Consolidated Financial Statements (Expressed in U.S. dollars) LOREX TECHNOLOGY INC.
KPMG LLP Telephone (416) 777-8500 Chartered Accountants Fax (416) 777-8818 Bay Adelaide Centre Internet www.kpmg.ca 333 Bay Street Suite 4600 Toronto ON M5H 2S5 Canada AUDITORS' REPORT TO THE SHAREHOLDERS We have audited the consolidated balance sheets of Lorex Technology Inc. as at September 30, 2009 and 2008 and the consolidated statements of operations and comprehensive income, shareholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at September 30, 2009 and 2008 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants, Licensed Public Accountants Toronto, Canada January 22, 2010 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. KPMG Canada provides services to KPMG LLP.
Consolidated Balance Sheets (Expressed in U.S. dollars) September 30, 2009 and 2008 2009 2008 Assets Current assets: Cash $ 315,293 $ 347,467 Accounts receivable 6,751,116 5,349,192 Inventory (note 3) 8,635,047 8,468,575 Prepaid expenses and deposits 823,485 865,259 Future income taxes (note 11) 94,709 15,435 16,619,650 15,045,928 Capital assets (note 4) 365,924 398,463 Intangible assets (note 5) 8,152 34,019 Future income taxes (note 11) 436,456 253,265 Goodwill (note 6) 710,069 718,309 Liabilities and Shareholders' Equity $ 18,140,251 $ 16,449,984 Current liabilities: Bank indebtedness (note 7) $ 6,162,184 $ 6,895,675 Accounts payable and accrued liabilities 6,028,536 5,375,340 12,190,720 12,271,015 Future income taxes (note 11) 10,709 47,924 Shareholders' equity: Capital stock (note 8) 9,746,310 9,746,310 Preferred share subscriptions (note 8) 1,119,087 Contributed surplus 1,328,941 1,223,227 Accumulated other comprehensive income 1,498,883 1,495,486 Deficit (7,754,399) (8,333,978) 5,938,822 4,131,045 Commitments and contingencies (note 17) Subsequent events (notes 1, 7 and 8) $ 18,140,251 $ 16,449,984 See accompanying notes to consolidated financial statements. On behalf of the Board: "Reuben Klein" "Beverly Lyons" Director Director 1
Consolidated Statements of Operations and Comprehensive Income (Expressed in U.S. dollars) 2009 2008 Revenue $ 46,810,408 $ 47,692,698 Cost of sales 31,235,958 32,417,657 Gross profit 15,574,450 15,275,041 Expenses: Marketing, selling and operations 9,351,222 10,326,865 Administration (note 13) 3,517,046 3,374,612 Research and development (note 10) 912,015 1,478,054 Interest 1,036,365 919,724 Amortization 277,957 611,069 Loss on foreign exchange 73,794 238,402 15,168,399 16,948,726 Profit (loss) before income taxes 406,051 (1,673,685) Income taxes (recovery) (note 11): Current 130,409 100,347 Future (303,937) (70,829) (173,528) 29,518 Profit (loss) for the year 579,579 (1,703,203) Other comprehensive income (loss) (note 1(c)): Unrealized gains (losses) on foreign currency translation of self-sustaining operations 3,397 (2,785) Comprehensive income (loss) $ 582,976 $ (1,705,988) Profit (loss) per share (note 12): Basic and diluted $ 0.02 $ (0.06) See accompanying notes to consolidated financial statements. 2
Consolidated Statements of Shareholders' Equity (Expressed in U.S. dollars) Accumulated Class B Preferred other Common preferred share Contributed comprehensive shares shares subscriptions surplus income (loss) Deficit Total Balance, September 30, 2007 $ 9,641,415 $ 104,895 $ $ 912,165 $ 1,498,271 $ (6,630,775) $ 5,525,971 Loss for the year (1,703,203) (1,703,203) Unrealized losses on foreign currency translation of self-sustaining operations (2,785) (2,785) Comprehensive loss (2,785) (1,703,203) (1,705,988) Options granted/forfeited 311,062 311,062 Balance, September 30, 2008 9,641,415 104,895 1,223,227 1,495,486 (8,333,978) 4,131,045 Profit for the year 579,579 579,579 Unrealized gains (losses) on foreign currency translation of self-sustaining operations 3,397 3,397 Comprehensive income 3,397 579,579 582,976 Options granted/forfeited 105,714 105,714 Receipts issued for preferred shares subscriptions (note 8) 1,119,087 1,119,087 Balance, September 30, 2009 $ 9,641,415 $ 104,895 $ 1,119,087 $ 1,328,941 $ 1,498,883 $ (7,754,399) $ 5,938,822 See accompanying notes to consolidated financial statements. 3
Consolidated Statements of Cash Flows (Expressed in U.S. dollars) 2009 2008 Cash provided by (used in): Operating activities: Profit (loss) for the year $ 579,579 $ (1,703,203) Items not involving cash: Amortization of capital and intangible assets 277,957 611,069 Stock option expense and stock-based compensation 112,928 305,881 Future income taxes (301,067) (76,785) Change in non-cash operating working capital: Accounts receivable (1,340,291) 2,476,973 Inventory (114,951) 3,169,394 Prepaid expenses and deposits 39,244 (113,532) Accounts payable and accrued liabilities 673,016 (1,083,252) (73,585) 3,586,545 Financing activities: Decrease in bank indebtedness (744,597) (3,436,357) Preferred share subscription 1,016,432 271,835 (3,436,357) Investing activities: Purchase of capital assets (229,162) (220,750) Effect of foreign currency translation on cash balances (1,262) (2,183) Decrease in cash (32,174) (72,745) Cash, beginning of year 347,467 420,212 Cash, end of year $ 315,293 $ 347,467 Supplemental cash flow information: Interest paid $ 642,464 $ 785,525 Income taxes paid 160,359 30,530 See accompanying notes to consolidated financial statements. 4
