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UNIVERSAL SECURITY INSTRUMENTS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 4, 2014

Forward-Looking Statements

When used in this discussion and elsewhere in this Annual Report on Form 10-K, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made, and readers are advised that various factors, including Risk Factors discussed in earlier filings and other risks, could affect our financial performance and could cause our actual results for future periods to differ materially from those anticipated or projected. We do not undertake and specifically disclaim any obligation to update any forward-looking statements to reflect occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

7 General



We are in the business of marketing and distributing safety and security products which are primarily manufactured through our 50% owned Hong Kong Joint Venture. Our financial statements detail our sales and other operational results, and report the financial results of the Hong Kong Joint Venture using the equity method. Accordingly, the following discussion and analysis of the fiscal years ended March 31, 2014 and 2013 relate to the operational results of the Company and its consolidated subsidiaries only and includes the Company's equity share of earnings in the Hong Kong Joint Venture. A discussion and analysis of the Hong Kong Joint Venture's operational results for these periods is presented below under the heading "Hong Kong Joint Venture."

While we believe that our overall sales are likely affected by the current global economic situation, we believe that we are specifically negatively impacted by the severe downturn in the U.S. housing market. As stated elsewhere in this report, our USI Electric subsidiary markets our products to the electrical distribution trade (primarily electrical and lighting distributors and manufactured housing companies); every downturn in new home construction and new home sales negatively impacts sales by our USI Electric subsidiary. Our operating results for the current fiscal years ended March 31, 2014 and 2013 continue to be significantly impacted by the economic downturn of the U.S. housing market. We anticipate that when and as the housing market recovers, sales by our USI Electric subsidiary will improve, as well.

We further believe that our fiscal 2014 retail sales were impacted by the movement of the smoke and carbon monoxide alarmretail markets toward ten-year sealed alarms to comply with new laws passed in several states, including California and New York. In May 2014, the Company previewed eleven new sealed smoke and carbon monoxide alarms at the International Hardware Show in Las Vegas, and the Company believes that prospective customers' responses were very positive. We anticipate that the first two sealed models will be available toward the end of our second fiscal 2015 quarter (September 2014) and the complete line should be available for sale before the end of our 2015 fiscal year. While the new sealed units are not ready for sale, we project that based on sales of the new sealed units, the Company will begin to return to profitability after the complete line of sealed units is available for sale.

Comparison of Results of Operations for the Years Ended March 31, 2014 and 2013

Sales. In fiscal year 2014, our net sales are $12,577,127 compared to sales in the prior year of $15,383,877, a decrease of $2,806,750 (18.2%). Our lower sales are primarily attributable to the timing of orders of our new carbon monoxide detector to a principal customer of these products during the prime seasonal selling period, which is the third quarter of our fiscal year.

Gross Profit.Gross profit margin is calculated as net sales less cost of goods sold expressed as a percentage of net sales. Our gross profit margin for the fiscal year ended March 31, 2014 was 22.6% compared to 28.2% in fiscal 2013. The decrease in 2014 gross margin is attributed to increased cost of product sold when compared to the prior year resulting primarily from changes in the mix of products sold and increased manufacturing costs of our Hong Kong Joint Venture.

Selling, General and Administrative Expense. Selling, general and administrative expenses decreased from $5,010,230 in fiscal 2013 to $4,251,274 in fiscal 2014. As a percentage of net sales, these expenses were 33.8% for the fiscal year ended March 31, 2014 and 32.6% for the prior fiscal year. The decrease in dollars primarily reflects a reduction of approximately $500,000 from amounts incurred in the fiscal year ended March 31, 2013 to market our new product line and decreases in selling commissions and freight costs due to reduced sales.

Research and Development. Research and development expense for the fiscal year ended March 31, 2014 was $592,488, of which approximately $450,000 was for new product development. Research and development expense for the fiscal year ended March 31, 2013 was $543,141, of which approximately $400,000 was for new product development. The increase in overall research and development expense for the 2014 period compared to the 2013 period was due to the cost of independent testing of additional new products in development.

