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: September 30, 2010




 ̈
            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: 001-32691





CHINA NEW ENERGY GROUP
COMPANY


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
              
              65-0972647(State
      or other jurisdiction of incorporation
                or
      organization)
              
              (I.R.S.
      Employer Identification No.)





Block
B1, 18/F,No. 85,Nanjing Road,


Tianjin
Emperor Place,Heping District,Tianjin, 300040


People's
Republic of China


(Address
of principal executive offices, Zip Code)




(86 22) 2321
0508


(Registrant’s
telephone number, including area code)




________________________________________________


(Former
name, former address and former fiscal year, if changed since last
report)





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   ̈   No   ̈





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 the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





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




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





APPLICABLE
ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
DURING THE PRECEDING FIVE YEARS





Indicate
by check mark whether the registrant has filed all documents and reports
required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act
of 1934 subsequent to the distribution of securities under a plan confirmed
by a court. Yes  ̈
No  ̈





APPLICABLE
ONLY TO CORPORATE ISSUERS





The
number of shares outstanding of each of the issuer’s classes of stock, as of
November 15, 2010 is as follows:





Class
      of Securities
                      
                      Shares
      OutstandingCommon
      Stock, $0.001 par value
                      
                      
                      107,070,281














Quarterly
Report on FORM 10-Q/A


Three and Nine
Months Ended September 30, 2010








TABLE
OF CONTENTS





PART
      IFINANCIAL
      INFORMATIONITEM
      1.
                  FINANCIAL
      STATEMENTS
                  F-1ITEM
      2.
                  MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
                  2ITEM
      3.
                  QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                  17ITEM
      4.
                  CONTROLS
      AND PROCEDURES
                  17PART
      IIOTHER
      INFORMATION17ITEM
      1:
                  LEGAL
      PROCEEDINGS
                  18ITEM
      1A:
                  RISK
      FACTORS
                  18ITEM
      2:
                  UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
                  18ITEM
      3:
                  DEFAULTS
      UPON SENIOR SECURITIES
                  18ITEM
      5:
                  OTHER
      INFORMATION
                  18ITEM
      6:
                  EXHIBITS
                  18









PART
I


FINANCIAL
INFORMATION




ITEM
1.     FINANCIAL
STATEMENTS.





CHINA
NEW ENERGY GROUP COMPANY





UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





Index to
condensed consolidated financial statements-unaudited





PageCondensed
      Consolidated Balance Sheets (Unaudited)
                          
                          F-2
      - F-3Condensed
      Consolidated Statements of Operations and Comprehensive Income (Loss)
      (Unaudited)
                          
                          F-4Condensed
      Consolidated Statements of Cash Flows (Unaudited)
                          
                          F-5Notes
      to Condensed Consolidated Financial Statements (Unaudited)
                          
                          F-6
      -F-44




F-1




CHINA
NEW ENERGY GROUP COMPANY


CONDENSED
CONSOLIDATED BALANCE SHEETS


September
      30,
              
              
              December
      31,2010
              
              
              2009ASSETS
              
              (Unaudited)CURRENT
      ASSETSCash
      and cash equivalents
              
              $
              580,731
              
              
              $
              2,672,884Restricted
      cash
              
              
              39,691
              
              
              
              180,352Accounts
      receivable, net of allowance for doubtful accounts of $219,842 and
      $-
              
              
              3,306,894
              
              
              
              4,619,232Receivable
      from sale of a subsidiary
              
              
              3,368,119
              
              
              
              5,119,055Inventories,
      net
              
              
              338,008
              
              
              
              271,104Prepaid
      expenses
              
              
              197,389
              
              
              
              179,011Deemed
      receivable from former shareholders of subsidiaries acquired for
      settlement of certain liabilities
              
              
              1,250,976
              
              
              
              1,983,782Current
      assets held for sale
              
              
              1,430,758
              
              
              
              1,768,278NET
      CURRENT ASSETS
              
              
              10,512,566
              
              
              
              16,793,698Property,
      plant and equipment, net
              
              
              10,472,634
              
              
              
              8,000,069Other
      receivables
              
              
              1,546,130
              
              
              
              2,091,092Deposits
      for acquisitions of subsidiaries
              
              
              18,822,946
              
              
              
              197,696Intangible
      assets, net
              
              
              1,195,612
              
              
              
              1,186,272Deposits
      paid for acquisition of long term assets
              
              
              2,245,362
              
              
              
              1,972,162Goodwill
              
              
              229,150
              
              
              
              224,488Non-current
      assets held for sale
              
              
              10,135,011
              
              
              
              9,760,345Derivative
      assets – put options
              
              
              1,598,093
              
              
              
              -TOTAL
      ASSETS
              
              $
              56,757,504
              
              
              $
              40,225,822LIABILITIES
      AND EQUITYCURRENT
      LIABILITIESAccounts
      payable
              
              $
              422,944
              
              
              $
              614,642Deposits
      receipt for disposal
              
              
              1,045,072
              
              
              
              -Accruals
      and other payable
              
              
              539,449
              
              
              
              187,904Acquisition
      consideration payable
              
              
              1,353,474
              
              
              
              1,651,888Short
      term bank loan
              
              
              223,944
              
              
              
              -Tax
      payable
              
              
              174,358
              
              
              
              1,323,815Registration
      rights penalties payable
              
              
              2,160,000
              
              
              
              2,160,000Related
      party payables
              
              
              99,926
              
              
              
              97,893Dividends
      payable on preferred stock
              
              
              249,411
              
              
              
              509,381Derivative
      financial instruments – warrants
              
              
              4,821,264
              
              
              
              6,768,106Derivative
      financial instruments – call options related to Series D Convertible
      Preferred Stock
              
              
              43,665,345
              
              
              
              -Liabilities
      to be settled by former shareholders of subsidiaries
    acquired
              
              
              1,250,976
              
              
              
              1,983,782Convertible
      notes
              
              
              4,034,315
              
              
              
              -Current
      liabilities held for sale
              
              
              437,761
              
              
              
              548,832TOTAL
      CURRENT LIABILITIES
              
              
              60,478,239
              
              
              
              15,846,243




F-2





CHINA
NEW ENERGY GROUP COMPANY


CONDENSED
CONSOLIDATED BALANCE SHEETS


September
      30,
              
              
              December
      31,2010
              
              
              2009(Unaudited)Commitments
      and contingencies (Note 23)Preferred
      Stock : 10,000,000 shares authorized, $0.001 par value Series A
      Convertible Preferred Stock : 2,098,918 and 2,098,918 shares issued
      and outstanding, liquidation preference of $10,137,774 and $10,137,774 as
      of September 30, 2010 and December 31, 2009
              
              
              7,031,818
              
              
              
              7,031,818Series
      B Convertible Preferred Stock: 1,116,388 and 1,116,388 shares issued and
      outstanding, liquidation preference of $5,399,969 and $5,399,969 as of
      September 30, 2010 and December 31, 2009
              
              
              2,153,307
              
              
              
              2,153,307Series
      C Convertible Preferred Stock : 18.73 and 0 shares issued and outstanding,
      liquidation preference of $15,000,000 and $0 as of September 30, 2010 and
      December 31, 2009
              
              
              15,000,000
              
              
              
              -CHINA
      NEW ENERGY'S STOCKHOLDERS' EQUITYSeries
      D Convertible Preferred Stock (see Derivative financial instruments – call
      options): 4 and 0 shares issued and outstanding, liquidation preference of
      $ 0 as ofboth
      September 30, 2010 and December 31, 2009
              
              
              -
              
              
              
              -Common
      Stock: 500,000,000 shares authorized, $0.001 par value, 107,070,281 and
      101,788,199 shares issued and outstanding, respectively
              
              
              107,070
              
              
              
              101,788Additional
      paid in capital
              
              
              (14,831,844
              )
              
              
              10,152,971(Accumulated
      deficit)/ Retained earnings
              
              
              (17,405,485
              )
              
              
              1,423,523Statutory
      surplus reserve fund
              
              
              1,746,890
              
              
              
              1,746,890Accumulated
      other comprehensive income
              
              
              2,311,044
              
              
              
              1,600,941TOTAL
      CHINA NEW ENERGY'S STOCKHOLDERS' EQUITY (DEFICIT)
              
              
              (28,072,325
              )
              
              
              15,026,113Non-controlling
      interest
              
              
              166,465
              
              
              
              168,341TOTAL
      EQUITY (DEFICIT)
              
              
              (27,905,860
              )
              
              
              15,194,454TOTAL
      LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND EQUITY
      (DEFICIT)
              
              $
              56,757,504
              
              
              $
              40,225,822




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





F-3





CHINA
NEW ENERGY GROUP COMPANY


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) –
(UNAUDITED)




For
      the three months ended
                
                
                For
      the nine months endedSeptember
      30,
                
                
                September
      30,2010
                
                
                2009
                
                
                2010
                
                
                2009Revenues:Connection
      services
                
                $
                124,803
                
                
                $
                1,095,454
                
                
                $
                2,479,344
                
                
                $
                1,747,312Natural
      gas
                
                
                37,263
                
                
                
                42,427
                
                
                
                84,165
                
                
                
                84,670162,066
                
                
                
                1,137,881
                
                
                
                2,563,509
                
                
                
                1,831,982Cost
      of Sales:Connection
      services
                
                
                145,435
                
                
                
                329,665
                
                
                
                717,113
                
                
                
                551,248Natural
      gas
                
                
                49,970
                
                
                
                48,202
                
                
                
                123,555
                
                
                
                106,619195,405
                
                
                
                377,867
                
                
                
                840,668
                
                
                
                657,867Gross
      (Loss) Profit
                
                
                (33,339
                )
                
                
                760,014
                
                
                
                1,722,841
                
                
                
                1,174,115Operating
      Expenses:General
      and administrative expenses
                
                
                1,312,808
                
                
                
                853,577
                
                
                
                3,797,133
                
                
                
                1,625,875Selling
      expenses
                
                
                65,509
                
                
                
                42,279
                
                
                
                217,145
                
                
                
                128,881Registration
      right liabilities
                
                
                -
                
                
                
                378,000
                
                
                
                -
                
                
                
                828,000Total
      operating expenses
                
                
                1,378,317
                
                
                
                1,273,856
                
                
                
                4,014,278
                
                
                
                2,582,756Operating
      loss
                
                
                (1,411,656
                )
                
                
                (513,842
                )
                
                
                (2,291,437
                )
                
                
                (1,408,641
                )Other
      Income (Expenses):Change
      in fair value of derivative financial instruments –
    warrants
                
                
                1,654,806
                
                
                
                6,041,231
                
                
                
                1,946,842
                
                
                
                8,017,275Change
      in fair value of derivative financial instruments – put options of
      backstop agreements and obligation to issuance of common stock relating to
      Series D preferred stock
                
                
                (9,975,502
                )
                
                
                -
                
                
                
                (9,975,502
                )
                
                
                -Interest
      income
                
                
                11,916
                
                
                
                5,520
                
                
                
                14,466
                
                
                
                7,754Interest
      expense
                
                
                (1,035,478
                )
                
                
                (1,113
                )
                
                
                (1,039,843
                )
                
                
                (4,123
                )Other
      income
                
                
                14,476
                
                
                
                3,307
                
                
                
                27,566
                
                
                
                3,400Other
      expenses
                
                
                (190,016
                )
                
                
                -
                
                
                
                (190,016
                )
                
                
                -Total
      other income (expenses)
                
                
                (9,519,798
                )
                
                
                6,048,945
                
                
                
                (9,216,487
                )
                
                
                8,024,306(Loss)
      Income From continuing operations, Before Income Tax
                
                
                (10,931,454
                )
                
                
                5,535,103
                
                
                
                (11,507,924
                )
                
                
                6,615,665Income
      Tax
                
                
                2,238
                
                
                
                181,885
                
                
                
                384,835
                
                
                
                187,993(Loss)
      Income From continuing operations, net of Income Tax
                
                
                (10,933,692
                )
                
                
                5,353,218
                
                
                
                (11,892,759
                )
                
                
                6,427,672Discontinued
      Operations:(Loss)
      Income from discontinued operations, net of income tax
                
                
                (231
                )
                
                
                809,506
                
                
                
                (85,877
                )
                
                
                1,894,543(Loss)
      Income from discontinued operations, net of Income Tax
                
                
                (231
                )
                
                
                809,506
                
                
                
                (85,877
                )
                
                
                1,894,543Net
      (Loss) Income
                
                
                (10,933,923
                )
                
                
                6,162,724
                
                
                
                (11,978,636
                )
                
                
                8,322,215Net
      Loss (Income) attributable to Non-controlling Interest
                
                
                4,597
                
                
                
                (25,104
                )
                
                
                1,876
                
                
                
                (18,200
                )Net
      (Loss) Income attributable to China New Energy Group
                
                
                (10,929,326
                )
                
                
                6,137,620
                
                
                
                (11,976,760
                )
                
                
                8,304,015Dividend
      and Deemed Dividend on Preferred Stock
                
                
                (6,378,098
                )
                
                
                (226,946
                )
                
                
                (6,851,248
                )
                
                
                550,946Net
      (Loss) Income attributable to China New Energy Group Common
      Stockholders
                
                
                (17,307,424
                )
                
                
                5,910,674
                
                
                
                (18,829,008
                )
                
                
                8,854,961Other
      Comprehensive Income:Net
      (Loss) Income
                
                
                (10,933,923
                )
                
                
                6,162,724
                
                
                
                (11,978,636
                )
                
                
                8,322,215Foreign
      currency translation loss
                
                
                (557,564
                )
                
                
                (13,763
                )
                
                
                (710,103
                )
                
                
                (24,442
                )Comprehensive
      Income attributable to Non-controlling interest
                
                
                -
                
                
                
                (17,052
                )
                
                
                -
                
                
                
                (12,026
                )Comprehensive
      (loss) income
                
                $
                (11,491,487
                )
                
                $
                6,131,909
                
                
                $
                (12,688,739
                )
                
                $
                8,285,747(Loss)
      Income per share – Basic(Loss)
      Income from continuing operations
                
                $
                (0.16
                )
                
                $
                0.06
                
                
                $
                (0.18
                )
                
                $
                0.05(Loss)
      Income from discontinued operations
                
                $
                (0.00
                )
                
                $
                0.01
                
                
                $
                (0.00
                )
                
                $
                0.02Total
      (loss) income per share
                
                $
                (0.16
                )
                
                $
                0.07
                
                
                $
                (0.18
                )
                
                $
                0.07(Loss)
      Income per share – Diluted(Loss) Income from
      continuing operations
                
                $
                (0.16
                )
                
                
                0.03
                
                
                
                (0.18
                )
                
                
                0.04(Loss) Income from
      discontinued operations
                
                $
                (0.00
                )
                
                $
                0.00
                
                
                $
                (0.00
                )
                
                $
                0.01Total
      (loss) income per share
                
                $
                (0.16
                )
                
                $
                0.03
                
                
                $
                (0.18
                )
                
                $
                0.05Weighted
      average common shares outstandingBasic
                
                
                106,687,887
                
                
                
                100,000,041
                
                
                
                102,488,123
                
                
                
                100,000,041Diluted
                
                
                252,046,676
                
                
                
                217,949,744
                
                
                
                234,554,522
                
                
                
                199,844,225




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




F-4




CHINA
NEW ENERGY GROUP COMPANY


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS – (UNAUDITED)





For
      The Nine Months EndedSeptember
      30,2010
              
              
              2009Cash
      flows from operating activities:Net
      (loss) income
              
              $
              (11,978,636
              )
              
              $
              8,322,215Net
      loss (income) from discontinued operations
              
              
              85,877
              
              
              
              (1,894,543
              )Net
      (loss) income from continuing operations
              
              $
              (11,892,759
              )
              
              $
              6,427,672Adjustments
      to reconcile net (loss) income to net cash used in operating
      activities:Change
      in fair value of derivative financial instruments –
    warrants
              
              
              (1,946,842
              )
              
              
              (8,017,275
              )Change
      in fair value of derivative financial instruments – put options of
      backstop agreements and obligation to issuance of common stock relating to
      Series D preferred stock
              
              
              9,975,502
              
              
              
              -Registration
      rights penalties
              
              
              -
              
              
              
              828,000Depreciation
      and amortization
              
              
              269,782
              
              
              
              140,275Non
      cash interest
              
              
              1,034,314Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              1,383,826
              
              
              
              (3,063,448
              )Other
      receivables
              
              
              578,176
              
              
              
              183,628Inventories
              
              
              (60,210
              )
              
              
              (37,228
              )Prepayment
              
              
              (14,544
              )
              
              
              18,010Other
      current assets
              
              
              -
              
              
              
              (87,610
              )Accounts
      payable
              
              
              (200,914
              )
              
              
              (461,528
              )Accruals
      and other payables
              
              
              1,370,634
              
              
              
              (541,671
              )Tax
      payable
              
              
              (1,156,523
              )
              
              
              (765,519
              )Cash
      used in operating activities – continuing operations
              
              
              (659,558
              )
              
              
              (5,376,694
              )Cash
      provided by (used in) operating activities – discontinued
      operations
              
              
              172,504
              
              
              
              4,461,586Net
      cash used in operating activities
              
              
              (487,054
              )
              
              
              (915,108
              )Cash
      flows from investing activitiesDeposit
      paid for property, plant and equipment
              
              
              (2,749,365
              )
              
              
              (1,108,880
              )Deposits
      paid for acquisitions of subsidiaries
              
              
              (18,625,250
              )
              
              
              -Payment
      made to acquire subsidiary – Chensheng
              
              
              -
              
              
              
              (1,838,946
              )Proceeds
      from sale of subsidiary
              
              
              1,825,010
              
              
              
              -Acquisition
      consideration payable
              
              
              (313,949
              )
              
              
              -Cash
      provided by (used in) investing activities-continuing
      operations
              
              
              (19,863,554
              )
              
              
              (2,947,826
              )Cash
      used in investing activities-discontinued operations
              
              
              (179,733
              )
              
              
              (2,083,662
              )Net
      cash provided by (used in) investing activities
              
              
              (20,043,287
              )
              
              
              (5,031,488
              )Cash
      flows from financing activitiesProceeds
      from convertible loan
              
              
              3,000,000
              
              
              
              -Proceeds
      from short term bank loan
              
              
              220,058
              
              
              
              -Change
      from restricted cash
              
              
              140,661
              
              
              
              24,279Proceeds
      from issuance of preferred stock
              
              
              15,000,000
              
              
              
              4,752,140Cash
      provided by financing activities-continuing operations
              
              
              18,360,719
              
              
              
              4,776,419Cash
      provided by financing activities-discontinued operations
              
              
              -
              
              
              
              439,060Net
      cash flows provided by financing activities
              
              
              18,360,719
              
              
              
              5,215,479Effect
      of exchange rate changes in cash and cash equivalents
              
              
              77,469
              
              
              
              (2,488
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              (2,092,153
              )
              
              
              (733,605
              )Cash
      and cash equivalents - beginning of period
              
              
              2,672,884
              
              
              
              5,612,356Cash
      and cash equivalents - end of period
              
              $
              580,731
              
              
              $
              4,878,751Supplemental
      disclosure of cash flow information:Cash
      paid for interest
              
              $
              -
              
              
              $
              -Cash
      paid for income tax
              
              $
              1,420,494
              
              
              $
              448,252Supplemental
      disclosure of non-cash investing and financing activities:Preferred
      stock dividends payable
              
              $
              260,872
              
              
              $
              135,000Preferred
      stock dividends paid in common stock
              
              $
              948,884
              
              
              $
              -Registration
      rights payable
              
              $
              2,160,000
              
              
              $
              900,000Acquisition
      consideration payable related to the acquisition of Wuyuan
              
              $
              636,850
              
              
              $
              -Acquisition
      consideration payable related to the acquisition of Zhanhua
      Jiutai
              
              $
              716,624
              
              
              $
              -Receivable
      for disposal of discontinued operations
              
              $
              3,368,119
              
              
              $
              -




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





F-5





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





1. Basis
of Presentation





The
financial statements are prepared in accordance with the accounting principles
generally accepted in the United States of America (“US GAAP”).  This
basis differs from that used in the statutory accounts of our subsidiaries in
China, which were prepared in accordance with the accounting principles and
relevant financial regulations applicable to enterprises in the
PRC.  All necessary adjustments have been made to present the
financial statements in accordance with US GAAP.





