SQS Software Quality Systems AG, Cologne
Consolidated Cash Flow Statement
As at 21 December 2007 (IFRS)

Notes

1.    Summary of Significant Accounting Policies

Basis of preparation

The Consolidated Financial Statements of SQS and its subsidiary companies ("SQS Group" or "SQS Konzern") are prepared in conformity with all IFRS Standards (International Financial Reporting Standards, formerly IAS = International Accounting Standards) and the Interpretations of the IASB (International Accounting Standards Board) adopted by the EU Commission and translated into the German language which are to be applied for those financial statements whose reporting period starts on or after 1 January 2007. The new and revised Standards and Interpretations of the IASB were not applied in the business year 2007 prior to the implementation date stipulated.

The Financial Information has been prepared on the historical cost basis. The Financial Information is presented in Euros and amounts are rounded to the nearest thousand (T€) except when otherwise indicated.

Statement of compliance

The Financial Information of SQS and its subsidiaries (together the ‘SQS Group’) has been prepared in accordance with IFRS as adopted for use in the EU.

First-time application of new standards, change in accounting policy and adjustment of figures from the previous year

SQS has applied the Standards and Interpretations of the IASB as applicable in the EU which are binding for financial years commencing on or after 1 January 2007. The changes have led to some additional information in the notes but do not have any effect on the accounting treatment of assets and liabilities or their valuation.

SQS does not apply any further changed or newly passed standards prior to the implementation date stipulated. Further, according to the assessment of SQS, the application of these standards would not have any effect on the financial statements.

Basis of consolidation

The Financial Information comprises the financial statements of SQS Software Quality Systems AG and its subsidiaries as at 31 December each year. Subsidiary company financial statements are prepared on a basis consistent with those of other SQS Group companies. All companies in the SQS Group have the same accounting reference date of 31 December.

All inter-company balances and transactions, including unrealised profits arising from intra-group transactions, have been eliminated in full. 

Subsidiaries are consolidated from the date on which control is transferred to the SQS Group and cease to be consolidated from the date on which control is transferred out of the SQS Group.

As at 31 December, the Company held interests in the share capital of more than 20 % of the following undertakings:

1.     Summary of Significant Accounting Policies (continued)

Taking effect on 1 September 2007 SQS Software Quality System AG acquired 100 % of the shares of Triton Unternehmensberatung GmbH and its subsidiaries. The acquisition comprises an initial consideration of 4.4 m€ in cash, and deferred consideration of up to 11.1 m€ in total, to be paid in a combination of cash and shares (49 % cash / 51 % stock). The deferred consideration is subject to Triton meeting specific earnout targets over the next two years, including profit after tax and revenue with additional customers. Triton has committed to an aggressive growth forecast in order to achieve the earnout targets. In addition, there is a provision for the sellers to agree, at their discretion, to a third year earnout with higher targets.

During the earnout period, Triton will stand as a separate business. Its three founders will continue to run the business.

3 % of the shares in Software Quality Systems (Schweiz) AG are held for legal reasons by members of the board of this entity in accordance with the interests of SQS.

SQS AG holds 15% of the shares of SQS Portugal Lda. with a book value of 0 € (previous year 0 €).

2. Taxes on earnings

Deferred income tax is provided, using the liability method, on all temporary differences at the balance sheet date between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. The calculation is based on the tax rates anticipated in the respective countries as at the realisation date. These are essentially based on the statutory provisions applicable or passed by the government at the date of the Financial Statements.

As a basic principle, SQS Software Quality Systems AG in Germany is liable to corporate income tax, the solidarity surcharge and trade tax. The results of the Company are subject to corporate income tax at 25%. A 5.5% solidarity surcharge is imposed on corporate income tax. The trade income tax amounts to 19% of the taxable income and is deductible for the purpose of determining the taxable income. This leads to a total income tax rate of approx. 40 %.

Effective 01 January 2008 the German corporate income tax has been reduced from 25% to 15%. Consequently the total income tax rate is reduced to approx. 30 %. Deferred taxes are recalculated with this new income tax rate.  

The tax credit granted to persons liable to tax in Germany follows the so-called half-income system, i.e. only 50 % of the income from the company is liable to tax in the hands of the shareholder.

Consolidated income tax expense / (income) is as follows:

A reconciliation of income tax applicable to the accounting profit before income tax at the statutory income tax rate to the income tax expense in the income statement is as follows:

Deferred taxes with an amount of 111 T€ were charged directly to equity.