Notes to Consolidated Financial Statements LOREX Technology Inc. ("LOREX" or the "Company") (TSX:LOX) provides businesses and consumers with leading edge video surveillance security solutions and sells its products under the LOREX and Digimerge brands. The LOREX brand, which caters to both small business and consumer markets, is available in over 9,000 retail locations across North America and in the UK. The Digimerge division distributes its products through major distributors in both North America and Europe. Both brands concentrate on the sale of wired, wireless and IP security surveillance equipment including cameras, digital video recorders and all-in-one systems. 1. Significant accounting policies: (a) Basis of presentation: The Company, as at September 30, 2009, was in default on both of its credit facilities under its loan agreement. On December 22, 2009, the Company refinanced its bank indebtedness with a new lender and repaid both of the credit facilities which were in default. The amount available for borrowing under the new facility is subject to covenants which would be met if the Company achieves its 2010 business plan (notes 7 and 14). (b) Basis of consolidation: The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries: Lorex Canada Inc. (an Ontario corporation), Lorex Corporation (a Delaware corporation), Strategic Vista Corporation Limited (a Hong Kong corporation), Digimerge Technologies Inc. (an Ontario corporation), XBL Solutions Inc. (an Ontario corporation), and Strategic Vista Direct, Inc. (a Delaware corporation). Intercompany transactions and balances are eliminated on consolidation. 5
1. Significant accounting policies (continued): (c) Foreign currency translation: The Company uses the U.S. dollar as its reporting currency for preparation of its consolidated financial statements. The U.S. dollar is the functional currency of certain of the Company's subsidiaries, Digimerge Technologies Inc., Lorex Corporation and Strategic Vista Corporation Limited. For other U.S. subsidiaries that are considered fully integrated foreign operations with foreign currency transactions, non-canadian dollar monetary assets and liabilities are translated into Canadian dollars at the rate of exchange prevailing as at the consolidated balance sheet dates, while non-monetary assets and liabilities are translated at historical rates of exchange. Revenue and expenses are translated into Canadian dollars at the rate in effect at the date of transaction. Realized and unrealized foreign exchange gains and losses are included in income (loss) for the year in which they occur. The Company and its subsidiaries that use the Canadian dollar as the functional currency translate all assets and liabilities at the year-end exchange rate and all revenue and expense items are translated at an average rate of exchange for the year for U.S. dollar reporting. Exchange rate differences arising on translation are recorded as a separate component as accumulated other comprehensive income of shareholders' equity. (d) Cash: Cash includes bank balances. (e) Inventory: Inventory is stated at the lower of cost and net realizable value. Cost is determined on a weighted average basis. The Company performs a quarterly assessment of its inventory value, taking into consideration factors such as inventory reliability, future demand for the inventory, expected new product introductions, competitive pressures and numerous other factors. A change to these assumptions could impact the valuation of inventory and have a resulting impact on margins. 6
1. Significant accounting policies (continued): (f) Capital and intangible assets: Capital and intangible assets are stated at cost. Amortization is calculated on a straightline basis, not to exceed estimated useful life, over the following terms: Property, plant and equipment: Furnishings and equipment Computer hardware and software Website Leasehold improvements Displays Product development: Tooling Product design Intangible assets: Patents, trademarks and licenses Purchased trademarks 3 years 3 years 3 years 3 years 2 years 3 years 3 years 3 years 5 years (g) Impairment of long-lived assets: The Company conducts its impairment test on long-lived assets, including capital and intangible assets, when events or changes in circumstances indicate that the carrying amount may not be recoverable. Management reviews the carrying value of the assets and considers whether an impairment charge should be recorded. The review is based on the assessment of the Company's intended use and projected estimated undiscounted cash flows expected from the underlying assets. Any impairment amount is measured as the amount by which the carrying amount of the asset exceeds its fair value, calculated using the discounted cash flows when quoted market prices are not available. (h) Goodwill: Goodwill is the residual amount that results when the purchase price of an acquired business exceeds the sum of the amounts allocated to the assets acquired, less liabilities assumed, based on their fair values. The amount of goodwill disclosed on the consolidated balance sheets has changed during the year due to foreign exchange. 7
