UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 31, 2013

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 001-34643

WPCS INTERNATIONAL INCORPORATED

(Exact name of registrant as specified in its charter)

	Delaware		98-0204758
	(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

One East Uwchlan Avenue

Suite 301

Exton, Pennsylvania 19341

(Address of principal executive offices) (zip code)

(610) 903-0400

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer ¨	Smaller reporting company x
(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of December 11, 2013, there were 1,558,669 shares of registrant’s common stock outstanding.

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

INDEX

PART I.	FINANCIAL INFORMATION

	ITEM 1.	Financial Statements

		Condensed consolidated balance sheets at October 31, 2013 (unaudited) and April 30, 2013	3-4

		Condensed consolidated statements of operations for the three and six months ended October 31, 2013 and 2012 (unaudited)	5

		Condensed consolidated statements of comprehensive (loss) income for the three and six months ended October 31, 2013 and 2012 (unaudited)	6

		Condensed consolidated statement of equity (deficit) for the six months ended October 31, 2013 (unaudited)	7

		Condensed consolidated statements of cash flows for the six months ended October 31, 2013 and 2012 (unaudited)	8-9

		Notes to unaudited condensed consolidated financial statements	10-27

	ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28-46

	ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	47

	ITEM 4.	Controls and Procedures	48

PART II.	OTHER INFORMATION

	ITEM 1.	Legal Proceedings	49
	ITEM 1A.	Risk Factors	49
	ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49
	ITEM 3.	Defaults Upon Senior Securities	49
	ITEM 4.	Mine Safety Disclosures	49
	ITEM 5.	Other Information	49
	ITEM 6.	Exhibits	49

	SIGNATURES		50

	2

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

	October 31,		April 30,
ASSETS	2013		2013
	(unaudited)		(Note 1)
CURRENT ASSETS:

Cash and cash equivalents	$	1,498,206	$	915,752
Restricted cash		-		1,869,178
Accounts receivable, net of allowance of $999,643 and $1,107,593 at October 31, 2013 and April 30, 2013, respectively		9,099,911		7,085,969
Costs and estimated earnings in excess of billings on uncompleted contracts		1,149,409		1,079,367
Deferred contract costs		1,745,324		1,597,894
Prepaid expenses and other current assets		237,962		140,122
Prepaid income taxes		2,185		2,185
Current assets held for sale		1,843,353		1,905,449
Total current assets		15,576,350		14,595,916

PROPERTY AND EQUIPMENT, net		2,370,591		2,754,734

OTHER INTANGIBLE ASSETS, net		-		16,228

OTHER ASSETS		63,347		227,259

OTHER ASSETS HELD FOR SALE		405,542		550,829

Total assets	$	18,415,830	$	18,144,966

	3

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED)

	October 31,		April 30,
LIABILITIES AND EQUITY	2013		2013
	(unaudited)		(Note 1)
CURRENT LIABILITIES:

Current portion of loans payable	$	46,773	$	43,942
Senior secured convertible notes, net of debt discount of $3,400,000 and $2,888,889, October 31, 2013 and April 30, 2013, respectively		-		1,111,111
Derivative liability - senior secured convertible notes		-		3,088,756
Accounts payable and accrued expenses		4,316,412		4,102,050
Accrued severance expense		1,381,249		-
Billings in excess of costs and estimated earnings on uncompleted contracts		1,998,367		1,619,307
Deferred revenue		420,550		113,503
Other payable		1,533,757		1,743,986
Short-term bank loan		3,283,860		2,432,205
Income taxes payable		46,816		139,557
Current liabilities held for sale		700,430		685,631
Total current liabilities		13,728,214		15,080,048

Loans payable, net of current portion		147,222		133,838
Derivative liability - warrants		-		3,858,508
Total liabilities		13,875,436		19,072,394

COMMITMENTS AND CONTINGENCIES

EQUITY:

WPCS EQUITY (DEFICIT):
Preferred stock - $0.0001 par value, 5,000,000 shares authorized, none issued		-		-
Common stock - $0.0001 par value, 14,285,714 shares authorized, 1,308,669 and 994,187 shares issued and outstanding at October 31, 2013 and April 30, 2013, respectively		131		99
Additional paid-in capital		62,803,147		50,844,183
Accumulated deficit		(60,420,463)		(54,054,389)
Accumulated other comprehensive income on foreign currency translation		1,294,816		1,433,541

Total WPCS equity (deficit)		3,677,631		(1,776,566)

Noncontrolling interest		862,763		849,138
Total equity (deficit)		4,540,394		(927,428)

Total liabilities and equity	$	18,415,830	$	18,144,966

The accompanying notes are an integral part of these condensed consolidated financial statements.

	4

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended				Six Months Ended
	October 31,				October 31,
	2013		2012		2013		2012
			(Note 1)			(Note 1)	(Note 1)
REVENUE	$	7,355,744	$	7,958,243	$	15,187,127	$	19,246,260

COSTS AND EXPENSES:
Cost of revenue		5,602,337		5,013,329		11,346,996		13,968,212
Selling, general and administrative expenses		1,854,241		2,061,126		3,837,815		4,156,282
Severance expense		-		-		1,474,277		-
Depreciation and amortization		214,895		268,179		457,952		572,286

		7,671,473		7,342,634		17,117,040		18,696,780

OPERATING (LOSS) INCOME		(315,729)		615,609		(1,929,913)		549,480

OTHER EXPENSE (INCOME):
Interest expense		2,380,885		320,608		3,540,942		441,013
Change in fair value of derivative liabilities		(2,208,155)		-		833,750		-

(Loss) income from continuing operations before income tax provision		(488,459)		295,001		(6,304,605)		108,467
Income tax (benefit) provision		(5,863)		(199,705)		18,288		(65,176)

(LOSS) INCOME FROM CONTINUING OPERATIONS		(482,596)		494,706		(6,322,893)		173,643
Discontinued operations:

Loss from operations of discontinued operations, net of tax provision of $0, $215,700, $0, and $269,864, respectively		(8,718)		(473,728)		(39,747)		(1,484,142)

(Loss) gain from disposal		-		(485,212)		-		1,839,419

(Loss) income from discontinued operations, net of tax		(8,718)		(958,940)		(39,747)		355,277

CONSOLIDATED NET (LOSS) INCOME		(491,314)		(464,234)		(6,362,640)		528,920

Net (loss) income attributable to noncontrolling interest		(18,310)		29,152		3,434		28,605

NET (LOSS) INCOME ATTRIBUTABLE TO WPCS	$	(473,004)	$	(493,386)		(6,366,074)	$	500,315

Basic and diluted net (loss) income per common share attributable to WPCS:

(Loss) income from continuing operations attributable to WPCS	$	(0.36)	$	0.47	$	(5.57)	$	0.15
(Loss) income from discontinued operations attributable to WPCS	$	(0.01)	$	(0.97)	$	(0.03)	$	0.35
Basic and diluted net (loss) income per common share attributable to WPCS	$	(0.37)	$	(0.50)	$	(5.60)	$	0.50

Basic weighted average number of common shares outstanding		1,272,877		994,187		1,136,750		994,187

Diluted weighted average number of common shares outstanding		1,272,877		995,469		1,136,750		998,160

The accompanying notes are an integral part of these condensed consolidated financial statements.