The
interim condensed consolidated financial statements included herein, presented
in accordance with United States generally accepted accounting principles and
stated in US dollars, have been prepared by the Group ( The Company’s operating
subsidiaries which together with the company are collectively referred to as the
“Group”)., without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
rules and regulations, although the Group believes that the disclosures are
adequate to make the information presented not misleading. These statements
reflect all adjustments, consisting of normal recurring adjustments, which, in
the opinion of management, are necessary for fair presentation of the
information contained therein. It is suggested that these interim condensed
consolidated financial statements be read in conjunction with the financial
statements of the Group for the year ended December 31, 2009 and notes thereto
included in the Form 10K of China New Energy Group Company filed on April 15,
2010. The Group follows the same accounting policies in the preparation of
interim reports.





Results
of operations for the interim periods are not indicative of annual
results.





2.     Organization
and description of business





China New
Energy Group Company (“CNER”, the “Company”, “we”, “us” or “our”) was
incorporated on March 28, 2008 in the state of Delaware USA, under the name of
Travel Hunt Holdings, Inc. (“Travel Hunt”). On May 27, 2008, Travel Hunt changed
its name to China New Energy Group Company in connection with a share exchange
transaction.




F-6





CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


2.    Organization
and description of business-continued





Principal
activity




The
principal activity of the Company is the operation of a natural gas distribution
network through its Chinese subsidiary companies and the following is the
organization structure of the Group:










F-7





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





2.        Organization
and description of business-continued





Willsky Development Ltd.
(“Willsky”)




Willsky
was incorporated on May 31, 2005 under the laws of the British Virgin
Islands.





Tianjin Sing Ocean Public
Utility Development Co., Ltd. (“SingOcean”)





In 2005,
Willsky acquired a 99% shareholding in SingOcean, which was formed in the PRC as
an equity joint venture to be operated for a period of 50 years until January
18, 2054, with registered capital of $4,500,000 (RMB31,897,000). SingOcean set
up a branch division in Acheng, Tianjin, called Tianjin Sing Ocean Public
Utility Development Co., Ltd. - Acheng Division (“SingOcean - Acheng Division”)
which is to be operated for a period of five years until December 28, 2010, but
the Acheng Division was sold in 2009.





Qinhuangdao Chensheng Gas
Company Limited (“Chensheng”)





On
September 16, 2008, our SingOcean subsidiary entered into an Equity Swap
Agreement with Mr. Xiu Hai Tian, whereby we acquired from Mr. Xiu
a 49% ownership interest in Chensheng, in exchange for our 99%
ownership in Hunchun Sing Ocean.  The parties to the Equity Swap
Agreement determined that the value of the 49% interest in Chensheng and the 99%
interest in Hunchun Sing Ocean were approximately equal and therefore there was
no cash or other consideration exchanged.





On
December 10, 2008, we entered into an Agreement for Equity Transfer with the
holders of the remaining 51% ownership interest in Chensheng. The Agreement was
consummated on December 30, 2008 and CNER purchased the remaining 51% of
Chensheng from 17 individuals, for an aggregate purchase price of approximately
$1,840,000 (RMB12,560,000). As a result, the Company owns 51% of Chensheng and
our 99%-owned subsidiary SingOcean owns 49% of Chensheng and thus the Group
ultimately owns 99.5% of Chensheng.





China New Energy (Tianjin)
Investment & Consulting Co., Ltd. (“Tianjin Investment”)





On
January 12, 2009, Tianjin Investment was established in the PRC and is engaged
in the business of investment holding and CNER owns 100% of Tianjin
Investment.





Yingkou Zhongneng Gas
Development Co., Ltd. (“Yingkou Zhongneng”)





On
January 23, 2009, Yingkou Zhongneng was established in the PRC through our 99%
owned subsidiary, SingOcean and operates a natural gas distribution network in
the city of Dashiqiao. As described in Note 4, on March 17, 2010, we entered
into an agreement to sell our interest in Yingkou Zhongneng.





Tianjin Binhai Zhongneng Gas
Co., Ltd. (“Binhai Zhongneng”)





On June
26, 2009, Binhai Zhongneng was established in the PRC by SingOcean and
Chengsheng. Through our 99.5%-owned subsidiary, Chensheng, SingOcean invested
$1,462,501 (RMB10,000,000) in cash for a 60.6% interest in Binhai Zhongneng, and
through our wholly-owned subsidiary, SingOcean, transferred $950,626
(RMB6,500,000) in assets for a 39.4% interest in Binhai Zhongneng. As a result,
the Group holds a 100% interest in Binhai Zhongneng.





F-8





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





2.        Organization
and description of business-continued





Zhanhua Jiutai Gas Co.Ltd.
(“Zhanhua Jiutai”)




On
December 12, 2009, Chensheng entered into an Equity Interest Purchase Agreement
to acquire all of the equity interests in Zhanhua Jiutai, a PRC company, from
the five shareholders of Zhanhua Jiutai, for a total purchase price of
$2,413,259 (RMB16,500,000).





Wuyuan County Zhongran Gas
Ltd. (“Wuyuan”)




On
December 16, 2009, Willsky entered into an Equity Interest Purchase Agreement to
acquire all of the equity interests in Wuyuan, a PRC company, from Flying Dragon
Investment Management Limited, for a total purchase price of $877,552
(RMB6,000,000), based on an appraised value of Wuyuan as of September 30,
2009.





China New Energy Investment
Company Ltd. (“Nixi”)





On August
25, 2010, Nixi was established in the PRC and is engaged in the business of
investment holding and enterprise management service and CNER owns 100% of
Nixi.





Operational Rights and Right
to Supply and Operate Gas Pipeline




The
Group, through SingOcean, has signed an “Investment
Agreement of Piped Gas Project Construction in Dashiqiao City” which states that
the Group is in charge of operations and management of the piped gas project in
Dashiqiao. On June 16, 2005, the Dashiqiao City Construction Bureau gave the
Group a certificate which confirmed that the Group has exclusive operational
rights for thirty years in Dashiqiao City. The Group receives a connection fee
of $380 (RMB2,600) per user. On March 17, 2010, SingOcean entered into an
agreement to sell our interest in Yingkou Zhongneng at approximately $3,200,000
(RMB21,900,000).





On June
10, 2005, the Group, through SingOcean, signed an “Investment
Agreement of Piped Gas Project Construction in Acheng City” which states that
the Group has the exclusive right to invest in and operate the gas pipeline
system in Acheng City for thirty years. The Group receives a connection fee of
$293 (RMB2,000) per user. This SingOcean - Acheng division was sold in the third
quarter of 2009.





On
October 8, 2005, Chengsheng signed an “Investment
Agreement of Piped Gas Project Construction in Qinhuangdao” which states that
Chengsheng has the exclusive right to invest in and operate the gas pipeline
system in Qinhuangdao for twenty-five years. The Group acquired Chengsheng in
the fourth quarter of 2008 to have the above operation rights. The Group
receives a connection fee of $351 (RMB2,400) per user.





2010
Acquisitions




In 2010,
we have entered into various agreements to acquire additional subsidiaries, as
described in Notes 16 and 17.





F-9





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





3.
Summary of Significant Accounting Policies





(a)
Basis of Presentation




The
financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America (“US GAAP”).  This
basis differs from that used in the statutory accounts of our subsidiaries in
China, which were prepared in accordance with the accounting principles and
relevant financial regulations applicable to enterprises in the
PRC.  All necessary adjustments have been made to present the
financial statements in accordance with US GAAP.





(b)
Use of Estimates




In
preparing consolidated financial statements in conformity with US GAAP,
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 revenues and
expenses during the reported periods. Actual results could differ from those
estimates.





Significant
Estimates





These
consolidated financial statements include some amounts that are based on
management's best estimates and judgments. The most significant estimates relate
to revenue recognition of gas connection contracts, depreciation of property,
plant and equipment, the valuation allowance for deferred taxes, impairment
testing of intangible assets, the fair value of derivative instrument
liabilities and various contingent liabilities. It is reasonably possible that
the above-mentioned estimates and others may be adjusted as more current
information becomes available, and any adjustment could be significant in future
reporting periods.





(c)
Principles of Consolidation





The
consolidated financial statements include the accounts of the Company and all of
its subsidiaries. All significant intercompany transactions and accounts have
been eliminated in consolidation.





(d)
Reclassification





Certain
amounts in the prior year have been reclassified to conform to the current
period’s presentation.





F-10





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





3.
Summary of Significant Accounting Policies-continued





(e) Revenue
Recognition




Among the
accounting policies adopted by the Group, the most critical one is the policy
regarding revenue recognition of the Group’s major sources of income from gas
connection services and sales of gases. In accordance with FASB ASC 650-10-S99
Revenue Recognition,
all of the following criteria must be met in order for us to recognize
revenue:





1.
            Persuasive
      evidence of an arrangement exists;




2.
            Delivery
      has occurred or services have been
rendered;




3.
            The
      seller's price to the buyer is fixed or determinable;
  and




4.
            Collectibility
      is reasonably assured.





Gas
connection revenue




Gas
connection revenue is recognized when the outcome of a contract can be estimated
reliably and the stage of completion at the balance sheet date can be measured
reliably.





Revenue
from gas connection contracts is recognized on the percentage of completion
method, measured by reference to the value of work carried out during the year.
When the outcome of a gas connection contract cannot be estimated reliably,
revenue is recognized only to the extent of contract costs incurred that it is
probable will be recoverable.





When the
outcome of a gas connection contract can be estimated reliably and the stage of
contract completion at the balance sheet date can be measured reliably, contract
costs are charged to the income statement by reference to the stage of
completion of the contract activity at the balance sheet date on the same basis
as revenue from the gas connection contract is recognized.





When the
outcome of a gas connection contract cannot be estimated reliably, contract
costs are recognized as expenses in the period in which they are incurred. When
it is probable that total contract costs will exceed contract revenue, the
expected loss is recognized as an expense immediately.





Where
contract costs incurred to date plus recognized profits less recognized losses
exceed progress billings, the surplus is shown as an amount due from customers
for contract work. For contracts where progress billings exceed contract costs
incurred to date plus recognized profits less recognized losses, the surplus is
shown as an amount due to customers for contract work. Amounts received before
the related work is performed are included in the consolidated balance sheet, as
a liability, as advances received. Amounts billed for work performed but not yet
paid by the customer are included in the consolidated balance sheet under trade
and other receivables.





During
the nine months ended September 30, 2010 and 2009, all the contracts for
connection services were started and completed in the same period.





Revenue
from sale of gas




Sales
revenue from the sale of gas represents the invoiced value of goods sold, net of
value-added tax (“VAT”). Revenue from the sale of gas is recognized when the
goods are delivered and title has passed.





All of
the Company’s products that are sold in the PRC are subject to Chinese
value-added tax of 3% of the gross sales price. This VAT may be offset by VAT
paid by the Company on raw materials and other materials included in the cost of
producing their finished product. The Company recorded VAT payable and VAT
receivable net of payments in the financial statements.





F-11





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





3.
Summary of Significant Accounting Policies-continued





(f)
Fair Value of Financial Instruments




The Group
records and discloses certain financial and non-financial assets and liabilities
at their fair value. The fair value of an asset is the price at which the asset
could be sold in an orderly transaction between unrelated, knowledgeable and
willing parties able to engage in the transaction. A liability’s fair value is
defined as the amount that would be paid to transfer the liability to a new
obligor in a transaction between such parties, not the amount that would be paid
to settle the liability with the creditor.





Assets
and liabilities recorded at fair value are measured using a three-tier fair
value hierarchy, which prioritizes the inputs used in measuring fair value.
These tiers include:




Level 1,
defined as observable inputs such as quoted prices in active
markets;




Level 2,
defined as inputs other than quoted prices in active markets that are either
directly or indirectly observable; and




Level 3,
defined as unobservable inputs in which little or no market data exists,
therefore requiring the Group to develop its own assumptions.





Our
derivative instrument liabilities are recorded at fair value. Our financial
instruments that are recorded at cost include cash and cash equivalents,
restricted cash, accounts receivable, receivables related to subsidiaries sold,
deposits for acquisitions, accounts payable, accrued expenses, dividends
payable, and other current liabilities. We believe the carrying values of these
financial instruments approximate their fair values due to their short-term
nature.





(g)
New accounting pronouncements




Fair
Value Measurements


In
January 2010, the FASB issued guidance to amend the disclosure requirements
related to recurring and nonrecurring fair value measurements. The guidance
requires disclosure of transfers of assets and liabilities between Level 1 and
Level 2 of the fair value measurement hierarchy, including the reasons and the
timing of the transfers and information on purchases, sales, issuance, and
settlements on a gross basis in the reconciliation of the assets and liabilities
measured under Level 3 of the fair value measurement hierarchy. The guidance is
effective for annual and interim reporting periods beginning after December 15,
2009, except for Level 3 reconciliation disclosures which are effective for
annual and interim periods beginning after December 15, 2010. The Company
adopted this guidance at January 1, 2010, except for the Level 3 reconciliation
disclosures on the rollforward activities, which it will adopt at the beginning
of January 1, 2011. Adoption did not have a material impact on our consolidated
financial statements.





Accounting
Standards Update ("ASU") ASU No. 2009-05 (ASC Topic 820), which amends Fair
Value Measurements and Disclosures - Overall, ASU No. 2009-13 (ASC Topic 605),
Multiple-Deliverable Revenue Arrangements, ASU No. 2009-14 (ASC Topic 985),
Certain Revenue Arrangements that include Software Elements, and various other
ASU's No. 2009-2 through ASU No. 2010-26 which contain technical corrections to
existing guidance or affect guidance to specialized industries or entities were
recently issued. These updates have no current applicability to the Company or
their effect on the financial statements would not have been
significant.





For a
description of further accounting policies, please see the December 31, 2009
10K.





F-12





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





4.
Discontinued Operations





Disposal of Yingkou
Zhongneng Gas Development Co.,Ltd in 2010 – completed in
2010




On March
17, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Hunan Zhongyouzhiyuan Gas Co., Ltd. (the“Purchaser").
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). On March 31, 2010, the agreement was
terminated.





On April
2, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Changsha Yuedu Steel Co., Ltd. (the “Purchaser”).
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). As of September 30, 2010, the Group received part of
the downpayment of $l,045,072 (RMB7,000,000) and recorded under Deposits receipt
for disposal of current liabilities.





As of
September 30, 2010, the legal procedures for the transfer of the ownership of
Yingkou have not been completed and the control of Yingkou still remains in the
Group; therefore, the Group recorded all the assets and liabilities of Yingkou
under the caption of “Current Assets Held for Sale”, “Non-current Assets Held
for Sale” and “Liabilities Held for Sale”. The operating activity of Yingkou was
recorded under the discontinued operations for the nine months ended September
30, 2010 and 2009.




The
following table displays summarized operating activity for the discontinued
operations of Yingkou for the three and nine months ended September 30, 2010 and
Yingkou and Acheng for the three and nine months ended September 30,
2009.




For
      the three months ended
                          
                          
                          For
      the nine months endedSeptember
      30,
                          
                          
                          September,
      302010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Revenue
                          
                          $
                          -
                          
                          
                          $
                          1,679,391
                          
                          
                          $
                          201,739
                          
                          
                          $
                          4,120,898Operating
      (loss) profit
                          
                          $
                          (231
                          )
                          
                          $
                          1,273,455
                          
                          
                          $
                          (85,877
                          )
                          
                          $
                          2,712,980(Loss)
      Profit before income taxes
                          
                          $
                          (231
                          )
                          
                          $
                          1,088,634
                          
                          
                          $
                          (85,877
                          )
                          
                          $
                          2,535,350Income
      tax expense
                          
                          $
                          -
                          
                          
                          $
                          279,128
                          
                          
                          $
                          -
                          
                          
                          $
                          640,807(Loss)
      Profit from discontinued operations, net of tax
                          
                          $
                          (231
                          )
                          
                          $
                          809,506
                          
                          
                          $
                          (85,877
                          )
                          
                          $
                          1,894,543
 
 F-13
  CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





5.
Restricted cash





At
September 30, 2010 and December 31, 2009, restricted cash of $39,691 and
$180,352 represented the cash held by an escrow agent for expenses relating to
investor and public relations.




6.
Other Receivables





Other
receivables consist of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Due
      from Tianjin East Ocean Gas Company Limited
                  
                  $
                  869,832
                  
                  
                  $
                  1,454,721Other
      receivables
                  
                  
                  676,298
                  
                  
                  
                  636,371Total
                  
                  $
                  1,546,130
                  
                  
                  $
                  2,091,092





The
balance due from Tianjin East Ocean Gas Company Limited (“East Ocean”)
represents the amount due from Hunchun to the Group which was assigned to East
Ocean when East Ocean obtained 99% ownership of Hunchun by the exchange of a 49%
ownership interest in Chensheng in 2008.





Other
receivables, which are unsecured, interest free, and have no fixed repayment
date, are mainly comprised of an amount due from the Dashiqiao City Construction
Bureau relating to various construction projects.  These deposits will
be refunded to us once certain construction milestones are
completed.




7.
Inventories





Inventories
at September 30, 2010 and December 31, 2009 of $338,008 and $271,104,
respectively, consist of raw materials and do not include any work in progress
or finished goods.