Interest Income and Other Income. Interest income for the fiscal year ended March 31, 2014 consisted of interest earned on cash deposits with our factor. During the fiscal years ended March 31, 2014 and 2013, we earned interest of $23,316 and $23,572, respectively from these deposits. Other income in the fiscal year ended March 31, 2013, included $66,862 that resulted from a gain on an insurance settlement.

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Interest Expense. During the fiscal years ended March 31, 2014 and 2013, we incurred no interest expense.

Income Taxes. For the fiscal years ended March 31, 2014 and 2013, our statutory Federal rate of tax is 34.0%. The rate of tax indicated by the provision for income tax expense as shown on the Consolidated Statements of Operations for the March 31, 2014 and 2013 varies from the expected statutory rate. Footnote F to the financial statements provides a reconciliation between the amount of tax that would be expected at statutory rates and the amount of tax expense or benefit provided at the effective rate of tax for each fiscal period.

For the fiscal year ended March 31, 2014, and 2013, we generated net operating loss carryovers to offset future federal and state income taxes of approximately $1,176,000 and $870,000, respectively. At March 31, 2014 and 2013, we had net operating loss carryovers of approximately $3,822,000 and $2,351,000, respectively. The Company recognizes a liability or asset for the deferred tax consequences of temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements. These temporary differences may result in taxable or deductible amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. The deferred tax assets are reviewed periodically for recoverability and valuation allowances are provided whenever it is more likely than not that a deferred tax asset will not be realized. Accordingly, the Company has established a full valuation allowance of $3,120,203 on its deferred tax asset at March 31, 2014, to recognize that certain tax credits expiring in future fiscal years are not likely to be realized. See "Critical Accounting Policies" below for further discussion regarding the need to reserve the previously established deferred tax assets.

Net Loss. We reported a net loss of $4,450,244 for the fiscal year 2014, compared to a net loss of $452,561 for fiscal 2013, a $3,997,683 (883.3%) decrease. The increase in the net loss is primarily attributed to a non-cash charge to provide an allowance for unrealizable deferred tax assets of approximately $2.3 million, lower sales for the fiscal year and lower earnings of the Hong Kong Joint Venture principally due to lower sales to the Company and its other customers. Our equity in the earnings of the Hong Kong Joint Venture decreased from $722,827 in fiscal 2013 to a loss of $159,947 in fiscal 2014, a $882,774 (122.1%) decrease.

Financial Condition, Liquidity and Capital Resources

Our cash needs are currently met by financial reserves and from our Factoring Agreement with CIT Group, which supplies both short-term borrowings and letters of credit to finance foreign inventory purchases. Based on specified percentages of our accounts receivable and inventory and letter of credit commitments, at March 31, 2014, our maximum borrowing availability under this Agreement was $1,000,000. Any outstanding principal balance under this Agreement is payable upon demand. The interest rate on the Factoring Agreement, on the uncollected factored accounts receivable and any additional borrowings is equal to the prime rate of interest charged by the factor which, as of March 31, 2014, was 3.25%. All borrowings are collateralized by all our accounts receivable and inventory. During the year ended March 31, 2014, working capital (computed as the excess of current assets over current liabilities) decreased by $1,415,892 from $9,570,671 on March 31, 2013, to $8,154,779 on March 31, 2014.

Our operating activities used cash of $851,941 for the year ended March 31, 2014 principally as a result of a loss from operations of $4,450,244. The operating loss was partially offset by a non-cash allowance for unrealizable deferred income tax assets of $2,310,835, and decreases in accounts receivable and amounts due from factor of $630,310 and decreases in prepaid expenses of $192,672.

Our operating activities used cash of $785,730 for the year ended March 31, 2013 principally as a result of the net loss of $452,561 adjusted for non-cash income of $722,827 provided through earnings of our Hong Kong Joint Venture and a decrease in trade accounts payable and accrued expenses of $565,774, partially offset by a reduction in inventory of $1,056,888.

Our investing activities provided cash of $382,792 and $264,268 during fiscal 2014 and 2013 principally as a result of cash distributions of the Hong Kong Joint Venture of $416,275 and $276,157 respectively.

