Hollysys Automation Technologies (HOLI) 6-K 2020 Q2 Current report (foreign)

Exhibit 99.2

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

CONTENTS

	Page
Unaudited condensed consolidated balance sheets as of June 30, 2019 and December 31, 2019		F-2
Unaudited condensed consolidated statements of comprehensive income for the six months ended December 31, 2018 and 2019		F-4
Unaudited condensed consolidated statements of cash flows for the six months ended December 31, 2018 and 2019	��	F-6
Unaudited condensed consolidated statements of stockholders’ equity for the six months ended December 31, 2018 and 2019		F-8
Notes to unaudited condensed consolidated financial statements for the six months ended December 31, 2018 and 2019		F-9

F-1

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS AS OF JUNE 30, 2019 AND DECEMBER 31, 2019

(In US dollars thousands except for number of shares and per share data)

			June 30,		December 31,
	Notes		2019		2019
					(Unaudited)
ASSETS
Current assets :
Cash and cash equivalents			$	332,509	$	403,860
Time deposits with original maturities over three months				145,139		146,745
Restricted cash				22,260		19,985
Accounts receivable, net of allowance for doubtful accounts of $47,162 and $45,348 as of June 30, 2019 and December 31, 2019 , respectively				282,594		239,492
Costs and estimated earnings in excess of billings, net of allowance for doubtful accounts of $6,981 and $6,672 as of June 30, 2019 and December 31, 2019 , respectively		7		197,955		227,490
Accounts receivable retention		7		5,468		4,911
Other receivables, net of allowance for doubtful accounts of $4,879 and $4,390 as of June 30, 2019 and December 31, 2019 , respectively				27,109		23,173
Advances to suppliers				12,901		17,522
Amounts due from related parties				36,295		26,515
Inventories		4		42,983		35,596
Prepaid expenses				644		510
Income tax recoverable				3,621		288
Total current assets				1,109,478		1,146,087
Non-current assets :
Restricted cash				3,618		2,657
Costs and estimated earnings in excess of billings				—		2,700
Accounts receivable retention		7		6,390		7,300
Prepaid expenses				2		10
Property, plant and equipment, net				76,006		78,059
Prepaid land leases		3		16,599		16,224
Intangible assets, net				1,383		1,208
Investments in equity investees		5		40,386		40,077
Investments securities				4,776		4,693
Goodwill				37,054		37,845
Deferred tax assets				13,725		8,328
Operating lease right-of-use assets		3		—		5,259
Total non-current assets				199,939		204,360
Total assets			$	1,309,417	$	1,350,447
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities (including amounts of the VIE without recourse to the primary beneficiary of $17,776 and $9,610 as of June 30, 2019 and December 31, 2019 , respectively):		1
Derivative financial liability			$	758	$	—
Short-term bank loans		8		1,909		1,436

F-2

Current portion of long-term loans	9		20,310			319
Accounts payable			110,384			115,166
Construction costs payable			94			1,289
Deferred revenue	7		141,385			142,025
Accrued payroll and related expenses			14,512			21,473
Income tax payable			2,541			4,795
Warranty liabilities	6		8,039			6,597
Other tax payables			665			4,481
Accrued liabilities			35,507			29,337
Amounts due to related parties			5,395			4,218
Operating lease liabilities	3		—			1,673
Total current liabilities			341,499			332,809
Accrued liabilities			3,530			7,620
Long-term loans	9		978			896
Accounts payable			—			3,824
Deferred tax liabilities			12,173			13,146
Warranty liabilities	6		4,077			4,117
Operating lease liabilities	3		—			3,180
Total non-current liabilities			20,758			32,783
Total liabilities			362,257			365,592
Commitments and contingencies	1 4		—			—
Stockholders’ equity:
Ordinary shares, par value $0.001 per share, 100,000,000 shares authorized; 60,342,099 shares and 60,537,099 shares issued and outstanding as of June 30, 2019 and December 31, 2019	11		60			61
Additional paid-in capital			223,634			223,673
Statutory reserves			48,698			49,427
Retained earnings			708,515			758,819
Accumulated other comprehensive loss			(35,521	)		(49,852	)
Total Hollysys Automation Technologies Ltd. stockholders’ equity			945,386			982,128
Non-controlling interests			1,774			2,727
Total equity			947,160			984,855
Total liabilities and equity		$	1,309,417		$	1,350,447

F-3

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019

(In US dollars thousands except for number of shares and per share data)

			Six monthsendedDecember 31,
	Notes		2018			2019
			(Unaudited)			(Unaudited)
Net revenues
Integrated solutions contract revenue			$	233,333		$	234,141
Product sales				13,957			12,661
Revenue from services				40,892			46,536
Total net revenues				288,182			293,338
Costs of integrated solutions contracts				161,593			163,985
Costs of products sold				3,662			3,430
Costs of services rendered				14,467			17,785
Gross profit				108,460			108,138
Operating expenses
Selling				15,569			17,670
General and administrative				20,347			21,224
Research and development				19,170			22,748
VAT refunds and government subsidies				(18,359	)		(9,799	)
Total operating expenses				36,727			51,843
Income from operations				71,733			56,295
Other income, net				6,475			3,327
Foreign exchange ( loss )/gain				(827	)		545
Gains on disposal of an  investment  in an equity investee				—			5,763
Share of net (losses) income of equity investees				(287	)		3,538
Interest income				5,995			6,128
Interest expenses				(316	)		(119	)
Dividend income from equity security investments				1,113			1,145
Income before income taxes				83,886			76,622
Income tax expenses		1 2		11,767			13,001
Net income				72,119			63,621
Less: net income ( loss es ) attributable to non-controlling interests				83			(125	)
Net income attributable to Hollysys Automation Technologies Ltd.			$	72,036		$	63,746
Other comprehensive income, net of tax of nil
T ranslation adjustments			$	(27,090	)	$	(13,253	)
Comprehensive income				45,029			50,368

F-4

Less: comprehensive (loss) income attributable to non-controlling interests			(179	)		953
Comprehensive income attributable to Hollysys Automation Technologies Ltd.		$	45,208			49,415
Net income per share:
Basic	1 3	$	1.19		$	1.05
Diluted	1 3	$	1.18		$	1.05
Shares used in net income per share computation:
Basic			60,450,930			60,504,151
Diluted			61,271,864			60,648,680

F-5

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019

(In US dollars thousands except for number of shares and per share data)

	Six months ended December 31,
	2018			2019
	(Unaudited)			(Unaudited)
Cash flows from operating activities:
Net income		72,119			63,621
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation of property, plant and equipment		3,826			4,602
Amortization of prepaid land leases		132			197
Amortization of intangible assets		155			156
Allowance for doubtful accounts		514			596
Loss on disposal of property, plant and equipment		39			10
Share of net loss (income) of equity investees		287			(3,538	)
Gains on deconsolidation of subsidiaries where the Company retains an equity interest		(4,748	)		—
G a ins on disposal of an investment in an equity investee		—			(5,763	)
Share-based compensation expenses		151			40
Deferred income tax (benefit) expense		(899	)		6,235
Accretion of convertible bond		115			57
Fair value adjustments of a bifurcated derivative		20			(5	)
Changes in operating assets and liabilities:
Accounts receivable and retention		(9,041	)		39,851
Costs and estimated earnings in excess of billings		(27,703	)		(35,083	)
Inventories		3,603			6,650
Advances to suppliers		(7,843	)		(4,812	)
Other receivables		11,345			3,687
Prepaid expenses and other assets		(211	)		128
Due from related parties		9,571			9,147
Accounts payable		(7,883	)		10,794
Deferred revenue		10,420			2,865
Accruals and other payables		9,638			1,861
Due to related parties		(2,312	)		(1,178	)
Income tax payable		6,275			5,541
Other tax payables		(6,092	)		3,789
Net cash provided by operating activities	$	61,478		$	109,448
Cash flows from investing activities:
Time deposits placed with banks		(156,940	)		(103,661	)
Maturity of time deposits		122,854			99,937
Purchases of property, plant and equipment		(1,234	)		(2,863	)
Proceeds from disposal of property, plant and equipment		251			292
Purchase of equity securities		(740	)		—
Cash reduced upon deconsolidation of subsidiary		(1,878	)		—
Proceeds received for the disposal of an equity inves tee		—			4,458
Acquisition of a subsidiary, net of cash acquired		—			(150	)
Net cash used in investing activities	$	(37,687	)	$	(1,987	)