	5

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(Unaudited)

	Three Months Ended				Six Months Ended
	October 31,				October 31,
	2013		2012		2013		2012
Consolidated net (loss) income	$	(491,314)	$	(464,234)	$	(6,362,640)	$	528,920
Other comprehensive income (loss) - foreign currency translation adjustments		97,267		(14,533)		(128,534)		9,156
Comprehensive (loss) income		(394,047)		(478,767)		(6,491,174)		538,076

Comprehensive (loss) income attributable to noncontrolling interest		(12,866)		50,881		13,625		36,000
Comprehensive (loss) income attributable to WPCS	$	(381,181)	$	(529,648)	$	(6,504,799)	$	502,076

The accompanying notes are an integral part of these condensed consolidated financial statements.

	6

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF EQUITY (DEFICIT)

SIX MONTHS ENDED OCTOBER 31, 2013

(Unaudited)

							Additional				Accumulated				Non-
	Preferred Stock			Common Stock			Paid-In		Accumulated		Other Compre-		WPCS		Controlling		Total
	Shares	Amount		Shares	Amount		Capital		Deficit		hensive Income		Equity (Deficit)		Interest		Equity (Deficit)

BALANCE, May 1, 2013	-	$	-	994,187	$	99	$	50,844,183	$	(54,054,389)	$	1,433,541	$	(1,776,566)	$	849,138	$	(927,428)

Stock-based compensation	-		-	-		-		22,511		-		-		22,511		-		22,511

Issuance of common stock from Warrant amendment, waiver and exchange agreement	-		-	38,740		4		88,711		-		-		88,715		-		88,715

Conversion of Notes	-		-	275,742		28		593,895		-		-		593,923		-		593,923

Reclassification of derivative liability upon conversion of Notes	-		-	-		-		686,856		-		-		686,856		-		686,856

Reclassification of derivative liability from Notes and Warrant amendment	-		-	-		-		7,166,991		-		-		7,166,991		-		7,166,991

Unamortized debt discount from Notes amendment	-		-	-		-		3,400,000		-		-		3,400,000		-		3,400,000

Other comprehensive (loss) income	-		-	-		-		-		-		(138,725)		(138,725)		10,191		(128,534)

Net income attributable to noncontrolling interest	-		-	-		-		-		-		-		-		3,434		3,434

Net loss attributable to WPCS	-		-	-		-		-		(6,366,074)		-		(6,366,074)		-		(6,366,074)

BALANCE, October 31, 2013	-	$	-	1,308,669	$	131	$	62,803,147	$	(60,420,463)	$	1,294,816	$	3,677,631	$	862,763	$	4,540,394

The accompanying notes are an integral part of these condensed consolidated financial statements.

	7

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended
	October 31,
	2013		2012
OPERATING ACTIVITIES :
Consolidated net (loss) income	$	(6,362,640)	$	528,920

Adjustments to reconcile consolidated net (loss) income to net cash provided by (used in) operating activities:
Depreciation and amortization		457,952		783,530
Gain from disposition of operations		-		(1,838,419)
Amortization of notes discount		3,053,867		-
Change in the fair value of derivative liabilities		833,750		-
Stock-based compensation		22,511		103,951
Provision for doubtful accounts		29,784		32,923
Amortization of debt issuance costs		277,095		294,803
Loss (gain) on sale of fixed assets		13,509		(23,384)
Deferred income taxes		-		(153,822)
Changes in operating assets and liabilities:
Restricted cash		1,869,178		-
Accounts receivable		(2,014,625)		1,893,605
Costs and estimated earnings in excess of billings on uncompleted contracts		(70,042)		62,920
Deferred contract costs		(126,513)		-
Inventory		-		(18,431)
Prepaid expenses and other current assets		(97,330)		(156,031)
Income taxes payable		(94,919)		119,232
Prepaid taxes		-		39,931
Other assets		(11,001)		15,157
Assets held for sale		112,262		-
Accounts payable and accrued expenses		213,526		(1,753,067)
Accrued severance expense		1,381,249		-
Billings in excess of costs and estimated earnings on uncompleted contracts		379,060		(1,575,966)
Deferred revenue		303,804		658,485
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES		170,477		(985,663)

	8

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(Unaudited)

	Six Months Ended
	October 31,
	2013		2012

INVESTING ACTIVITIES:
Acquisition of property and equipment, net	$	(17,620)	$	(229,513)
Proceeds from sale of operations, net of transaction costs		-		4,554,009
NET CASH (USED IN) PROVIDED BY INVESTING ACTIVITIES		(17,620)		4,324,496

FINANCING ACTIVITIES:
Net proceeds from Section 16(b) settlement		-		222,413
Debt issuance costs		(102,182)		(56,514)
Repayments under lines of credit		-		(3,929,817)
Repayment to senior secured convertible notes		(9,507)		-
Repayments under loans payable, net		(23,534)		(53,619)
Repayments to joint venture partner, net		-		(2,516,123)
Repayments of capital lease obligations		-		(14,588)
Borrowings under short-term bank loan		816,100		2,367,645
Repayments under other payable		(210,229)		-
Borrowings under other payable		-		793,927
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES		470,648		(3,186,676)

Effect of exchange rate changes on cash		(41,051)		(42,234)

NET INCREASE IN CASH AND CASH EQUIVALENTS		582,454		109,923
CASH AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD		915,752		811,283
CASH AND CASH EQUIVALENTS, END OF THE PERIOD	$	1,498,206	$	921,206

The accompanying notes are an integral part of these condensed consolidated financial statements.

	9

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - LIQUIDITY AND BASIS OF PRESENTATION

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of WPCS International Incorporated (WPCS) and its wholly- and majority-owned subsidiaries, as follows, collectively referred to as “we”, “us” or the "Company". United States-based subsidiaries include WPCS Incorporated, WPCS International – Suisun City, Inc. (Suisun City Operations), WPCS International – Lakewood, Inc. (Lakewood Operations), WPCS International – Hartford, Inc. (Hartford Operations), WPCS International – Trenton, Inc. (Trenton Operations), WPCS International – Seattle, Inc. (Seattle Operations), and WPCS International – Portland, Inc. (Portland Operations). International operations include WPCS Asia Limited, 60% of Taian AGS Pipeline Construction Co. Ltd. (China Operations), WPCS Australia Pty Ltd., WPCS International – Brendale, Pty Ltd., and The Pride Group (QLD) Pty Ltd. (Pride), (collectively, Australia Operations).

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for quarterly reports on Form 10-Q of Article 10 of Regulation S-X and do not include all of the information and note disclosures required by accounting principles generally accepted in the United States of America. Accordingly, the unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the fiscal year ended April 30, 2013 included in the Company’s Annual Report on Form 10-K. The accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) which are, in the opinion of the management, considered necessary for a fair presentation of condensed consolidated financial position, results of operations and cash flows for the interim periods. Operating results for the three and six month periods ended October 31, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending April 30, 2014. The amounts for the April 30, 2013 balance sheet have been extracted from the audited consolidated financial statements included in Form 10-K for the year ended April 30, 2013.

