459,750
|
|
2016
|
|
|
320,386
|
|
2017
|
|
|
4,846
|
|
|
|
$
|
4,340,810
|
|
During
the year ended December 31, 2013, rent expenses amounted to $2,815,315, of which $2,747,167 and $68,148 were recorded as cost of
sales and general and administrative expense, respectively.
During
the year ended December 31, 2012, rent expenses amounted to $2,396,870, of which $2,326,337 and $70,533 were recorded as cost of
sales and general and administrative expense, respectively.
Social
Benefits Coverage
We
have obtained social benefits coverage for employees who work at the Junlong headquarters. For other employees, because of the
high mobility of their work, and the difficulty of transferring social benefits coverage from one province to another, they usually
work on a probationary basis and do not enter into long employment relationships with us. Because the cost of social benefits coverage
is considerable compared to their total monthly income, the Company allows the employees to decide whether or not to pay the social
benefits coverage. It is reasonable to assume that the company is subject to administrative fines and penalties as a result of
its failure to obtain social insurance for these employees.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
18. Concentrations
The
Company did not have any customer constituting greater than 10% of net sales for the years ended December 31, 2013 and 2012.
At
December 31, 2013 and 2012, there was one supplier of consignment snacks and drinks with amounts due from the Company of $227,981
and $-0-, respectively, which accounted for 100% and 100% of the Company’s account payable.
19. Operating Risk
and Uncertainties
Interest
rate risk
The
interest rates and terms of repayment of bank and other borrowings are disclosed in Note 9. Other financial assets and liabilities
do not have material interest rate risk.
Foreign
currency risk
Most
of the transactions of the Company were settled in Renminbi. In the opinion of the directors, the Company does not have significant
foreign currency risk exposure.
Company’s
operations are substantially in foreign countries
Substantially
all of the Company’s services are provided in China. The Company’s operations are subject to various political, economic,
and other risks and uncertainties inherent in China. Among other risks, the Company’s operations are subject to the risks
of restrictions on transfer of funds; export duties, quotas, and embargoes; domestic and international customs and tariffs; changing
taxation policies; foreign exchange restrictions; and political conditions and governmental regulations.
The
Chinese government began tightening its regulation of internet cafes in 2001. In particular, a large number of unlicensed internet
cafes have been closed. In addition, the Chinese government has imposed higher capital (RMB10,000,000 is required for a regional
internet café chain and RMB50,000,000 is required for a national internet café chain) and facility requirements for
the establishment of internet cafes. Furthermore, the Chinese government’s policy, which encourages the development of a
limited number of national and regional internet cafe chains and discourages the establishment of independent internet cafes, may
slow down the growth of internet cafes. Recently, the Ministry of Culture, together with other government authorities, issued a
joint notice suspending the issuance of new internet cafe chain licenses. Any intensified government regulation of internet cafes
could restrict our ability to maintain and expand our internet cafes.
Currently,
the Company uses only one internet service provider. However, there are other internet service providers available to the Company.
The management of the Company believes that the risk of loss of internet services is not that high because other service providers
are available to the Company.
20. Segment Information
The
Company applies the provisions of ASC 280, "Disclosures about Segments of an Enterprise and Related Information". The
Company views its operations and manages its business as one segment: the operation of an internet café chain. Factors used
to identify the Company's single operating segment include the organizational structure of the Company and the financial information
available for evaluation by the chief operating decision-maker in making decisions about how to allocate resources and assess performance.
The Company operates predominantly in one geographical area, the PRC.
CHINA
INTERNET CAFE HOLDINGS GROUP, INC. AND SUBSIDIARIES
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE YEARS ENDED DECEMBER 31, 2013 AND 2012
21. Subsequent Events
On
January 27, 2014, the Company entered into a health products distribution agreement (the “Distribution Agreement”)
with Beijing Eastern Union Medical Biotechnology, Ltd. and its subsidiary Ningxia Eastern Outai Medicine, Ltd. (collectively, “Eastern
Union”) to distribute and sell Eastern Union’s Yiyou Series of nutriceutical products including melatonin tablets,
Vitamin B tablets, calcium and zinc chewable tablets and multi-vitamin tablets (the “Products”). Pursuant to the agreement,
the Company will acquire the Products on consignment and sell them to customers on the non-medical market in Guangdong Province,
China, through the Company’s 62 internet cafés in Shenzhen, China. The agreement is valid from January 27, 2014 to
January 30, 2015. The Company has the right to renew the agreement upon termination.
On
February 22, 2014, in accordance with its terms, all Series A and Series B Warrants expired.
On
February 27, 2014, the Board approved the Company’s 2014 Incentive Stock Plan (the “2014” Plan). The 2014 Plan
provides for grant of incentive stock options, nonstatutory stock options, restricted stock, restricted stock purchase offers
and other types of stock-based awards to the Company’s employees, officers, directors and consultants. Pursuant to the terms
of the 2014 Plan, either the Board or a board committee designated by the Board is authorized to administer the plan, including
determining which eligible participants will receive awards, the number of shares of common stock subject to the awards and the
terms and conditions of such awards. Up to 2,568,952 shares of common stock are issuable pursuant to awards the 2014 Plan. Unless
terminated earlier by the Board, the 2014 Plan shall terminate at the close of business on February 26, 2024. As of the date of
this report, no shares have been granted under the 2014 Plan.
As of March 26, 2014, the Company has
evaluated subsequent events for potential recognition and disclosure through the date of the financial statement issuance.