Financing activities provided cash of $81,250 during the fiscal year ended March 31, 2014 as a result of the sale of common stock to an employee in exercise of an option to purchase said common stock. Financing activities used cash of $225,920 during the fiscal year ended March 31, 2013, resulting from the repurchase of the Company's common stock in accordance with the Company's stock repurchase plan.

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Our cash needs are currently met by funds generated from operations. As stated above, we believe that sales by the Company and by our USI Electric subsidiary have been negatively impacted by the severe downturn in the U.S. housing market. We anticipate that when and as the housing market recovers, sales by the Company and by our USI Electric subsidiary will improve, thereby improving our profitability and increasing our capital resources. The Company continues to develop and market its next generation of products, including a new line of sealed battery safety alarms, and anticipates that sales of these new products will help the Company return to profitability. While we expect that our cash and cash equivalents and availability under our Factoring Agreement will be sufficient to fund our operations and increases in inventory for the next 12 months, we have initiated discussions with CIT Group to increase our availability under the Factoring Agreement.

Hong Kong Joint Venture



The financial statements of the Hong Kong Joint Venture are included in this Form 10-K beginning on page JV-1. These financial statements are presented in accordance with International Financial Reporting Standards used by the International Financial Standards Board (IFRS) and there are no (IFRS) to US GAAP differences in the Hong Kong Joint Venture's accounting policies.

In fiscal year 2014, sales of the Hong Kong Joint Venture were $19,054,691, compared to $22,031,665 in fiscal 2013. During the fiscal year ended March 31, 2014, sales to the Company declined approximately $2,235,000 due to decreased purchasing by the Company in line with decreased demand in the U.S. domestic market, and sales to unaffiliated customers declined approximately $744,000, due to decreased demand from a single large customer in Germany.

Net loss was $437,940 for fiscal year 2014 compared to net income of $1,647,461 for the fiscal year ended March 31, 2013. The decrease in net income for fiscal 2014 was primarily due to lower sales to the Company and to higher costs for salaries and wages included in selling, general and administration expenses.

Gross margins of the Hong Kong Joint Venture for fiscal 2014 decreased to 23.3% from 24.6% in the prior fiscal year. The primary reason for the decrease is the increase in labor in the production cost.

Selling, general and administrative expenses of the Hong Kong Joint Venture for fiscal 2014 were $5,310,546, compared to $4,499,939 in the prior fiscal year. The increase in dollars as compared to the prior fiscal year results primarily from higher labor costs. As a percentage of sales, these expenses were 27.9% and 20.4%, respectively, for the fiscal years ended March 31, 2014 and 2013.

Investment income and interest income, net of interest expense was $681,883 for fiscal year 2014, compared to $491,474 for fiscal year 2013.

Cash needs of the Hong Kong Joint Venture are currently met by funds generated from operations. During fiscal year 2014, working capital decreased from $9,834,568 on March 31, 2013 to $9,287,873 on March 31, 2014.

Critical Accounting Policies



Management's discussion and analysis of our consolidated financial statements and results of operations are based upon our Consolidated Financial Statements included as part of this document. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate these estimates, including those related to bad debts, inventories, income taxes, impairment of long-lived assets, and contingencies and litigation. We base these estimates on historical experiences and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies affect management's more significant judgments and estimates used in the preparation of its consolidated financial statements. For a detailed discussion on the application of these and other accounting policies, see Note A to the consolidated financial statements included in this Annual Report. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty and actual results could differ from these estimates. These judgments are based on our historical experience, terms of existing contracts, current economic trends in the industry, information provided by our customers, and information available from outside sources, as appropriate. Our critical accounting policies include:

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Income Taxes: The Company recognizes a liability or asset for the deferred tax consequences of temporary differences between the tax basis of assets or liabilities and their reported amounts in the financial statements. These temporary differences may result in taxable or deductible amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. The deferred tax assets are reviewed periodically for recoverability and a valuation allowance is provided whenever it is more likely than not that a deferred tax asset will not be realized. The Company established an initial valuation allowance of $300,000 on its deferred tax assets during the year ended March 31, 2013 to recognize that certain foreign tax credits expiring in future periods will likely not be realized. Upon further review of updated projected taxable income and the components of the deferred tax asset in accordance with applicable accounting guidance at September 30, 2013, it was determined that it is more likely than not that the tax benefits associated with the remaining components of the deferred tax assets will not be realized. This determination was made based on continued taxable losses during fiscal 2014, which were not in line with projections, as well as product offering delays which cause uncertainty as to whether the Company will generate sufficient taxable income to use the deferred tax assets prior to their expiration. Accordingly, a valuation allowance was established to fully offset the value of the deferred tax assets. Our ability to realize the tax benefits associated with the deferred tax assets depends primarily upon the timing of future taxable income and the expiration dates of the components of the deferred tax assets. If sufficient future taxable income is generated, we may be able to offset a portion of future tax expenses.