The Company provides design-build engineering services that focus on the implementation requirements of communications infrastructure. The Company provides its engineering capabilities including wireless communication, specialty construction and electrical power to the public services, healthcare, energy and corporate enterprise markets worldwide.

Liquidity and Going Concern

The accompanying condensed consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The unaudited condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

At October 31, 2013, the Company has losses from operations, and has outstanding balances due to its former surety under a forbearance agreement of $1,533,757. These factors raise substantial doubt about the Company’s ability to continue as a going concern.

As further described in Note 4, “Senior Secured Convertible Notes”, on December 4, 2012, the Company entered into a Securities Purchase Agreement (the Purchase Agreement) with six accredited investors (the Buyers) pursuant to which, the Company sold an aggregate of (i) $4,000,000 principal amount of senior secured convertible notes (the Notes) and (ii) warrants (the Warrants) to purchase 2,274,796 shares of the Company's common stock (Common Stock), to the Buyers for aggregate gross proceeds of $4,000,000 (the Financing). The closing of the Financing was completed on December 5, 2012 (the Closing Date).

	10

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

As more fully described in Note 12, “Commitments and Contingencies,” on July 12, 2012, the Company executed the Surety Financing and Confession of Judgment Agreement (the Financing Agreement) with Zurich American Insurance Company (Zurich). Under the terms of the Financing Agreement, Zurich advanced the Company $793,927 to assist in the completion of the project contract with the Camden County Improvement Authority for work at the Cooper Medical Center of Rowan University (the Owner or Cooper Project). The Company was in default under the terms of the Financing Agreement.

On April 17, 2013, the Company executed the Surety Forbearance and Confession of Judgment Agreement (the Forbearance Agreement) with Zurich, which supersedes the Financing Agreement. The Company is currently in default under the Forbearance Agreement due to its failure to pay the monthly Interim Liability Payment of $25,000 for the month of December 2013. In addition, the Company does not have the ability to discharge the Loss Amount of $1,533,757 due December 31, 2013 under the Forbearance Agreement. The Company is currently in discussions with Zurich for the settlement of the Loss Amount due under the Forbearance Agreement. There can be no assurance that the Company will be successful in settling with Zurich the Loss Amount due.

The Company has submitted a claim and request for equitable adjustment to the Owner in the amount of $2,421,425 (the Claim) for significant delays, disruptions and construction changes that were beyond its control related to the Cooper Project, which was completed in the fiscal year ended April 30, 2013. If the Company is successful in the settlement of this Claim, the Company expects to use the proceeds from the claim to repay Zurich the remaining amounts due under the Forbearance Agreement. There can be no assurance that the Company will be successful in settling with the Owner for all or a portion of the submitted claim.

The Company's continuation as a going concern beyond the next twelve months and its ability to discharge its liabilities and commitments in the normal course of business is ultimately dependent upon the execution of its future plans, which include the following: (1) its ability to generate future operating income, reduce operating expenses and produce cash from its operating activities, which will be affected by general economic, competitive, and other factors, many of which are beyond the Company's control; (2) the repayment of, or the modification of the terms under the Zurich Forbearance Agreement; (3) the settlement of the claim with the Owner; and (4) obtaining additional funds, either through financing or sale of assets. There can be no assurance that the Company’s plans to ensure continuation as a going concern will be successful.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A summary of significant accounting policies consistently applied in the preparation of the accompanying unaudited condensed consolidated financial statements follows:

Principles of Consolidation

All significant intercompany transactions and balances have been eliminated in these condensed consolidated financial statements.

Cash and Cash Equivalents

Cash and cash equivalents include all cash and highly-liquid investments with a maturity at time of purchase of three months or less.

Restricted Cash

In connection with the terms of the Notes, all payments of accounts receivable of the Company (and its domestic subsidiaries) are deposited into an account (the Lockbox Account) controlled by Worldwide Stock Transfer, LLC (the Collateral Agent). The Company is permitted to receive from the Lockbox Account on a daily basis, such cash equal to (A) (i) the cash balance in the Lockbox Account plus (ii) 95% of the available qualified accounts receivable, less (iii) $250,000, minus (B) the amount of principal, accrued interest and costs and expenses owed pursuant to the Notes. At any given time, the Company considers the cash held in the Lockbox Account that it is not yet permitted to draw down based on the calculation above, to be restricted cash. Restricted cash is classified as a current asset, consistent with the classification of the Notes as a current liability. Based on the calculation above, the Company had the ability to draw down all of the cash held in the Lockbox Account, and as a result there was no restricted cash balance reported at October 31, 2013.

Accounts Receivable

Accounts receivable are due within contractual payment terms and are stated at amounts due from customers net of an allowance for doubtful accounts. Credit is extended based on evaluation of a customer's financial condition. Accounts outstanding longer than the contractual payment terms are considered past due. The Company determines an allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, the customer's current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.

	11

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Derivative Instruments

The Company’s derivative liabilities are related to embedded conversion features of the Notes and the common stock Warrants issued in connection with the Purchase Agreement. For derivative instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in fair value recognized in earnings each reporting period. The Company uses the binomial lattice model to value the derivative instruments at inception and subsequent valuation dates and the value is re-assessed at the end of each reporting period, in accordance with Accounting Standards Codification (ASC) 815. Derivative instrument liabilities are classified in the consolidated balance sheets as current or non-current based on whether or not the net-cash settlement of the derivative instrument could be required within twelve months of the balance sheet date.

Fair Value of Financial Instruments

The Company’s material financial instruments at October 31, 2013 and for which disclosure of fair value is required by certain accounting standards consisted of cash and cash equivalents, accounts receivable, accounts payable, line of credit and loans payable. The fair values of cash and cash equivalents, accounts receivable, and accounts payable are equal to their carrying value because of their liquidity and short-term maturity. Management believes that the fair values of the line of credit and loans payable do not differ materially from their aggregate carrying values in that substantially all the obligations bear variable interest rates that are based on market rates or interest rates that are periodically adjustable to rates that are based on market rates.

Other Intangible Assets

Other intangible assets have finite useful lives and are comprised of customer lists. The Company reviews its other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In performing a review for impairment, the Company compares the carrying value of the assets with their estimated future undiscounted cash flows from the use of the asset and eventual disposition. If the estimated undiscounted future cash flows are less than carrying value, an impairment loss is charged to operations based on the difference between the carrying amount and the fair value of the asset.

Other intangible assets consist of the following at October 31, 2013 and April 30, 2013:

	Estimated useful life	October 31,		April 30,
	(years)	2013		2013

Customer list	3-9	$	1,078,250	$	1,190,083
Less accumulated amortization			(1,078,250)		(1,173,855)
		$	-	$	16,228

Amortization expense of other intangible assets for the six months ended October 31, 2013 and 2012 was $16,228 and $32,502, respectively. There are no expected residual values related to these intangible assets.

Revenue Recognition

The Company generates its revenue by providing design-build engineering services for communications infrastructure. The Company’s design-build services report revenue pursuant to customer contracts that span varying periods of time. The Company reports revenue from contracts when persuasive evidence of an arrangement exists, fees are fixed or determinable, and collection is reasonably assured.

