NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business: Universal Security Instruments, Inc.’s (“the Company”) primary business is the sale of smoke alarms and other safety products to retailers, wholesale distributors and to the electrical distribution trade which includes electrical and lighting distributors as well as manufactured housing companies. The Company imports all of its safety and other products from foreign manufacturers. The Company, as an importer, is subject to numerous tariffs which vary depending on types of products and country of origin, changes in economic and political conditions in the country of manufacture, potential trade restrictions and currency fluctuations.

Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. We believe that our 50% ownership interest in the Hong Kong Joint Venture allows us to significantly influence the operations of the Hong Kong Joint Venture. As such, we account for our interest in the Hong Kong Joint Venture using the equity method of accounting. We have included our investment balance as a non-current asset and have included our share of the Hong Kong Joint Venture’s income in our consolidated statement of operations. The investment and earnings are adjusted to eliminate intercompany profits.

Use of Estimates: In preparing financial statements in conformity with accounting principles generally accepted in the United States of America (US GAAP), management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents:   Cash equivalents consist of highly liquid investments with original maturities of three months or less from the date of purchase. At times, the Company maintains cash and investment balances in financial institutions, which may exceed federally insured limits. The Company has not experienced any losses relating to such accounts and believes it is not exposed to a significant credit risk on its cash and cash equivalents and investments. The carrying value of cash and cash equivalents approximates their fair value based on their short-term maturities at March 31, 2012 and 2011.

Revenue Recognition: The Company recognizes sales upon shipment of products, when title has passed to the buyer, net of applicable provisions for any discounts or allowances. We recognize revenue when the following criterion are met: evidence of an arrangement, fixed and determinable fee, delivery has taken place, and collectability is reasonably assured. Customers may not return, exchange or refuse acceptance of goods without our approval. We have established allowances to cover anticipated doubtful accounts based upon historical experience.

Warranties: We generally provide warranties, on the safety products, from one to ten years to the non-commercial end user on all products sold. The manufacturers of our safety products provide us with a one-year warranty on all products we purchase for resale. Claims for warranty replacement of products beyond the one-year warranty period covered by the manufacturers have not been historically material and we do not record estimated warranty expense or a contingent liability for warranty claims.

Stock-Based Compensation: In October 2011, the stockholders approved the Company’s 2011 Non-Qualified Stock Option Plan authorizing the issuance of 120,000 options to purchase the Company’s common stock. At March 31, 2012, 97,000 options have been issued at an exercise price of $5.51.

We account for share-based payments using the fair value method. We recognize all share-based payments to employees and non-employee directors in our financial statements based on their grant date fair values, calculated using the Black-Scholes option pricing model. Compensation expense related to share-based awards is recognized on a straight-line basis based on the value of share awards that are expected to vest during the requisite service period on the grant date, which is revised if actual forfeitures differ materially from original expectations.

The expected term of stock options granted was based on the Company’s historical option exercise experience and post-vesting forfeiture experience using the historical expected term from the vesting date. The expected volatility of the options granted was determined using historical volatilities based on stock prices over a look-back period corresponding to the expected term. The risk-free interest rate was determined using the yield available for zero-coupon U.S. government issues with a remaining term equal to the expected term of the options. The forfeiture rate was determined using historical pre-vesting forfeiture rates since the inception of the plans. The company has never paid a dividend; and, as such, the dividend yield is zero.

Stock Repurchase Program : In October 2011, the Company announced a stock buyback program under which the Board authorized the purchase of up to 100,000 shares of common stock. Shares may be purchased from time to time under this program in the open market, through block trades and/or in negotiated transactions. The program will terminate when 100,000 shares of common stock have been repurchased by the Company pursuant to the program (unless increased or decreased by the Board of Directors).

The following table sets forth information with respect to purchases by the Company of its common stock during the fiscal year ended March 31, 2012:

Research and Development: Research and development costs are charged to operations as incurred.

Accounts Receivable: 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 sells trade receivables on a pre-approved non-recourse basis to the Factor under the Factoring Agreement on an ongoing basis. Factoring charges recognized on sales of receivables are included in selling, general and administrative expenses in the consolidated statements of income and amounted to $56,943 and $57,161 for the years ended March 31, 2012 and 2011, respectively. The Agreement for the sale of accounts receivable provides for continuation of the program on a revolving basis until terminated by one of the parties to the Agreement.