F-6

Cash flows from financing activities:
Proceeds from short-term bank loans		3,207			2,274
Repayments of short-term bank loans		(3,555	)		(2,752	)
Proceeds from long-term bank loans		332			177
Repayments of long-term bank loans		(300	)		(260	)
Payment of dividends		(10,862	)		(12,713	)
Repayments of convertible bond		—			(20,753	)
Net cash used in financing activities		(11,178	)		(34,027	)
Effect of foreign exchange rate changes		(8,143	)		(5,319	)
Net increase in cash, cash equivalents and restricted cash	$	4,470		$	68,115
Cash, cash equivalents and restricted cash, beginning of period		287,309			358,387
Cash, cash equivalents and restricted cash, end of period	$	291,779		$	426,502
Reconciliation of cash, cash equivalents and restricted cash to the consolidated balance sheets:
Cash and cash equivalents		270,806			403,860
Current portion of restricted cash		16,897			19,985
Non-current portion of restricted cash		4,076			2,657
Total cash, cash equivalents and restricted cash		291,779			426,502
Supplemental cash flow data
Non-Cash Investing Activities:
Acquisition of property, plant and equipment included in construction costs payable and accrued liabilities		431			5,220
Disposal of shares of a subsidiary	$	4,378			—

F-7

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019

(In US dollars thousands except for number of shares)

	Ordinary shares				Additional paid-in capital			Statutory reserves		Retained earnings			Accumulated other comprehensive loss			Total Hollysys Automation Technologies Ltd. stockholders’ equity			Non- controlling interests			Total equity
	Shares		Amount
Balance at June 30, 2018		60,342,099	$	60	$	223,396		$	45,970	$	578,079		$	(5,453	)	$	842,052		$	301		$	842,353
Effect of change in accounting principle - ASC 606		—		—		—			—		21,389			—			21,389			—			21,389
Share-based compensation		—		—		151			—		—			—			151			—			151
Net income for the period		—		—		—			—		72,036			—			72,036			83			72,119
Appropriations to statutory reserves		—		—		—			313		(313	)		—			—			—			—
Dividend paid		—		—		—			—		(10,862	)		—			(10,862	)		—			(10,862	)
Translation adjustments		—		—		—			—		—			(26,828	)		(26,828	)		(262	)		(27,090	)
Balance at December 31, 2018 (Unaudited)		60,342,099	$	60	$	223,547		$	46,283	$	660,329		$	(32,281	)	$	897,938		$	122		$	898,060
Balance at June 30, 2019		60,342,099	$	60	$	223,634		$	48,698	$	708,515		$	(35,521	)	$	945,386		$	1,774		$	947,160
Issu anceof restricted shares		195,000		1		(1	)		—		—			—			—			—			—
Share-based compensation		—		—		40			—		—			—			40			—			40
Net income ( loss ) for the period		—		—		—			—		63,746			—			63,746			(125	)		63,621
Appropriations to statutory reserves		—		—		—			729		(729	)		—			—			—			—
Dividend paid		—		—		—			—		(12,713	)		—			(12,713	)		—			(12,713	)
Translation adjustments		—		—		—			—		—			(14,331	)		(14,331	)		1,078			(13,253	)
Balance at December 31, 2019 (Unaudited)		60,537,099		61		223,673			49,427		758,819			(49,852	)		982,128			2,727		$	984,855

F-8

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 1 -     ORGANIZATION AND BUSINESS BACKGROUND

Hollysys Automation Technologies Ltd. (“Hollysys” or the “Company”) was established under the laws of the British Virgin Islands (“BVI”) on February 6, 2006.

As of December 31, 2019, the Company had subsidiaries incorporated in countries and jurisdictions including the People’s Republic of China (“PRC”), Singapore, Malaysia, Macau, Hong Kong,

BVI

, India and Indonesia.

The Company makes a determination at the inception of each arrangement whether an entity in which the Company has made an investment or in which the Company has other variable interests is considered a variable interest entity (“VIE”). The Company consolidates a VIE when it is deemed to be the primary beneficiary. The primary beneficiary of a VIE is the party that meets both of the following criteria: (i) has the power to make decisions that most significantly affect the economic performance of the VIE; and (ii) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. Periodically, the Company determines whether any changes occurred requiring a reassessment of whether it is the primary beneficiary of a VIE. If the Company is not deemed to be the primary beneficiary in a VIE, the investment or other variable interests in a VIE is accounted for in accordance with applicable GAAP.

In November 2015, Concord Electrical Contracting Ltd (“CECL“) was established in Doha, Qatar, by Concord Corporation Pte. Ltd. (“CCPL”), a wholly-owned subsidiary of the Company incorporated under the laws of Singapore, and a Qatar citizen as a nominee shareholder, with 49% and 51% of equity interest in CECL, respectively. Through a series of contractual arrangements signed in November 2015 and September 2016, CCPL is entitled to appoint the majority of the directors of CECL who have the power to direct the activities that significantly impact CECL’s economic performance. In addition, CCPL is entitled to 95% of the variable returns or losses from CECL’s operations. In accordance with Accounting Standards Codification (“ASC”) 810,

Consolidation

, despite the lack of technical majority ownership, there exists a parent-subsidiary relationship between CCPL and CECL through the series of contractual arrangements and CCPL is considered the primary beneficiary of CECL. CECL was concluded as a VIE of the Company and consolidated by the Company since inception.

The carrying amounts and classifications of the assets and liabilities of the VIE are as follows:

	June 30, 2019		December 31, 2019
			(Unaudited)
Current assets	$	23,946	$	10,008
Non-current assets		167		126
Total assets		24,113		10,134
Current liabilities	$	17,776	$	9,610
Total liabilities		17,776		9,610

F-9

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

	Six months ended December 31,
	2018			2019
	(Unaudited)			(Unaudited)
Revenue	$	11,641		$	365
Cost of revenue		9,443			200
Net profit		1,653			165
Net cash ( used   in ) provided by  operating activities		(2,004	)		785
Net cash used in investing activities		—			—
Net cash provided by financing activities		—			—

As of December 31, 2019, the current assets of the VIE included amounts due from subsidiaries of the Company amounting to $2,826 (June 30, 2019: $3,506), and the current liabilities of the VIE included amounts due to subsidiaries of the Company amounting to $52 (June 30,

2019

: nil), which were all eliminated upon consolidation by the Company. Creditors of the VIE do not have recourse to the general credit of the Company for the liabilities of the VIE. The Company through CCPL is obligated to absorb the VIE’s expected losses and to provide financial support to the VIE if required. For the six months ended December 31, 2018 and 2019, the Company has not provided financial support other thanwhich it was contractually required to provide. The Company believes that there are no assets of the VIE that can be used only to settle obligations of the VIE.

The Company, its subsidiaries and the VIE, (collectively the “Group”) are principally engaged in the manufacture, sale and provision of integrated automation systems and services, mechanical and electrical solution services and installation services in the PRC, Southeast Asia and the Middle East.

 

NOTE 2 -     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

These unaudited interim condensed consolidated financial statements of the Company, its subsidiaries and VIE (collectively the “Group”) have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information using accounting policies that are consistent with those used in the preparation of the Group’s audited consolidated financial statements for the fiscal year ended June 30, 2019. Accordingly, these unaudited interim condensed consolidated financial statements do not include all of the information and footnotes required by U.S. GAAP for annual financial statements.