In accordance with § 37 KStG (German corporation tax law) SQS has capitalised the corporation tax credit on 31 December 2006 at present value of 1,426 T€. As per 31 December 2007 unaccrued interest of 86 T€ has been added to the corporation tax credit. This tax credit is paid off by ten instalments from the year 2008 to 2017. The present value has been discounted using an interest rate of 5,5 %. 

For the assessment of the deferred tax claims and debts, SQS Software Quality Systems AG applies a tax rate based on the current tax law in Germany of 30% (2006: 40%) which takes into account corporation tax, the solidarity surcharge and trade tax. For the deferred tax claims of the overseas subsidiaries, the local tax rates are taken as the basis.

Deferred income tax relates to the following:

Deferred tax assets are recognised when it is considered probable that economic benefit will flow to the entity. Based on the earnings situation of the past and on the business expectations for the foreseeable future, value adjustments are determined if applicable.

Where a company has suffered losses, deferred tax claims thereon are capitalised if the ability in the future to set off the losses with later income is permissible under the respective national provisions. According to the planning of SQS AG and SQS Austria, a return to taxable profits is regarded as very probable. Due to the limited utilisation of tax losses in The Netherlands an adjustment of (76) T€ was made according to the deferred tax asset of SQS BV.

SQS Austria has capitalised a tax asset with an amount of 162 T€. Although the company has suffered losses in the current and preceding periods the management is expecting sustainable

Increases in the future profits.

3. Earnings per share

The earnings/ (loss) per share presented in accordance with IAS 33 are shown in the following table:

Undiluted earnings per share are calculated by dividing the profit for the year attributable to equity shareholders by the weighted average number of shares in issue during 2007: 19,098,779 (2006: 16,471,084).

Diluted earnings per share are determined by dividing the profit for the year attributable to equity shareholders by the weighted average number of shares in issue plus any share equivalents which would lead to a dilution.

The adjusted earnings per share 2007 and 2006 were calculated by adjusting the profit after tax for the corporate income tax asset of 86 T€ (2006: 1,426 T€), the tax advantage of Cresta acquisition in the amount of 0 T€ (2006: 656 T€), deferred taxes of 0 T€ (2006: 381 T€), the interest cost of the Cresta and Triton purchase obligations of 561 T€ (2006: 276 T€) and amortisation cost of the acquired customer relationship as part of a business combination Triton of  241 T€. Further the difference between taxes on income payable under local GAAP and IFRS (468 T€ (2006: 771 T€)) has been adjusted. This results in an adjusted profit after taxes of 7,917 T€ (2006: 4,573 T€). This divided by 19,098,779 shares (2006: 16,471,084) shows adjusted earnings per share of 0.41 € (2006: 0.28 €).

The management board considers that there are share equivalents which could have a dilutive effect. One of these are the convertible bonds granted to the vendor of the shares in SQS Group (UK) Ltd in a total nominal amount of 53 T€, divided into 52,800 convertible bonds of a nominal value of € 1.00 each. The other one are the stock options given to employees. On a weighted average basis over the year this were 692,016 shares. Both effects lead to an immaterial difference between undiluted earnings and diluted earnings per share. The number of potential shares are calculated pro rata temporis.

4. Intangible assets

The development of the intangible assets of the SQS Group is presented as an appendix to the Consolidated Notes (Consolidated Fixed Asset Analysis).

The composition of this item is as follows:

No impairment losses in accordance with IAS 36 on account of falling anticipated payments were necessary in the business year 2007. Development costs were capitalised in the business year in the amount of 1.874 T€ (in the previous year 2,578 T€) and amortised over a period of 36 months, as the conditions under IAS 38 were fulfilled.

The scheduled amortisation of goodwill was, in compliance with IFRS 3, no longer carried out. Under the performance of an impairment test in accordance with IAS 36 in the version of 2007, no reduction in the value of the goodwill was required.

Taking effect from 1 July 2006 SQS purchased 100 % of the shares of Cresta Group Ltd. This transaction included purchased goodwill of T€ 16,724 as per 01 July 2006. In accordance with the terms of the purchase agreement SQS has the obligation to pay for the realised over achievement of Cresta. In 2007 this led to an increase in goodwill of 7,720 T€.

The management of SQS integrated this asset into the UK based business and allocated the goodwill to this segment.