	12

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company records revenue and profit from long-term contracts on a percentage-of-completion basis, measured by the percentage of contract costs incurred to date to the estimated total costs for each contract. Contracts in process are valued at cost plus accrued profits less earned revenues and progress payments on uncompleted contracts. Contract costs include direct materials, direct labor, third party subcontractor services and those indirect costs related to contract performance. Contracts are generally considered substantially complete when engineering is completed and/or site construction is completed.

The Company has numerous contracts that are in various stages of completion. Such contracts require estimates to determine the appropriate cost and revenue recognition. Cost estimates are reviewed monthly on a contract-by-contract basis, and are revised periodically throughout the life of the contract such that adjustments to profit resulting from revisions are made cumulative to the date of the revision. Significant management judgments and estimates, including the estimated cost to complete projects, which determines the project’s percent complete, must be made and used in connection with the revenue recognized in the accounting period. Current estimates may be revised as additional information becomes available. If estimates of costs to complete long-term contracts indicate a loss, provision is made currently for the total loss anticipated. For the six months ended October 31, 2013 and 2012, the Company has provided aggregate loss provisions of approximately $12,000 and $99,000, respectively, related to anticipated losses on long-term contracts.

The length of the Company’s contracts varies but is typically between three months and two years. Assets and liabilities related to long-term contracts are included in current assets and current liabilities in the accompanying condensed consolidated balance sheets as they will be liquidated in the normal course of contract completion, although this may require more than one year.

The Company records revenue and profit from short-term contracts for the China Operations under the completed contract method, whereas income is recognized only when a contract is completed or substantially completed. Accordingly, during the period of performance, billings and deferred contract costs are accumulated on the consolidated balance sheets, but no revenue or income is recorded before completion or substantial completion of the work. The Company’s decision is based on the short-term nature of the work performed.

The Company also recognizes certain revenue from short-term contracts when equipment is delivered or the services have been provided to the customer. For maintenance contracts, revenue is recognized ratably over the service period.

Income Taxes

The Company accounts for income taxes pursuant to the asset and liability method which requires deferred income tax assets and liabilities to be computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

On a periodic basis, the Company evaluates its ability to realize its deferred tax assets net of its deferred tax liabilities and adjusts such amounts in light of changing facts and circumstances, including but not limited to the level of past and future taxable income, and the current and future expected utilization of tax benefit carryforwards. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is required to reduce the net deferred tax assets to the amount that is more likely than not to be realized in future periods. The Company considers past performance, expected future taxable income and prudent and feasible tax planning strategies in assessing the amount of the valuation allowance. The Company’s forecast of expected future taxable income is based over such future periods that it believes can be reasonably estimated. Based on its analysis as of October 31, 2013, the Company continues to provide a full valuation allowance on its domestic and foreign deferred tax assets. The Company will continue to evaluate the realization of its deferred tax assets and liabilities on a periodic basis, and will adjust such amounts in light of changing facts and circumstances.

The Company performed a review for uncertainty in income tax positions in accordance with authoritative guidance. This review did not result in the recognition of any material unrecognized tax benefits as of October 31, 2013 and April 30, 2013. Management continually evaluates expiring statutes of limitations, audits, proposed settlements, changes in tax law and new authoritative rulings. The Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in selling, general and administrative expenses. For the six months ended October 31, 2013 and 2012, the Company recognized no interest or penalties. The statute of limitations for the Company's Federal, state and foreign income tax returns prior to fiscal years 2009 are closed.

	13

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Net (Loss) Income Per Common Share

Basic and diluted net (loss) income per common share is computed as net (loss) income divided by the weighted average number of common shares outstanding for the period. Diluted net (loss) income per common share reflects the potential dilution that could occur from common stock issuable through exercise of stock options. The table below presents the computation of basic and diluted net (loss) income per common share from continuing operations for the three and six months ended October 31, 2013 and 2012, respectively:

Basic net (loss) income per share from continuing operations computation

	Three Months Ended				Six Months Ended
	October 31,				October 31,
	2013		2012		2013		2012
Numerator:

Net (loss) income attributable to WPCS	$	(464,286)	$	465,554	$	(6,326,327)	$	145,038

Denominator:

Basic weighted average shares outstanding		1,272,877		994,187		1,136,750		994,187

Basic net (loss) income per common share attributable to WPCS	$	(0.36)	$	0.47	$	(5.57)	$	0.15

Diluted net (loss) income per share from continuing operations computation

	Three Months Ended				Six Months Ended
	October 31,				October 31,
	2013		2012		2013		2012
Numerator:

Net (loss) income attributable to WPCS	$	(464,286)	$	465,554	$	(6,326,327)	$	145,038

Denominator:

Basic weighted average shares outstanding		1,272,877		994,187		1,136,750		994,187

Incremental shares from assumed conversion:
Conversion of stock options		-		1,282		-		3,973

Diluted weighted average shares		1,272,877		995,469		1,136,750		998,160

Diluted net (loss) income per common share attributable to WPCS	$	(0.36)	$	0.47	$	(5.57)	$	0.15

The following were excluded from the computation of diluted shares outstanding due to the losses from continuing operations for the three and six months ended October 31, 2013 as they would have had an anti-dilutive impact on the Company's net loss.

	Three Months Ended	Six Months Ended
	October 31	October 31
	2013	2013
Common stock equivalents:
Stock options	1,273	1,831
Conversion of senior secured convertible notes	678,808	790,044
Stock warrants	1,646,426	1,136,479

Totals	2,326,507	1,928,354

Noncontrolling Interest

Noncontrolling interest for the three and six months ended October 31, 2013 and 2012 consists of the following:

	Three Months Ended				Six Months Ended
	October 31,				October 31,
	2013		2012		2013		2012
Balance, beginning of period	$	875,629	$	1,102,440	$	849,138	$	1,117,322

Net (loss) income attributable to noncontrolling interest		(18,310)		29,152		3,434		28,605

Other comprehensive income attributable to noncontrolling interest		5,444		21,729		10,191		7,394

Balance, end of period	$	862,763	$	1,153,321	$	862,763	$	1,153,321

	14

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Use of Estimates

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. The most significant estimates relate to the calculation of percentage-of-completion on uncompleted contracts, allowance for doubtful accounts, realization of deferred tax assets, and amortization method and lives of customer lists. Actual results could differ from those estimates.

Recently Issued Accounting Pronouncements

In December 2011, the FASB issued ASU No. 2011-11 (ASU 2011-11), Disclosures about Offsetting Assets and Liabilities where entities are required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements, and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. These disclosures assist users of financial statements in evaluating the effect or potential effect of netting arrangements on a company’s financial position. The adoption of ASU 2011-11 on May 1, 2013 did not have a material impact on the Company’s unaudited condensed consolidated financial statements.