F-14





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





8.
Property, Plant and Equipment, net





Property,
plant and equipment consist of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Cost:Leasehold
      improvements
                  
                  $
                  168,576
                  
                  
                  $
                  75,673Building
                  
                  
                  81,255
                  
                  
                  
                  79,603Office
      Equipment
                  
                  
                  139,672
                  
                  
                  
                  112,987Motor
      Vehicles
                  
                  
                  329,608
                  
                  
                  
                  304,359Gas
      Transportation Vehicles
                  
                  
                  194,135
                  
                  
                  
                  190,099Gas
      Station
                  
                  
                  185,405
                  
                  
                  
                  181,511Machinery
                  
                  
                  181,631
                  
                  
                  
                  134,484Underground
      Gas Pipelines
                  
                  
                  3,930,690
                  
                  
                  
                  2,388,733$
                  5,210,972
                  
                  
                  $
                  3,467,449Less:
      Accumulated depreciation
                  
                  
                  (513,457
                  )
                  
                  
                  (324,706
                  )$
                  4,697,515
                  
                  
                  $
                  3,142,743Construction-in-progress
                  
                  
                  5,775,119
                  
                  
                  
                  4,857,326$
                  10,472,634
                  
                  
                  $
                  8,000,069





Construction-in-progress
represents labor costs, materials, and capitalized interest incurred in
connection with the construction of pipelines and networks. No depreciation is
provided for construction-in-progress until it is completed and placed into
service. Most construction-in-progress we purchased with cash and in general the
assembling process can be done in less than 12 weeks. Therefore, no interest
expense was capitalized as the capitalized interest was not
significant.





The gas
pipelines, gas station, and other constructed assets belong to the Group, not to
the municipalities or other units that contract with the Group to provide the
hookups and the gas distribution to the households. Depreciation is provided for
these assets as they are used in operations.





During
the three months ended September 30, 2010, depreciation expense amounted to
$95,155, of which $52,156 and $42,999 was recorded as cost of sales and as
general and administrative expenses, respectively.





During
the nine months ended September 30, 2010, depreciation expense amounted to
$254,752, of which $144,497 and $110,255 was recorded as cost of sales and as
general and administrative expenses, respectively.





During
the three months ended September 30, 2009, depreciation expense amounted to
$46,596, of which $33,569 and $13,027 was recorded as cost of sales and as
general and administrative expenses, respectively.





During
the nine months ended September 30, 2009, depreciation expense amounted to
$125,301, of which $96,649 and $28,652 was recorded as cost of sales and as
general and administrative expenses, respectively.





F-15





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





9.
Intangible Assets, net





Intangible
assets consist of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Land
      use rights
                  
                  $
                  1,236,404
                  
                  
                  $
                  1,211,250Less:
      accumulated amortization
                  
                  
                  (40,792
                  )
                  
                  
                  (24,978
                  )$
                  1,195,612
                  
                  
                  $
                  1,186,272





Amortization
expense for the three months ended September 30, 2010 and 2009 was $5,037 and
$4,977, respectively.





Amortization
expense for the nine months ended September 30, 2010 and 2009 was $15,030 and
$14,974, respectively.





Estimated
amortization for the next five years and thereafter is as follows:





Remainder
      of 2010
                    
                    $
                    5,0102011
                    
                    
                    20,0402012
                    
                    
                    20,0402013
                    
                    
                    20,0402014
                    
                    
                    20,040Thereafter
                    
                    
                    1,110,442Total
                    
                    $
                    1,195,612





F-16





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





10.
Acquisition Consideration Payable




September 30,
                        2010
                      
                      
                      December 31,
                        2009Acquisition
      consideration payable relating to the purchase of Zhanhua
      Jiutai
                      
                      $
                      716,624
                      
                      
                      $
                      1,015,038Acquisition
      consideration payable relating to the purchase of Wuyuan
                      
                      
                      636,850
                      
                      
                      
                      636,850Total
                      
                      $
                      1,353,474
                      
                      
                      $
                      1,651,888





The
acquisition consideration payable as of September 30, 2010 represents the
remaining amounts due as of that date in connection with the December 2009
acquisitions of Zhanhua Jiutai and Wuyuan (see Notes 2 & 16). This amount
will be due according to the payment terms under the Equity Interest Purchase
Agreement.





11.
Related Party Payables





Related
party payables consist of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Tianjin
      Huan Long Trading Ltd.
                    (non-controlling
      shareholder of a subsidiary)
                  
                  $
                  99,926
                  
                  
                  $
                  97,893





The
balances have no stated terms for repayment and are not interest
bearing.





12.
Short Term Loan





Short
term loans represent the borrowings from commercial banks that are due within
one year. These loans consisted of the following:





September 30,
                    2010
                  
                  
                  December 31,
                    2009Loan
      from Bank of Communications, interest rate at 6.906% per annum, due June
      10, 2011, guaranteed by land use right of Chensheng.
                  
                  $
                  223,944
                  
                  
                  $
                  -





The
interest expenses for the above loans for the three months ended September 30,
2010 and 2009 amounted to $3,126 and $-, respectively.





The
interest expenses for the above loans for the nine months ended September 30,
2010 and 2009 amounted to $3,126 and $-, respectively.





F-17





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009




13.
Capital Stock
 
 Common
Stock
 
 We are
authorized to issue 500,000,000 shares of Common Stock, $0.001 par value.
Holders of Common Stock are entitled to one vote for each share held of record
on each matter submitted to a vote of shareholders. Subject to the prior rights
of any class or series of preferred stock which may from time to time be
outstanding, if any, holders of Common Stock are entitled to receive ratably,
dividends when, as, and if declared by our Board of Directors out of funds
legally available for that purpose and, upon our liquidation, dissolution, or
winding up, are entitled to share ratably in all assets remaining after payment
of liabilities and payment of accrued dividends and liquidation preferences on
the preferred stock, if any. As long as any shares of our Series A and Series B
Preferred Stock are outstanding, the terms of those instruments prohibit us from
paying dividends on the Common Stock. Holders of Common Stock have no preemptive
rights and have no rights to convert their Common Stock into any other
securities.  The outstanding Common Stock is duly authorized and
validly issued, fully-paid, and non-assessable.
 
 Except as
otherwise required by Delaware law, and subject to the rights of the holders of
preferred stock, all stockholder action is taken by the vote of a majority of
the outstanding shares of Common Stock present at a meeting of stockholders at
which a quorum consisting of a majority of the outstanding shares of Common
Stock is present in person or by proxy. However, for so long as the number of
outstanding shares of Series B Preferred Stock is at least 30% of the total
number of shares of Series B Preferred Stock originally issued, the holders of
Series B Preferred Stock vote together as a single class with the holders of the
Company’s Common Stock, and the holders of any other class or series of shares
entitled to vote with the Common Stock, with the holders of Series B Preferred
Stock being entitled to 70% of the total votes on all such matters regardless of
the actual number of shares of Series B Preferred Stock then outstanding, and
the holders of Series A Preferred Stock and Common Stock being entitled to their
proportional share of the remaining 30% of the total votes based on their
respective voting power.
 
 At
September 30, 2010 and December 31, 2009, 107,070,281 and 101,788,199 shares of
Common Stock were issued and outstanding, respectively.
 
 Series
A Convertible Preferred Stock
 
 In
connection with the August 20, 2008 private placement, the Company filed a
Certificate of Designations of Preferences, Rights and Limitations of Series A
Convertible Preferred Stock with the Secretary of State of the State of Delaware
(the "Certificate").  The Company’s Certificate of Incorporation authorizes
it to issue 10,000,000 shares of Preferred Stock and by the filing, 5,500,000
shares were designated as Series A Convertible Preferred Stock ("Series A
Preferred Stock").  On August 20, 2008, the Company issued 1,857,373 shares
of Series A Preferred Stock to China Hand Fund I, LLC (“China
Hand”).
 
 On May 1,
2009, the Company issued an additional 241,545 shares of Series A Preferred
Stock to China Hand in connection with a make-good provision. At September 30,
2010 and December 31, 2009, 2,098,918 shares of Series A Preferred Stock were
issued and outstanding.
 F-18
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 
 13.
Capital Stock-continued
 
 Dividends
  The
holders of the Series A Preferred Stock are entitled to cumulative
dividends at a rate of 6% per annum of the stated price paid per share of $4.83,
compounded daily and payable semi-annually on June 1 and December
1. Dividends are payable in shares of Common Stock or, at the option of the
Company, in cash. If paid in shares of Common Stock, the number of shares to be
issued is determined by dividing the dividend payable by 90% of the
volume-weighted average price for the 20 days preceding the dividend payment
date of June 1 or December 1. As long as any shares of Series A Preferred Stock
are outstanding, the Company may not declare or pay dividends with respect to
the Common Stock.
 
 Voting
Rights
  In
addition to the right to vote as a separate class of securities, the holders of
the Preferred Stock are entitled to vote together with the holders of the
Company’s Common Stock, with each such holder of Series A Preferred Stock
entitled to the number of votes equal to the number of shares of the Company’s
Common Stock in to which such Series A Preferred Stock would be converted if
converted on the record date for the taking of a vote. However, for so long as
the number of outstanding shares of Series B Preferred Stock is at least 30% of
the total number of shares of Series B Preferred Stock originally issued, the
holders of Series B Preferred Stock vote together as a single class with the
holders of the Company’s Common Stock and the holders of any other class or
series of shares entitled to vote with the Common Stock, including the Series A
Preferred Stock, with the holders of Series B Preferred Stock being entitled to
70% of the total votes on all such matters regardless of the actual number of
shares of Series B Preferred Stock then outstanding, and the holders of Series A
Preferred Stock and Common Stock being entitled to their proportional share of
the remaining 30% of the total votes based on their respective voting
power.
  Liquidation
  Upon any
liquidation, dissolution or winding-up of the Company, whether voluntary or
involuntary (each, a “Liquidation Event”), the holders of the Series A
Preferred Stock are entitled to receive out of the assets of the Company,
whether such assets are capital or surplus, for each share of Series A Preferred
Stock an amount equal to $4.83, plus any accumulated but unpaid dividends
thereon (the “Liquidation Value”), before any distribution or payment is made to
the holders of any securities which are junior to the Series A Preferred Stock
upon the occurrence of a Liquidation Event and after any distributions or
payments made to holders of any class or series of securities which are senior
to the Series A Preferred Stock upon the occurrence of a Liquidation Event. If
the assets of the Company are insufficient to pay in full such amounts, then the
entire assets to be distributed to the Series A Holders will be distributed
among the Series A Holders ratably in accordance with the respective amounts
that would be payable on such shares if all amounts payable thereon were paid in
full. In the event the assets of the Company available for distribution to the
holders of shares of Series A Preferred Stock upon the occurrence of a
Liquidation Event are insufficient to pay in full all amounts to which such
holders are entitled, no such distribution shall be made on account of any
shares of any other class or series of capital stock of the Company ranking on a
parity with the shares of Series A Preferred Stock upon the occurrence of such
Liquidation Event unless proportionate distributive amounts are paid on account
of the shares of Series A Preferred Stock, ratably, in proportion to the full
distributable amounts for which holders of all such parity shares are
respectively entitled upon the occurrence of such Liquidation
Event.
 F-19
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 13.
Capital Stock-continued
 
 Conversion
  Each
share of Series A Preferred Stock is initially convertible, at any time at the
option of the holder, into 35 shares of the Company’s Common Stock, subject to
future adjustments as provided for in the Certificate. The Series A Preferred
Stock will automatically convert into shares of the Company’s Common Stock
immediately prior to any transaction resulting in a Change in Control of the
Company. Further, provided there is an effective registration statement covering
the shares to be received on conversion, the Company may require conversion of
the Series A Preferred Stock if the volume-weighted average price for at least
20 trading days in any consecutive 30 day period equals or exceeds twice the
conversion price and the trading volume on each day in the 30 day period has
equaled or exceeded 100,000 shares.
 
 The
conversion price of the Series A Preferred Stock will be adjusted for standard
anti-dilution events, including stock dividends or stock splits or
reclassification of shares of the Common Stock. For as long as any shares of
Series A Preferred Stock remain outstanding, the Company may not enter into any
Variable Rate Transactions or Most Favored Nation transactions. If the Company
does enter into a Variable Rate Transaction, in which it issues debt or equity
securities that are convertible into shares of Common Stock at a conversion or
exercise price that is based upon or varies with the trading price for shares of
the Common Stock or enters into a Most Favored Nation transaction in which the
Company issues any securities in a capital raising transaction or series of
transactions on terms more favorable than those granted to the holders of the
Series A Preferred Stock, the holders of the Series A Preferred Stock are
entitled to adjustment of the conversion price and to receive additional shares
or other rights. Furthermore, if the Company issues (except in an underwritten
public offering approved by holders of the Series A Preferred Stock in which the
gross proceeds to the Company are not less than $20 million) any shares of
Common Stock or securities convertible into shares of Common Stock at a price
which is less than the conversion price then in effect, the conversion price
will be reduced to that lower price.
 
 As long
as 20% of the shares of Series A Preferred Stock remain outstanding, the Company
may not issue any other preferred stock (except for the issuance of Series A
Preferred Stock and Series B Preferred Stock issued pursuant to the agreements
under which those Series were originally issued) or any convertible debt
convertible into Common Stock, without the consent of the holders of outstanding
shares of Series A Preferred Stock.
 F-20
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
  13.
Capital Stock-continued
 
 Series
B Convertible Preferred Stock
 
 On April
30, 2009, the Company entered into a Series B Convertible Preferred Stock
Securities Purchase Agreement with China Hand, as described in Note 14. In
connection with this private placement, the Company filed a Certificate of
Designations of Preferences, Rights and Limitations of Series B Convertible
Preferred Stock with the Secretary of State of the State of Delaware,
designating 2,000,000 shares as Series B Preferred Stock. At September 30, 2010
and December 31, 2009, there were 1,116,388 shares of Series B Preferred Stock
issued and outstanding.
 
 Dividends
  The
holders of the Series B Preferred Stock are entitled to cumulative dividends at
a rate of 6% per annum of the stated price paid per share of $4.837, compounded
daily and payable semi-annually in arrears on June 1 and December 1 of each
year. Dividends are payable in shares of Common Stock or, at the option of the
Company, in cash. If paid in shares of Common Stock, the number of shares to be
issued is determined by dividing the dividend payable by 90% of the
volume-weighted average price for the 20 days preceding the dividend payment
date of June 1 or December 1. As long as any shares of Series B Preferred Stock
are outstanding, the Company may not declare or pay dividends with respect to
the Common Stock.
 
 Voting
Rights
  In
addition to the right to vote as a separate class of securities, the holders of
the Preferred Stock are entitled to vote together with the holders of the
Company’s Common Stock, with each such holder of Preferred Stock entitled to the
number of votes equal to the number of shares of the Company’s Common Stock in
to which such Preferred Stock would be converted if converted on the record date
for the taking of a vote. For so long as the number of outstanding shares of
Series B Preferred Stock is at least 30% of the total number of shares of Series
B Preferred Stock issued under the Securities Purchase Agreement, the holders of
Series B Preferred Stock shall vote together as a single class with the holders
of the Company’s Common Stock, and the holders of any other class or series of
shares entitled to vote with the Common Stock, with the holders of Series B
Preferred Stock issued under the Securities Purchase Agreement being entitled to
70% of the total votes on all such matters regardless of the actual number of
shares of Series B Preferred Stock then outstanding, and the holders of Series A
Preferred Stock and Common Stock being entitled to their proportional share of
the remaining 30% of the total votes based on their respective voting
power.
 F-21
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 13.
Capital Stock-continued
 
 Liquidation
  Upon any
liquidation, dissolution or winding-up of the Company, whether voluntary or
involuntary (each, a “Liquidation Event”), the Series B Holders shall be
entitled to receive out of the assets of the Company, whether such assets are
capital or surplus, for each share of Series B Preferred Stock an amount equal
to the Original Purchase Price, which is $4.837 per share, plus any accumulated
but unpaid dividends thereon (the “Series B Liquidation Value”), before any
distribution or payment shall be made to the holders of any securities which are
junior to the Series B Preferred Stock upon the occurrence of a Liquidation
Event and after any distributions or payments made to holders of any class or
series of securities which are senior to the Series B Preferred Stock upon the
occurrence of a Liquidation Event. Upon the occurrence of a Liquidation Event,
the right of the Series B Holders to receive Liquidation Value hereunder shall
rank pari passu with that of the holders of Series A Preferred Stock (the
“Series A Holders”). If the assets of the Company shall be insufficient to pay
in full such amounts, then the entire assets to be distributed to the Series B
Holders shall be distributed among the Series B Holders and the Series A Holders
ratably in accordance with the respective amounts that would be payable on such
shares if all amounts payable thereon were paid in full. In the event the assets
of the Company available for distribution to the holders of shares of Series B
Preferred Stock upon the occurrence of a Liquidation Event shall be insufficient
to pay in full all amounts to which such holders are entitled, no distribution
shall be made on account of any shares of any other class or series of capital
stock of the Company ranking on a parity with the shares of Series B Preferred
Stock upon the occurrence of such Liquidation Event unless proportionate
distributive amounts shall be paid on account of the shares of Series B
Preferred Stock, ratably, in proportion to the full distributable amounts for
which holders of all such parity shares are respectively entitled upon the
occurrence of such Liquidation Event.
 
 Conversion
  Each
share of Series B Preferred Stock is initially convertible, at any time at the
sole option of the holder of such Preferred Stock, at a conversion price of
$0.1382 per share, into 35 shares of the Company’s Common Stock, subject to
future adjustments as provided for in the Certificate. The Series B Preferred
Stock will automatically convert into shares of the Company’s Common Stock
immediately prior to any transaction resulting in a change in control of the
Company.
 
 The
conversion price of the Series B Preferred Stock will be adjusted for standard
anti-dilution events, including stock dividends or stock splits or
reclassification of shares of the Common Stock. For as long as any shares of
Series B Preferred Stock remain outstanding, the Company may not enter into any
Variable Rate Transactions or Most Favored Nation transactions. If the Company
does enter into a Variable Rate Transaction, in which it issues debt or equity
securities that are convertible into shares of Common Stock at a conversion or
exercise price that is based upon or varies with the trading price for shares of
the Common Stock or enters into a Most Favored Nation transaction in which the
Company issues any securities in a capital raising transaction or series of
transactions on terms more favorable than those granted to the holders of the
Series B Preferred Stock, the holders of the Series B Preferred Stock are
entitled to adjustment of the conversion price and to receive additional shares
or other rights. Furthermore, if the Company issues (except in an underwritten
public offering approved by holders of the Series A Preferred Stock in which the
gross proceeds to the Company are not less than $20 million) any shares of
Common Stock or securities convertible into shares of Common Stock at a price
which is less than the conversion price then in effect, the conversion price
will be reduced to that lower price.
 