The Company follows ASC 740-10 that gives guidance to tax positions related to the recognition and measurement of a tax position taken or expected to be taken in a tax return and requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not to be sustained upon an examination, based on the technical merits of the position.

Interest and penalties related to income tax matters are recorded as income tax expenses. The Company has recorded a long-term liability of $25,000 for an uncertain income tax position, tax penalties and any imputed interest thereon. See Note F, Income Taxes.

Revenue Recognition: Revenue is recognized at the time product is shipped and title passes pursuant to the terms of the agreement with the customer, the amount due from the customer is fixed and collectability of the related receivable is reasonably assured. We establish allowances to cover anticipated doubtful accounts and sales returns based upon historical experience. The Company nets the factored accounts receivable with the corresponding advance from the Factor, with the net amount reflected in the consolidated balance sheet. The Company assigns trade receivables on a pre-approved non-recourse basis to the Factor under the Factoring Agreement on an ongoing basis.

Inventories: Inventories are valued at the lower of market or cost. Cost is determined on the first in/first out method. We evaluate inventories on a quarterly basis and write down inventory that is deemed obsolete or unmarketable in an amount equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions.

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Recently Issued Accounting Pronouncements

Changes to accounting principles generally accepted in the United States of America (U.S. GAAP) are established by the Financial Accounting Standards Board (FASB) in the form of accounting standards updates (ASU's) to the FASB's Accounting Standards Codification.

The Company considers the applicability and impact of all ASU's. Recently issued ASU's were evaluated and determined to be either not applicable or are not expected to have a material impact on our consolidated financial statements.

Revision of Prior Period Financial Statements

Certain amounts appearing in the condensed consolidated balance sheet as of March 31, 2013 have been revised to correct for an immaterial error and to conform to the current year's presentation. The Company had not previously recorded its proportionate share of the Hong Kong Joint Ventures other comprehensive income amounts. These consisted of the impact of foreign currency exchange rates on the translation of certain subsidiaries of the Hong Kong Joint Venture and changes in the fair value of investments held by the Hong Kong Joint Venture that are classified as available for sale. As a result, the Company adjusted the opening balance sheet of the earliest year presented, increasing its investment in the Hong Kong Joint Venture and accumulated other comprehensive income by $1,083,603 as of April 1, 2012. The adjustments also increased its previously reported investment in the Hong Kong Joint Venture and accumulated other comprehensive income as of March 31, 2013 by $1,376,410. Since these two components represented the only components of other comprehensive income, the Company had not previously presented a Statement of Comprehensive Income (Loss). The Company has, in the accompanying Financial Statements, presented a separate condensed consolidated statement of comprehensive loss for the twelve months ended March 31, 2014 and 2013.

The Company assessed the materiality of the error in accordance with the Securities and Exchange Commission (the SEC) Staff Accounting Bulletin Nos. 99 and 108 (SAB 99 and 108), and based on an analysis of quantitative and qualitative factors, determined that the error was immaterial to each of the prior reporting periods affected and, therefore, amendment of reports previously filed with the SEC was not required.

Accumulated Other Comprehensive Income

The following table presents the changes in Accumulated Other Comprehensive Income by component for the fiscal year ended March 31, 2014:

Currency Investment Translation Securities Total Balance - March 31, 2013 $ 1,172,486$ 203,924$ 1,376,410 Other comprehensive loss $ (44,678 )$ (141,605 )$ (186,283 ) Balance - March 31, 2014 $ 1,127,808$ 62,319$ 1,190,127 12


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