In the opinion of the Company’s management, the accompanying unaudited interim condensed consolidated financial statements contain all normal recurring adjustments necessary to present fairly the financial position, operating results and cash flows of the Group for each of the periods presented. The results of operations for the six months period ended December 31, 2019 are not necessarily indicative of results to be expected for any other interim period or for the year ending June 30, 2020. The consolidated balance sheet as of June 30, 2019 was derived from the audited consolidated financial statements at that date but does not include all of the disclosures required by U.S. GAAP for annual financial statements. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements for the year ended June 30, 2019.

Principles of Consolidation

The consolidated financial statements include the financial statements of the Company, its subsidiaries and a VIE. All inter-company transactions and balances between the Company, its subsidiaries, and the VIE are eliminated upon consolidation. The Company includes the results of operations of acquired businesses from the respective dates of acquisition.

F-10

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Use of estimates

The preparation of financial statements in conformity with US GAAP 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 date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management evaluates estimates, including those related to the expected total costs of integrated

solution

s

contracts

 and service

contracts, allowance for doubtful accounts, fair value of bifurcated derivative, warranties, valuation allowance of deferred tax assets 

and

impairment of goodwill and other long-lived assets. Management bases the estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results could differ materially from those estimates.

Foreign currency translations and transactions

The Company’s functional currency is the United States dollars (“US dollars” or “$”); whereas the Company’s subsidiaries and VIE use the primary currency of the economic environment in which their operations are conducted as their functional currency. According to the criteria of ASC 830

,

Foreign Currency Matters

(“ASC 830”)

the Company uses the US dollars as its reporting currency.

The Company translates its assets and liabilities into US dollars using the rate of exchange prevailing at the balance sheet date, and the statements of comprehensive loss are translated at average rates during the reporting period. Adjustments resulting from the translation of financial statements from the functional currency into US dollars are recorded in stockholders’ equity as part of accumulated other comprehensive loss. Transactions dominated in currencies other than the functional currency are translated into functional currency at the exchange rates prevailing on the transaction dates, and the exchange gains or losses are reflected in the consolidated statements of comprehensive income for the reporting period.

Transactions denominated in foreign currencies are measured into the functional currency at the exchange rates prevailing on the transaction dates. Foreign currency denominated financial assets and liabilities are

re-measured

at the exchange rates prevailing at the balance sheet date. Exchange gains and losses are included in earnings in the statement of comprehensive loss for the reporting period, except for those arising from intercompany transactions that are of investment nature, which are recorded as translation adjustments in other comprehensive loss.

Business combinations

The Company accounts for its business combinations using the purchase method of accounting in accordance with ASC Topic 805 

Business Combinations

(“ASC 805”)

. The purchase method of accounting requires that the consideration transferred to be allocated to the assets, including separately identifiable assets and liabilities the Company acquired based on their estimated fair values. The consideration transferred of an acquisition is measured as the aggregate of the fair values at the date of exchange of the assets given, liabilities incurred, and equity instruments issued as well as the contingent considerations and all contractual contingencies as of the acquisition date. Identifiable assets, liabilities and contingent liabilities acquired or assumed are measured separately at their fair value as of the acquisition date, irrespective of the extent of any

non-controlling

interests. The excess of (i) the total cost of the acquisition, fair value of the

non-controlling

interests and acquisition date fair value of any previously held equity interest in the acquiree over (ii) the fair value of the identifiable net assets of the acquiree, is recorded as goodwill. If the cost of acquisition is less than the fair value of the net assets of the subsidiary acquired, the difference is recognized as income in the statement of comprehensive income.

The determination and allocation of fair values to the identifiable assets acquired, liabilities assumed and

non-controlling

interests is based on various assumptions and valuation methodologies requiring considerable management judgment. The most significant variables in these valuations are discount rates, terminal values, as well as the assumptions and estimates used to determine the cash inflows and outflows. The Company determines discount rates to be used based on the risk inherent in the related activity’s current business model and industry comparisons. Terminal values are based on the expected life of assets and forecasted cash flows over that period.

Acquisition-related costs are recognized as general and administrative expenses in the statements of comprehensive income as incurred.

F-11

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Cash and cash equivalents

Cash and cash equivalents consist of cash on hand and bank deposits, which are unrestricted as to withdrawal and use. All highly liquid investments that are readily convertible to known amounts of cash with original stated maturities of three months or less are classified as cash equivalents.

Time deposits with original maturities over three months

Time deposits with original maturities over three months consist of deposits placed with financial institutions with original maturity terms from four months to one year. As of December 31, 2019, $137,398, $6,732, and $2,615 of time deposits with original maturities over three months were placed in financial institutions in the PRC, Singapore, and Malaysia, respectively. As of June 30, 2019, $137,036, $7,403, and $700 of time deposits with original maturities over three months were placed in financial institutions in the PRC, Singapore, and Malaysia, respectively.

Restricted cash

Restricted cash mainly consists of the cash deposited in banks pledged for performance guarantees, or bank loans. These cash balances are not available for use until these guarantees are expired or cancelled, or the loans are repaid.

Revenue recognition

Integrated solutions contracts

Revenues generated from designing, building, and delivering customized integrated industrial automation systems are recognized over time as customer simultaneously receives and consumes the benefits provided by the Company’s performance as it occurs or because the customers control the related asset as it is created or enhanced. The contracts for designing, building, and delivering customized integrated industrial automation systems are legally enforceable and binding agreements between the Company and customers.

The duration of contracts depends on the contract size and ranges from six months to five years excluding the warranty period. The majority of the contract duration is longer than one year.

Revenue generated from mechanical and electrical solution contracts for the construction or renovation of buildings, rail or infrastructure facilities are also recognized over time as customer simultaneously receives and consumes the benefits provided by the Company’s performance as it occurs or because the customers control the related asset as it is created or enhanced. The contracts for mechanical and electrical solution are legally enforceable and binding agreements between the Company and customers.

The duration of contracts depends on the contract size and the complexity of the construction work and ranges from

six months

to

three years

excluding the warranty period. The majority of the contract duration

is

longer than one year.

In accordance with ASC 606,

Revenue from Contract with Customers

(“ASC 606”), recognition is based on an estimate of the income earned to date, less income recognized in earlier periods. Extent of progress toward completion is measured using the cost-to-cost method where the progress (the percentage complete) is determined by dividing costs incurred to date by the total amount of costs expected to be incurred for the integrated solutions contracts. The Company’s estimates of total costs expected to be incurred for an integrated solutions contract include assumptions regarding the Company’s future effort or input such as direct costs of equipment and materials and direct labor costs. Significant estimation uncertainty exists due to the long construction periods and sensitivity of these assumptions to extent of progress towards completion and estimated total costs of integrated solutions contracts, which are realized in the current period as revenue and gross profit, respectively. Provisions, if any, are made in the period when anticipated losses become evident on uncompleted contracts.

The Company reviews and updates the estimated total costs of integrated solutions contracts

pe

r

iodically

. The Company accounts for revisions to contract revenue and estimated total costs of integrated solution

s

contracts, including the impact due to approved change orders, in the period in which the facts

and circums

t

ance

that cause the revision become known as changes in estimates. Unapproved change orders are considered claims. Claims are recognized only when it has been awarded by customers.

During the

six mont

hs

 ended D

ecember 31, 20

1

8 and 2019, the Company did not recognize any revenue related to claims.

Excluding the impact of change orders, if the estimated total costs of integrated solution

s

contracts, which w

ere

 revised during the six months ended December 31, 2018 and 2019, had been used as a basis of recognition of integrated contract revenue since the contract commencement, net income for the six months ended December 31, 2018 and 2019 would have been

increased by $925 and

decreased by $6,280,

respectively; basic

net income per share and diluted net income per share for six months ended December 31, 2018 and 2019

would have been increased by

$0.02 and

decreased

by $0.10, respectively; and diluted net income per share for

the

six months ended December 31, 2018 and 2019 would have been

increased by $0.02 and

decreased

by $0.10, respectively.