1. Significant accounting policies (continued): Goodwill is not amortized and is tested for impairment annually, or more frequently, if events or changes in circumstances indicate that the asset might be impaired. The impairment test is carried out in two steps. In the first step, the carrying amount of the reporting unit is compared with its fair value. When the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary. The second step is carried out when the carrying amount of a reporting unit exceeds its fair value, in which case, the implied fair value of a reporting unit's goodwill is compared with its carrying amount to measure the amount of the impairment loss, if any. The implied fair value of goodwill is determined in the same manner as the value of goodwill is determined in a business combination, using the fair value of the reporting unit as if it was the purchase price. When the carrying amount of reporting unit goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to the excess and is presented as a separate line in the statement of operations and comprehensive income. The Company conducted its annual goodwill assessment in the fourth quarter of fiscal 2009 and 2008 and concluded there was no impairment in the recorded value of the goodwill. (i) Research and development costs: Research costs are expensed as incurred. Development costs are expensed as incurred unless the development project is for a technically feasible product that management intends to produce and market and for which the intended market is clearly defined and adequate resources exist to complete the project. Deferred development costs will be amortized on a straight-line basis over a three-year period commencing with commercial production or use of the products under development. (j) Stock-based compensation: The Company accounts for stock option payments using the fair value method. Under the fair value method, stock-based payments are measured at the fair value of equity instruments determined using the Black-Scholes option pricing model and are amortized over the vesting period. The offset to the recorded cost is contributed surplus. For modified stock options, the fair value of the modified stock options was compared to the fair value of the options immediately before their terms were modified using the Black-Scholes option pricing model to determine the amount to be expensed for the modification. 8
1. Significant accounting policies (continued): (k) Revenue recognition: The Company earns all of its revenue from the sale of products to its customers. Revenue is recognized when title passes to customers, which is generally at the time goods are received by the customer, and when there is reasonable assurance of the consideration that will be received, taking into account the extent to which goods may be returned. Cash discounts, volume discounts and certain marketing programs provided to customers are deducted from revenue when earned. (l) Income taxes: The Company provides for income taxes using the asset and liability method of accounting for income taxes. Under this method, future income tax assets and liabilities are determined based on differences between financial statement values and tax values of assets and liabilities and are measured using substantively enacted income tax rates and laws expected to be in effect when the differences are expected to reverse. The Company establishes a valuation allowance against future income tax assets if, based on available information, it is more likely than not that some or all of the future income tax assets will not be realized. (m) Profit (loss) per share: Basic profit (loss) per share is calculated using the weighted average number of common shares outstanding during the year. The computation of diluted profit (loss) per share assumes the basic weighted average number of shares outstanding during the year is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive common shares had been issued. The dilutive effect of warrants, Class B preferred shares, preferred share subscriptions and stock options is determined using the treasury stock method. 9