Financing Receivables. In September 2010, the FASB issued, and the Company adopted, an Accounting Standards Update requiring enhanced disclosure of the credit quality of financing receivables, as defined therein, and the adequacy of allowances for credit losses. Management considers amounts due from the Company’s factor to be “financing receivables”. Trade accounts receivable, other receivables, and receivables from our Hong Kong Joint Venture are not considered to be financing receivables.

The Company sells the majority of its short-term receivables arising in the ordinary course of business to our factor. At the time a receivable is sold to our factor the credit risk associated with the credit worthiness of the debtor is assumed by the factor. The Company continues to bear any credit risk associated with delivery or warranty issues related to the products sold.

Management assesses the credit risk of both its trade accounts receivable and its financing receivables based on the specific identification of accounts that have exceeded credit terms. An allowance for uncollectible receivables is provided based on that assessment. Changes in the allowance account from one accounting period to the next are charged to operations in the period the change is determined. Amounts ultimately determined to be uncollectible are eliminated from the receivable accounts and from the allowance account in the period that the receivables’ status is determined to be uncollectible.

Based on the nature of the factoring agreement and prior experience, no allowance for uncollectible financing receivables has been provided. At March 31, 2012, an allowance of $75,000 has been provided for uncollectible trade accounts receivable.

Shipping and Handling Fees and Costs: The Company includes shipping and handling fees billed to customers in net sales. Shipping and handling costs associated with inbound freight are included in cost of goods sold. Shipping and handling costs associated with outbound freight are included in selling, general and administrative expenses and totaled $356,171 and $308,278 in fiscal years 2012 and 2011, respectively.

Inventories: Inventories are stated at the lower of cost (first in/first out method) or market. Included as a component of finished goods inventory are additional non-material costs. These costs include overhead costs, freight, import duty and inspection fees of $571,219 and $398,397 at March 31, 2012 and 2011, respectively. Inventories are shown net of an allowance for inventory obsolescence of $70,000 and $100,000 as of March 31, 2012 and 2011, respectively.

The Company reviews inventory quarterly to identify slow moving products and valuation allowances are adjusted when deemed necessary.

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 will 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. The Company follows the financial pronouncement that gives guidance related to the financial statement of 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, See Note F, Income Taxes .

Recently Issued Accounting Pronouncements: Changes to accounting principles generally accepted in the United States of America (US. GAAP) are established by the Financial Accounting Standards Board (FASB) in the form of accounting standards updated (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.

Foreign currency : The activity and accounts of the Hong Kong Joint Venture are denominated in Hong Kong dollars and are translated to US dollars in consolidation. The Company translates the accounts of the Hong Kong Joint Venture at the applicable exchange rate in effect at the year end date for balance sheet purposes and at the average exchange rate for the reporting period for statement of operation purposes. Transaction gains and losses arising from transactions denominated in foreign currencies are included in the results of operations. The Company currently does not maintain cash in foreign banks to support its operations in Hong Kong.

Net Income per Share: The Company reports basic and diluted earnings per share. Basic earnings per share is computed by dividing net income for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income for the period by the weighted number of common shares and common share equivalents outstanding (unless their effect is anti-dilutive) for the period. All common share equivalents are comprised of stock options. Diluted loss per common share for the year ended March 31, 2012 excludes the effect of all stock options, as their effect is antidilutive. As a result, the weighted average number of common shares outstanding is identical for the year ended March 31, 2012 for both basic and diluted shares.

NOTE B – PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost, less accumulated depreciation and amortization. Depreciation and amortization are provided by using the straight-line method for financial reporting purposes and accelerated methods for income tax purposes.

The estimated useful lives for financial reporting purposes are as follows:

Property and equipment consist of the following:

Depreciation and amortization expense totaled $41,522 and $61,025 for fiscal years ended March 31, 2012 and 2011, respectively.

NOTE C - INVESTMENT IN THE HONG KONG JOINT VENTURE

The Company holds a 50% interest in a Joint Venture with a Hong Kong Corporation, which has manufacturing facilities in the People’s Republic of China, for the manufacturing of consumer electronic products. As of March 31, 2012, the Company has an investment balance of $13,083,493 for its 50% interest in the Hong Kong Joint Venture. There are no material differences between the generally accepted accounting principles (GAAP) used in the Hong Kong Joint Venture’s accounting policies when compared to US GAAP.