F-12

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

The Company combines a group of contracts as one project if they are closely related and are, in substance, part

s

of a single project with an overall profit margin. The Company segments a contract into several projects, when they are of different business substance, for example, with different business negotiation, solutions, implementation plans and margins.

Revenue in excess of billings on the contracts is recorded as costs and estimated earnings in excess of billings. Billings in excess of revenues recognized on the contracts are recorded as deferred revenue until the above revenue recognition criteria are met. Recognition of accounts receivable and costs and estimated earnings in excess of billings are discussed below.

The Company generally recognizes 100% of the

contractual revenue when the customer acceptance has been obtained and no further major costs are estimated to be incurred, and normally this is also when the warranty period commences. Revenues are presented net of value-added tax collected on behalf of the government.

Product sales

The Company’s products mainly include hardware and software. Revenue generated from sales of products is recognized when control of promised goods is transferred to the Company’s customers in an amount of consideration to which an entity expects to be entitled to in exchange for those goods. Revenues are presented net of value-added tax collected on behalf of the government.

Services rendered

The Company mainly provides

the following

services:

The

 Company provides maintenance service which

is

generally completed onsite at the customers’ premises. Revenue is recognized over time by using the

cost-to-cost

method to measure the progress towards the completion of the performance obligation as the customer simultaneously receives and consumes the benefits from the services rendered by the Company.

As costs incurred represent work performed, the Company believes this method best depicts transfer of control to the customer. Revenues are presented net of value-added tax collected on behalf of the government

.

The

Company also separately sells extended warranties to their integrated solution customers for a fixed period. Such arrangements are negotiated separately from the corresponding integrated solution system and are usually entered into upon the expiration of the warranty period attached to the integrated

solutions contracts

. During the extended warranty period, the Company is responsible for addressing issues related to the system. Part replacement is not covered in such services. The Company uses time elapsed to measure the progress toward complete satisfaction of the performance obligation and recognizes revenue ratably over the contractual term.

Revenues are presented net of value

-added tax collected

on behalf of

the

government

.

F-13

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Excluding the impact of change orders, if the estimated total costs of service contracts, which were revised during the

si

x months

 ended December 31,

2018 and

2019, had been used as a basis of recognition of service contract revenue since the contract commencement, net income for the

six months

ended December 31,

2018 a

nd

2019 would have been decreased by

$238 and $

3,212

, respectively;

basic net income per share for

th

e

six months

ended December 31,

2018 and

2019 would have been decreased by

$0.004 and $

0.05

, re

s

pectively;

and diluted net income per share for the

six mo

n

ths

 ended December 31,

2018 and

2019, would have decreased by

$0.004 and $

0.05

, re

spe

ctively.

 Revisions to the estimated total costs for the

six mont

hs

 ended December 31, 2019 were made in the ordinary course of business.

Contract assets

Contract assets include amounts that represent the rights to receive payment for goods or services that have been transferred to the customer, with the rights conditional upon something other than the passage of time. Accordingly, the Company include

s

the following in contract assets: (i) unbilled amounts resulting from revenue recognized exceeding amounts billed to customers for integrated solutions contracts and maintenance service contracts using the cost-to-cost method, which are recorded in the balance sheet as “costs and estimated earnings in excess of billing”; and (ii) accounts receivable retention amounts which

are

held by customers

of

Concord and Bond Groups

and

pay

able to th

e Group

upon the issuance of the final completion certificate and completion of the defects liability period.

Performance of the integrated solutions contracts will often extend over long periods and the Company’s right to receive payments depends on its performance in accordance with the contractual terms. There are different billing practices in the PRC, overseas operating subsidiaries and the VIE (Concord and Bond Groups). For the Company’s PRC subsidiaries, billings are issued based on milestones specified in the contracts negotiated with customers. In general, there are four milestones: 1) project commencement, 2) system manufacturing and delivery, 3) installation,

trial-run

and customer acceptance, and 4) end of the warranty period. The amounts to be billed at each milestone are specified in the contract. All

integrated

solutions

contracts have the first milestone, but not all contracts require prepayments. The length of each interval between two continuous billings under an integrated

solutions

contract varies depending on the duration of the contract (under certain contracts, the interval lasts more than a year) and the last billing to be issued for an integrated

solutions

contract is scheduled at the end of a warranty period.

There are no significant financing components in the integrate solutions contracts.

For Concord and Bond Groups, billing claims rendered are subject to the further approval and certification of the customers or their designated consultants. Payments are made to Concord or Bond Groups based on the certified billings according to the payment terms mutually agreed between the customers and Concord or Bond Groups. Certain amounts are retained by the customer and payable to Concord and Bond Groups upon

the issuance

of

the

final

completion certificate and completion of the

defects liability period. The retained amounts are recorded as accounts receivable retention

.

Contract liabilities

Contract liabilities include the amounts that reflect obligations to provide goods or services for which payment has been received. Contract liabilities are presented in the balance sheet as deferred revenue.

The Company receives prepayments for

integrated solutions contracts,

product

sales

and service contracts for goods or services to be provided in the future. Prepayments received are recorded as deferred revenue

, which

 is recognized as revenue based on the

revenue recognition policies disclosed above for

integrated solutions contracts

, product sales

and services

rendered

.

Accounts receivable, costs and estimated earnings in excess of billings

and accounts receivable retention

The carrying value of the Company’s accounts receivable, costs and estimated earnings in excess of billings and accounts receivables retention, net of the allowance for doubtful accounts, represents their estimated net realizable value. An allowance for doubtful accounts is recognized when it is probable that the Company will not collect the amount and is written off in the period when deemed uncollectible. The Company periodically reviews the status of contracts and decides how much of an allowance for doubtful accounts should be made based on factors surrounding the credit risk of customers and historical experience. The Company does not require collateral from its customers and does not charge interest for late payments by its customers.

Inventories

Inventories are composed of raw materials, work in progress, purchased and manufactured finished goods and low value consumables. Inventories are stated at the lower of cost and net realizable value. The Company uses the weighted average cost method as inventory costing method.

The Company assesses the lower of cost and net realizable value for

non-saleable,

excess or obsolete inventories based on its periodic review of inventory quantities on hand and the latest forecasts of product demand and production requirements from its customers. The Company writes down inventories for

non-saleable,

excess or obsolete raw materials,

work-in-process

and finished goods by charging such write-downs to cost of integrated solutions contracts and/or costs of products sold.

F-14

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Warranties

Warranties represent a major term under integrated solutions contracts and maintenance service contracts, which will last, in general, for one to three years or otherwise specified in the terms of the contract. The Company accrues warranty liabilities under a service contract as a percentage of revenue recognized, which is derived from its historical experience, in order to recognize the warranty cost for the related contract throughout the contract period.

Property, plant and equipment, net

Property, plant and equipment, other than construction in progress, are recorded at cost and are stated net of accumulated depreciation and impairment, if any. Depreciation expense is determined using the straight-line method over the estimated useful lives of the assets as follows:

Buildings	30  -50  years
Machinery	5 - 10 years
Software	3 - 5 years
Vehicles	5 - 6 years
Electronic and other equipment	3 - 10 years

Construction in progress represents uncompleted construction work of certain facilities which, upon completion, management intends to hold for production purposes. In addition to costs under construction contracts, other costs directly related to the construction of such facilities, including duty and tariff, equipment installation and shipping costs, and borrowing costs are capitalized. Depreciation commences when the asset is placed in service.

Maintenance and repairs are charged directly to expenses as incurred, whereas betterment and renewals are capitalized in their respective accounts. When an item is retired or otherwise disposed of, the cost and applicable accumulated depreciation are removed and the resulting gain or loss is recognized for the reporting period.

Prepaid land leases, net

Prepaid land lease payments, for the land use right of

four

 parcels of land in the PRC, three parcels of leasehold land in Malaysia and one parcel of leasehold land in Singapore, are initially stated at cost and are subsequently amortized on a straight-line basis over the lease terms of 49 to 88 years.