1. Significant accounting policies (continued): (n) Use of estimates: The preparation of financial statements requires management to make 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 and the reported amounts of revenue and expenses during the year. Significant estimates are used in determining, but are not limited to, the allowance for doubtful accounts, provision for returns, inventory valuation, income tax valuation allowances, the useful lives and valuation of capital and intangible assets, goodwill and product development and the fair value of the reporting units for purposes of goodwill impairment. Actual results could differ from those estimates. (o) Comparative figures: Certain comparative figures have been reclassified to conform with the financial statement presentation adopted in the current year. 2. Changes in accounting policies and recent Canadian accounting pronouncements: (a) Changes in accounting policies: (i) Goodwill and intangible assets: In February 2008, The Canadian Institute of Chartered Accountants ("CICA") issued Handbook Section 3064, Goodwill and Intangible Assets ("Section 3064"). Section 3064 states that upon their initial identification, intangible assets are to be recognized as assets only if they meet the definition of an intangible asset and the recognition criteria. This section also provides further information on the recognition of internally generated intangible assets, including research and development costs. As for subsequent measurement of intangible assets, goodwill, and disclosure, Section 3064 carries forward the requirements of the old Handbook Section 3062, Goodwill and Other Intangible Assets. The new section was effective on October 1, 2008, however, the Company concluded that this section did not impact the consolidated financial statements. 10
2. Changes in accounting policies and recent Canadian accounting pronouncements (continued): (ii) Financial instruments: Effective October 1, 2007, the Company adopted CICA Handbook Section 3862, Financial Instruments - Disclosures ("Section 3862"), Section 3863, Financial Instruments - Presentation ("Section 3863"), and Section 1535, Capital Disclosures ("Section 1535"). Section 3862 requires entities to provide disclosure in their financial statements that enable users to evaluate the significance of financial instruments on an entity's financial position and its performance and the nature and extent of risks arising from financial instruments to which the entity is exposed during the year and at the balance sheet date, and how the entity manages those risks. Section 3863 establishes standards for presentation of financial instruments and nonfinancial derivatives. It deals with the classification of financial instruments, from the perspective of the issuer, between liabilities and equities, the classification of related interest, dividends, gains and losses, and circumstances in which financial assets and financial liabilities are offset. Section 1535 establishes standards for disclosing information about an entity's capital and how it is managed. It describes the disclosure requirements of the entity's objectives, policies and processes for managing capital, the quantitative data relating to what the entity regards as capital, whether the entity has complied with capital requirements, and, if it has not complied, the consequence of such non-compliance. The adoption of these standards did not have any impact on the classification and measurement of the Company's financial instruments. The disclosures pursuant to these Handbook sections are included in notes 14 and 16. 11
2. Changes in accounting policies and recent Canadian accounting pronouncements (continued): (iii) Credit risk and fair values of financial assets and liabilities: In January 2009, the CICA issued Emerging Issues Committee ("EIC") Abstract No. 173, Credit Risk and the Fair Value of Financial Assets and Financial Liabilities. The EIC provides guidance on evaluating credit risk of an entity and counterparty when determining the fair value of financial assets and financial liabilities, including derivative instruments. The application of this EIC had no effect on the Company's consolidated financial statements. (b) Recent Canadian accounting pronouncements: (i) Consolidated financial statements: In January 2009, the CICA issued Handbook Section 1601, Consolidated Financial Statements, which replaces the existing standards. This Section establishes the standards for preparing consolidated financial statements and is effective for 2011. Earlier adoption is permitted. Management is currently evaluating the impact of adopting this standard on the Company's consolidated financial statements. (ii) Financial instruments - disclosures: In June 2009, the CICA amended Handbook Section 3862, Financial Instruments - Disclosures, to include additional disclosure requirements about fair value measurement for financial instruments and liquidity risk disclosures. These amendments require a three-level hierarchy that reflects the significance of the inputs used in making the fair value measurements. Fair value of financial assets and financial liabilities included in Level 1 are determined by reference to quoted prices in active markets for identical assets and liabilities. Assets and liabilities in Level 2 include valuations using inputs other than the quoted prices for which all significant inputs are based on observable market data, either directly or indirectly. Level 3 valuations are based on inputs that are not based on observable market data. This amended standard is effective for annual financial statements relating to fiscal years ending after September 30, 2009. Management is currently evaluating the impact of adopting this standard on the Company's consolidated financial statements. 12