	15

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3 - COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS

The asset, “Costs and estimated earnings in excess of billings on uncompleted contracts”, represents revenue recognized in excess of amounts billed. The liability, “Billings in excess of costs and estimated earnings on uncompleted contracts”, represents billings in excess of revenue recognized.Costs and estimated earnings on uncompleted contracts consist of the following at October 31, 2013 and April 30, 2013:

	October 31, 2013		April 30, 2013

Costs incurred on uncompleted contracts	$	50,890,087	$	72,951,142
Provision for loss on uncompleted contracts		(11,972)		(23,376)
Estimated contract profit		1,928,749		2,391,027
		52,806,864		75,318,793
Less: Billings to date		53,655,822		75,858,733
Totals	$	(848,958)	$	(539,940)

Costs and estimated earnings in excess of billings on uncompleted contracts	$	1,149,409	$	1,079,367
Billings in excess of cost and estimated earnings on uncompleted contracts		1,998,367		1,619,307
Totals	$	(848,958)	$	(539,940)

Revisions in the estimated gross profits on contracts and contract amounts are made in the period in which circumstances requiring the revisions become known. During the three and six months ended October 31, 2013, the effect of such revisions in estimated contract profits resulted in an increase to gross profits of approximately $26,000 and $149,000, respectively, and during the three and six months ended October 31, 2012, the effect of such revisions resulted in an increase in gross profits of $1,047,000 and $1,563,000, respectively, from that which would have been reported had the revised estimates been used as the basis of recognition for contract profits in prior years.

Although management believes it has established adequate procedures for estimating costs to complete open contracts, additional costs could occur on contracts prior to completion.

NOTE 4 - SENIOR SECURED CONVERTIBLE NOTES

On December 4, 2012, the Company entered into the Purchase Agreement with the Buyers pursuant to which the Company sold an aggregate of (i) $4,000,000 principal amount of Notes and (ii) Warrants to purchase 2,274,796 shares of the Company's Common Stock to the Buyers for aggregate gross Financing proceeds of $4,000,000. In connection with the Financing, (i) the Company entered into a registration rights agreement with the Buyers (the Registration Rights Agreement), (ii) the Company and its subsidiaries entered into a security and pledge agreement in favor of the collateral agent for the Buyers (the Security Agreement), and (iii) subsidiaries of the Company entered into a guaranty in favor of the collateral agent for the Buyers (the Guaranty). The Closing Date of the Financing was December 5, 2012.

Pursuant to the terms of the Notes, the Company deposited the initial funds received from the Financing, minus $2,178,516, (the Initial Lending Amount) into the Lockbox Account controlled by the Collateral Agent, as collateral agent on behalf of the Buyers. The Company used the Initial Lending Amount to repay the existing loan of $2,000,000, plus $78,516 of interest accrued and fees and expenses to Sovereign Bank, N.A. (Sovereign), which credit agreement was terminated in connection with the Notes, and $100,000 for Buyer legal fees in connection with the Notes. In addition, all payments of accounts receivable of the Company (and its domestic subsidiaries) shall be deposited into the Lockbox Account. The Company is permitted to receive from the Lockbox Account, on a daily basis, such amount of cash equal to: (A) (i) cash balance in the Lockbox Account plus (ii) 95% of available qualified accounts receivable minus (iii) $250,000 minus (B) amount of principal, accrued interest, fees, costs and expenses owed pursuant to the Notes. The Notes contain certain customary representations and warranties, affirmative and negative covenants, and events of default. The principal covenant is that the Company shall maintain a current ratio of not less than 0.6 to 1.0 as of the last calendar day of each month. As of October 31, 2013, the Company is in compliance with the covenants.

The Notes were initially convertible into shares of Common Stock at a conversion price of $2.6376 per share (the Conversion Price). The Conversion Price was to be adjusted to 85% of the average of the closing bid prices for the five consecutive trading dates immediately prior to the following adjustment dates: (1) the earlier of the effective date of a registration statement or six months after closing (the First Adjustment); (2) the later of the date that is three months after the First Adjustment or one year after closing (the Second Adjustment); and (3) on the Stockholder Approval Date of February 28, 2013. On the Stockholder Approval Date, the Conversion Price was adjusted to $2.1539 per share. There was no adjustment to the Conversion Price on the First Adjustment date.

	16

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Warrants are exercisable for a period of five years from the Closing Date at an initial exercise price of $3.2970 per share (the Exercise Price). The Exercise Price was subject to the same adjustments as provided in the Notes as described above and, as a result, the Exercise Price was adjusted to $2.1539 per share on the Stockholder Approval Date.

On October 25, 2013, the Company entered into an amendment, waiver and exchange agreement (the Amendment) with the Buyers that amended the conversion features of the Warrants and Notes. Pursuant to the Amendment, the Buyers exchanged 154,961 of their Warrants for 38,740 shares of common stock (the Shares) and warrants to purchase 154,961 shares of common stock (Exchange Warrants). Effectively, for every four Warrants surrendered, the Buyer received a unit of four Exchange Warrants and one Share. It was determined that the Black-Scholes value of one warrant being exchanged was equal to $1.83, resulting in four Warrants being equal to $7.32 and the parties valued the unit at a price of $7.52. As a result, the Shares issued were calculated at $0.20, and by the operation of the terms of the Notes, the conversion price of the Notes automatically adjusted to $0.20. The Exchange Warrants are exercisable for a period of five years from the date of issuance of the original Warrants at an initial exercise price of $2.1539 per share. The exercise price will only adjust in the event of any future stock splits or dividends.

Pursuant to the Amendment, the Buyers permanently waived, effective as of October 24, 2013, various provisions of the Warrants, including the anti-dilution protection from the issuance of securities at a price lower than the Exercise Price, the adjustment to market price on the first anniversary of the date of issuance of the Warrants and the Black-Scholes valuation upon the occurrence of a Fundamental Transaction (as defined in the Warrants). As a result of these waivers, the exercise price of the Warrants will only adjust in the event of any future stock splits or dividends. The Exercise Price of the Warrants remains at $2.1539 per share. After the Amendment, the Warrants and Exchange Warrants have the same terms, conditions and rights.

In addition, pursuant to the Amendment, the Buyers permanently waived various provisions of the Notes, including the adjustment to the conversion price under a Fundamental Transaction (as defined in the Notes), the anti-dilution protection from the issuance of securities at a price lower than the current exercise price and the adjustment to market price on the first anniversary of the date of issuance of the Notes. As a result of these waivers, the conversion price of the Notes will only adjust in the event of any future stock splits or dividends.

Further, the Buyers waived certain events of default that had occurred under the Notes as more fully described as follows. Pursuant to the terms of the Notes, an event of default occurs when the Company’s common stock is suspended or threatened with suspension from trading on The NASDAQ Capital Market (or an equivalent market). On October 7, 2013, the Company received a notice from the Staff of the Listing Qualifications Department of The NASDAQ Stock Market LLC (NASDAQ) indicating that the Company’s common stock would be subject to delisting from The NASDAQ Capital Market on October 16, 2013 due to the Company’s non-compliance with the applicable $2.5 million stockholders’ equity requirement, as set forth in Listing Rule 5550(b) (1). As a result of the notice from NASDAQ, an event of default occurred under the Notes, which was waived by the Buyers pursuant to the Amendment. The closing of the Amendment transaction occurred on October 30, 2013.