Intangible assets, net

Intangible assets are carried at cost less accumulated amortization and any impairment. Intangible assets acquired in a business combination are recognized initially at fair value at the date of acquisition. Intangible assets are amortized using a straight-line method

.

The estimated useful lives for the intangible assets are as follows:

Category	Estimated useful life
Patents and copyrights		5  -  10  y ears

Residual values are considered nil.

Income taxes

The Company follows the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is

more-likely-than-not

that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rate is recognized in tax expense in the period that includes the enactment date of the change in tax rate.

F-15

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

The Company adopted ASC 740,

Income Taxes

(“ASC 740”)

,

which clarifies the accounting and disclosure for uncertainty in income taxes. Interests and penalties arising from underpayment of income taxes shall be computed in accordance with the related tax laws. The amount of interest expense is computed by applying the applicable statutory rate of interest to the difference between the tax position recognized and the amount previously taken or expected to be taken in a tax return. Interests and penalties recognized in accordance with ASC 740 are classified in the financial statements as a component of income tax expense. In accordance with the provisions of ASC 740, the Company recognizes in its financial statements the impact of a tax position if a tax return position or future tax position is “more likely than not” to prevail based on the facts and technical merits of the position. Tax positions that meet the “more likely than not” recognition threshold are measured at the largest amount of tax benefit that has a greater than fifty percent likelihood of being realized upon settlement. The Company’s estimated liability for unrecognized tax positions which is included in accrued liabilities is periodically assessed for adequacy and may be affected by changing interpretations of laws, rulings by tax authorities, changes and/or developments with respect to tax audits, and expiration of the statute of limitations. The outcome for a particular audit cannot be determined with certainty prior to the conclusion of the audit and, in some cases, appeal or litigation process. The actual benefits ultimately realized may differ from the Company’s estimates. As each annual filling is done, adjustments, if any, are recorded in the Company’s financial statements. Additionally, in future periods, changes in facts, circumstances, and new information may require the Company to adjust the recognition and measurement estimates with regard to individual tax positions. Changes in recognition and measurement estimates are recognized in the period in which the changes occur.

Segment reporting

In accordance with ASC 280

,

Segment reporting

(“ASC 280”)

segment reporting is determined based on how the Company’s chief operating decision maker (“CODM”) review operating results to make decisions about allocating resources and assessing performance of the Company. According to management’s approach, the Company organizes its internal financial reporting structure based on its main product and service offerings. The Company operates in three principal business segments, namely industrial automation (“IA”), rail transportation (“Rail”) and mechanical and electrical solutions (“M&E”). The Company does not allocate any assets to the three segments as management does not use the information to measure the performance of the reportable segments.

Investments in

equity investees

and equity

securities

The Company accounts for its equity investments under the equity method when the Company has rights and ability to exercise significant influence over the investees. The investments in entities over which the Company has the ability to exercise significant influence are accounted for using the equity method. Significant influence is generally considered to exist when the Company has an ownership interest in the voting stock of the investee between 20% and 50%. Other factors, such as representation on the investee’s board of directors and the impact of commercial arrangements, are also considered in determining whether the equity method of accounting is appropriate.

Under the equity method, original investments are recorded at cost and adjusted by the Company’s share of undistributed earnings or losses of these entities, by the amortization of any basis difference between the amount of the Company’s investment and its share of the net assets of the investee, and by dividend distributions or subsequent investments.

When dividends from an investee exceed the carrying amount of an equity method investment, the excess distribution is recognized as a gain and reported as share of net income of equity investees, net in the statements of comprehensive income when the Company is not liable for the obligations of the investee nor otherwise committed to provide financial support. In such cases, subsequent equity method earnings are not recorded until subsequent earnings equal the gain recorded.

Unrealized inter-company profits and losses related to equity investees are eliminated. An impairment charge, being the difference between the carrying amount and the fair value of the equity investee, is recognized in the consolidated statements of comprehensive income when the decline in value is considered other than temporary.

The Company uses the cumulative earnings approach to classify distributions received from equity investees. Under this approach, distributions received from equity investees are presumed to be a return on the investment and

are

classified as cash inflows from operating activities unless the distributions received exceed cumulative equity in earnings recognized by the investor. In such case, the excess is considered a return of investment and is classified as cash inflows from investing activities.

For equity investments other than those accounted for under the equity method or those that result in consolidation of the investee, the Company measures equity investments with readily determinable fair values at fair value and recognizes any changes in fair value in net income. However, for

equity investments that do not have readily determinable fair values and do not qualify for the existing practical expedient in ASC 820 to estimate fair value using the net asset value per share (or its equivalent) of the investment, the Company chose to measure those investments at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. At each reporting date, the Company is required to make a qualitative assessment as to whether equity investments without a readily determinable fair value for which the measurement alternative is elected is impaired. In the event that a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than the carrying value, the carrying value is written down to its fair value. A variety of factors are considered when determining if a decline in fair value is below carrying value, including, among others, the financial condition and prospects of the investee.

F-16

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Income per share

Income per share is computed in accordance with ASC 260 (“ASC 260”),

Earnings per Share

. Basic income per ordinary share is computed by dividing income attributable to holders of ordinary shares by the weighted average number of ordinary shares outstanding during the period. Diluted income per ordinary share reflects the potential dilution that could occur if securities or other contracts to issue ordinary shares were exercised or converted into ordinary shares.

Fair value measurements

The Company has adopted ASC 820,

Fair Value Measurements and Disclosures

(“ASC 820”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. It does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. It establishes a three-level valuation hierarchy of valuation techniques based on observable and unobservable inputs, which may be used to measure fair value and include the following:

Level 1	-	Quoted prices in active markets for identical assets or liabilities.
Level 2	-	Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3	-	Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

Classification within the hierarchy is determined based on the lowest level of input that is significant to the fair value measurement.

ASC 820 describes three main approaches to measuring the fair value of assets and liabilities: (1) market approach; (2) income approach and (3) cost approach. The market approach uses prices and other relevant information generated from market transactions involving identical or comparable assets or liabilities. The income approach uses valuation techniques to convert future amounts to a single present value amount. The measurement is based on the value indicated by current market expectations about those future amounts. The cost approach is based on the amount that would currently be required to replace an asset.

F-17

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Recent accounting pronouncements

Recently Adopted Standards

On July 1, 2019, the Company adopted Accounting Standards Update (“ASU”) No. 2016-02 (“ASU 2016-02”),

Leases (Topic 842)

, using the modified retrospective transition method and elected the transition option to use an effective date of July 1, 2019 as the date of initial application. As a result, the comparative periods were not restated.

The Company has elected the package of practical expedients permitted which allows the Company not to reassess the following at adoption date: (i) whether any expired or existing contracts are or contains a lease, (ii) the lease classification for any expired or existing leases, and (iii) initial direct costs for any expired or existing leases (i.e. whether those costs qualify for capitalization under ASU

2016-02)

. The Company also elected the short-term lease exemption for certain classes of underlying assets including office space and warehouses, with a lease term of

12

months or less.

The Company’s accounting policy effective on the adoption date of ASU 2016-02 is as follows:

Operating lease as lessee

The Company determines if an arrangement is a lease at inception. The Company classifies a lease as a finance lease or an operating lease at lease commencement date as appropriate under ASC 842. The Company has operating leases for certain offices and warehouses and does not have any finance leases for the six months ended December 31, 2018 and 2019.

For operating leases, the Company records a lease liability and corresponding right-of-use (ROU) asset at lease commencement. Lease terms are based on the non-cancellable term of the lease and may contain options to extend the lease when it is reasonably certain that the Company will exercise the option. Lease liabilities represent the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement.

The Company estimates its incremental borrowing rate for its leases at the commencement date to determine the present value of future lease payments when the implicit rate is not readily determinable in the lease. In estimating its incremental borrowing rate, the Company considers its credit rating and publicly available data of borrowing rates for loans of similar amount, currency and term as the lease.