3. Inventory: 2009 2008 Goods on hand $ 6,531,851 $ 6,493,203 Goods in transit 1,922,196 1,805,872 Other inventory 181,000 169,500 $ 8,635,047 $ 8,468,575 The Company makes routine assessments to ensure that all inventory is recorded at the lower of cost and net realizable value and, in 2009, recorded in its cost of sales an amount of $701,190 (2008 - $1,086,405) in relation to amounts for certain items determined to exceed the net realizable value. 4. Capital assets: Accumulated Net book 2009 Cost amortization value Property, plant and equipment: Furnishings and equipment $ 343,087 $ 195,491 $ 147,596 Computer hardware and software 517,219 512,161 5,058 Website 118,968 118,968 Leasehold improvements 174,815 99,553 75,262 Displays 47,361 47,361 1,201,450 973,534 227,916 Product development: Tooling 460,057 322,049 138,008 $ 1,661,507 $ 1,295,583 $ 365,924 13
4. Capital assets (continued): Accumulated Net book 2008 Cost amortization value Property, plant and equipment: Furnishings and equipment $ 179,418 $ 174,157 $ 5,261 Computer hardware and software 522,996 488,089 34,907 Website 120,348 106,703 13,645 Leasehold improvements 97,276 88,693 8,583 Displays 51,864 47,363 4,501 971,902 905,005 66,897 Product development: Tooling 2,527,981 2,196,578 331,403 Product design 433,117 432,954 163 2,961,098 2,629,532 331,566 $ 3,933,000 $ 3,534,537 $ 398,463 5. Intangible assets: Accumulated Net book 2009 Cost amortization value Patents, trademarks and licenses $ 5,865 $ 4,415 $ 1,450 Purchased trademarks 243,886 237,184 6,702 $ 249,751 $ 241,599 $ 8,152 Accumulated Net book 2008 Cost amortization value Patents, trademarks and licenses $ 256,409 $ 237,717 $ 18,692 Purchased trademarks 246,717 231,390 15,327 $ 503,126 $ 469,107 $ 34,019 14
6. Goodwill: On September 29, 2003, the Company, through one of its subsidiaries, acquired the operating assets of Mansoor Electronics Inc., a Markham, Ontario based distributor of video surveillance and alarm products. An amount of Cdn. $761,336 was recorded for goodwill as part of the fair value of the assets acquired. The difference in the current year's recorded amount is due to foreign exchange differences. 7. Bank indebtedness: As at September 30, 2009, the Company was in default of its credit facilities which included a $13,000,000 credit facility for revolving credit loans that bore interest at the 90-day LIBOR rate plus 4.75%. The $13,000,000 facility was for a three-year term expiring on May 31, 2010. The credit line was secured by the accounts receivable and inventory of the Company's subsidiaries. The amount available under the facility was subject to certain financial ratios, as defined by the agreement. As of September 30, 2009, the Company had $5,717,752 (2008 - $5,784,571) outstanding under this facility and $250,000 (2008 - $250,000) in letters of credit outstanding. In addition, a separate credit facility of $2,000,000 was established by the Company with the same lender that bore interest at 90-day LIBOR rate plus 5.75%. The $2,000,000 facility was repayable in equal instalments over a 36-month term expiring on May 31, 2010. As of September 30, 2009, the unamortized balance of this facility was $444,432 (2008 - $1,111,104). The credit facility was secured by the accounts receivable and inventory of the Company's subsidiaries. Subsequent to year end, on December 22, 2009, the Company refinanced its bank indebtedness with a new lender and subsequently terminated and repaid both of its old credit facilities outstanding of $4,200,000 and incurred a prepayment fee of $260,000 which is included in accounts payable and accrued liabilities. The new credit facility consists of $10,000,000 for revolving credit loans that bear interest at the U.S. floating base rate plus 1.75% for loan balances denominated in U.S. dollars, and at the Canadian floating prime rate plus 1.75% for loan balances denominated in Canadian dollars. The $10,000,000 facility is for a three-year term expiring on December 21, 2012. The credit line is secured by the accounts receivable and inventory of the Company's subsidiaries. The amount available for borrowing under the facility is subject to a financial ratio, as defined by the agreement. The new credit facility imposes a debt covenant, which consists of a quarterly minimum fixed charge coverage ratio. 15