The following represents summarized financial information derived from the audited financial statements of the Hong Kong Joint Venture as of March 31, 2012 and 2011.

During the years ended March 31, 2012 and 2011, the Company purchased $10,152,081 and $8,130,109, respectively, of finished product from the Hong Kong Joint Venture, which represents 96.2% and 85.6%, respectively, of the Company’s total finished product purchases for the years ended at March 31, 2012 and 2011. Amounts due the Hong Kong Joint Venture included in Accounts Payable totaled $449,430 and $453,480 at March 31, 2012 and 2011, respectively. Amounts due from the Hong Kong Joint Venture included in Accounts Receivable totaled $584,594 and $301,380 at March 31, 2012 and 2011, respectively.

The Company’s investment in the Hong Kong Joint Venture as recorded on the Company’s Consolidated Balance sheets has been adjusted by the intercompany profit of the Hong Kong Joint Venture in the Inventory of the Company.

NOTE D - AMOUNTS DUE FROM FACTOR

The Company sells certain of its trade receivables on a pre-approved, non-recourse basis to a Factor. Since these are sold on a non-recourse basis, the factored trade receivables and related repayment obligations are not separately recorded in the Company’s consolidated balance sheets. The Agreement provides for financing of up to a maximum of $1,000,000 with the amount available at any one time based on cash on deposit, 90% of uncollected non-recourse receivables sold to the factor, and 50% of qualifying inventory. Financing of approximately $1,000,000 is available at March 31, 2012. Any outstanding amounts due to the factor are payable upon demand and bear interest at the prime rate of interest charged by the factor, which is 3.25% at March 31, 2012. Any amount due to the factor is also secured by the Company’s inventory. There were no borrowings outstanding under this agreement at March 31, 2012.

Under this Factoring Agreement, the Company sold receivables of approximately $9,979,020 and $10,360,042 during the years ended March 31, 2012 and 2011, respectively. Gains and losses recognized on the sale of factored receivables include the fair value of the limited recourse obligation. The uncollected balance of non-recourse receivables held by the factor amounted to $1,719,731 and $1,569,126 at March 31, 2012 and 2011. The amount of the uncollected balance of non-recourse receivables borrowed by the Company as of March 31, 2012 and 2011 is $0 and $0, respectively. Collected cash maintained on deposit with the factor earns interest at the factor’s prime rate of interest less three percentage points (effective rate of 0.25%) at March 31, 2012 and 2011.

NOTE E - LEASES

During January 2009, the Company entered into an operating lease for its office and warehouse location in Owings Mills, Maryland which expires in March 2019. This lease is subject to increasing rentals at 3% per year. In June 2009, we amended this lease to include an additional 3,000 square feet of warehouse. The Company has the right to terminate the lease after five years for a one-time payment of $42,000. In February 2004, the Company entered into an operating lease for 2,600 square foot office in Naperville, Illinois. During fiscal 2012, the lease was expanded to approximately 3,400 square feet and the lease was extended to February 2015 with rentals increasing at 3% per year.

Each of the operating leases for real estate has renewal options with terms and conditions similar to the original lease. Rent expense, including common area maintenance, totaled $176,575 and $171,080 for the years ended March 31, 2012 and 2011, respectively.

NOTE F – INCOME TAXES

The Company files its income tax returns in the U.S. federal jurisdiction, and various state jurisdictions. Deferred income tax assets and liabilities are computed and recognized for those differences that have future tax consequences and will result in net taxable or deductible amounts in future periods. Deferred tax expense or benefit is the result of changes in the net asset or liability for deferred taxes. The deferred tax liabilities and assets for the Company result primarily from tax credit carryforwards, reserves and accrued liabilities

For the fiscal year ended March 31, 2012, the Company has an accumulated net operating loss carryover of approximately $1,578,107 that the Company may carry-forward to offset future taxable income. The Company generated no foreign tax credits for the period. At March 31, 2012, the Company has $1,522,886 of foreign tax and $82,778 of research and development credit carry-forward available to offset future federal income taxes.

For the fiscal year ended March 31, 2011, the Company has an accumulated net operating loss of approximately $812,651 that the Company may carryforward to offset future taxable income. The Company generated $113,136 of foreign tax credits for the period. At March 31, 2011, the Company has $1,522,886 of foreign tax credit carryforward and $48,186 of research and development credit available to offset future federal income taxes.