Effective on 1 September 2007, SQS acquired the shares of Triton Unternehmensberatung GmbH and its subsidiaries. According to IAS 36 the impairment test was not required because of the short notice since the initial purchase price allocation. As per 31 December 2007 no indications for any impairment losses had been observed.

The business combination was analysed following IFRS 3 in the purchase price allocation. This allocation lead to a goodwill of 9,944 T€.

The impairment test was carried out in accordance with IAS 36.80 for SQS UK based business, as well as for the Dutch subsidiary. This is the lowest level at which the management of the SQS Group continuously monitors the underlying value of the goodwill acquired with each transaction.

In order to test the recoverability of the goodwill held, the future estimated cash flows of the business units are compared with the goodwill valuations using a discounted cash flow methodology.

For this purpose, the current plans of the companies, which take into consideration the status of the accounts up until the end of November of the business year, were taken as the basis. For the year 2008, detailed planning is available in this regard; for the following years up until 2012, assumptions were made for the individual result and asset or debt items. For the period thereafter, a constant cash flow was assumed in accordance with the DCF method.

With regard to the development of earnings, it is assumed for both subsidiaries that also in the future an above-average growth in sales against the market can be achieved. In both geographical markets, the justification is clear. In the UK, a growth of approximately 54 % against prior year was achieved in the business year 2007 and 15 % in 2006. A corresponding further increase in personnel is planned. It is further assumed that the gross margin can be increased. In addition, it is assumed that there will be an increase in the productivity of the employees. The marketing costs and also the general and administrative costs are planned to rise absolutely whilst falling relative to sales. The central administration is, with the capacities existing today, sufficient to cope with further growth. Also for the Netherlands an increase in sales of 105 % is expected for 2008 due to the order backlog situation and scheduled hiring of additional consultants. For the following years the growth is reduced to 10 % from 2009 on. It is assumed that both headcounts and daily rates will increase while general and administrative costs will decrease relative to sales.

In the planning period, on the basis of these expectations and planning assumptions, annual cash flows will be achieved which ensure a reasonable rate of return on the funds invested.

In accordance with IAS 36, the following special features were taken into account:

• Expenses and income, assets and debts in connection with taxes on earnings, such as active and passive deferred taxes, tax reimbursement claims, tax liabilities and tax accruals, were eliminated both from the book value and from the use value,
• the cash flows, either in or out, from financing activities have not been taken into account,
• For reasons of practicability, in compliance with IAS 36.79, the trade receivables and trade creditors and also other liabilities were included in our calculations when estimating the future cash flows and the book value,
• For the transition from the value of the entire business to the use value of the equity holders, the entire liabilities at the market value (= book value) were eliminated,
• Growth rate of the perpetuity of 2 %,
• The goodwill was allocated entirely to the book value of the cash generating unit in accordance with IAS 36.80 and IAS 36.81,
• The discount rate was determined in accordance with IAS 36.55-57; as the capital cost rate for the equity, a risk-adjusted pre-tax interest rate of 9.75 % p.a was assumed, which was calculated from a risk-free interest rate, an average risk surcharge and also a factor to take into consideration branch and other risks. For the interest on capital from outside sources, the actual interest rate of the companies of 5.7 % for capital from outside sources was taken, with a slightly increasing trend in the future. Neither interest rate is corrected by taxes. The discounting was then carried out with the average interest rate weighted according to the ratio of shareholders' equity / capital from outside sources.

For the remaining goodwill values, the cash generating unit is the operating unit which currently derives the benefit from the investment. This is, in the one case, the region North, in the other case the region West/East of SQS Software Quality Systems AG. In both cases, the remaining book values of the cash generating units or the goodwill are so small in relation to the anticipated returns that a detailed investigation was waived.

The amortisation of development costs is included in the costs for research and development. The amortisation of software and remaining intangible assets as well as the impairment losses under IAS 36 are spread over the functional costs in accordance with an allocation key.

No write-ups on account of the lapse of the reasons which led to value adjustments in previous years needed to be carried out in 2007, as was also the case in the business year 2006.

5. Equity

SQS is listed on the AIM market in London and on the Open Market in Frankfurt (Main).

The development of the equity is presented in the Consolidated Development of Shareholders' Equity.

Subscribed Capital

The subscribed capital amounts to 21,546,309 € (in the previous year 17,190,823 €). It is divided into 21,546,309 (in the previous year 17,190,823) individual registered shares with an arithmetical share in the share capital of 1 € each. Each share entitles the holder to one right to vote. No preference shares have been issued. The capital is fully paid up.