 As long
as 20% of the shares of Series B Preferred Stock remain outstanding, the Company
may not issue any other preferred stock (except for the issuance of Series A
Preferred Stock and Series B Preferred Stock issued pursuant to the agreements
under which those Series were originally issued) or any convertible debt
convertible into Common Stock, without the consent of 75% of the holders of
outstanding shares of Series B Preferred Stock.
 F-22
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 13.
Capital Stock-continued
 
 Series
C Convertible Preferred Stock
 
 On
September 14, 2010, the Company entered into and consummated the sale of
securities pursuant to a Series C and Series D Convertible Preferred Stock
Securities Purchase Agreement (the “Securities Purchase Agreement”) with China
Hand Fund I, LLC (“China Hand”), providing for the sale to China Hand of (i)
18.73 shares of the Company’s Series C Convertible Preferred Stock (“Series C
Preferred Stock”) for an aggregate purchase price of $15,000,000, and (ii) 4
shares of the Company’s Series D Convertible Preferred Stock (“Series D
Preferred Stock”) in consideration for entering into the Backstop Agreement
described below in Note 14. (the “Private Placement”). The proceeds of the
Private Placement will be used to finance the first installment of the purchase
price due for the acquisition by a wholly-owned subsidiary of the Company of (i)
a 70% equity interest in each of Beijing Century Dadi Gas Engineering Co., Ltd.,
a PRC limited liability company (“Century Dadi”) and (ii) Zhoulu Dadi Gas Co.
Ltd., a PRC limited liability company (“Zhoulu Dadi”) (see note
16).
 
 Immediately
following the closing of the Private Placement, China Hand transferred its
rights to the Series C Preferred Stock and to 2 of the shares of Series D
Preferred Stock to Vicis Capital Master Fund (“Vicis”).
 
 At
September 30, 2010 and December 31, 2009, there were 18.73 shares and 0 shares
respectively of Series C Preferred Stock issued and outstanding.
 
 Dividends
 
 The
holders of the Series C Preferred Stock are entitled to receive dividends on an
as converted basis with the holders of the Company’s Common Stock.
 
 Voting
Rights
 
 In
addition to the right to vote as a separate class of securities, the holders of
the Series C Preferred Stock have full voting rights and powers equal to the
voting rights such holders would have if the Series C Preferred Stock were
converted at the date that a vote is taken. The Series C Preferred Stock holders
are entitled to notice of any stockholders meeting in accordance with the Bylaws
of the Company, and are entitled to vote, with respect to any question upon
which holders of Common Stock have the right to vote, including, without
limitation, the right to vote for the election of directors, voting together
with the holders of Common Stock as one class.
 F-23
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 13.
Capital Stock-continued
 
 Series
C Convertible Preferred Stock
 
 For so
long as any shares of Series C Preferred Stock remain outstanding, without the
affirmative approval of the Holders of 75% of the shares of the Series C
Preferred Stock then outstanding (by vote or written consent, as provided by
law), the Company shall not:
 
 i. in any
manner authorize, issue or create (by reclassification or otherwise) any new
class or series of shares having rights, preferences or privileges equal or
senior to the Series C Preferred Stock;
 
 ii.
adversely alter or change the rights, preferences, designations or privileges of
the Series C Preferred Stock;
 
 iii.
amend the Company’s Articles of Incorporation or By-laws in a manner that
adversely affects the rights, preferences, designations or privileges of the
Holders;
 
 iv.
increase or decrease the authorized number of shares of preferred stock of the
Company or otherwise reclassify the Company's outstanding
securities;
 
 v.
redeem, purchase or otherwise acquire (or pay into or set funds aside for a
sinking fund for such purpose) any share or shares of Preferred Stock or Common
Stock; provided, however, that this restriction shall not apply to repurchases
of shares of Common Stock from employees, officers, directors, consultants or
other persons performing services for the Company or any subsidiary pursuant to
agreements that are approved by the Board under which the Company has the option
to repurchase such shares at cost upon the occurrence of certain events, such as
the termination of employment, or through the exercise of any right of first
refusal; and provided further, that this restriction shall not apply to any
conversion, redemption or other acquisition of shares of Series C Convertible
Stock pursuant to the Series C Certificate of Designation, any Transaction
Documents, Series A Financing Transaction Documents or Series B Financing
Transaction Documents (as defined in the Securities Purchase Agreement);
or
 
 vi.
voluntarily file for bankruptcy, liquidate the Company’s assets or make an
assignment for the benefit of the Company’s creditors.
 F-24
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 13.
Capital Stock-continued
 
 Liquidation
 
 Upon any
liquidation, dissolution or winding-up of the Company, whether voluntary or
involuntary
 (each, a
“Liquidation Event”), the Series C Holders shall be entitled to receive out of
the assets of the Company, whether such assets are capital or surplus, for each
share of Series C Preferred Stock an amount equal to the Original Purchase Price
of $800,854.24, plus any accumulated but unpaid dividends thereon (the
“Liquidation Value”), before any distribution or payment shall be made to the
holders of any securities which are junior to the Series C Preferred Stock upon
the occurrence of a Liquidation Event and after any distributions or payments
made to holders of any class or series of securities which are senior to the
Series C Preferred Stock upon the occurrence of a Liquidation Event. Upon the
occurrence of a Liquidation Event, the right of the Holders to receive
Liquidation Value hereunder shall rank pari passu with that of the holders of
Series A Preferred Stock (the “A Holders”) and Series B Preferred Stock (the “B
Holders”). If the assets of the Company shall be insufficient to pay in full
such amounts, then the entire assets to be distributed to the Holders shall be
distributed among the Holders, the A Holders and the B Holders ratably in
accordance with the respective amounts that would be payable on such shares if
all amounts payable thereon were paid in full. In the event the assets of the
Company available for distribution to the holders of shares of Series C
Preferred Stock upon the occurrence of a Liquidation Event shall be insufficient
to pay in full all amounts to which such holders are entitled, no distribution
shall be made on account of any shares of any other class or series of capital
stock of the Company ranking on a parity with the shares of Series C Preferred
Stock upon the occurrence of such Liquidation Event unless proportionate
distributive amounts shall be paid on account of the shares of Series C
Preferred Stock, ratably, in proportion to the full distributable amounts for
which holders of all such parity shares are respectively entitled upon the
occurrence of such Liquidation Event. At the election of a Holder made by
written notice delivered to the Company at least two business days prior to the
effective date of the subject transaction, as to the shares of Series C
Preferred Stock held by such Holder, a Fundamental Transaction or Change in
Control shall be treated as a Liquidation Event as to such Holder.
 
 Conversion
 
 (a)  Conversion at Option of
Holder.Each share of Series C Preferred Stock is convertible, at any
time and from time to time, at the option of the Holder, into 5,647,011 shares
of Common Stock.
 
 (b) Automatic
Conversion. All of the 18.73 outstanding shares of Series C Preferred
Stock shall be automatically converted into 105,768,516 shares of Common Stock
upon the later to occur of: (i) May 31, 2011 or (ii) the date upon which the
Company completes the acquisition of at least 70% of the equity interests in
Century Dadi (the “Acquisition End Date”).
 
 In the
event the Company, prior to the Acquisition End Date, closes on the sale or
issuance of Common Stock, or any securities convertible into or exchangeable
for, directly or indirectly, Common Stock ("Convertible Securities”), or any
rights or warrants or options to purchase any such Common Stock or Convertible
Securities, with a price, conversion price, or exercise price which is less than
the Conversion Price, then the Conversion Price will be reduced to that lower
price.
 F-25
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
  13.
Capital Stock-continued
 
 Accounting
 In
accordance with the guidance in ASC 815-15-25 Derivatives and Hedging –
Recognition, the Series C Preferred Stock is considered to be an equity
instrument and, accordingly, the embedded conversion option has not been
separated and accounted for as a derivative financial instrument. The carrying
value of the Series C Preferred Stock was $15,000,000. As required by ASC
470-20-30 Beneficial
Conversion Features, the Company recognized a beneficial conversion
feature as of the date of issuance of the Series C Preferred Stock, based on the
proceeds received of $15,000,000. The amount of the beneficial conversion
feature was $6,158,051. Because the holders of the Series C Preferred Stock may
convert their shares at any time, the beneficial conversion feature recorded of
$6,158,051 was immediately recognized as a deemed dividend to those holders. The
carrying value of the Series C Preferred Stock is its liquidation value of
$15,000,000.
 
 Because
the Series C Preferred Stock has conditions for its redemption that may be
outside our control, including the right of the holders to request redemption at
the liquidation value in the event of a Fundamental Transaction or a Change in
Control, in accordance with FASB ASC 480-10-S99 Distinguishing Liabilities from
Equity, the Series C Preferred Stock has been classified outside of
Stockholders’ Equity in our consolidated balance sheet.
 
 Series
D Convertible Preferred Stock
 
 On
September 14, 2010, the Company entered into and consummated the sale of
securities pursuant to a Series C and Series D Convertible Preferred Stock
Securities Purchase Agreement (the “Securities Purchase Agreement”) with China
Hand Fund I, LLC (“China Hand”), providing for the sale to China Hand of 18.73
shares of the Company’s Series C Convertible Preferred Stock (“Series C
Preferred Stock”) in consideration for an aggregate purchase price of
$15,000,000, and 4 shares of the Company’s Series D Convertible Preferred Stock
(“Series D Preferred Stock”) in consideration for entering into the Backstop
Agreement described below in Note 14.
  Dividends
 
 The
Series D Preferred Stock is not entitled to receive dividends.
 
 Voting
Rights
 
 Except as
otherwise provided by law, the holders of the Series D Preferred Stock have no
voting rights and powers.
 
 Liquidation
 
 The
shares of Series D Preferred Stock have no liquidation preference. No holder of
shares of the Series D Preferred Stock is entitled to receive any distributions
upon liquidation, dissolution or winding-up of the Company.
 F-26
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
  13.
Capital Stock-continued
 
 Series
D Convertible Preferred Stock
 
 Conversion
 
 Automatic
Conversion Upon Qualifying Financing. All of the outstanding shares of Series D
Preferred Stock will be automatically converted into shares of Common Stock upon
the later to occur of: (i) May 31, 2011 or (ii) the date upon which the Company
completes the acquisition of at least 70% of the equity interests in Century
Dadi (the “Acquisition End Date”.
 
 The
number of shares of Common Stock into which each share of Series D Preferred
Stock will be converted is as follows:
 
 A = (B *
(.72/.28) - C–D)/4
 
 Where:
 A =
number of common shares into which each share of Series D will be convertible on
and after the Acquisition End Date.
 
 B=
219,605,986, the aggregate of the number of common shares outstanding and the
number of common shares into which outstanding shares of Series A and Series B
Preferred Stock may be converted as of the date of issuance of the Series D
Preferred Stock.
 
 C = The
number of shares of Common Stock into which the 18.73 shares of Series C
Convertible Preferred Stock may be converted on the Issuance Date plus any
shares of Common Stock into which shares of Series C Convertible Preferred Stock
which may be converted upon conversion of any convertible promissory notes
convertible into such stock outstanding on the Issuance Date.
 
 D =
number of shares of outstanding Common stock, plus the number of shares of
Common stock into which any convertible preferred stock, debt or other
convertible securities are convertible, issued to new investors between October
1, 2010 and April 30, 2011, which result in gross proceeds to the Company which
do not exceed $54,500,000.
 
 As of the
date of issuance, based on the Company’s plans and expectations as to the number
of shares to be issued in additional financings with new investors between
October 1, 2010 and April 30, 2011 (none of which financings are yet subject to
written agreements), the Company expects the Series D Preferred Stock to convert
into 174,661,380 shares of Common Stock. Such number of shares of Common Stock
is subject to adjustment based on the actual additional financings entered into
by the Company between October 1, 2010 and April 30, 2011 and the per share
price at which such additional financings are consummated.
 
 Accounting
 
 The
Series D Preferred Stock has no stated value, is not redeemable, does not vote,
is not entitled to dividends and has no liquidation value. As such, it has no
substantive characteristics other than the conversion rights. The Series D
Preferred Stock was issued in consideration of the Backstop Agreement (described
below in Note 14) and in consideration of the efforts of China Hand in promoting
the financial development efforts of the Company. Because the number of shares
to be issued on conversion of the Series D Preferred Stock is variable, based on
the amount and terms of future financings and the extent to which China Hand is
required to fulfill its commitment under the Backstop Agreement, the Company’s
obligation to issue shares on conversion of the Series D Preferred Stock has
been recorded as a liability, initially at the $34,932,276 value of the shares
expected to be issued.  At each reporting period, the value of this
obligation is marked-to-market, based on any changes in the number of shares
expected to be issued on conversion and based on the market price of the
Company’s Common Stock. At September 30, 2010, based solely on changes in the
market price of the Company’s Common Stock, this obligation had increased to
$43,665,345. Because China Hand and its affiliates control more than 50% of the
Company’s Common Stock (including assumed conversion of outstanding shares of
Series A and Series B Preferred Stock) the initial value of the Series D
Preferred Stock obligation was recognized as a dividend.  Subsequent
changes in the obligation after its initial recognition are charged to income as
they occur, until such time as the obligation under the Series D Preferred Stock
is settled by conversion.
 F-27
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 14.
Private Placement of Series A, B, C and D Convertible Preferred Stock and
Warrants
 
 May
1, 2009 Private Placement
 
 On April
30, 2009, the Company entered into a second Securities Purchase Agreement with
China Hand and on May 1, 2009, the Company issued to China Hand 1,116,388 shares
of the Company’s Series B Convertible Preferred Stock and 7,814,719
warrants to purchase Common Stock, for aggregate gross proceeds of $5,400,000.
The warrants are exercisable at any time at an initial exercise price of $0.187
per share (subject to adjustment) for a period of five years following the date
of issuance The terms of the Series B Preferred Stock are described in Note 13
and the warrants are further described in Note 15.
 
 Kuhns
Brothers acted as placement agent in connection with the second private
placement. As compensation for its services, Kuhns Brothers received a cash fee
of $540,000, representing 10% of the gross proceeds received from the private
placement, as well as warrants to purchase 3,907,358 shares of the Company’s
Common Stock, representing 10% of the aggregate number of shares of Common Stock
issuable to China Hand on conversion of the Series B Preferred
Stock.
 
 As
discussed in Note 15, on May 1, 2009, the fair value of the 7,814,719 warrants
issued to China Hand with the Series B Convertible Preferred Stock was
$3,246,693 and the fair value of the 3,907,358 warrants issued to Kuhns Brothers
was $1,623,346.
 
 After
deducting the placement agent cash fees and other costs of $130,528, the Company
received net cash proceeds of $4,729,472.
 
 Amendment and Restatement of
Certain Registration Rights
  In
connection with the second private placement, the Company and China Hand amended
and restated the Registration Rights Agreement dated August 20, 2008 and
China Hand waived any registration delay payments that may have accrued under
that Registration Rights Agreement up to the date of the Amended
Agreement.  Pursuant to the Amended and Restated Registration Rights
Agreement, the Company agreed to register all of the shares of Common Stock
underlying the securities issued to China Hand in the August 20, 2008 and May 1,
2009 private placements and to file a Registration Statement covering the resale
of the shares by May 31, 2009. The Company is subject to registration delay
payments if it is unable to file the Registration Statement, cause it to become
effective or maintain its effectiveness as required by the Amended and Restated
Registration Rights Agreement.  Registration delay payments accrue at
a rate of 1% per month of the aggregate investment amount paid by the holder
applicable to each securities purchase agreement or $144,000 per month, provided
that the maximum aggregate amount of the registration delay payments will be
$2,160,000, or 15% of the gross proceeds of the private placements. As of
September 30, 2010, the Company has not filed the required Registration
Statement.
 
 Management
expects to file the required Registration Statement and use its best efforts to
have it effective by the second quarter of 2011. In accordance with the guidance
in FASB ASC 815-40-05 Accounting for Registration Payment
Arrangements (formerly FSP EITF 00-19-2), the Company has accrued the
$144,000 per month registration delay payments for the period from June 1, 2009
to August 31, 2010. As of September 30, 2010 and December 31, 2009, the Company
has accrued $2,160,000 (which is the maximum amount of the registration delay
payments) for these registration delay payments.
 F-28
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 14.
Private Placement of Series A, B, C and D Convertible Preferred Stock and
Warrants-continued
 
 September
14, 2010 Private Placement
 
 Securities Purchase
Agreement
 On
September 14, 2010, the Company entered into and consummated the sale of
securities pursuant to a Series C and Series D Convertible Preferred Stock
Securities Purchase Agreement (the “Securities Purchase Agreement”) with China
Hand Fund I, LLC (“China Hand”), providing for the sale to China Hand of 18.73
shares of the Company’s Series C Convertible Preferred Stock (“Series C
Preferred Stock”) in consideration for an aggregate purchase price of
$15,000,000 and 4 shares of the Company’s Series D Convertible Preferred Stock
(“Series D Preferred Stock”) in consideration for entering into the Backstop
Agreement described below. The proceeds of the Private Placement will be used to
finance the first installment of the purchase price due for the acquisition by a
wholly-owned subsidiary of the Company of (i) a 70% equity interest in each of
Beijing Century Dadi Gas Engineering Co., Ltd., a PRC limited liability company
(“Century Dadi”) and (ii) Zhoulu Dadi Gas Co. Ltd., a PRC limited liability
company (“Zhoulu Dadi”).
 
 Immediately
following the closing of the Private Placement, China Hand transferred its
rights to the Series C Preferred Stock and to 2 of the shares of Series D
Preferred Stock to Vicis Capital Master Fund (“Vicis”).
 
 Backstop
Agreement
 In
connection with the closing of the Private Placement, the Company and China Hand
entered into a Backstop Agreement dated as of September 14, 2010 (the “Backstop
Agreement”). The Backstop Agreement provides that China Hand has committed to
provide additional financing of up to $20,100,000 to the extent that the Company
is unable to raise capital from third party investors. The proceeds of the
additional financing will be used to fund in part the payment of the second and
third installments of the purchase price due in connection with the acquisition
of Century Dadi and Zhoulu Dadi.
 
 On or
before April 15, 2011, China Hand will purchase from the Company a number of
shares of Common Stock determined by dividing (x) $20,100,000 minus all amounts
raised by the sale of securities to third party investors by (y)
$0.14179.  The value to the Company of its put right to sell shares to
China Hand under this agreement was initially valued at $2,840,527 using a
binomial valuation model.  The value of this right will be
marked-to-market each period until the commitment under the Backstop Agreement
is fulfilled or expires.  At September 30, 2010, the value of the put
under the Backstop Agreement had declined to $1,598,093.  The initial
value of the put was recorded as part of the dividend recognized in connection
with the issuance of the Series D Preferred Stock to China Hand, described above
in Note 13. Subsequent changes in the value of the put are charged to
income.
 
 Registration Rights
Agreement
 Also in
connection with the closing of the Private Placement, the Company and China Hand
entered into a Registration Rights Agreement dated as of September 14, 2010 (the
“Registration Rights Agreement”) under which the Company granted China Hand
piggy-back registration rights exercisable after December 31, 2010 with respect
to the shares of common stock issuable upon conversion of Series C Preferred
Stock and Series D Preferred Stock that may not be sold without registration in
accordance with Rule 144.  The Registration Rights Agreement does not
provide for any specific penalties in the event of non-performance by the
Company and no such penalties have been recognized at September 30,
2010.
 