7. Bank indebtedness (continued): In relation to the credit facilities entered into during fiscal 2007, the Company issued 500,000 warrants at a strike price of Cdn. $0.3025 to the lender. Using the Black-Scholes model, the fair value of the warrants of $105,567 and the finance costs of $271,556 related to the loan were deferred and are accounted for using the effective interest method over 36 months. The fair value of the warrants was recorded to contributed surplus. The following were the assumptions used to derive the Black-Scholes model value of Cdn. $0.224: Risk-free interest rate 4.54% Expected life 5 years Expected volatility 81% Expected dividends The warrants expire the earlier of the term of the facility and May 31, 2012. As a result of a replacement of the facility on December 22, 2009, the warrants expired on January 21, 2010. As at September 30, 2009, the weighted average interest rate on the Company's borrowings was 7.73% (2008-7.57%). 8. Capital stock: 2009 2008 Authorized: 200,000 Class A preferred shares with an 8% cumulative dividend accruing from January 1, 1998, redeemable at the option of the Company at $1 per share 150,000 Class B preferred shares with an 8% cumulative dividend accruing from January 1, 1998, redeemable at the option of the Company at $1 per share Unlimited common shares Issued: 150,000 Class B preferred shares $ 104,895 $ 104,895 26,954,083 common shares 9,641,415 9,641,415 9,746,310 9,746,310 12,500,000 preferred share subscriptions 1,119,087 $ 10,865,397 $ 9,746,310 16
8. Capital stock (continued): No dividends have been declared or paid on the common shares and Class B preferred shares. At September 30, 2009, there were $131,505 (Cdn. $141,000) (2008 - $121,710 (Cdn. $129,000)) in unpaid cumulative dividends on the Class B preferred shares. In 2009, the Company issued receipts for 12,500,000 preferred shares of a new Class which would each be convertible to the holder into one common share of the Company. The new preferred shares would rank senior to the common shares of the Company, the non-voting Class A preferred shares and the non-voting Class B preferred shares with respect to a distribution of the Company's assets upon dissolution or wind-up of the Company and would otherwise have the same voting and dividend rights as the common shares. Subsequent to year end, the Company issued the preferred shares. Subsequent to the year end, on October 7, 2009, the Company raised an additional $409,500 for working capital needs by issuing 4,336,195 common shares at Cdn. $0.10. 9. Stock-based compensation: The Company's 1999 and 2007 stock option plans have been established for the benefit of the members of the Board of Directors, officers, full-time employees and consultants of the Company and its subsidiaries. The Company has set aside an aggregate of 6,500,000 common shares for issuance arising from the exercise of options under these plans. The exercise price of each option is determined by the Board of Directors but shall not be less than the closing market price on the last trading day prior to the grant date. New options issued under the current plan vest over a period determined by the Board of Directors but shall not exceed 10 years. 17
9. Stock-based compensation (continued): There were no new stock options granted in 2009. On January 17, 2008, the Company granted 370,000 new stock options at a strike price of Cdn. $0.395, with a five-year term and a vesting period of three years. A summary of the status of the Company's stock option plans as at and for the years ended September 30, 2009 and 2008 is presented below: 2009 2008 Weighted Weighted average average exercise exercise Options price (Cdn.) Options price (Cdn.) Outstanding, beginning of year 3,259,500 $ 0.320 3,022,500 $ 0.310 Granted 370,000 0.395 Forfeited (545,000) 0.320 (133,000) 0.310 Outstanding, end of year 2,714,500 0.320 3,259,500 0.320 Options exercisable, end of year 1,697,326 $ 0.320 963,167 $ 0.320 The following table summarizes information about stock options outstanding as at September 30, 2009: Options outstanding Options exercisable Weighted average Weighted Weighted remaining average average Number contractual exercise Number exercise Exercise price (Cdn.) outstanding life (years) price (Cdn.) exercisable price (Cdn.) $0.310 2,419,500 1.9791 $ 0.310 1,517,048 $ 0.310 $0.395 295,000 3.3014 0.395 180,278 0.395 18
9. Stock-based compensation (continued): The weighted average fair value of a stock option granted for 2008 with an exercise price equal to the estimated market price of a common share on the date of grant was Cdn. $0.26. The fair value of the stock options was determined using the Black-Scholes option pricing model based on the following assumptions: Risk-free interest rate 3.96% Expected life 4 years Expected volatility 90% Expected dividends 10. Research and development: 2009 2008 Labour expenses $ 800,565 $ 1,094,479 Materials 40,935 75,741 Subcontractors' costs 70,515 307,834 $ 912,015 $ 1,478,054 11. Income taxes: 2009 2008 Income taxes (recovery) based on Canadian statutory tax rate $ 134,503 $ (569,694) Effect on recovery attributable to the following items: Foreign operations subject to different tax rates 77,662 56,005 Impact of tax rate changes and other adjustments 629,324 (139,590) Permanent items 138,837 132,215 Unrealized foreign exchange loss 93,330 Change in valuation allowance (1,153,854) 457,252 $ (173,528) $ 29,518 Future income taxes are recognized for future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their tax basis. 19