The movements in the issued share capital are as follows:

By resolution of the General Meeting of 12 July 2005, the management board was authorized to increase the share capital by 1,500,000 € up until 12 July 2010 with the approval of the Supervisory board, either through one single or several issues of newly registered non-par value shares in return for cash or contributions in kind (Authorised Capital II).

The management board resolved on 21 March 2007 using in according to § 4.5 of the articles of association of SQS the authorisation on the increase of the share capital until 12 July 2010 by issuance of 1,500,000 new registered non-par value shares against contribution in cash (Authorised Capital II). The Supervisory board has consented to this resolution. This resolution became effective with the entry in the commercial register on 3 April 2007.

By resolution of the General Meeting of 30 Mai 2007, the management board was authorized to increase the share capital by 4,300,000 € up until 30 May 2012 with the approval of the Supervisory board, either through one single or several issues of newly registered non-par value shares in return for cash or contributions in kind (New Authorised Capital II).

The Supervisory board has consented to the resolution of the management board of the Company dated 03 September 2007 on the capital increase out of the Authorised Capital II from 18,690,823 € by 2,855,486 € to 21,546,309 € against redemption of obligations from the Cresta purchase. The issue price amounted to EUR 1.00 per share. The capital increase was registered on the commercial register on September 21, 2007.

SQS had no shares in its ownership as at 31 December 2007.

Conditional capital

The General Meeting of 12 April 2002 resolved the conditional increase in the share capital by an amount of up to 31,112 €. The resolution became effective with the entry of 6 June 2002. Following the increase in capital, the conditional capital amounted to 43,556.80 € as at 16 August 2005 and to 74,668.80 € as at 20 September 2005 and the subsequent entry in the Commercial Register of 23 September 2005, the existing conditional capital was revoked and increased again by 52,800 €.

The conditional capital serves as security for the convertible bonds.

The General Meeting of 2 June 2006 resolved a new conditional capital by an amount of up to 1,500,000 €  by issuance of up to 1,500,000 new individual registered shares (Conditional Capital II). The conditional Capital II serves to grant up to 1,500,000 share options until 31 December 2008 as incentive compensation for SQS employees and executives. This resolution became effective with the entry of 30 June 2006.

Authorised capital

The General Meeting of 30 Mai 2007 resolved the authorisation of the management board with the approval of the Supervisory board to increase of the share capital until 30 May 2012 by issuance of up to 4,300,000 new registered non-par value shares against contribution in cash or in kind (Authorised Capital II). This authorisation was partially used by issuance of 2,855,486 new registered non-par value shares against contribution in kind. After this the residual Authorised Capital II is amounted to 1,444,514 €

5.     Equity (continued)

Thereafter, the authorised capital developed as follows:

Statutory reserves

The statutory reserves in SQS AG were formed in accordance with Section 150 of the Stock Corporation Act (Germany).

Other reserves

The foreign currency translation differences arise on conversion of the opening reserves of subsidiary undertakings where the functional currency of the subsidiary is not the Euro. It amounts to (248) T€ (2006: (31) T€).

IPO costs are accounted for net of taxes in the amount of (1,133) T€ (2006: (1,074) T€).

Retained earnings

Retained earnings represent the accumulated retained profits less losses of SQS Group.

No dividends have been paid or proposed in any of the financial years ended 31 December 2006.

Convertible bonds with conversion rights

SQS has, on the basis of the resolution of the General Meeting of 14 September 2005, undertaken to grant the vendor of the shares in SQS Group (UK) Ltd convertible bonds in a total nominal amount of 53 T€, divided into 52,800 convertible bonds of a nominal value of 1.00 € each, if the party entitled pays into SQS the nominal amount of 1.00 € per share. The exercise of the right of conversion expires on 31 July 2008. Up until completion of the preparation of these Financial Statements but after 31 December 2007, the party entitled has exercised this right. This resulted in the issue of 52,800 new shares on 20 February 2008.

6. Notes to the Cash Flow Statement

The cash flow statement shows how the funds of the Group have changed in the course of the business year through outflows and inflows of funds. The payments are arranged according to investment, financing and business activities.

The sources of funds on which the cash flow statement is based consist of cash and cash equivalents (cash on hand and bank balances).

Cologne, 06 March 2008
SQS Software Quality Systems AG

(R. van Megen)          (R. Gawron)

SQS Software Quality Systems AG
Stollwerckstrasse 11
D-51149 Cologne

END