 Convertible Notes
Offering
 On
September 14, 2010, the Company entered into and consummated the sale to certain
accredited investors pursuant to Note Purchase Agreements (the “Note Purchase
Agreements”) of Convertible Notes due October 15, 2010 (the “Notes”) in the
aggregate principal amount of $3,000,000. The Notes pay no interest and in lieu
thereof, the Company will issue a total of 1.67 shares of Series C Preferred
Stock if the Notes are repaid before the maturity date of October 15, 2010. The
value of the Series C Preferred Stock to be issued will be recorded as interest
expense.  As of September 30, 2010, the Company recognized
$1,034,314 as accrued interest.  On October 15, 2010, the Company
agreed with the investors to extend the maturity date to December 31, 2010. The
holder of the Notes has no right to convert the Notes. However, if the Notes are
not paid at maturity, they will convert automatically into a total of 3.75
shares of Series C Preferred Stock.
  At
September 30, 2010 and December 31, 2009, the carrying value of the Notes was
$4,034,314 and $0, respectively.
 F-29
 
 CHINA
NEW ENERGY GROUP COMPANY
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009
 15.
Derivative financial instruments - warrants
 
 In
connection with the sale of its Series A and Series B Convertible Preferred
Stock to China Hand, an accredited investor, the Company issued Common Stock
warrants to China Hand and to the Company’s placement agent.
 
 Effective
January 1, 2009, the Company adopted the provisions of FASB ASC 815-40-15-5
Derivatives and Hedging
(formerly EITF Issue 07-5). Because the warrants are denominated in U.S. dollars
whereas the Company’s functional currency is the Renminbi, the warrants are not
considered to be indexed only to the Company’s Common Stock. Furthermore, the
warrants contain full ratchet anti-dilution protection requiring the exercise
price of the warrants to be reduced in the event that the Company issues
securities in the future at a lower price. Accordingly, the warrants do not
qualify for the exemption from being accounted for as derivative financial
instruments provided by FASB ASC 815-10-15-74. In addition, because the warrants
contain a provision requiring the Company to re-purchase the warrants from the
investor in certain circumstances, the Company has concluded that the warrants
issued in 2008 should be accounted for as derivative financial instruments from
the time they were originally issued.
 
 Derivative
instruments are recorded at fair value and marked-to-market each period until
they are exercised or expire, with any change in the fair value charged or
credited to income each period. Because these warrants do not trade in an active
securities market, we estimate their fair value using the Cox-Ross-Rubinstein
(“CRR”) binomial model.
 
 On August
20, 2008, the fair value of the 13,001,608 warrants issued to China Hand in
connection with the Series A Convertible Preferred Stock was $1,968,182 and the
fair value of the 6,500,804 warrants issued to the placement agent was $984,091.
The fair values were based on the five year life of the warrants, the exercise
price of $0.187, estimated volatility of 66%, a risk free interest rate of 3%
and an assumed dividend rate of 0%.
 
 On May 1,
2009, the fair value of the 7,814,719 warrants issued to China Hand in
connection with the Series B Convertible Preferred Stock was $3,246,693 and the
fair value of the 3,907,358 warrants issued to the placement agent was
$1,623,346. The fair values were computed using the CRR model, based on the five
year life of the warrants, the exercise price of $0.187, estimated volatility of
90%, a risk free interest rate of 2.03% and an assumed dividend rate of
0%.
 
 At
September 30, 2010 and December 31, 2009, the fair value of the warrants was
$4,821,264 and $6,768,106, respectively, based on the following
assumptions:
 September
      30, 2010
              
              
              December
      31, 2009Warrants
      outstanding
              
              
              31,224,489
              
              
              
              31,224,489Exercise
      price
              
              $
              0.187
              
              
              $
              0.187Annual
      dividend yield
              
              
              0
              %
              
              
              0
              %Expected
      life (years)
              
              
              2.89–3.59
              
              
              
              3.64-4.33Risk-free
      interest rate
              
              
              0.62%-0.82
              %
              
              
              2.02%
      - 2.36
              %Expected
      volatility
              
              
              85
              %
              
              
              90
              %
 
 Because
of the limited trading history of the Company’s Common Stock, expected
volatility is based on the historical volatility of a similar U.S. public
company with a longer trading history. The Company has no reason to believe that
the future volatility of its Common Stock over the remaining life of these
warrants will differ materially from this estimate. The expected life of the
warrants is based on their remaining term. Risk-free interest rates are based on
published rates for U.S. Treasury securities for the remaining term of the
warrants. The expected dividend yield is based on the Company’s current and
expected dividend policy.
 
 The
Company recognized a gain of $1,654,806 and $ 6,041,231 from the change in
fair value of these warrants for the three months ended September, 2010 and
2009. The Company recognized a gain of $1,946,842 and $8,017,275 from the
change in fair value of these warrants for the nine months ended September
30, 2010 and 2009.


F-30





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





16.
Acquisitions of Subsidiaries





Zhanhua Jiutai Gas Co.Ltd.
(“Zhanhua Jiutai”)




On
December 12, 2009, Chensheng, our indirect wholly-owned subsidiary, entered into
an Equity Interest Purchase Agreement to acquire 100% of the outstanding equity
interests of Zhanhua Jiutai, a PRC company, from the five shareholders of
Zhanhua Jiutai, for a total purchase price of $2,413,269
(RMB16,500,000).





Below
sets forth the payment terms of the acquisition consideration payable under the
Equity Interest Purchase Agreement.





1) The
amount of the first installment is 58% of the total transfer price, Renminbi
9,500,000 Yuan (approximately $1.40 million). The Transferee (CNER) shall make
the first installment payment to the Transferors (former shareholders) within 13
working days as of the effective day of the Equity Transfer
Agreement.





2) The
amount of the second installment payment is 36% of the total transfer price,
that is, Renminbi 6,000,000 Yuan (approximately $0.87 million). And the second
installment payment is completed within the sixth month as of the date of the
first installment payment. The Parties agree that all the debts owed by Zhanhua
Jiutai, including but not limited to the amount owed to the original
shareholders, the amount payable to suppliers and construction teams, salaries
and benefits payable to employees, taxes payable to tax bureau and so on should
have been paid up by the Transferors at its own cost. Otherwise, the Transferee
shall have the right to refuse to make the second installment
payment.





3) The
amount of the third installment payment is 6% of the total transfer price, that
is, Renminbi 1,000,000 Yuan (approximately $0.14 million) will be paid to the
Transferors on December 31, 2010 on the condition that the Transferors are free
of any liabilities.





As of
September 30, 2010, the total outstanding on the acquisition of Zhanhua Jiutai
is $716,624 which is recorded under the Acquisition consideration payable (see
Note 10).





The
acquisition of Zhanhua Jiutai was accounted for as a business combination, in
accordance with FASB ASC 805 Business
Combinations.  The results of Zhanhua Jiutai and the estimated
fair market values of the assets and liabilities have been included in the
Group’s consolidated financial statements from the date of acquisition. The
assets acquired and liabilities assumed of Zhanhua Jiutai were recorded based on
their fair values, as follows:





Other
      receivables
                  
                  $
                  2,925Inventories
                  
                  
                  82,939Property,
      plant and equipment
                  
                  
                  139,014Construction
      in progress
                  
                  
                  2,218,043Advance
      accounts
                  
                  
                  (254,140
                  )Goodwill
                  
                  
                  224,488Purchase
      price
                  
                  $
                  2,413,269





F-31





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





16.
Acquisitions of Subsidiaries - continued





Zhanhua Jiutai Gas Co.Ltd.
(“Zhanhua Jiutai”)




Zhanhua
Jiutai did not commence business up to the acquisition date, and therefore, the
pro forma financial information for the nine months ended September 30, 2009 is
the same as the actual figure shown in the statement of Condensed Consolidated
Statements of Operations and Comprehensive Income.





In
accordance with FASB 810-10-5, the condensed consolidated balance sheet at
September 30, 2010 includes certain liabilities of Zhanhua Jiutai assumed by the
five former shareholders of Zhanhua Jiutai in 2009, as the Group consolidates
Zhanhua Jiutai.





The
following table summarizes the liabilities to be settled by the former
shareholders, but which are included in our balance sheet as of September 30,
2010. In accordance with the Agreement, these liabilities were not assumed by
Chensheng and will be settled by the five former shareholders of Zhanhua Jiutai
in 2010.





Accounts
      payable
                  
                  $
                  562,775Other
      payables
                  
                  
                  370,404Salary
      payables
                  
                  
                  4,378Liabilities
      to be settled by former shareholders
                  
                  $
                  937,557Deemed
      receivable from former shareholders for settlement of certain
      liabilities
                  
                  $
                  937,557





Wuyuan County Zhongran Gas
Ltd. (“Wuyuan”)




On
December 16, 2009, Willsky entered into an Equity Interest Purchase Agreement to
acquire 100% of the outstanding equity interests in Wuyuan, a PRC company, from
Flying Dragon Investment Management Limited, for a total purchase price of
$877,552 (RMB6,000,000), which purchase price was based on an appraised value of
Wuyaun as of September 30, 2009.





Below
sets forth the payment terms of the acquisition consideration payable under the
Equity Interest Purchase Agreement.





1) The
amount of the first installment is 27.5% of the Consideration, namely Renminbi
1,650,000 Yuan (approximately $0.24 million). The Transferee shall make the
first installment payment to the Transferor before December 20,
2009.





2) The
amount of the second installment is 52.5% of the Consideration, namely Renminbi
3,150,000 Yuan (approximately $0.46 million) shall be paid on April 30, 2010.
The Parties agree that all the debts owed by Wuyuan, including but not limited
to the amount owed to the original shareholders, the amount payable to suppliers
and construction teams, salaries and benefits payable to employees, taxes
payable to tax bureau and so on should have been paid up by the Transferor at
its own cost. Otherwise, the Transferee shall have the right to refuse to make
the second installment payment.





3) The
amount of the third installment is 20% of the Consideration, namely Renminbi
1,200,000 Yuan (approximately $0.18 million) shall be considered as deposit of
this transaction and will be paid to the Transferor on August 31, 2010 on the
condition that the Transferor is free of any liabilities.





As of
September 30, 2010, the total outstanding on the acquisition of Wuyuan is
$636,850 which is recorded under the Acquisition consideration payable (see Note
10).  Per the Equity Interest Purchase Agreement, pre-conditions of
the second payment were not satisfied and CNER decided to delay the acquisition
payment until the transferor fulfilled all conditions of the
agreement.





F-32





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





16.
Acquisitions of Subsidiaries - continued





Wuyuan County Zhongran Gas
Ltd. (“Wuyuan”)





The
acquisition of Wuyuan was accounted for as a business combination, in accordance
with FASB ASC 805 Business
Combinations. The results of Wuyuan and the estimated fair market values
of the assets and liabilities have been included in the Group’s consolidated
financial statements from the date of acquisition. The purchase price of
$877,552 was less than the fair value of the assets acquired and liabilities
assumed of Wuyuan on the date of the acquisition December 16, 2009 and,
accordingly, we recognized a gain related to the acquisition, as
follows:





Prepaid
      expenses
                  
                  $
                  650,120Other
      receivables
                  
                  
                  89,598Inventories
                  
                  
                  67Construction
      in progress
                  
                  
                  203,742Intangible
      assets
                  
                  
                  244,000Assets
      acquired
                  
                  $
                  1,187,527Less:
      Purchase consideration (net of $3,081 cash received)
                  
                  
                  (874,471
                  )Gain
      on acquisition of Wuyuan
                  
                  $
                  313,056





Wuyuan
did not commence business up to the acquisition date, and therefore, the pro
forma financial information for the nine months ended September 30, 2009 is the
same as the actual figure shown in the statement of Condensed Consolidated
Statements of Operations and Comprehensive Income.





In
accordance with FASB 810-10-5, the condensed consolidated balance sheet at
September 30, 2010 includes certain liabilities of Wuyuan assumed by the former
shareholder of Wuyuan in 2009, as the Group consolidates Wuyuan.





The
following table summarizes the liabilities to be settled by the former
shareholder but which are included in our balance sheet as of September 30,
2010. In accordance with the Agreement, these liabilities were not assumed by
the Company and will be settled by the former shareholder of Wuyuan in
2010.





Accounts
      payable
                  
                  $
                  107,514Other
      current liabilities
                  
                  
                  205,905Liabilities
      to be settled by former shareholder
                  
                  $
                  313,419Deemed
      receivable from former shareholder for settlement of certain
      liabilities
                  
                  $
                  313,419





F-33





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





16.
Acquisitions of Subsidiaries – continued





Beijing
Century Dadi Gas Engineering Co., Ltd. (“Century Dadi”) and


Zhoulu
Dadi Gas Co. Ltd (“Zhoulu Dadi”)





On
September 14, 2010, the Company’s wholly-owned PRC subsidiary, China New Energy
Investment Co., Ltd (“ Nixi ”), entered into Century Dadi Acquisition Agreement
andZhoulu Dadi Agreement
with Beijing Fengyin Xianghe Scientific Technology Co., Ltd. (“ Seller ”), a PRC
company controlled by Mr. Tang Zhixiang (“ Mr. Tang ”), to acquire a 70%
equity interest in Beijing Century Dadi Gas Engineering Co., Ltd., a PRC
company (“ Century Dadi ”) and 70% equity interest in Zhoulu Dadi Gas
Co. Ltd., a PRC company(“Zhoulu Dadi”)from the
Seller.





The
Century Dadi Acquisition Agreement replaces the agreement originally executed on
March 8, 2010 between China New Energy Group Company and Mr. Tang (which
agreement was terminated pursuant to a Supplementary Agreement of Equity
Transfer Agreement dated September 14, 2010).




Century
Dadi and its affiliated companies are primarily engaged in the business of the
supply of natural gas and construction and development of a gas pipeline network
in urban areas.





The total
purchase price for the 70% equity interest in Century Dadi and Zhoulu Dadi is
$39.71 million (RMB 270,000,000) which is $20 million for each acquisition. The
purchase price is payable in three installments which are $17.6 million, $19.12
million and $2.99 million.  Each payment is subject to satisfaction of
certain preconditions.





Seller
and Mr. Tang currently collectively own approximately 48% of the equity of
Century Dadi. Within 45 days following the payment of the first installment into
the mutually managed account of $17,600,000, Seller is required to have acquired
100% of the equity of Century Dadi.





The
Company has an optional right to acquire the other 30% equity interest in
Century Dadi and Zhoulu Dadi at $10 million (RMB 130,000,000) after the
completion of the acquisition of the 70% equity interest in century Dadi and
Zhoulu Dadi.





As of
September 30, 2010, the Company deposited $17,600,000 of first installment of
the purchase consideration into a mutually managed account for the acquisition
of Century Dadi and Zhoulu Dadi and the Company recorded under Deposits for
acquisitions of subsidiaries of non-current assets.





F-34





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





17.
Deposits for Acquisitions of Subsidiaries





Fuzhou City Lean Zhongran
Gas Inc., a PRC company (“Lean Zhongran”)




On
December 16, 2009, Willsky entered into an Equity Interest Purchase Agreement to
acquire all of the outstanding equity interests in Lean Zhongran, a PRC company,
from Flying Dragon Resource Development Limited, for a total purchase price of
approximately $702,782 (RMB4,800,000). The purchase price is based on an
appraised value of Lean Zhongran as of September 30, 2009 and will be adjusted
to reflect the appraised value of the assets as of the closing date. The closing
of the transaction is subject to approval by our Board of
Directors.





Fuzhou Flying Dragon
Zhongran Gas Inc. (“Fuzhou Zhongran”)




On
January 5, 2010, Willsky entered into an Equity Interest Purchase Agreement, to
acquire all of the outstanding equity interests in Fuzhou Flying Dragon Gas
Inc., a PRC company (“Fuzhou Zhongran”) from Flying Dragon Resource Development
Limited and Flying Dragon Investment Management Limited. The effectiveness of
the Agreement was subject to the approval of our Board of Directors, which
approval was granted on December 2, 2009.





Under the
Agreement, Willsky will purchase 100% of the outstanding equity interests in
Fuzhou Zhongran for a total purchase price of approximately $3,800,000
(RMB26,000,000).  The purchase price is based on an appraised value of
Fuzhou Zhongran as of September 30, 2009 and will be adjusted to reflect the
appraised value of the assets as of the closing date.





As of
September 30, 2010, the transfers of the ownership of Lean Zhonran and Fuzhou
Zhongran were not completed and the Group paid $1,222,946 as deposits and
recorded it under the caption of Deposits for acquisition.





The
stockholder of Lean Zhongran, Flying Dragon Resources Investment Management
Limited and Flying Dragon Resource Development Limited are two different
companies but controlled by same person.




Beijing Century Dadi Gas
Engineering Co., Ltd. (“Century Dadi”) and
 Zhoulu Dadi Gas Co. Ltd
(“Zhoulu Dadi”)
  During
September 30, 2010, the Company deposited $17,600,000 of first installment of
the purchase consideration into a mutually managed account for the acquisition
of Century Dadi and Zhoulu Dadi and the Company recorded under Deposits for
acquisitions of subsidiaries of non-current assets. (See Note 16)
 
 Deposits
for acquisitions of subsidiaries




September
      30,
                2010
              
              
              December
      31,
                2009Deposit
      relating to the purchase of Lean Zhongran
              
              $
              197,696
              
              
              
              197,696Deposit
      relating to the purchase of Fuzhou Zhongran
              
              
              1,025,250
              
              
              
              -Deposits
      put into a mutually managed account relating to the purchases of Century
      Dadi and Zhoulu Dadi
              
              
              17,600,000
              
              
              
              -Total
              
              $
              18,822,946
              
              
              
              197,696




F-35





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





18.  Deemed
Receivable From Former Shareholders Of Subsidiaries Acquired For Settlement Of
Certain Liabilities





Deemed
receivable from former shareholders of subsidiaries acquired for settlement of
certain liabilities of $1,250,976 as of September 30, 2010, represents the
liabilities of Zhanhua Jiutai and Wuyuan which are to be settled by the former
shareholders of Zhanhua Jiutai and Wuyuan, as disclosed in Note 16. These
amounts will be due in future financial reporting periods.





19.
Non-controlling Interests in Subsidiaries





As of
September 30, 2010, Tianjin Huan Long Trading directly held a 1% non-controlling
interest in our subsidiary SingOcean and indirectly held a 0.5% non-controlling
interest in Chengsheng and Zhanhua Jiutai and a 0.3% non-controlling interest in
Binhai Zhongneng. The total of these non-controlling interests at September 30,
2010 was $166,465 and their share of net income for the nine months ended
September 30, 2010 was $1,876.





As of
December 31, 2009, Tianjin Huan Long Trading directly held a 1% non-controlling
interest in our subsidiary SingOcean and indirectly held a 0.5% non-controlling
interest in Chengsheng and Zhanhua Jiutai and a 0.3% non-controlling interest in
Binhai Zhongneng. The total of these non-controlling interests at December 31,
2009 was $168,341 and their share of net loss for the nine months ended
September 30, 2009 was $18,200.