11. Income taxes (continued): Future income tax assets and liabilities comprise the following as at September 30: 2009 2008 Future income tax assets: Current: Provision for returns $ 100,268 $ 59,332 Inventory reserve 654,036 427,748 Deferred finance charges 2,003 Other 121,849 6,390 876,153 495,473 Less valuation allowance 781,444 480,038 94,709 15,435 Long-term: Income tax effect of net operating losses carried forward 1,505,538 2,903,634 Share issue costs 9,327 Capital assets 44,394 48,950 Investment 63,011 73,941 Other 302,189 181,807 1,924,459 3,208,332 Less valuation allowance 1,488,003 2,955,067 436,456 253,265 531,165 268,700 Future income tax liabilities: Capital assets 10,709 47,924 Net future income tax assets $ 520,456 $ 220,776 20
11. Income taxes (continued): At September 30, 2009, the Company has net operating loss carryforwards for federal income tax purposes of approximately Cdn. $4,833,895 in Canada and U.S. $728,443 in the United States expiring as follows: Canadian losses: 2014 $ 663,792 2026 5,119 2027 1,806,968 2028 1,773,030 2029 584,986 $ 4,833,895 U.S. losses: 2026 $ 728,443 12. Profit (loss) per share: The computation of basic and diluted profit (loss) per share is as follows: 2009 2008 Basic and diluted: Profit (loss) for the year $ 579,579 $ (1,703,203) Less preferred share dividends 9,795 8,310 Basic and diluted loss attributable to common shareholders $ 569,784 $ (1,711,513) Basic weighted average common shares outstanding 26,954,083 26,954,083 Basic profit (loss) per share $ 0.02 $ (0.06) Diluted weighted average common shares outstanding 27,981,480 26,954,083 Diluted profit (loss) per share $ 0.02 $ (0.06) 21
12. Profit (loss) per share (continued): Stock options issued under the Company's stock option plan (note 9) and warrants issued by the Company (note 7) were excluded from the diluted weighted average common shares outstanding because the impact would be anti-dilutive. 13. Related party transactions and balances: The Company had the following transactions with a party related through the estate of a late director which held an equity interest subject to a voting trust having significant influence over the shares of the Company. The transactions were in the normal course of business and were measured at the exchange amount, which is the amount of consideration established and agreed to by the related parties. (a) The following transactions took place with a related company, in which a director and officer of the Company had an equity interest: 2009 2008 Rental income included in administration expenses $ 49,585 $ 103,869 Accounts receivable include $21,290 at exchange amount (2008 - $106,970) due from this related party in respect of amounts paid by the Company on behalf of the related party for rent. The amount due is non-interest bearing, due on demand and has been recorded at the exchange amount. (b) Legal fees of $131,073 (2008 - nil) were paid or accrued to a law firm in which one of the directors is a partner. 14. Financial instruments: (a) Credit risk: Credit risk arises from the possibility that certain parties will be unable to discharge their obligations. The Company routinely assesses the financial strength of its customers and mitigates against identified exposure primarily by lowering credit limits and/or reducing or ending business activity with high risk accounts. 22
14. Financial instruments (continued): (b) Foreign exchange risk: Varying portions of the Company's Canadian subsidiaries' sales, purchases, operating costs and borrowings costs are denominated in Canadian dollars. This results in cash, accounts receivable, accounts payable and accrued liabilities balances being denominated in Canadian dollars. Changes in the value of the Canadian dollar versus the U.S. dollar impacts the financial results reported by the Company. A 10 percent strengthening (weakening) of the Canadian dollar against the foreign currency as per below at September 30, 2009 would have increased (decreased) equity and net income by the amount shown below. This analysis assumes that all other variables remain constant. Net income Year ending September 30, 2009 $ 116,297 The Company does not use derivative instruments to reduce its exposure to exchange rate risk. (c) Fair values: The carrying amounts of cash, accounts receivable and accounts payable and accrued liabilities approximate their fair values due to the relatively short-term maturity of these financial instruments. The carrying value of bank indebtedness approximates its fair value as the interest rate applied to the debt fluctuates with the market interest rate. Cash is classified as financial assets held-for-trading which are recorded at fair value. Accounts receivable are classified as loans and receivables which are recorded at amortized cost. Bank indebtedness, accounts payable and accrued liabilities and longterm debt are classified as other financial liabilities, which are recorded at amortized cost using the effective interest rate method. 23