Operating leases are presented as “operating lease ROU assets” and “operating lease liabilities”on the consolidated balance sheet. Prepaid land leases are separately classified on the consolidated balance sheets. Lease liabilities that become due within one year of the balance sheet date are classified as current liabilities. Operating lease ROU asset represents the right to use an underlying asset for the lease term and are recognized in an amount equal to the lease liability adjusted for any lease payments made prior to commencement date, less any lease incentives received and any initial direct costs incurred by the Company.

F-18

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

After lease commencement, operating lease liabilities are measured at the present value of the remaining lease payments using the discount rate determined at lease commencement. Operating lease ROU assets are measured at the amount of the lease liabilities and further adjusted for prepaid or accrued lease payments, the remaining balance of any lease incentives received, unamortized initial direct costs and impairment of the ROU assets, if any. Operating lease expense is recognized as a single cost on a straight-line basis over the lease term.

The cumulative effect of the changes made to the Company’s consolidated balance sheet as of July 1, 2019 for the adoption of ASU 2016-02 is as follows:

	Balance as of June 30, 2019		Adjustments due to   the adoption of ASU 2016-02			Balance as of July 1, 2019
Assets:
Prepaid expenses		644		(363	)		281
Operating lease ROU assets		—		5,903			5,903
Prep aid land leases		16,599		—			16,599
Liabilities:
Operating lease liabilities (current)		—		(1,862	)		(1,862	)
Operating lease liabilities (non-current)		—		(3,678	)		(3,678	)

The impact of adopting ASU 2016-02 on the Company’s unaudited consolidated balance sheet as of December 31, 2019 are as follows:

	As reported			Legacy GAAP		Effect of the adoption of ASU  2016-02 Higher/(lower)
Assets:
Prepaid expenses		510			916		(406	)
Operating lease ROU assets		5,259			—		5,259
Prepaid land leases		16,224			16,224		—
Liabilities:
Operating lease liabilities (current)		(1,673	)		—		(1,673	)
Operating lease liabilities (non-current)		(3,180	)		—		(3,180	)

The impact of adopting ASU 2016-02 on the Company’s opening retained earnings and current period net income and cash flows was insignificant.

Operating lease as lessor

The Company classifies a lease as an operating, sales-type or direct financing lease at lease commencement date as appropriate under ASC 842. For operating leases, the Company recognized rental income over the non-cancellable lease term on a straight-line basis. The Company does not have any sales-type or direct financing lease

s

for the six months ended December 31, 2018 and 2019.

F-19

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Standards Effective in Future Years

In June 2016, the FASB issued ASU No. 2016-13,

Measurement of Credit Losses on Financial Instruments

. The guidance requires to present assets held at amortized cost and available for sale debt securities net of the amount expected to be collected. The guidance requires the measurement of expected credit losses to be based on relevant information from past events, including historical experiences, current conditions and reasonable and supportable forecasts that affect collectability. The guidance will be effective for fiscal years and interim periods beginning after December 15, 2019 and early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Different components of the guidance require modified retrospective or prospective adoption. In November 2018, the FASB issued ASU No. 2018-19,

Codification Improvements to Topic 326, Financial Instruments—Credit Losses

, which clarifies that receivables arising from operating leases should be accounted for in accordance with ASC 842,

Leases

(“ASC 842”) instead of ASC Subtopic 326-20. Based on financial instruments currently held by the Company, the adoption of ASU 2016-13 will primarily impact accounts receivable, costs and estimated earnings in excess of billings, accounts receivable retention, amount due from related parties and other receivables. The Company is currently evaluating this guidance and the impact on its consolidated financial statements. The Company expect the adoption of ASU 2016-13 to increase the disclosures associated with the allowance for doubtful accounts on trade receivables.

In January 2017, the FASB issued ASU No. 2017-04 (“ASU 2017-04”),

Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment

. ASU 2017-04 eliminates the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value. This standard is effective for the annual or any interim goodwill impairment tests beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the effect that this guidance will have on its consolidated financial statements.

In August 2018, the FASB issued ASU No. 2018-13

, Fair Value Measurement (Topic 820), Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement

. The guidance modifies and enhances the disclosure requirements for fair value measurements. This update is effective in fiscal years, including interim periods, beginning after December 15, 2019, and early adoption is permitted. The Company is currently evaluating this guidance and the impact on its consolidated financial statements.

In December 2019, the FASB issued ASU 2019-12, “

Simplifying the Accounting for Income Taxes,”

as part of its Simplification Initiative to reduce the cost and complexity in accounting for income taxes. This standard removes certain exceptions related to the approach for intra period tax allocation, the methodology for calculating income taxes in an interim period and the recognition of deferred tax liabilities for outside basis differences. It also amends other aspects of the guidance to help simplify and promote consistent application of GAAP. The guidance is effective for interim and annual periods beginning after December 15, 2020, with early adoption permitted. The Company is currently evaluating this guidance and the impact on its consolidated financial statements.

NOTE 3 -     OPERATING LEASES

Operating lease as lessee

The Company’s lease agreements include payments for land use rights and lease payments that are largely fixed, do not contain material residual value guarantees or variable lease payments. The leases, other than prepaid land leases, have remaining lease terms of up to five years. Certain lease agreements include terms with options to extend the lease, however none of these have been recognized in the Company’s right-of-use assets or lease liabilities since those options were not reasonably certain to be exercised.

The Company’s leases do not contain restrictions or covenants that restrict the Company from incurring other financial obligations.

	Six months ended December 31, 2019
Operating lease costs		848
Short-term lease costs		242
Amortization of prepaid land leases		197
Total lease costs		1,287

F-20

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

	Six months ended December 31, 2019
Other information
Cash paid for amounts included in the measurement of operating lease liabilities		970
ROU assets obtained in exchange for new operating lease liabilities		549
Weighted-average remaining lease term (in years):
Operating leases		3.5
Weighted-average discount rate:
Operating leases		4.0	%

For the six months ended December 31, 2019, total 

lease costs

of

$589

were recorded in selling expenses, $518 were recorded in general and administrative expenses, and

$180

were recorded in research and development expenses.

Total expenses under operating leases were $1,166 for the six months ended December 31, 2018.

The total amortization of prepaid land leases was $132 for the six months ended December 31, 2018.

Future minimum lease payments for operating leases as of December 31, 2019 are as follows:

	As of December 31, 2019
January 1, 2020 – December 31, 2020	$	1,651
January 1, 2021 – December 31, 2021		1,453
January 1, 2022 – December 31, 2022		1,134
January 1, 2023 – December 31, 2023		670
January 1, 2024 and onwards		195
Total minimum lease payments		5,103
Less: imputed interest		250
Total lease liability balance	$	4,853

Operating lease as

l

essor

The Company entered into operating lease arrangements to lease out its buildings located in Beijing with lease term ranging from ten to fifteen years. The lease arrangements include lease payments that are largely fixed

and do not contain

variable lease payments. The leases do not contain any contingent rental income clauses or options for a lessee to purchase the buildings.

Total rental income for the six months ended December 31, 201

8

and 201

9

were

$

838 and

$

2,937, respectively and were recorded under “other income” on the condensed consolidated statements of comprehensive income.

F-21

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Future minimum lease payments to be received for these operating lease arrangements for each of the five succeeding fiscal years as of December 31, 2019 are as follows:

	As of December 31, 2019
January 1, 2020 – December 31, 2020	$	3,123
January 1, 2021 – December 31, 2021		3,217
January 1, 2022 – December 31, 2022		3,314
January 1, 2023 – December 31, 2023		3,413
January 1, 2024 – December 31, 2024		3,515
January 1, 2025 and onwards		16,304
Total	$	32,886

NOTE 4 -     INVENTORIES

Components of inventories are as follows:

	June 30, 2019		December 31, 2019
			(Unaudited)
Raw materials	$	17,150	$	15,791
Work in progress		15,097		10,384
Finished goods		10,736		9,421
	$	42,983	$	35,596

NOTE 5 -     INVESTMENTS IN EQUITY INVESTEES

In May 2019

, the Company entered into an agreement to dispose all of its 22.02% interests in Beijing IPE Biotechnology Co., Ltd., for cash consideration of $9,087

, of which $4,629

was received in cash in May 2019

and $4,458

was received in cash in September 2019

. The transaction was completed in September 2019

with a gain of $5,763

recognized in “Gains on disposal of an investment in an equity

investee

” in the consolidated statements of comprehensive income for the six months ended June 30, 2019

.