F-36





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





20.
Income Taxes





USA




The
Company and its subsidiary and branch divisions are subject to income taxes on
an entity basis on income arising in, or derived, from the tax jurisdiction in
which they operate. As the Group had no income generated in the United States,
there was no tax expense or tax liability due to the Internal Revenue Service of
the United States as of September 30, 2010 and December 31, 2009.





BVI




Willsky
is incorporated under the International Business Companies Act of the British
Virgin Islands and accordingly, is exempted from payment of British Virgin
Island’s income taxes.





PRC




Pursuant
to the PRC Income Tax Laws, the prevailing statutory rate of enterprise income
tax is 25% for SingOcean, Chensheng and Yingkou for fiscal years 2010 and 2009.
Chensheng was taxed at 1% of revenues from January to June 2009.  From
July 2009 onwards, Chensheng is taxed at 25% of net income.




The
current year tax provision was $384,835 and $187,993 for the nine months ended
September 30, 2010 and 2009, respectively.  The Group has recorded no
deferred tax assets or liabilities as of September 30, 2010 and December 31,
2009, because all significant differences in tax basis and financial statement
amounts are permanent differences.





For the three months ended
                    September 30,
                  
                  
                  For the nine months ended
                    September 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Income
      Tax Expense:Current
      tax
                  
                  $
                  2,238
                  
                  
                  $
                  181,885
                  
                  
                  $
                  384,835
                  
                  
                  $
                  187,993Change
      in deferred tax assets – Net operating loss
                  
                  
                  278,367
                  
                  
                  
                  1,488,889
                  
                  
                  
                  755,252
                  
                  
                  
                  1,688,402Change
      in valuation allowance
                  
                  
                  (278,367
                  )
                  
                  
                  (1,488,889
                  )
                  
                  
                  (755,252
                  )
                  
                  
                  (1,688,402
                  )Total
                  
                  $
                  2,238
                  
                  
                  $
                  181,885
                  
                  
                  $
                  384,835
                  
                  
                  $
                  187,993





We follow
the guidance in FASB ASC 740 Accounting for Uncertainty in Income
Taxes.  We have not taken any uncertain tax positions on any of
our open income tax returns filed through the period ended September 30,
2010.  Our methods of accounting are based on established income tax
principles and are properly calculated and reflected within our income tax
returns.  In addition, we have timely filed extension of income tax
returns in all applicable jurisdictions in which we believe we are required to
make an income tax return filing.





We
re-assess the validity of our conclusions regarding uncertain tax positions on a
quarterly basis to determine if facts or circumstances have arisen that might
cause us to change our judgment regarding the likelihood of a tax position’s
sustainability under audit.  We have determined that there were no
uncertain tax positions for the nine months ended September 30, 2010 and
2009.





F-37





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





20.
Income Taxes - continued





All of
the Group’s income before income taxes is from PRC sources. Actual income tax
expense reported in the consolidated statements of operations and comprehensive
income differ from the amounts computed by applying the PRC statutory income tax
rate of 25% to income before income taxes for the three and nine months ended
September 30, 2010 and 2009 for the followings reasons:




For
      the three months ended
                September
      30,
              
              
              For
      the nine months ended
                September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009(Loss)
      Income from continuing operations before income taxes
              
              $
              (10,931,454
              )
              
              $
              5,535,103
              
              
              $
              (11,507,924
              )
              
              $
              6,615,665Computed
      “expected” income tax expense at 25% in 2010 and 2009, except on the net
      income of Chensheng of $2,931 in 2009
              
              $
              (2,732,863
              )
              
              $
              1,366,119
              
              
              $
              (2,876,981
              )
              
              $
              1,636,259Income
      tax expense of Chensheng - charged at 0.8% of gross sales of $694,109 in
      2009
              
              
              -
              
              
              
              71,460
              
              
              
              -
              
              
              
              6,941Tax
      effect of net taxable permanent differences
              
              
              2,607,381
              
              
              
              233,195
              
              
              
              3,094,004
              
              
              
              233,195Effect
      of cumulative tax losses
              
              
              123,244
              
              
              
              (1,488,889
              )
              
              
              167,812
              
              
              
              (1,688,402
              )$
              2,238
              
              
              $
              181,885
              
              
              $
              384,835
              
              
              $
              187,993




Our
policy for recording interest and penalties associated with audits is to record
such items as a component of income tax expense. There were no interest and
penalties recorded for the nine months ended September 30, 2010 and
2009.





F-38





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





21.
Earnings Per Share





Basic
earnings per share is computed by dividing net income attributable to common
shareholders by the weighted average number of common shares outstanding during
the period. Diluted earnings per share reflects the potential dilution of
securities by including other potential common stock, including convertible
preferred stock, stock options and warrants, in the weighted average number of
common shares outstanding for a period, if dilutive.  The numerators
and denominators used in the computations of basic and dilutive earnings per
share are presented in the following table:




For
      The Three months Ended
              
              
              For
      The Nine months EndedSeptember
      30,
              
              
              September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009BASICNumerator
      for basic (loss) earnings per share from continuing operations
      attributable to China New Energy Group’s common
    stockholders:Net
      (loss) Income From Continuing Operations
              
              $
              (10,929,326
              )
              
              
              6,137,620
              
              
              $
              (11,976,760
              )
              
              
              8,304,015Deemed
      dividend on preferred stock issued
              
              
              (6,158,051
              )
              
              
              -
              
              
              
              (6,158,051
              )
              
              
              (2,350,829
              )Dividend
      on preferred stock
              
              
              (220,047
              )
              
              
              (226,946
              )
              
              
              (694,197
              )
              
              
              (550,946
              )(Loss)
      Income From Continuing Operations used in computing basic (loss) earnings
      per share
              
              $
              (17,307,424
              )
              
              
              5,910,674
              
              
              
              (18,829,008
              )
              
              
              5,402,240Basic
      (loss) earnings per share from continuing operations
              
              
              (0.16
              )
              
              
              0.06
              
              
              
              (0.18
              )
              
              
              0.05Numerator
      for basic (loss) earnings per share from discontinued
      operationsNet
      (loss) Income from Discontinued Operations
              
              
              (231
              )
              
              
              809,506
              
              
              
              (85,877
              )
              
              
              1,894,543(Loss)
      Income from Discontinued Operations used in computing basis (loss)
      earnings per share
              
              
              (231
              )
              
              
              809,506
              
              
              
              (85,877
              )
              
              
              1,894,543Basic
      (loss) earnings per share from discontinued operations
              
              
              (0.00
              )
              
              
              0.01
              
              
              
              (0.00
              )
              
              
              0.02Weighted
      average outstanding shares of common stock
              
              
              106,687,887
              
              
              
              100,000,041
              
              
              
              102,488,123
              
              
              
              100,000,041




F-39





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





21.
Earnings Per Share – continued




For
      The Three months Ended
              
              
              For
      The Nine months EndedSeptember
      30,
              
              
              September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009DILUTEDNumerator
      for diluted (loss) earnings per share from continuing operations
      attributable to China New Energy Group’s common
    stockholders:Net
      (loss) Income From Continuing Operations
              
              $
              (17,307,424
              )
              
              $
              5,910,674
              
              
              $
              (18,829,008
              )
              
              $
              5,402,240Deemed
      dividend on preferred stock issued
              
              
              6,158,051
              
              
              
              -
              
              
              
              6,158,051
              
              
              
              2,350,829Dividend
      on preferred stock
              
              
              220,047
              
              
              
              226,946
              
              
              
              694,197
              
              
              
              550,946(Loss)
      Income From Continuing Operations used in computing diluted (loss)
      earnings per share
              
              
              (10,929,326
              )
              
              
              6,137,620
              
              
              
              (11,976,760
              )
              
              
              8,304,015Diluted
      (loss) earnings per share from continuing operations
              
              
              (0.16
              )
              
              
              0.03
              
              
              
              (0.18
              )
              
              
              0.04Numerator
      for diluted (loss) earnings per share from discontinued
      operationsNet
      (loss) Income From Discontinued Operations
              
              
              (231
              )
              
              
              809,506
              
              
              
              (85,877
              )
              
              
              1,894,543(Loss)
      Income From Discontinued Operations used in computing diluted (loss)
      earnings per share
              
              
              (231
              )
              
              
              809,506
              
              
              
              (85,877
              )
              
              
              1,894,543Diluted
      (loss) earnings per share from discontinued operations
              
              
              (0.00
              )
              
              
              0.00
              
              
              
              (0.00
              )
              
              
              0.01Weighted
      average outstanding shares of common stock
              
              
              106,687,887
              
              
              
              100,000,041
              
              
              
              102,488,123
              
              
              
              100,000,041Weighted
      average shares of convertible preferred stock outstanding
              
              
              135,992,903
              
              
              
              112,535,710
              
              
              
              120,440,698
              
              
              
              91,644,433Warrants
      and contingently issuable shares
              
              
              9,365,886
              
              
              
              5,413,993
              
              
              
              11,625,701
              
              
              
              8,199,751Common
      stock and common stock equivalents
              
              
              252,046,676
              
              
              
              217,949,744
              
              
              
              234,554,522
              
              
              
              199,844,225(Loss)
      earnings per share:Basic
              
              $
              (0.16
              )
              
              $
              0.07
              
              
              $
              (0.18
              )
              
              $
              0.07Diluted
              
              $
              (0.16
              )
              
              $
              0.03
              
              
              $
              (0.18
              )
              
              $
              0.05Potential
      common shares outstanding as of September 30,:
              
              2010
              
              
              2009Series A Convertible Preferred
      Stock
              
              
              73,462,130
              
              
              
              73,462,130Series B Convertible Preferred
      Stock
              
              
              39,073,580
              
              
              
              39,073,580Series
      C Convertible Preferred Stock
              
              
              126,944,807
              
              
              
              -Warrants
    outstanding
              
              
              31,224,489
              
              
              
              31,224,489270,705,006
              
              
              
              143,760,199




For the
nine months ended September 30, 2010 and 2009, the number of securities was
270,705,006 and 143,760,199, respectively, not included in the diluted EPS
because the effect would have been anti-dilutive.





F-40





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





22.
Business and Geographical Segments





The
Group’s operations are classified into two principal reportable segments which
are the provision of gas pipe connection services and the provision of natural
gas. Separate management of each segment is required because each business
unit is subject to different production and technology strategies.





Reportable
Segments





For
      the three months ended September 30, 2010
                
                
                For
      the three months ended September 30, 2009Connection
                
                
                
                
                
                
                
                
                
                
                
                Connectionservices
                
                
                Natural
      gas
                
                
                Corporate
                
                
                Total
                
                
                services
                
                
                Natural
      gas
                
                
                Corporate
                
                
                TotalExternal
      revenue
                
                $
                124,803
                
                
                
                37,263
                
                
                
                -
                
                
                
                162,066
                
                
                $
                1,095,454
                
                
                
                42,427
                
                
                
                -
                
                
                
                1,137,881Interest
      income
                
                
                11,916
                
                
                
                -
                
                
                
                -
                
                
                
                11,916
                
                
                
                5,520
                
                
                
                -
                
                
                
                -
                
                
                
                5,520Interest
      expense
                
                
                (1,164
                )
                
                
                -
                
                
                
                (1,034,314
                )
                
                
                (1,035,478
                )
                
                
                (1,113
                )
                
                
                -
                
                
                
                -
                
                
                
                (1,113
                )Depreciation
      and amortization
                
                
                40,255
                
                
                
                11,900
                
                
                
                48,037
                
                
                
                100,192
                
                
                
                21,782
                
                
                
                11,787
                
                
                
                18,004
                
                
                
                51,573Income
      tax
                
                
                2,238
                
                
                
                -
                
                
                
                -
                
                
                
                2,238
                
                
                
                181,885
                
                
                
                -
                
                
                
                -
                
                
                
                181,885Net
      income (loss)
                
                
                (18,818
                )
                
                
                (12,707
                )
                
                
                (10,902,398
                )
                
                
                (10,933,923
                )
                
                
                851,888
                
                
                
                48,235
                
                
                
                5,262,601
                
                
                
                6,162,724Expenditures
      for long-lived assets
                
                
                427,462
                
                
                
                -
                
                
                
                164,201
                
                
                
                591,663
                
                
                
                281,087
                
                
                
                2,055
                
                
                
                161,309
                
                
                
                444,451





F-41





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009





22.
Business and Geographical Segments – continued





Reportable
Segments





For
      the nine months ended September 30, 2010
                      
                      
                      For
      the nine months ended September 30, 2009Connection
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      Connectionservices
                      
                      
                      Natural
      gas
                      
                      
                      Corporate
                      
                      
                      Total
                      
                      
                      services
                      
                      
                      Natural
      gas
                      
                      
                      Corporate
                      
                      
                      TotalExternal
      revenue
                      
                      $
                      2,479,344
                      
                      
                      
                      84,165
                      
                      
                      
                      -
                      
                      
                      
                      2,563,509
                      
                      
                      
                      1,747,312
                      
                      
                      
                      84,670
                      
                      
                      
                      -
                      
                      
                      
                      1,831,982Interest
      income
                      
                      
                      14,466
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      14,466
                      
                      
                      
                      7,754
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      7,754Interest
      expense
                      
                      
                      (5,529
                      )
                      
                      
                      -
                      
                      
                      
                      (1,034,314
                      )
                      
                      
                      (1,039,843
                      )
                      
                      
                      (1,372
                      )
                      
                      
                      -
                      
                      
                      
                      (2,751
                      )
                      
                      
                      (4,123
                      )Depreciation
      and amortization
                      
                      
                      108,988
                      
                      
                      
                      35,509
                      
                      
                      
                      125,285
                      
                      
                      
                      269,782
                      
                      
                      
                      61,198
                      
                      
                      
                      35,451
                      
                      
                      
                      43,626
                      
                      
                      
                      140,275Income
      tax
                      
                      
                      384,835
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      384,835
                      
                      
                      
                      187,993
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      187,993Net
      income (loss)
                      
                      
                      1,762,231
                      
                      
                      
                      (39,390
                      )
                      
                      
                      (13,701,477
                      )
                      
                      
                      (11,978,636
                      )
                      
                      
                      1,212,001
                      
                      
                      
                      (21,948
                      )
                      
                      
                      7,132,162
                      
                      
                      
                      8,322,215Expenditures
      for long-lived assets
                      
                      
                      2,524,808
                      
                      
                      
                      -
                      
                      
                      
                      224,557
                      
                      
                      
                      2,749,365
                      
                      
                      
                      795,229
                      
                      
                      
                      152,342
                      
                      
                      
                      161,309
                      
                      
                      
                      1,108,880




As
      of September 30, 2010
                  
                  
                  As
      of December 31, 2009Total
      Assets
                  
                  $
                  12,470,356
                  
                  
                  
                  2,370,808
                  
                  
                  
                  41,916,340
                  
                  
                  
                  56,757,504
                  
                  
                  $
                  23,608,532
                  
                  
                  
                  2,820,280
                  
                  
                  
                  13,797,010
                  
                  
                  
                  40,225,822




F-42





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE NINE MONTHS


ENDED
SEPTEMBER 30, 2010 AND 2009





23.
Concentrations and Credit Risk





Cash -
Cash includes cash on hand and demand deposits in accounts maintained with state
owned banks within the PRC. The Group considers all highly liquid instruments
purchased with original maturities of three months or less, and money market
accounts, to be cash equivalents. Total cash in these banks at September 30,
2010 and December 31, 2009 amounted to $580,731 and $2,672,884, respectively, of
which no deposits were covered by insurance. Also, as of September 30, 2010, the
Group held $39,691 for a corporate legal counsel’s trust account which is the
balance form December 31, 2009. As of  December 31, 2009, the Group
held $180,352 in restricted cash in a corporate legal counsel’s trust account,
in accordance with an agreement with investors to restrict use of the funds to
pay preferred stock dividends and investor relation expenses. Nonperformance by
these institutions could expose the Group to losses not covered by insurance.
Management reviews the financial condition of these institutions on a periodic
basis.  The Group has not incurred any losses on these accounts from
nonperformance by the aforementioned institutions.





Major
customers – For the three months ended September 30, 2010, two customers
accounted for approximately 99% of the Company’s sales. For the nine months
ended September 30, 2010, three customers accounted for approximately 54% of the
Company’s sales and one customer accounted for approximately 50% of the
Company’s accounts receivable as of September 30, 2010.





For the
three months ended September 30, 2009, four customers accounted for
approximately 62% of the Company’s sales. For the nine months ended September
30, 2009, one customer accounted for approximately 12% of the Company’s sales
and three customers accounted for approximately 40% of the Company’s accounts
receivable as of September 30, 2009.





Major
suppliers – For the three months ended September 30, 2010, one supplier
accounted for approximately 100% of the Company's purchases. For the nine months
ended September 30, 2010, four suppliers accounted for approximately 81% of the
Company's purchases and four suppliers accounted for approximately 74% of the
Company’s accounts payable as of September 30, 2010.





For the
three months ended September 30, 2009, two suppliers accounted for approximately
47% of the Company's purchases. For the nine months ended September 30, 2009,
one supplier accounted for approximately 11% of the Company's purchases and four
suppliers accounted for approximately 71% of the Company’s accounts payable as
of September 30, 2009.





Political
and economic risks - The Group's operations are carried out in the PRC.
Accordingly, the Group's business, financial condition, and results of
operations may be influenced by the political, economic, and legal environments
in the PRC, and by the general state of the PRC's economy. The Group's
operations in the PRC are subject to specific considerations and significant
risks not typically associated with companies in North America and Western
Europe. These include risks are associated with, among others, the political,
economic, and legal environments, and foreign currency exchange. The Group's
results may be adversely affected by changes in governmental policies with
respect to laws and regulations, anti-inflationary measures, currency conversion
and remittance abroad, and rates and methods of taxation, among
others.





The Group
does not require collateral to support financial instruments that are subject to
credit risk.





Environmental
Matters - The Group does not anticipate any material future cash requirements
related to environmental issues. If circumstances change, the Group will record
the estimated charges necessary to return sites to their original
condition.





F-43





CHINA
NEW ENERGY GROUP COMPANY


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE NINE MONTHS


ENDED
SEPTEMBER 30, 2010 AND 2009





24.
Commitments and Contingencies





Operating
Leases - In the normal course of business, the Group leases office space under
operating lease agreements. The operating lease agreements generally contain
renewal options that may be exercised at the Company’s discretion after the
completion of the base rental term. The Company is obligated under operating
leases requiring minimum rentals as follows:





Remainder
      of 2010
                      
                      $
                      34,7262011
                      
                      
                      136,5062012
                      
                      
                      56,878Thereafter
                      
                      
                      -Total
      minimum lease payments
                      
                      $
                      228,110





During
the three months ended September 30, 2010 and 2009, rental expenses included in
general and administrative expenses were $65,894 and $34,293,
respectively.





During
the nine months ended September 30, 2010 and 2009, rental expenses included in
general and administrative expenses were $225,732 and $94,241,
respectively.