14. Financial instruments (continued): (d) Liquidity risk: Liquidity risk is the risk that the Company cannot meet a demand for cash or fund its operations as they become due. Liquidity risk also includes the risk of not being able to liquidate assets in a timely manner at a reasonable price. As at September 30, 2009, the Company was in default of its loan agreement and its lender was reserving its rights including the right to call the loan and was accruing default interest which would become payable should the Company fail to replace the lender by January 14, 2010. The Company refinanced its bank indebtedness on December 22, 2009 with a new lender and repaid both of its old credit facilities (note 7). In maintaining a sufficient liquidity level, the Company manages timely accounts receivable collection and inventory turnover to facilitate cash flows and to sustain excess availability. In an environment of economic uncertainty, the Company is subject to an increased risk of customer payment defaults or more delayed customer payment patterns which could result in a reduced borrowing base and lower availability. The Company actively assesses the creditworthiness of its customers and adjusts credit limits where it considers appropriate. In some cases, this may limit the level of shipments the Company will make to a customer, which would also contribute to reduced cash flow and availability due to lower revenue. The following are the contractual maturities of financial liabilities: 2010 2011 Credit facility (i) $ 5,717,752 $ Term debt (i) 444,432 Accounts payable and accrued liabilities As due Lease commitments 286,967 270,355 (i) Repaid subsequent to year end, as described in note 7. 24
14. Financial instruments (continued): (e) Interest rate risk: The Company is exposed to interest rate risks arising from the $13,000,000 revolving credit facility that bears interest at 90-day LIBOR rate plus 4.75%, and the $2,000,000 credit facility that bears interest at 90-day LIBOR rate plus 5.75%. Unfavourable changes in the applicable interest rate may result in an increase in interest expense. The Company does not use derivative instruments to reduce its exposure to interest rate risk. As at September 30, 2009, the Company had $5,717,752 outstanding under the revolving credit facility and an unamortized balance of $444,432 under the term debt. Cash flow sensitivity analysis on variable credit facilities is as follows: Net income 100 base 100 base points increase points decrease Year ending September 30, 2009 $ (49,299) $ There would be no expected impact of a 100 base point decrease due to an interest rate floor. Subsequent to year end, the Company replaced both of its credit facilities with a new $10,000,000 facility (note 7). 25
15. Segmented information: The Company derives over 90% of its revenue from the sale of its products in the North American market. On a geographic basis, the Company's revenue was from the following regions: Capital and Revenue intangible assets Goodwill 2009 2008 2009 2008 2009 2008 United States $ 41,672,723 $ 41,945,631 $ $ 2,486 $ $ Canada 4,221,691 4,038,794 374,076 429,996 710,069 718,309 Other 915,994 1,708,273 $ 46,810,408 $ 47,692,698 $ 374,076 $ 432,482 $ 710,069 $ 718,309 At September 30, 2009, five customers accounted for approximately 64% of consolidated accounts receivable (2008 - five customers accounted for approximately 57% of consolidated accounts receivable). For the year ended September 30, 2009, the Company had two customers (2008 - one customer), each contributing greater than 10% and accounting for a total of approximately 37% of consolidated revenue (2008 - one customer accounted for approximately 26% of consolidated revenue). 16. Capital disclosures: The Board's policy is to maintain a sufficient capital base in order to preserve investor, creditor and market confidence and to sustain future development of the business. Management monitors investor activity by noting significant market transactions and ongoing trading activity. The Board's strategy is to not pay dividends and use positive cash flow to fund growth and reduce bank debt. 26
17. Commitments and contingencies: As at September 30, 2009, there are a number of claims where the outcome has been estimated by the Company and provided for in these financial statements. It is not possible to determine the amounts that may ultimately be assessed against the Company with respect to these claims but management believes that the difference between any ultimate assessment and amounts provided for in these financial statements would not have a material impact on the business or financial position of the Company. In addition, the Company is obligated under operating leases for office premises and equipment. The future minimum operating lease commitments are as follows: 2010 2011 2012 2013 2014 Future minimum operating lease commitments $ 286,967 $ 270,355 $ 237,130 $ 237,130 $ 177,848 27