NOTE 

6

 -     WARRANTY LIABILITIES

	Six months ended
	December 31, 2018			December 31, 2019
	(Unaudited)			(Unaudited)
Beginning balance	$	7,858		$	12,116
Deconsolidation of a subsidiary		(130	)		—
Expense accrued		2,415			543
Expense incurred		(2,205	)		(1,817	)
Translation adjustments		(257	)		(128	)
	$	7,681		$	10,714
Less: current portion of warranty liabilities		(5,318	)		(6,597	)
Long-term warranty liabilities	$	2,363		$	4,117

F-22

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 7  -    REVENUE FROM CONTRACTS WITH CUSTOMERS

Remaining Unsatisfied Performance Obligations (“RUPO”)

As of December 31, 2019, the Company’s backlog relating to unsatisfied (or partially unsatisfied) performance obligations in contracts with its customers was $587.0 million. The Company expects to recognize the majority of its remaining performance obligations as revenue within the next three years.

Disaggregation of revenues

The Company assesses revenues based upon the nature or type of goods or services it provides and the geographic location of the related businesses. The geographic locations are consistent with the reportable segments. For more information on the reportable segments, see Note 15, “Segment Reporting”. The following table presents disaggregated revenue information:

	Six months ended December 31, 2019
	PRC		Non-PRC		Total
Integrated solutions contracts revenue	$	210,331		23,810		234,141
Product sales		11,738		923		12,661
Maintenance service contracts		26,772		18,479		45,251
Extended warranty service revenue		1,285		—		1,285
Total	$	250,126		43,212		293,338

Contract assets and contract liabilities

Contract assets include amounts that represent the rights to receive payment for goods or services that have been transferred to the customer, with the rights conditional upon something other than the passage of time. Accordingly, the Company include

s

the following in contract assets: (i) unbilled amounts resulting from revenue recognized exceeding amounts billed to customers for integrated solutions contracts and maintenance service contracts using the cost-to-cost method, which are included in the consolidated balance sheets as “costs and estimated earnings in excess of billing”; and (ii) accounts receivable retention amounts which

a

re held by customers

o

f Concord and Bond Groups

and payable to the Group

upon the issuance of the final completion certificate and completion of the defects liability period.

Contract liabilities include the amounts that reflect obligations to provide goods or services for which payment has been received. Contract liabilities are presented in the consolidated balance sheets as deferred revenue.

These contract assets and liabilities are calculated on a contract-by-contract basis and reported on a net basis at the end of reporting period. The Company recognized revenue of $60,914 for the six months ended December 31, 2019, which was previously deferred and included in the contract liability at the beginning of the year. This revenue was driven primarily by performance obligations satisfied.

Contract assets and contract liabilities are summarized below:

	June  3 0 , 2019		December  3 1 , 2019
Contract assets, current	$	203,423		232,401
Contract assets, non-current		6,390		7,300
Contract liabilities		141,385		142,025

The increase in contract assets was primarily due to new contracts and timing of revenue recognized relative to its billings. The increase in contract liabilities was primarily due to an increase in the receipt of advance payments and the timing of contractual milestones. No other factors materially impacted the change in the contract liabilities balance.

F-23

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 

8

 -     SHORT-TERM BANK LOANS

On June 30, 2019, the Company’s short-term bank borrowings consisted of revolving bank loans of $1,909 from several banks, which were subject to an annual interest rate of 4.60%. Some of the short-term loans are secured by the pledge of restricted cash and a building

 by the Company

with carrying value

s

of

$1,013 and

$939 as of June 30, 2019, respectively.

On December 31, 2019, the Company’s short-term bank borrowings consisted of revolving bank loans of $1,436 from several banks, which were subject to annual interest rates of 4.60%. Some of the short-term loans are secured by the pledge of restricted cash and buildings

 by the Company

with carrying values of $943 and

$

1,030 as of December 31, 2019, respectively.

For the six months ended December 31, 2018 and 2019, interest expenses on short-term bank loans amounted to $28 and $29, respectively.

As of June 30, 2019, the Company had available lines of credit from various banks in the PRC, Singapore and Malaysia amounting to $265,560, of which $77,911 was utilized and $187,649 is available for use. These lines of credit were secured by the pledge of restricted cash and buildings

by the

C

ompany

with carrying value

s

of $13,401 and $3,018, respectively.

As of December 31, 201

9

, the Company had available lines of credit from various banks in the PRC, Singapore and Malaysia amounting to $330,806, of which $71,229 was utilized and $259,577 is available for use. These lines of credit were secured by the pledge of restricted cash and buildings

 by the Company

with carrying value

s

of $6,668 and $3,007, respectively.

F-2

4

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 

9

 -     LONG-TERM LOANS

	June 30, 2019			December 31, 2019
				(Unaudited)
Malaysian Ringgit (MYR) denominated loan		947			905
Singapore Dollar (SGD) denominated loan		346			310
Convertible Bond		19,995			—
	$	21,288		$	1,215
Less: current portion		(20,310	)		(319	)
	$	978		$	896

Scheduled principal payments for all outstanding long-term loans as of December 31, 2019 are as follows:

	December 31, 2019
	(Unaudited)
January 1, 2020 – December 31, 2020	$	406
January 1, 2021 – December 31, 2021		276
January 1, 2022 – December 31, 2022		229
January 1, 2023 – December 31, 2023		125
January 1, 2024 and onwards		179
	$	1,215

For the six months ended December 31, 2018 and 2019, interest expenses of long-term loans incurred amounted to $288 and $90 respectively,

nil

and nil was capitalized as construction in progress

 respectively

.

NOTE 

10

 -     FAIR VALUE MEASUREMENTS

Financial instruments include cash and cash equivalents, restricted cash, time deposits with maturities over three months, accounts receivable, other receivables, amounts due to or from related parties, accounts payable, short-term bank loans, long-term bank loans and bifurcated derivative. The carrying values of these financial instruments, other than long-term bank loans and a bifurcated derivative (which is a recurring fair value measurement), approximate their fair values due to their short-term maturities. The carrying value of the Company’s long-term bank loans other than the Convertible Bond approximates its fair value as the long-term bank loans are subject to floating interest rates. These assets and liabilities, excluding cash and cash equivalents (which fall into level 1 of the fair value hierarchy), fall into level 2 of the fair value hierarchy.

The carrying value of the Convertible Bond is $19,995 as of June 30, 201

9

,

 whereas the fair value is $19,502 as of June 30, 201

9

.

 The fair value measurements of the Convertible Bond falls into level 3 of the fair value hierarchy.

The Convertible Bond was repaid in full on August 29, 2019. There were no liabilities measured at fair value

on a recurring or non-recurring basis

as of

Decemb

er 31

, 2019.

The derivative financial liability represents the

fair

value of the

non-conversion

compensation feature bifurcated from the convertible bond. The changes in fair value of the

non-conversion

compensation feature during the six months ended December 31, 201

9

are shown in the following table.

F-2

5

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

	Fair value measurements as of December 31, 2019 using significant unobservable inputs (Level 3)
	Non-conversion compensation feature related to the Convertible Bond
Balance as at June 30, 2019	$	758
Settlement		(753	)
Change in fair-value (included within other expenses, net)		(5	)
Balance as of December 31, 2019 (Unaudited)	$	—

Assets measured at fair value on a nonrecurring basis as of June 30, 2019 are stated below:

 

	June 30, 2019
	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Total
Assets:
Retained equity interest in a former subsidiary (i)	$	—	$	—	$	4,110	$	4,110
Goodwill (ii)		—		—		—		—
Total assets measured at fair value on a non-recurring basis	$	—	$	—	$	4,110	$	4,110

 

(i) The retained equity interest in Beijing Hollysys Intelligent Technologies Co., Ltd. was measured at fair value using the discounted cash flow method which involves significant unobservable inputs such as terminal growth rate and discount rate.