On November 5, 2013, the Company entered into an amendment agreement (the Note Amendment) with the Buyers. The closing of the Note Amendment transaction occurred on November 5, 2013, and the Note Amendment was deemed effective as of October 31, 2013. The Note Amendment eliminated certain features of the Notes which would otherwise result in substantial accounting charges to the Company.

Prior to the Note Amendment, if an event of default existed under the Notes, the Buyers would have been entitled to redeem $3,400,000 in aggregate principal and interest of the Notes for a redemption price equal to the greater of 125% of (x) the deemed value of the shares of common stock underlying the Note (the Intrinsic Value) and (y) the outstanding principal and unpaid interest under the Notes (the Base Value). The Note Amendment reduces and fixes the event of default redemption price by eliminating the Intrinsic Value calculation and modifying the Base Value calculation and interest rate to more accurately make-whole the holders of the Notes from the loss of interest from an early redemption of the Notes and the decreased value of the Notes without such Intrinsic Value rights. As revised, the event of default redemption amount equals the sum of the Conversion Amount (as defined in the Notes) to be redeemed, plus a make-whole amount equal to the amount of any interest that, but for any redemption of the Notes on such given date, would have accrued with respect to the Conversion Amount being redeemed under the Notes at the interest rate then in effect for the period from such given date through October 31, 2023, the amended maturity date of the Notes, discounted to the present value of such interest using a discount rate of 2.5% per annum. As a result, the fixed value of the event of default redemption price is approximately $10,900,000. In addition, the interest rate of the Notes was amended to 15% per annum, subject to increase to 25% per annum if an event of default occurs and is continuing.

The modifications to the Notes as a result of the Amendment and Note Amendment described above included a change in the conversion price of the Notes from $2.1539 to $0.20, and a change in the maturity date of the Note, from June 5, 2014 to October 31, 2023. As a result of the significant modifications of the Notes, the Company determined that the Notes were extinguished and New Notes were being issued. In connection with this modification, the Company compared the present value of the beneficial conversion features of the Notes to the New Notes. The Company determined that the present value of the New Notes exceeded the present value of the Notes, by more than 10%, primarily as a result of the change in the conversion price of the New Notes to $0.20 as compared to the $2.1539 under the Notes which resulted in the application of extinguishment accounting. The modification of the Note debt instrument for the six months ended October 31, 2013, resulted in the debt instruments being exchanged with substantially different terms and extinguishment accounting was applied resulting in a loss on extinguishment of debt for the unamortized discount related to the Notes of $1,299,304. In addition, the Company recorded a new debt discount based on the fixed conversion rate and exercise price of $0.20 per share of $3,400,000 related to the remaining proceeds of the New Notes.

A summary of the Notes and New Notes at October 31, 2013 is as follows:

	October 31, 2013
Senior secured convertible notes, interest at 4% per annum to maturity June 5, 2014 (Notes)	$	3,406,077
Debt discount - value attributable to derivatives attached to Notes		(1,299,304)
Total - current portion, Notes		2,106,773
Redemption of Notes		(6,077)
Loss on extinguishment of debt - Notes		1,299,304
Senior secured convertible notes, interest at 15% per annum to maturity October 31, 2023 (New Notes)		3,400,000
Debt discount - value attributable to beneficial conversion features, New Notes		(3,400,000)
Total - current portion, New Notes	$	-

	17

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

As of October 31, 2013, $593,923 of Notes was converted into 275,742 shares of the Company’s Common Stock. In addition, $6,077 of Notes was redeemed for cash at the request of a Buyer.

The terms of the Notes and New Notes that follow remained the same after the extinguishment of debt described above. The Company has the right, at any time after one year from the Closing Date, to redeem all, but not less than all, of the outstanding Notes, upon not less than 20 trading days nor more than 30 trading days prior written notice. The redemption price shall equal 120% of the amount of principal and interest being redeemed.

The Buyers agreed to restrict their ability to convert the Notes and/or exercise the Warrants and receive shares of the Company’s Common Stock such that the number of shares of Common Stock held by the Buyer in the aggregate and its affiliates after such conversion or exercise does not exceed 9.99% of the then issued and outstanding shares of the Company’s Common Stock.

Pursuant to the Registration Rights Agreement, the Company agreed to file a registration statement with the SEC, within 30 days following receipt of a request from a Buyer (or 45 days with respect to an underwritten offering), covering such shares of common stock issuable upon conversion of the Notes or exercise of the Warrants, as requested by the Buyers, and have such registration statement declared effective by the SEC within 90 days thereafter. The Company also agreed to notify the Buyers if the Company at any time proposes to register any of its securities under the Securities Act of 1933, as amended, and of such Buyers’ right to participate in such registration. In connection with the conversion described above, no request has been received from a Buyer to register such shares.

If the Company fails to comply with the registration statement filing, effective date or maintenance date filing requirements, it is required to pay the Buyers a registration delay payment in cash equal to 2% of the Buyer’s original principal amount stated on such Investors’ Note as of the Closing Date on the date of each failure, and on every thirty (30) day anniversary of the respective failures (Registration Delay Payment). Notwithstanding the foregoing, in no event shall the aggregate amount of Registration Delay Payments exceed 10% of such Investor’s original principal amount stated on the Note on the Closing Date. The Company accounts for such Registration Delay Payments as contingent liabilities. Accordingly, the Company recognizes such damages when it becomes probable that they will be incurred and amounts are reasonably estimable.

Pursuant to the Guaranty, subsidiaries of the Company guaranteed to the collateral agent, for the benefit of the Buyers, the punctual payment, as and when due and payable, of all amounts owed by the Company in respect of the Purchase Agreement, the Notes and the other transaction documents executed in connection with the Purchase Agreement.

Pursuant to the Security Agreement, the Company and its subsidiaries granted, in favor of the collateral agent for the Buyers, a continuing security interest in all personal property and assets of the Company and its subsidiaries, as collateral security for the obligations of the Company and its subsidiaries under the Purchase Agreement, the Notes, the Guaranty and the other transaction documents.

NOTE 5 – OTHER DEBT

Short-Term Bank Loan

Effective August 1, 2013, the China Operations entered into a loan with the Bank of China (the Short-Term Bank Loan). The Short-Term Bank Loan provides for a loan in the amount of $3,283,860. The proceeds from the Short-Term Bank Loan were used to repay outstanding unsecured loans of $2,404,545 due to the Company’s joint venture partner, Taian Gas Group (TGG). The Short-Term Bank Loan has an interest rate of 7.38%, and interest is due on a quarterly basis. The Short-Term Bank Loan matures on August 1, 2014, and is guaranteed by TGG.

Loans Payable

The Company’s long-term debt also consists of notes issued by the Company or assumed in acquisitions related to working capital funding and the purchase of property and equipment in the ordinary course of business. At October 31, 2013, loans payable obligations totaled $193,995 with interest rates ranging from 4.24% to 8.99%.