As of
September 30, 2010 and 2009, the Group did not have any contingent
liabilities.





The Group
is obligated to provide uninterrupted piped gas to connected users and to ensure
safety in the process of piped gas operations. The volume of gas to be supplied
by the Group is expected to grow with any increase in gas users. The Group has
selected three qualified gas resource suppliers to ensure stable operations in
meeting its obligations.





25.
Subsequent events





The
Company evaluated subsequent events through the time of filing this Quarterly
Report on Form 10-Q. No significant events occurred subsequent to the balance
sheet date but prior to the filing of this report that would have a material
impact on our Condensed Consolidated Financial Statements.





F-44




ITEM 2.
            MANAGEMENT’S DISCUSSION AND
      ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS.





Special
Note Regarding Forward Looking Statements





This
Quarterly Report on Form 10-Q, including the following “Management’s Discussion
and Analysis of Financial Condition and Results of Operations,” contains
forward-looking statements that are based on the beliefs of our management, and
involve risks and uncertainties, as well as assumptions, that, if they ever
materialize or prove incorrect, could cause actual results to differ materially
from those expressed or implied by such forward-looking statements. The words
“believe,” “expect,” “anticipate,” “project,” “targets,” “optimistic,” “intend,”
“aim,” “will” or similar expressions are intended to identify forward-looking
statements. All statements, other than statements of historical fact, are
statements that could be deemed forward-looking statements, including statements
regarding new and existing products, technologies and opportunities; statements
regarding market and industry segment growth and demand and acceptance of new
and existing products; any projections of sales, earnings, revenue, margins or
other financial items; any statements of the plans, strategies and objectives of
management for future operations; any statements regarding future economic
conditions or performance; uncertainties related to conducting business in
China; any statements of belief or intention; and any statements of assumptions
underlying any of the foregoing. All forward-looking statements included in this
report are based on information available to us on the date of this report. We
assume no obligation and do not intend to update these forward-looking
statements, except as required by law.





In this
report, unless indicated otherwise, references to:





·
            “China New Energy,” “the
      company,” “we,” “us,” or “our,” are references to the combined business of
      China New Energy Group Company and its wholly-owned subsidiaries, Willsky,
      Wuyuan,Tianjin Investment, SingOcean, Chensheng  and Yingkou
      Zhongneng, Zhanhua Jiutai, Binhai Zhongneng, but do not include the
      stockholders of China New
Energy;





·
            “Willsky” are references to
      Willsky Development, Ltd.





·
            “Wuyuan” are references to Wuyuan
      County Zhongran Gas Limited.





·
            “Tianjin Investment” are
      references to China New Energy(Tianjin) Investment & Consulting
      Co.,Ltd.





·
            “SingOcean” are references to
      Tianjin SingOcean Public Utility Development Co.,
    Ltd.





·
            “Chensheng” are references to
      Qinhuangdao Chensheng Gas Co.
Ltd.





·
            “Yingkou Zhongneng” are reference
      to Yingkou Zhongneng Gas Development Company
    Limited.





·
            “Zhanhua Jiutai” are reference to
      Zhanhua Jiutai Gas Co.
Limited.





·
            “Binhai Zhongneng” are reference
      to Tianjin Binhai Zhongneng Gas Company
  Limited.





·
            “China,” “Chinese” and “PRC,” are
      references to the People’s Republic of
  China;





·
            “BVI” are references to the
      British Virgin Islands;





·
            “RMB” refer to Renminbi, the
      legal currency of China;





·
            “U.S. dollar,” “$” and “US$” are
      to the legal currency of the United
  States;




2





·
            “SEC” means the Securities and
      Exchange Commission; and





·
            “Securities Act” means the
      Securities Act of 1933, as amended, and “Exchange Act” mean the Securities
      Exchange Act of 1934, as
amended.





Overview
of Our Business





We are a
natural gas company engaged in the development of natural gas distribution
networks, and the distribution of natural gas to residential, industrial and
commercial customers in small and medium sized cities in China.





We
currently own the exclusive rights to develop distribution networks to provide
natural gas to industrial, commercial and residential consumers in the cities of
Nandaihe, Zhanhua, and Shangrao. Currently, these distribution networks provide
natural gas to an aggregate of approximately 26,300 consumers in these
cities.





We
procure our natural gas by purchasing natural gas from third-party suppliers.
Once natural gas is extracted by the supplier, all water content and impurities
are removed.  Natural gas is then delivered by truck to either (1) our
natural gas supply stations, where the gas is either depressurized and then
delivered to households through pipelines or delivered directly to customers in
pressurized tanks, or (2) to gas stations where the gas is sold for use in motor
vehicles.




Our major
business activities include development and construction of local gas
distribution networks, transportation of natural gas from suppliers to our
storage facilities in a given operational location, and operating and
maintaining the gas distribution networks.





Our
Current Organizational Structure





China New
Energy Group Company was incorporated on March 28, 2008 in the state of Delaware
USA, under the name of Travel Hunt Holdings, Inc.  On May 27, 2008,
Travel Hunt changed its name to China New Energy Group Company in connection
with a share exchange transaction as described below.





Willsky
Development Ltd. (Willsky) was incorporated on May 31, 2005 in the British
Virgin Islands. On March 28, 2008, Travel Hunt Holdings, Inc. completed a
reverse acquisition transaction with Willsky whereby Travel Hunt Holdings, Inc.
issued to the shareholder of Willsky 94,908,650 shares of its common stock in
exchange for all of the issued and outstanding capital stock of Willsky.
Simultaneous with the consummation of the share exchange, the shareholder of
Willsky, Eternal International Holding Group Ltd, a Hong Kong corporation, or
Eternal International, distributed 85,417,785 shares of Travel Hunt Holdings,
Inc. common stock as a dividend. Accordingly, following this distribution,
Eternal International beneficially owns approximately 9.49% of Travel Hunt
Holdings, Inc. outstanding capital stock. Willsky thereby became Travel Hunt
Holdings, Inc.’s wholly-owned subsidiary and the former shareholders of Willsky
became Travel Hunt Holdings, Inc. controlling stockholders.





Concurrently
with the reverse merger, Fountainhead Capital Management Limited and La Pergola
Investments Limited, the previously existing shareholders of Travel Hunt,
surrendered to the Company a total of 2,000,000 shares of the common stock of
the Company for cancellation in exchange for $660,000 payable through the
delivery of a six month Convertible Promissory Note. After surrender, the
existing shareholders retained 5,091,391 shares of our common
stock.





After the
reverse acquisition, the total common stock issued and outstanding of the
Company as of December 31, 2008 was 100,000,041 shares.




3


This
transaction has been accounted for as a reverse acquisition and recapitalization
of the Company whereby Willsky is deemed to be the accounting acquirer (legal
acquiree) and the Company the accounting acquiree (legal acquirer). The
historical financial statements for periods prior to March 28, 2008 are those of
Willsky, except that the equity section and earnings per share have been
retroactively restated to reflect the reverse acquisition.





In 2005,
Willsky acquired 99% of the equity of SingOcean which was formed in the PRC as
an equity joint venture to be operated for a period of 50 years until January
18, 2054 with registered capital of $4.5 million (RMB31,897,000).





On
September 16, 2008, we, through our 99%-owned subsidiary SingOcean,
entered into an Equity Swap Agreement with Mr. Xiu Hai Tian, whereby we
acquired fromMr. Xiu a 49%
ownership interest in Chensheng, in exchange for our 99% ownership in
Hunchun SingOcean.  The parties to the Equity Swap Agreement
determined that the value of the 49% interest in Chensheng and the 99% interest
in Hunchun Sing Ocean were approximately equal and therefore there was no cash
or other consideration involved in the transaction from either
party.





On
December 10, 2008, the Company entered into an Agreement for Equity Transfer
with the holders of the remaining 51% outstanding equity in
Chensheng.  Pursuant to the Agreement for Equity Transfer, the Company
agreed to purchase the remaining 51% of the outstanding equity of Chensheng from
17 individuals for an aggregate purchase price of RMB 12.56 million
(approximately $1.84 million).  The transaction was consummated on
December 30, 2008, following which the Company now owns 51% of the equity of
Chensheng, and Tianjin Sing Ocean now owns 49% of the equity of
Chensheng.





On
January 12, 2009, Tianjin Investment was established in the PRC and engaged in
the business of investment holding.





On
January 23, 2009, Yingkou Zhongneng was established in the PRC and operates a
natural gas distribution network in the city of Dashiqiao. On March 17, 2010, we
entered into an agreement to sell our interest in Yingkou
Zhongneng.





On June
26, 2009, Binhai Zhongneng was established. Through our 99.5%-owned subsidiary,
Chensheng contributed $1,462,501 (RMB10,000,000) in cash representing 60.6% of
the shareholding of Binhai Zhongneng and, through our wholly-owned subsidiary,
SingOcean contributed $950,626 (RMB6,500,000) in assets representing 39.4% of
the shareholding of Binhai Zhongneng. As a result, the group holds 100% of
Binhai Zhongneng.





On
December 12, 2009, Chensheng, our indirect wholly-owned subsidiary, entered into
an Equity Interest Purchase Agreement to acquire all of the outstanding equity
interest of Zhanhua Jiutai from the 5 shareholders of Zhanhua Jiutai. Under this
Agreement, Chensheng agreed to purchase 100% of the outstanding equity interest
of Zhanhua Jiutai from the Zhanhua Jiutai Shareholders for a total purchase
price of $2,413,259 (RMB 16,500,000).





On
December 16, 2009, the Company entered into an Equity Interest Purchase
Agreement to acquire all of the outstanding equity interest of Wuyuan from
Flying Dragon Investment Management Limited. Under this Agreement, the Company
agreed to purchase 100% of the outstanding equity interest of Wuyuan for a total
purchase price of $877,552 (RMB 6,000,000), which purchase price is based on an
appraised value of Wuyuan as of September 30, 2009.





On August
25, 2010, China New Energy Investment Company Ltd. (Nixi) was established in the
PRC and is engaged in the business of investment holding and enterprise
management service, and CNER owns 100% of Nixi.





Recent
Development





On
September 14, 2010, the Company’s wholly-owned PRC subsidiary, China New Energy
Investment Co., Ltd (“Buyer”), entered into
an Equity Transfer Agreement (the “Century Dadi Acquisition
Agreement”) with Beijing Fengyin Xianghe Scientific Technology Co., Ltd.
(“Seller”), a
PRC company controlled by Mr. Tang Zhixiang (“Mr. Tang”), to
acquire a 70% equity interest in Beijing Century Dadi Gas Engineering Co., Ltd.,
a PRC company (“Century Dadi”) from
the Seller.


4




On
September 14, 2010, Buyer also entered into an Equity Transfer Agreement (the
“Zhoulu Dadi
Agreement”) with Seller and Mr. Tang, to acquire a 70% equity interest in
Zhoulu Dadi Gas Co. Ltd., a PRC company (“Zhoulu Dadi”) from the
Seller.





Summaries
of the terms of the Century Dadi Acquisition Agreement and Zhoulu Dadi Agreement
(the “September Acquisition Agreements”) are incorporated by reference to the
Form 8-K filed with SEC on September 14, 2010.





On
October 28, 2010, Buyer and Mr. Tang restructured the September Acquisition
Agreements and entered into an Equity Transfer Agreement (the “Tianjin Dadi
Agreement”) with Seller and Mr. Tang, to acquire a 70% equity interest in
Tianjin Dadi Friendship Co. Ltd., a PRC company (“Tianjin Dadi”) from the
Seller.  Prior to entering into the Tianjin Dadi Agreement the
ownership of Century Dadi and Zhoulu Dadi were restructured such that they are
now both owned by Tianjin Dadi.  The material terms of the Tianjin
Dadi Agreement are the same as the September Acquisition Agreements and Buyer
will still be acquiring 70% of each of Century Dadi and Zhoulu Dadi through
Tianjin Dadi, their parent company.





In
connection with the execution of the Tianjin Dadi Agreement, on October 28,
2010, Seller, Buyer and Tianjin Dadi entered into an Exclusive Option Agreement,
an Equity Transfer Agreement for 30% of the Equity of Tianjin Dadi, and a
General Framework Agreement. After the completion of the transfer of the 70%
interest under the Tianjin Dadi Agreement, Buyer has the right to purchase the
remaining 30% equity interest in Tianjin Dadi then owned by Seller.





On
October 28, 2010, Seller, Buyer and Mr. Tang entered into a Supplementary
Agreement for the Escrow Terms and Conditions for the First Installment, where
Buyer agrees to lend Seller 50% of the escrow fund (a total of RMB 60,000,000)
before the releasing of the first installment when the following conditions are
satisfied: a)  the acquisition of 70% equity interest in Tianjin Dadi
is approved by local Ministry of Commerce; b) Tianjin Dadi’s subsidiaries shall
have achieved the shareholder structure required by Buyer; c) All application
documents for applying for registration in Administration for Industry and
Commerce for the 70% equity transfer to Buyer have been duly signed and provided
to Buyer; and d) a Loan Agreement will be signed between the Buyer and
Seller.  The loan will be guaranteed by Beijing Dadi Gas Engineering
Co, Ltd.





In
connection with the Supplementary Agreement for the Escrow Terms and Conditions
for the First Installment, on October 28, 2010, Seller, Buyer and Mr. Tang
entered into a Loan Agreement, where Seller borrowed RMB 60,000,000 from the
Buyer for the equity acquisition of the subsidiaries of Century Dadi and Zhoulu
Dadi. The loan is guaranteed by Beijing Dadi Gas Engineering Co, Ltd. with all
its assets.





On
November 9, 2010, Buyer and Seller entered into a Loan Agreement, where Seller
agrees to loan Buyer a total of RMB 7,500,000 with an annual interest rate of
5.56%. The term of the loan is 3 months, starting from the execution
date.  The loan is for the business development purpose of the Company
and is not related to the acquisition of Tianjin Dadi.




Critical Accounting
Policies





Accounting
policies discussed in this section are those that we consider to be most
critical to an understanding of our financial statements because they inherently
involve significant judgment and uncertainties.  For all of these
estimates, we caution that future events rarely develop exactly as forecast, and
the best estimates routinely require adjustment.


5




Revenue
Recognition





Among the
accounting policies adopted by the Group, the most critical one is the policy
regarding revenue recognition of the Group’s major sources of income, namely,
gas connection services and sales of gases. In accordance with the SEC's Staff
Accounting Bulletin ("SAB") No. 104, under this policy, all of the following
criteria must be met in order for us to recognize revenue:





1.       Persuasive evidence of an arrangement
exists;


2.       Delivery has occurred or services have
been rendered;


3.       The seller's price to the buyer is fixed
or determinable; and


4.       Collectibility is reasonably
assured.




Gas
connection revenue




Gas
connection revenue is recognized when the outcome of a contract can be estimated
reliably and the stage of completion at the balance sheet date can be measured
reliably.





Revenue
from gas connection contracts is recognized on the percentage of completion
method, measured by reference to the value of work carried out during the year.
When the outcome of a gas connection contract cannot be estimated reliably,
revenue is recognized only to the extent of contract costs incurred that it is
probable will be recoverable.





When the
outcome of a gas connection contract can be estimated reliably and the stage of
contract completion at the balance sheet date can be measured reliably, contract
costs are charged to the income statement by reference to the stage of
completion of the contract activity at the balance sheet date on the same basis
as revenue from the gas connection contract is recognized.





When the
outcome of a gas connection contract cannot be estimated reliably, contract
costs are recognized as expenses in the period in which they are incurred. When
it is probable that total contract costs will exceed contract revenue, the
expected loss is recognized as an expense immediately.





Where
contract costs incurred to date plus recognized profits less recognized losses
exceed progress billings, the surplus is shown as an amount due from customers
for contract work. For contracts where progress billings exceed contract costs
incurred to date plus recognized profits less recognized losses, the surplus is
shown as an amount due to customers for contract work. Amounts received before
the related work is performed are included in the consolidated balance sheet, as
a liability, as advances received. Amounts billed for work performed but not yet
paid by the customer are included in the consolidated balance sheet under trade
and other receivables.





During
the three and nine months ended September 30, 2010 and 2009, all the contracts
for connection services were started and completed.





Revenue
from sale of gas





Sales
revenue from sale of gas represents the invoiced value of goods sold, net of
value-added tax (“VAT”). Revenue from sale of gas is recognized when the goods
are delivered and title has passed.





All of
the Company’s products that are sold in the PRC are subject to Chinese
value-added tax of 3% of the gross sales price. This VAT may be offset by VAT
paid by the Company on raw materials and other materials included in the cost of
producing their finished product. The Company recorded VAT payable and VAT
receivable net of payments in the financial statements.





Use
of Estimates





In
preparing consolidated financial statements in conformity with US GAAP,
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 revenues and
expenses during the reported periods. Actual results could differ from those
estimates


6




Significant
Estimates





These
consolidated financial statements include some amounts that are based on
management's best estimates and judgments. The most significant estimates relate
to revenue recognition of gas connection contracts, depreciation of property,
plant and equipment, the valuation allowance for deferred taxes, impairment
testing of intangible assets and various contingent liabilities. It is
reasonably possible that the above-mentioned estimates and others may be
adjusted as more current information becomes available, and any adjustment could
be significant in future reporting periods.





Reportable
Operating Segments





For the
nine months ended September 30, 2010, we had sales revenue of $2.56
million of which $2.48 million, or 97%, was from connection services
while $0.08 million, or 3%, was from gas sales.





Our
revenue for the nine months ended September 30, 2010 was mainly contributed by
the connection services segment as we concentrate our efforts to provide our
services to property developers.  Thus, the gas consumption will begin
when the properties are sold in the market.  Currently, the volume of
gas sales to connected households is not high.This phenomenon does affect our
revenue structure.





Third
Quarter Financial Performance Highlights





The
following are some financial highlights for the third quarter of 2010 (MM
represents million):





Revenues:
Our revenues were $0.16 MM for the third quarter of 2010, a decrease of 86%
from the same period of 2009.





Gross
Margin: Gross margin was a loss of 20% for the third quarter of 2010
compared to gross margin of 67% for the third quarter of 2009,
representing a percentage decrease of 87%.





Operating
Expenses: Operating expenses (including selling, general
and administrative expenses) were $1.38 MM for the third quarter of
2010, an increase of 8% from the same period of 2009.





Net Income /
(Loss): A net
loss of $10.93 MM resulted for the third quarter of 2010, while the
net income for the same period of 2009 was $6.16 MM. The decrease of net income
was mainly due to: (1) a decrease in revenues of connection fees by
$0.98 MM; (2) an increase of operating expenses by $0.1 MM;
(3) a change in fair value of derivative financial instruments which
resulted in other expenses of $8.32 MM while it resulted in other income of
$6.04 MM for the same period of 2009; and (4) the value of Series Preferred
Stock C was $1.03 MM, which was recorded as accrued interest for the third
quarter of 2010.





Fully diluted net
income per share: Fully diluted net loss per share was $0.16 for the
third quarter of 2010, as compared to net income per share of
$0.03 for the same period of 2009.