(ii) As of June 30, 2019, the Company’s goodwill of nil was related to the acquisition of Concord Group. The Company engaged an independent third-party appraiser to assist with the valuation of the goodwill related to the Concord Group using two-step test approach, which indicated the implied fair value of the goodwill via a residual approach to be nil. Based on the test result, the Company recorded a goodwill impairment charge of $11,623.

There were no financial assets measured at fair value on a recurring basis as of June 30, 2019 and December 31, 2019. There were no assets measured at fair value on a non-recurring basis as of December 31, 2019.

F-2

6

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 

11

 -     STOCKHOLDERS’ EQUITY

On September 27, 2019, the Company declared a regular annual cash dividend of $0.21 per share to the holders of the Company’s ordinary shares. The record date was October 22, 2019, and the dividend was paid on November 12, 2019.

On September 27, 2018, the Company declared a regular annual cash dividend of $0.18 per share to the holders of the Company’s ordinary shares. The record date was October 22, 2018, and the dividend was paid on November 12, 2018.

NOTE 1

2

 -     INCOME TAX

Effective tax rate

The Company’s effective income tax rate (“ETR”) was

17.0% for the six months ended December 31, 2019 as compared to

14.0% for the six months ended December 31, 2018. The ETR

fluctuates as a result of th

e

Company’s subsidiaries contributing different pre-tax income mixes and being subject to different tax rates.

NOTE 13 -     INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share attributable to Hollysys for the six months indicated:

	Six months ended December 31,
	2018		2019
	(Unaudited)		(Unaudited)
Numerator:
Net income attributable to the Company - basic	$	72,036	$	63,746
Net income attributable to the Company - diluted (i)	$	72,324	$	63,838
Denominator:
Weighted average ordinary shares outstanding used in computing basic income per share		60,450,930		60,504,151
Effect of dilutive securities
Convertible Bond		796,200		130,882
Restricted shares		24,734		13,647
Weighted average ordinary shares outstanding used in computing diluted income per share		61,271,864		60,648,680
Income per share - basic	$	1.19		1.05
Income per share - diluted	$	1.18		1.05

(i) For the six months ended December 31, 2018 and 2019, interest accretion related to the Convertible Bond of $288 and 93 respectively, is added back to derive net income attributable to the Company for computing diluted income per share.

Vested and unissued restricted shares of 108,831 and 48,706 shares are included in the computation of basic and diluted income per share for the six months ended December 

31, 2018 and 2019,

respectively

.

The effects of share options have been excluded from the computation of diluted income per share for the six months ended December 31, 2018

and 2019

as their effects would be anti-dilutive.

F-2

7

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

NOTE 1

4

 -     COMMITMENTS AND CONTINGENCIES

Capital commitments

As of December 31, 2019, the Company had approximately $574 in capital obligations for the coming twelve months, mainly for the Company’s information system construction.

Purchase obligations

As of December 31, 2019, the Company had $176,824 purchase obligations

 in total ($148,440, $17,740, $7,096 and $3,548 over the periods of less than one year, one to three years, three to five years and more than five years from December 31, 2019, respectively)

.

They are related to purchases of inventories, mainly for fulfillment of in-process or newly entered contracts resulting from the expansion of the Company’s operations.

Performance guarantee and standby letters of credit

The Company had

stand-by

letters of credit of $759 and outstanding performance guarantees of $55,825 as of December 31, 2019, with restricted cash of $8,185 pledged to banks. The purpose of the

stand-by

letter of credit and performance guarantees is to guarantee that the performance of the Company’s deliveries reach the

pre-agreed

requirements specified in the integrated solutions contracts. The guarantee is to ensure the functionality of the Company’s own work. The disclosed amount of

stand-by

letters of credit and outstanding performance guarantees represent the maximum potential amount of future payments the Company could be required to make under such guarantees.

The Company accounts for performance guarantees and stand-by letters of credit in accordance with ASC 460

,

Guarantees

(“ASC 460”)

.

Accordingly, the Company evaluates its guarantees to determine whether (a) the guarantee is specifically excluded from the scope of ASC 460, (b) the guarantee is subject to ASC 460 disclosure requirement only,

but

not subject to the initial recognition and measurement provisions, or (c) the guarantee is required to be recorded in the financial statements at fair value.

F-2

8

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

Both the performance guarantees and the

stand-by

letters of credit are for the Company’s commitment of its own future performance, and the outcome of which is within its own control. As a result, performance guarantees and

stand-by

letters of credit are subject to ASC 460 disclosure requirements only.

NOTE 1

5

 -     SEGMENT REPORTING

The CODM

of the Company

has been identified as the Chairman, Chief Executive Officer and Chief Financial Officer of the Company. The Company organizes its internal financial reporting structure based on its main product and service offerings.

Based on the criteria established by ASC 280, the Company has determined that the reportable segments of the Company consist of (1) IA, (2) Rail, (3) M&E, in accordance with the Company’s organization and internal financial reporting structure. The CODM assesses the performance of the operating segments based on the measures of revenues, costs and gross profit. Other than the information provided below, the CODM does not use any other measures by segments.

Summarized information by segments for the six months ended December 31, 2018, and 2019 is as follows:

	Six months ended December 31, 2018
	(Unaudited)
	IA		Rail		M&E		Consolidated
Revenues from external customers
Integrated solutions contract revenue	$	90,357		75,883		67,093		233,333
Product sales		10,337		3,620		—		13,957
Maintenance service revenue		6,119		33,218		41		39,378
Extended warran ty service reven ue		364		1,150		—		1,514
Total		107,177		113,871		67,134		288,182
Costs of revenue		69,125		53,423		57,174		179,722
Gross profit	$	38,052		60,448		9,960		108,460

	Six months ended December 31, 2019
	(Unaudited)
	IA		Rail		M&E		Consolidated
Revenues from external customers
Integrated solutions contract revenue	$	116,288		82,546		35,307		234,141
Product sales		9,164		3,497		—		12,661
Maintenance ser vice revenue		7,921		36,625		705		45,251
Extended warrant y ser vice revenue		555		730		—		1,285
Total		133,928		123,398		36,012		293,338
Costs of revenue		88,722		67,370		29,108		185,200
Gross profit	$	45,206		56,028		6,904		108,138

F-29

HOLLYSYS AUTOMATION TECHNOLOGIES LTD.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE SIX MONTHS ENDED DECEMBER 31, 2018 AND 2019 - continued

(Amounts in thousands except for number of shares and per share data)

The majority of the Company’s revenues and long-lived assets other than goodwill and intangible assets are derived from and located in the PRC. The following table sets forth the revenues by

geographical

area:

	Six months ended December 31,
	2018		2019
	(Unaudited)		(Unaudited)
Revenues:
PRC	$	213,742	$	250,126
Non-PRC		74,440		43,212
	$	288,182	$	293,338

The following table sets forth the long-lived assets other than goodwill and intangible assets by geographical area:

	June 30, 2019		December 31, 2019
			(Unaudited)
Long-lived assets other than goodwill and acquired intangible assets
PRC	$	125,781	$	126,102
Non-PRC		11,986		12,951
	$	137,767	$	139,053

NOTE 16 -     SUBSEQUENT EVENTS

The ongoing coronavirus (“COVID-19”) outbreak emanating from China at the beginning of 2020 has surged outside China recently. The Company’s business operations and financial condition may be materially and adversely affected as a result of any slowdown in economic growth, operation disruptions or other losses that may be incurred due to inability to collect outstanding accounts receivable and other asset impairments. Due to the significant uncertainties surrounding the COVID-19 outbreak, the extent of the negative impact to the Company’s operating results and financial condition cannot be reasonably estimated at this time.

F-

30