	18

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 – DERIVATIVE LIABILITIES

Senior secured convertible notes- embedded conversion features

Immediately prior to entering into the Amendment and Note Amendment, the Notes met the definition of a hybrid instrument, as defined in ASC 815. The hybrid instrument was comprised of (i) a debt instrument, as the host contract and (ii) an option to convert the debentures into common stock of the Company, as an embedded derivative and recorded them as a discount to the Notes. The embedded derivatives derive their value based on the underlying fair value of the Company’s common stock. The embedded derivatives are not clearly and closely related to the underlying host debt instrument since the economic characteristics and risk associated with these derivatives are based on the common stock fair value. As a result, the Company determined the final fair value of the embedded derivatives and recognized a derivative liability of $4,000,437. The changes in the fair value of the embedded derivative were immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying condensed consolidated statements of operations. For the three and six months ended October 31, 2013, the Company recognized a loss of $61,408 and $1,598,537, respectively.

The Company estimated the fair value of the embedded derivatives using a binomial lattice model with the following assumptions: conversion price of $0.20 per share; risk free interest rate of 0.08%; expected life of 1.5 years; expected dividend of zero; a volatility factor of 134%; and a volume weighted average common stock price of $2.07 per share as of October 31, 2013. The expected lives of the instruments are equal to underlying term of the senior secured convertible notes. The expected volatility is based on the historical price volatility of the Company’s common stock. The risk-free interest rate represents the U.S. Treasury constant maturities rate for the expected life of the related conversion option. The dividend yield represents anticipated cash dividends to be paid over the expected life of the conversion option.

As a result of the Amendment and Note Amendment, the exercise price of the Notes were fixed at $0.20 per share, and will only adjust in the event of any future stock splits or dividends, and the redemption price of the Notes in the event of default was fixed at approximately $10,900,000. As a result, the Company determined that the modifications changed the instruments classification to an equity instrument which has resulted in bifurcation and liability accounting no longer being required. Accordingly, the Company reclassed the total former derivative liability related to the Notes of $4,000,437 to additional paid-in capital at October 31, 2013.

Common stock warrants

Immediately prior to entering into the Amendment, the Company determined that the fair value of the Warrants issued in connection with the issuance of the Notes under the Purchase Agreement was a derivative liability and recorded them as a discount to the Notes. The Company has recognized a final derivative liability of $3,093,722. The changes in the fair value of the embedded derivative were immediately recognized in earnings and classified as a gain or loss on the embedded derivative financial instrument in the accompanying condensed consolidated statements of operations. For the three and six months ended October 31, 2013, the Company recognized a gain of $2,269,563 and a loss of $764,786, respectively.

The Company estimated the fair value of the warrant derivative using a binomial lattice model with the following assumptions: conversion price of $2.1539 per share; risk free interest rate of 1.31%; expected life of 5 years; expected dividend of zero; a volatility factor of 81%; and a volume weighted average common stock price of $2.07 per share as of October 31, 2013. The expected lives of the instruments are equal to the contractual term of the Warrants. The expected volatility is based on the historical price volatility of the Company’s common stock. The risk-free interest rate represents the U.S. Treasury constant maturities rate for the expected life of the related warrants. The dividend yield represents anticipated cash dividends to be paid over the expected life of the conversion option.

In connection with the Amendment, the Company recorded $72,832 of additional non-cash interest expense for the fair value of the 154,961 Exchange Warrants issued. The Company estimated the fair value of the Exchange Warrants using the Black-Scholes-Merton pricing model with the following assumptions: conversion price of $2.1539; risk free interest rate of 1.070%; expected life of 5 years; expected dividend of zero; a volatility factor of 138.2%; and a common stock price of $2.17 as of October 23, 2013. In addition, the Company recorded the fair value of the 38,740 Shares issued with the Exchange Warrants at a fair value of $88,715 based on the closing market price on October 25, 2013 of $2.29 per share.

As a result of the Amendment and Note Amendment, the exercise price of the Warrants was fixed at $2.1539 per share, and will only adjust in the event of any future stock splits or dividends. As a result, the Company determined that the modifications changed the instruments classification to an equity instrument that has resulted in bifurcation and liability accounting no longer being required. Accordingly, the Company reclassed the total former derivative liability related to the Warrants of $3,093,722 to additional paid-in capital at October 31, 2013.

	19

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 - FAIR VALUE MEASUREMENTS

As defined by the ASC, fair value measurements and disclosures establish a hierarchy that prioritizes fair value measurements based on the type of inputs used for the various valuation techniques (market approach, income approach and cost approach). The levels of hierarchy are described below:

	·	Level 1: Observable inputs such as quoted market prices in active markets for identical assets or liabilities.

	·	Level 2: Inputs other than quoted market prices that are observable for the asset or liability, either directly or indirectly; these include quoted prices for similar assets or liabilities in active markets, such as interest rates and yield curves that are observable at commonly-quoted intervals.

	·	Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions, as there is little, if any, related market activity.

The following table summarizes the financial liabilities measured at fair value on a recurring basis as of October 31, 2013, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

		Quoted Prices in									Total Increase (Reduction)
		Active Markets for		Significant Other		Significant					in Fair Value
Balance Sheet		Identical Assets or		Observable Inputs		Unobservable		October 31, 2013	April 30, 2013		Recorded at
Location		Liabilities (Level 1)		(Level 2)		Inputs (Level 3)		Total	Total		October 31, 2013
Liabilities:

Derivative liability - secured convertible notes	$	-	$	-	$	-	$	-	3,088,756	$	1,598,536

Derivative liability - warrants	$	-	$	-	$	-	$	-	3,858,508	$	(764,786)

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 derivative liabilities related to the senior secured convertible notes and warrants for the period ended October 31, 2013, prior to reclassification to an equity instrument as a result of the Amendment and Note Amendment.

October 31, 2013

	Notes		Warrants

Balance at beginning of year	$	3,088,756	$	3,858,508
Reduction in derivative instruments from note exercise		(686,856)		-
Change in fair value of derivative liabilities		1,598,537		(764,786)
		4,000,437		3,093,722
Reclassification of derivative liabilities to additional paid-in capital		(4,000,437)		(3,093,722)
Balance at end of period	$	-	$	-

	20

WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 - RELATED PARTY TRANSACTIONS

In connection with the acquisition of Pride, the Company leases its Woombye, Queensland, Australia location from Pride Property Trust, of which the former shareholders of the Pride Group (QLD) Pty Ltd. are the members. For each of the six month periods ended October 31, 2013 and 2012, the rents paid for this lease were $50,169 and $58,915, respectively.

The China Operations revenue earned from TGG and subsidiaries was $0 for each of the six months ended October 31, 2013 and 2012. The China Operations accounts receivable due from TGG and subsidiaries was $0 and $221,474 as of October 31, 2013 and 2012, respectively. In addition, during the three months ended October 31, 2013, the Company received dividends from the China Operations of $367,981 that had been declared and accrued by TAGS in prior fiscal years.

As further described in Note 11, “Discontinued Operations”, the Company entered into a Securities Purchase Agreement to sell 100% of the shares of Pride for $1,400,000 to Turquino Equity LLC, whose managing member is Andrew Hidalgo, former Chairman and Chief Executive Officer of the Company.