At March 31, 2012, the Company has net operating loss carryforwards and tax benefit carryforwards of $1,578,107 and $1,605,664, respectively, which expire at various dates from 2013 through 2030.  There are certain limitations to the use and application of these deferred tax assets.

Management reviews net operating loss carryforwards and income tax credit carryforwards to evaluate if those amounts are recoverable.  Based on historical results and projections of future operations and taxable income, the recoverability of these deferred tax assets is determined to be more likely than not; and, accordingly, no valuation allowance is deemed necessary at March 31, 2012.

The components of income tax expense (benefit) from continuing operations for the Company are as follows:

The reconciliation between the statutory federal income tax provision and the actual effective tax provision for continuing operations is as follows:

The Company adopted new income tax guidance regarding uncertain tax positions on April 1, 2007. As a result of the implementation, the Company recognized an $86,000 liability for unrecognized tax benefits, which was accounted for as a reduction of the April 1, 2007 retained earnings balance. The total amount of unrecognized tax attributes as of the date of the adoption was approximately $86,000 and includes income taxes, tax penalties and imputed interest. Interest and penalties related to adjustments to income taxes as filed, have not been significant. The Company includes any such interest and penalties in its tax provision. During the fiscal year ended March 31, 2011, the amount of the unrecognized tax attributes were reduced by $21,459, including deemed interest and penalties. That amount, if ultimately recognized, would reduce the Company’s annual effective tax rate.

NOTE G - SHAREHOLDERS’ EQUITY

Stock Repurchase Program – The following table sets forth information with respect to purchases of common stock by the Company or any affiliated purchasers during the fiscal year ended March 31, 2012:

In October 2011, the Company announced a stock buyback program and authorized the purchase of up to 100,000 shares of common stock. Shares may be purchased from time to time under this program in the open market, through block trades and/or in negotiated transactions. The program will terminate when 100,000 shares of common stock have been repurchased by the Company pursuant to the program (unless increased or decreased by the Board of Directors).

Stock Options – Under the terms of the Company’s 2011 Non-Qualified Stock Option Plan, 120,000 shares of common stock were reserved for the granting of stock options, of which 97,000 options have been issued as of March 31, 2012.

Under the terms of the Company’s now expired 1978 Non-Qualified Stock Option Plan, as amended, 1,170,369 shares of common stock were reserved for the granting of stock options, of which 1,149,638 options had been issued as of March 31, 2009. There are no options outstanding under the 1978 Non-Qualified Stock Option Plan.

In March 2009, 25,000 options were issued at $3.25 for restricted shares of the Company’s common stock. These options were not issued under the now expired 1978 Non-Qualified Stock Option Plan and became fully vested after one year with a right to exercise until March 2014.

The following tables summarize the status of exercisable stock options at March 31, 2012 and option transactions for the years then ended:

The following table summarizes information about stock options outstanding at March 31, 2011:

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions; no annual dividends, expected volatility of 57.73%, risk-free interest rate of 0.3% and expected lives of two years used for options granted in fiscal 2012. There were no options granted in fiscal 2011. The fair value of options granted in fiscal 2012 approximates $170,000. Fifty percent of the options vest one year after issuance, with the remaining fifty percent vesting twenty-three months after issuance.

As of March 31, 2012, the unrecognized compensation cost related to share-based compensation arrangements that we expect to vest is $144,519. The aggregate intrinsic value of currently exercisable options was $53,250 at March 31, 2012.

NOTE H - COMMITMENTS AND CONTINGENCIES

From time to time, the Company is involved in various lawsuits and legal matters. It is the opinion of management, based on the advice of legal counsel, that these matters will not have a material adverse effect on the Company’s financial statements.

NOTE I - MAJOR CUSTOMERS

The Company is primarily a distributor of safety products for use in home and business under both its trade names and private labels for other companies. As described in Note C, the Company purchased a majority of its products from its 50% owned Hong Kong Joint Venture.

For the fiscal year ended March 31, 2012, the Company had one customer, Facilities Maintenance, that represented 12.3% of the Company’s product sales.

NOTE J - QUARTERLY FINANCIAL DATA (UNAUDITED)