NOTE 9 - SHAREHOLDERS’ EQUITY

Stock-Based Compensation Plans

In September 2006, the Company adopted the 2007 Incentive Stock Plan, under which officers, directors, key employees or consultants may be granted options. Under the 2007 Incentive Stock Plan, 57,142 shares of common stock were reserved for issuance upon the exercise of stock options, stock awards or restricted stock. These shares were registered under Form S-8. Under the terms of the 2007 Incentive Stock Plan, stock options are granted at exercise prices equal to the fair market value of the common stock at the date of grant, and become exercisable and expire in accordance with the terms of the stock option agreement between the optionee and the Company at the date of grant. These options generally vest based on between one to three years of continuous service and have five-year contractual terms. At October 31, 2013, options to purchase 48,563 shares were outstanding at exercise prices ranging from $2.52 to $21.98. At October 31, 2013, there were 6,794 options available for grant under the 2007 Incentive Stock Plan.

In September 2005, the Company adopted the 2006 Incentive Stock Plan, under which officers, directors, key employees or consultants may be granted options. Under the 2006 Incentive Stock Plan, 57,142 shares of common stock were reserved for issuance upon the exercise of stock options, stock awards or restricted stock. These shares were registered under Form S-8. Under the terms of the 2006 Incentive Stock Plan, stock options are granted at exercise prices equal to the fair market value of the common stock at the date of grant, and become exercisable and expire in accordance with the terms of the stock option agreement between the optionee and the Company at the date of grant. These options generally vest based on between one to three years of continuous service and have five-year contractual terms. At October 31, 2013, options to purchase 46,911 shares were outstanding at exercise prices ranging from $2.52 to $4.20. At October 31, 2013, there were 6 options available for grant under the 2006 Incentive Stock Plan.

In March 2003, the Company established a stock option plan pursuant to which options to acquire a maximum of 59,523 shares of the Company's common stock were reserved for grant (the "2002 Plan"). These shares were registered under Form S-8. Under the terms of the 2002 Plan, the options are exercisable at prices equal to the fair market value of the stock at the date of the grant and become exercisable in accordance with terms established at the time of the grant. These options generally vest based on between one to three years of continuous service and have five-year contractual terms. At October 31, 2013, options to purchase 14,636 shares were outstanding at exercise prices ranging from $4.20 to $24.71. There are no further shares available for grant under the 2002 Plan as the ten-year term of the 2002 Plan was reached in March 2013.

The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing model. Compensation cost is then recognized on a straight-line basis over the vesting or service period and is net of estimated forfeitures. There were 1,760 stock options granted during the six months ended October 31, 2013. There were 87,857 stock options granted during the six months ended October 31, 2012.

The Company recorded stock-based compensation of $22,511 and $103,951 for the six months ended October 31, 2013 and 2012, respectively. At October 31, 2013, the total compensation cost related to unvested stock options granted to employees and directors under the Company’s stock option plans but not yet recognized was approximately $4,000 and is expected to be recognized over a weighted-average period of 7 months.

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WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company has elected to adopt the shortcut method for determining the initial pool of excess tax benefits available to absorb tax deficiencies related to stock-based compensation. The shortcut method includes simplified procedures for establishing the beginning balance of the pool of excess tax benefits (the APIC Tax Pool) and for determining the subsequent effect on the APIC Tax Pool and the Company’s consolidated statements of cash flows of the tax effects of share-based compensation awards. Excess tax benefits related to share-based compensation are reflected as financing cash inflows.

Reverse Stock Split

Effective May 28, 2013, the Company amended its Certificate of Incorporation, as amended, pursuant to which the Company affected a one-for-seven reverse split of the Company’s issued and outstanding shares of common stock (the Reverse Stock Split) and reduced the number of authorized shares of common stock by the same ratio, from 100 million to 14,285,715. The total issued and outstanding common stock was decreased from 6,954,766 shares to 994,187 shares. All share-related and per share information have been adjusted to give effect to the Reserve Stock Split.

The purpose of the Reverse Stock Split was to raise the per share trading price of WPCS common stock to regain compliance with the $1.00 per share minimum bid price requirement for a continued listing on the NASDAQ Capital Market. In order to maintain the WPCS listing on the NASDAQ Capital Market, on or before June 24, 2013, the Company’s common stock was required to have a minimum closing bid price of $1.00 per share for a minimum of ten prior consecutive trading days, which was achieved.

Section 16(b) Settlement

On August 7, 2006, Maureen Huppe, a stockholder of the Company, filed suit in the United States District Court Southern District of New York, against defendants Special Situations Fund III QP, L.P. and Special Situations Private Equity Fund, L.P. (collectively SSF), former stockholders of the Company, alleging violations of Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p (b) (Section 16(b)). SSF made sales of 20,445 shares of the Company’s common stock from December 15, 2005 to January 30, 2006, at prices ranging from $64.26 to $88.34 per share. On April 12, 2006, SSF purchased 95,209 shares of the Company’s common stock at $49.00 per share.

The complaint sought disgorgement from SSF for any "short-swing profits" obtained by them in violation of Section 16(b), as a result of the foregoing sales and purchases of the Company’s common stock within periods of less than nine months while SSF was a beneficial owner of more than 10% of the Company’s common stock. The complaint sought disgorgement to the Company of all profits earned by SSF on the transactions, attorneys’ fees and other expenses. While the suit named the Company as a nominal defendant, it contained no claims against nor sought relief from the Company.

On June 13, 2012, the parties executed a court approved settlement which resolved this Section 16(b) action. Pursuant to this settlement, SSF agreed to pay the Company $529,280 in disgorgement of short-swing profits, less the fees and expenses agreed upon by the plaintiffs of $272,539 in connection with the settlement, resulting in the remainder, or $254,361, paid to the Company. The Company recorded the net proceeds as additional paid-in capital.

NOTE 10 - SEGMENT REPORTING

The Company's reportable segments are determined and reviewed by management based upon the nature of the services, the external customers and customer industries and the sales and distribution methods used to market the products. The Company organizes its reportable segments to correspond with its primary service lines: wireless communications, specialty construction and electrical power. Management evaluates performance based upon income (loss) before income taxes. Corporate includes corporate salaries and external professional fees, such as accounting, legal and investor relations costs which are not allocated to the other segments. Corporate assets primarily include cash and cash equivalents and prepaid expenses.

As part of the divestiture transactions more fully described in Note 11, “Discontinued Operations”, the Company reclassified the reporting units within its reportable segments. As a result, wireless communications includes the Suisun City Operations, specialty construction includes the China Operations, and electrical power includes the Trenton, Seattle and Portland Operations, for each of the periods presented. The segment information presented below contains the operating results for the continuing operations only. The Lakewood, Hartford and Australia Operations are reported as discontinued operations, and were previously reported in the wireless communications segment. Segment results for the three and six months ended October 31, 2013 and 2012 are as follows:

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WPCS INTERNATIONAL INCORPORATED AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Three Months Ended October 31, 2013

For the Three Months Ended October 31, 2012

Corporate

Wireless
Communications

Specialty
Construction

Electrical
Power

Total

Corporate

Wireless
Communications

Specialty
Construction

Electrical
Power

Total