Taxation





As a
Delaware company, the Company is subject to United States taxation, but no
provision for income taxes was made for the nine months ended September 30,
2010 and 2009 as the Company did not have reportable taxable income for the
period.





Willsky,
a wholly-owned subsidiary of the Company, is subject to BVI taxation, but no
provision for income taxes was made for the nine months ended
September 30, 2010 and 2009 as Willsky did not have reportable taxable
income for the period.





SingOcean
is subject to the tax laws of the PRC at  the prevailing
statutory rate of enterprise income tax of 25%.


7




Prior to
2009, Chensheng was subject to the tax laws of the PRC being taxed on 0.8%
of annual sales. Starting from January 1, 2009, the tax rate was
changed to 1% on sales.  On July 1, 2009, the tax rate was changed to 25%
on net income.




Binhai
Zhongneng is subject to the tax laws of the PRC at  the
prevailing statutory rate of enterprise income tax of 25%.




Zhanhua
is subject to the tax laws of the PRC at the prevailing statutory rate
of enterprise income tax of 25%.





Wuyuan is
subject to the tax laws of the PRC at the prevailing statutory rate of
enterprise income tax of 25%.




Tianjin
Investment is subject to the tax laws of the PRC at the prevailing
statutory rate of enterprise income tax of 25%.




Nixi is
subject to the tax laws of the PRC at the prevailing statutory rate of
enterprise income tax of 25%.




On April
22, 2009, the State Administration of Taxation issued the Notice Concerning
Relevant Issues Regarding Cognizance of Chinese Investment Controlled
Enterprises Incorporated Offshore as Resident Enterprises pursuant to Criteria
of de facto Management Bodies, or the Notice, further interpreting the
application of the New EIT Law and its implementation with respect to
non-Chinese enterprises or group controlled offshore entities. Pursuant to the
Notice, an enterprise incorporated in an offshore jurisdiction and controlled by
a Chinese enterprise or group will be classified as a “non-domestically
incorporated resident enterprise” if (i) its senior management in charge of
daily operations reside or perform their duties mainly in China; (ii) its
financial or personnel decisions are made or approved by bodies or persons in
China; (iii) its main properties, accounting books, corporate seal, board and
shareholder minutes are kept in China; and (iv) directors with voting rights or
senior management often reside in China.  Such resident enterprise
would be subject to an EIT rate of 25% on its worldwide income and must pay
a withholding tax at a rate of 10% when paying dividends to its non-PRC
shareholders. However, it remains unclear as to whether the Notice is applicable
to an offshore enterprise incorporated by a Chinese natural
person.  Nor are detailed measures available on the imposition of
tax on non-domestically incorporated resident enterprises. Therefore, it is
unclear how tax authorities will determine tax residency based on the facts of
each case.





However,
as our case substantially meets the foregoing criteria, there is a likelihood
that we are deemed to be a resident enterprise by Chinese tax authorities. If
the PRC tax authorities determine that we are a “resident enterprise” for PRC
enterprise income tax purposes, a number of unfavorable PRC tax consequences
could follow. First, we may be subject to the enterprise income tax at a rate of
25% on our worldwide taxable income as well as subject to PRC enterprise income
tax reporting obligations. In our case, this would mean that income such as
interest on financing proceeds and non-China source income would be subject to
PRC enterprise income tax at a rate of 25%. Second, although under the New EIT
Law and its Implementing Rules dividends paid to us from our PRC subsidiaries
would qualify as “tax-exempt income,” we cannot guarantee that such dividends
will not be subject to a 10% withholding tax, as the PRC foreign exchange
control authorities, which enforce the withholding tax, have not yet issued
guidance with respect to the processing of outbound remittances to entities that
are treated as resident enterprises for PRC enterprise income tax purposes.
Finally, it is possible that future guidance issued with respect to the new
“resident enterprise” classification could result in a situation in which a 10%
withholding tax is imposed on dividends we pay to our non-PRC stockholders and
with respect to gains derived by our non-PRC stockholders from transferring our
shares. We are actively monitoring the possibility of “resident enterprise”
treatment and are evaluating appropriate organizational changes to avoid this
treatment, to the extent possible.


8


Results
of Operations




Comparison
of Three Months Ended September 30, 2010 and 2009





The
following table summarizes the results of our operations during the three-month
periods ended September 30, 2010 and 2009:





(All
amounts, other than percentages, are in thousands of U.S. dollars)





For
      the three months endedSeptember
      30,2010
                          
                          
                          2009
                          
                          
                          Change
                          
                          
                          Change%Revenues:
                          
                          
                          162
                          
                          
                          
                          1,138
                          
                          
                          
                          (976
                          )
                          
                          
                          -86
                          %Cost
      of Sales:
                          
                          
                          195
                          
                          
                          
                          378
                          
                          
                          
                          (183
                          )
                          
                          
                          -48
                          %Gross
      Profit
                          
                          
                          (33
                          )
                          
                          
                          760
                          
                          
                          
                          (793
                          )
                          
                          
                          -104
                          %Total
      operating expenses
                          
                          
                          1,378
                          
                          
                          
                          1,274
                          
                          
                          
                          104
                          
                          
                          
                          8
                          %Loss
      from operations
                          
                          
                          (1,411
                          )
                          
                          
                          (514
                          )
                          
                          
                          (897
                          )
                          
                          
                          175
                          %Other
      Income (Expenses):Change
      in fair value of derivative financial instruments
                          
                          
                          (8,321
                          )
                          
                          
                          6,041
                          
                          
                          
                          (14,362
                          )
                          
                          
                          -238
                          %Interest
      income(expenses)
                          
                          
                          (1,024
                          )
                          
                          
                          4
                          
                          
                          
                          (1,028
                          )
                          
                          
                          -25700
                          %Other
      income
                          
                          
                          (175
                          )
                          
                          
                          3
                          
                          
                          
                          (178
                          )
                          
                          
                          -5933
                          %(Loss)
      Income From Continuing Operations, Before Income Tax
                          
                          
                          (10,931
                          )
                          
                          
                          5,534
                          
                          
                          
                          (16,465
                          )
                          
                          
                          -298
                          %Income
      Tax
                          
                          
                          2
                          
                          
                          
                          182
                          
                          
                          
                          (180
                          )
                          
                          
                          -99
                          %(loss)
      Income from discontinued operations
                          
                          $
                          (0
                          )
                          
                          
                          810
                          
                          
                          
                          (810
                          )
                          
                          
                          -100
                          %Net
      (Income) Loss Attributable to Non-controlling Interest
                          
                          
                          4
                          
                          
                          
                          (25
                          )
                          
                          
                          29
                          
                          
                          
                          -116
                          %Net
      (Loss)Income
                          
                          
                          (10,934
                          )
                          
                          
                          6,163
                          
                          
                          
                          (17,097
                          )
                          
                          
                          -277
                          %





Revenues.  Revenues
are derived primarily from connection fees and sales of natural
gas.  Revenues decreased $0.98 MM, or 86%, to $0.16 MM for the three
months ended September 30, 2010 from $1.14 MM for the same period in 2009. This
decrease was mainly attributable to a decrease in number of connection
households.





Cost of
Sales.   Cost of sales consists primarily of connection
costs and purchase of natural gas from our suppliers and
depreciation.




Our cost
of sales decreased by $0.18 MM, or 48%, to $0.20 MM for the three months ended
September 30, 2010 from $0.38 MM during the same period in 2009. Such decrease
was mainly attributable to a decrease in number of connection
households.




Gross
Profit.Our
gross profit decreased by $0.79 MM, or 104%, to a loss of $0.03 MM for the three
months ended September 30, 2010 from $0.76 MM during the same period in
2009.  Gross profit as a percentage of revenues or gross profit
margin, was 20% for the three months ended September 30, 2010.  The
gross profit margin during the same period in 2009 was 67%. Such decrease in
gross profit margin was mainly due to a decrease of revenue for connection
fees.




Total Operating
ExpensesThe total operating expenses consist of two
components, the first one is registration right penalties and the other is
general and administrative expenses (“SG&A”).  For the three
months ended September 30, 2010, the total operating expenses were $1.38 MM
while the amount was $1.27 MM for the same period of 2009, or increased by
8%.  This increase was mainly due to the fact that we are expanding
our company. Management believes that the relatively high SG&A expenses
will continue as we endeavor to expand our
business, especially, registration right liabilities is $0.38 MM for
the same period 2009.


9




Loss from operationsOur loss
from operations increased by $0.9 MM, or 175%, to $1.41 MM for the three
months ended September 30, 2010 from loss $0.51 MM during the same period
in 2009. This increase was mainly due to an increase in operating expenses
and a decrease in number of connection households.





Other
Income (Expenses)





Change In Fair Value ofderivative financial
instruments:For
the three months ended September 30, 2010, the change in fair value of
derivative financial instruments was recorded as other expenses of
$8.32 MM while the one incurred in the same period of 2009 was recorded as other
income of $6.04 MM.





The
Company adopted a FASB accounting standard, which defines determining whether an
instrument (or embedded feature) is indexed to an entity’s own
stock.  This accounting standard specifies that a contract that would
otherwise meet the definition of a derivative but is both (a) indexed to
the Company’s own stock and (b) classified in stockholders’ equity in the
statement of financial position would not be considered a derivative financial
instrument.  This FASB accounting standard provides a new two-step
model to be applied in determining whether a financial instrument or an embedded
feature is indexed to an issuer’s own stock and thus able to qualify for the
scope exception.





As a
result of adopting this FASB accounting standard, warrants previously treated as
equity pursuant to the derivative treatment exemption are no longer afforded
equity treatment because the warrants have a downward ratchet provision on the
exercise price. As a result, the warrants are not considered indexed to the
Company’s own stock, and as such, all future changes in the fair value of
these warrants will be recognized currently in earnings until such time as the
warrants are exercised or expired.





On August
20, 2008, the fair value of the 13,001,608 warrants issued with the Series A
Convertible Preferred Stock to China Hand was $1.97 MM and the fair value of
6,500,804 warrants issued to Kuhns Brothers was $0.98 MM. The fair value was
computed using the Cox-Ross-Rubinstein (“CRR”) Binomial Model under the
following assumptions: (1) expected life of 5 years, (2) volatility of 90%, (3)
risk free interest rate of 3% and dividend rate of 0%.





On May 1,
2009, the fair value of the 7,814,719 warrants issued with the Series B
Convertible Preferred Stock to China Hand was $3.25 MM and the fair value of
3,907,358 warrants issued to Kuhns Brothers was $1.62 MM. The fair value was
computed using the Cox-Ross-Rubinstein (“CRR”) Binomial Model under the
following assumptions: (1) expected life of 5 years, (2) volatility of 90%, (3)
risk free interest rate of 2.03% and dividend rate of 0%.





As of
September 30, 2010, the fair value of the warrants was $4.82 MM, derivative
financial instruments – call options related to Series D Convertible
Preferred Stock was 43.67 MM and derivative assets- -put options was
1.60MM.  Therefore, the Company recognized a $8.32 MM loss from the
change in fair value for the three months ended September 30, 2010 and
a $6.04 MM gain from the change in fair value during the same period in
2009.





Income (loss)From Continuing Operations, Before
Income Tax.Our loss
from continuing operations before income tax increased by $16.47 MM to
$10.93 MM for the three months ended September 30, 2010 from an income of $5.53
MM during the same period in 2009.  Such decrease was mainly due
to: (1) a decrease in revenues of connection fees by
$0.98 MM; (2) an increase of operating expenses by $0.1 MM;
(3) a change in fair value of derivative financial instruments which
resulted in other expenses of $8.32 MM while it resulted in other income of
$6.04 MM for the same period of 2009; and (4) the value of Series Preferred
Stock C was $1.03 MM, which was recorded as accrued interest for the third
quarter of 2010.





Income
(Loss) From Discontinued Operations





Disposal of Yingkou
Zhongneng Gas Development Co.,Ltd in 2010 – completed in
2010


10




On March
17, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Hunan Zhongyouzhiyuan Gas Co., Ltd. (the“Purchaser").
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). On March 31, 2010, the agreement was
terminated.





On April
2, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Changsha Yuedu Steel Co., Ltd. (the “Purchaser”).
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). As of September 30, 2010, the Group received part of
the downpayment of $l,045,072 (RMB7,000,000) and recorded it under Deposits
receipt for disposal of current liabilities.





As of
September 30, 2010, the legal procedures for the transfer of the ownership of
Yingkou have not been completed and the control of Yingkou still remains in the
Group; therefore, the Group recorded all the assets and liabilities of Yingkou
under the caption of “Current Assets Held for Sale”, “Non-current Assets Held
for Sale” and “Liabilities Held for Sale”. The oprating activity of Yingkou was
recorded under the discontinued operations for the nine months ended September
30, 2010 and 2009.





The
following table displays summarized operating activity for the discontinued
operations of Yingkou for the three months ended September 30, 2010 and Yingkou
and Acheng for the three months ended September 30, 2009.





For
      the three months endedSeptember
      30,2,010
                    
                    
                    
                    2,009(Unaudited)
                    
                    
                    (Unaudited)Revenue
                    
                    $
                    -
                    
                    
                    $
                    1,679,391Operating
      (loss) profit
                    
                    $
                    -231
                    
                    
                    $
                    1,273,455(Loss)
      Profit before income taxes
                    
                    $
                    -231
                    
                    
                    $
                    1,088,634Income
      tax expense
                    
                    $
                    -
                    
                    
                    $
                    279,128(Loss)
      Profit from discontinued operations, net of tax
                    
                    $
                    -231
                    
                    
                    $
                    809,506





NetIncome(loss).
Net
loss increased by $17.1 MM to a net loss of $10.93 MM for the three
months ended September 30, 2010, from net income of $6.16 MM for the same period
of 2009, which is mainly due to: (1) a decrease in revenues of connection fees
by $0.98 MM; (2) an increase of operating expenses by
$0.1 MM; (3) a change in fair value of derivative financial
instruments which resulted in other expenses of $8.32 MM while it resulted in
other income of $6.04 MM for the same period of 2009; and (4) the value of
Series Preferred Stock C was $1.03 MM, which was recorded as accrued interest
for the third quarter of 2010.


11




Comparison
of Nine Months Ended September30, 2010 and 2009




The
following table summarizes the results of our operations during the nine-months
ended September 30, 2010 and 2009:





(All
amounts, other than percentages, are in thousands of U.S. dollars)





For
      the nine months endedSeptember
      30.2010
                              
                              
                              2009
                              
                              
                              Change
                              
                              
                              Change%Revenues:
                              
                              
                              2,564
                              
                              
                              
                              1,832
                              
                              
                              
                              732
                              
                              
                              
                              40
                              %Cost
      of Sales:
                              
                              
                              841
                              
                              
                              
                              658
                              
                              
                              
                              183
                              
                              
                              
                              28
                              %Gross
      Profit
                              
                              
                              1,723
                              
                              
                              
                              1,174
                              
                              
                              
                              549
                              
                              
                              
                              47
                              %Total
      operating expenses
                              
                              
                              4,014
                              
                              
                              
                              2,583
                              
                              
                              
                              1,431
                              
                              
                              
                              55
                              %Loss
      from operations
                              
                              
                              (2,291
                              )
                              
                              
                              (1,409
                              )
                              
                              
                              (882
                              )
                              
                              
                              63
                              %Other
      Income (Expenses):Change
      in fair value of derivative financial instruments
                              
                              
                              (8,029
                              )
                              
                              
                              8,017
                              
                              
                              
                              (16,046
                              )
                              
                              
                              -200
                              %Interest
      income(expenses)
                              
                              
                              (1,025
                              )
                              
                              
                              4
                              
                              
                              
                              (1,029
                              )
                              
                              
                              -25725
                              %Other
      income
                              
                              
                              (162
                              )
                              
                              
                              3
                              
                              
                              
                              (165
                              )
                              
                              
                              -5500
                              %(Loss)
      Income From Continuing Operations, Before Income Tax
                              
                              
                              (11,507
                              )
                              
                              
                              6,615
                              
                              
                              
                              (18,122
                              )
                              
                              
                              -274
                              %Income
      Tax
                              
                              
                              385
                              
                              
                              
                              188
                              
                              
                              
                              197
                              
                              
                              
                              105
                              %(Loss)
      Income from discontinued operations
                              
                              $
                              (86
                              )
                              
                              
                              189
                              
                              
                              
                              (275
                              )
                              
                              
                              -146
                              %Net
      (Income) Loss Attributable to Non-controlling Interest
                              
                              
                              2
                              
                              
                              
                              (18
                              )
                              
                              
                              20
                              
                              
                              
                              -111
                              %Net
      (Loss) Income
                              
                              
                              (11,979
                              )
                              
                              
                              8,322
                              
                              
                              
                              (20,301
                              )
                              
                              
                              -244
                              %





Revenues.  Revenues
are derived primarily from connection fees and sales of natural
gas.  Revenues increased $0.73 MM, or 40%, to $2.56 MM for
the nine months ended September 30, 2010 from $1.83 MM for the same
period in 2009. This increase was mainly attributable to an increase in number
of connection households and an industry customer.





Cost of
Sales.   Cost of sales consists primarily of connection
costs and purchase of natural gas from our suppliers and
depreciation.





Our cost
of sales increased by $0.18 MM, or 28%, to $0.84 MM for the nine months
ended  September 30, 2010 from $0.66 MM during the same period in
2009. Such increase was mainly attributable to an increase in the number of
households connected to our distribution network.





Gross
Profit.Our
gross profit increased by $0.55 MM, or 47%, to $1.72 MM for the nine months
ended September 30, 2010 from $1.17 MM during the same period in
2009.  Gross profit as a percentage of revenues, or gross profit
margin, was 67% for the nine months ended September 30,
2010.  The gross profit margin during the same period in 2009 was 64%.
Such increase in gross profit margin was mainly due to an increase of revenues
of connection fees.





Total Operating ExpensesThe
total operating expenses consist of two components, the first one is
registration right penalties and the other is general and administrative
expenses (“SG&A”). For the nine months ended September 30, 2010, the
total operating expenses were $4.01 MM while the amount was $2.58 MM
for the same period of 2009, or increased by 55%.  This increase was
mainly due to the fact that we are expanding our company. Management
believes that the relatively high SG&A expenses will continue as we
endeavor to expand our business.


12




Loss from operationsOur loss
from operations increased by $0.88 MM, or 63%, to $2.29 MM for
the nine months ended September 30, 2010 from $1.41 MM during the
same period in 2009.  This increase in loss from operations was
mainly due to an increase in gross profit which was offset by the increase in
operating expenses of $1.43 MM.





Total
Other Income (Expenses)





Change In Fair Value ofderivative financial
instruments:For
the nine months ended September 30, 2010, the change in fair value of derivative
financial instruments was recorded as other expenses of $8.03 MM while
it resulted in other income of $8.02 MM for the same period of
2009.





The
Company adopted a FASB accounting standard, which defines determining whether an
instrument (or embedded feature) is indexed to an entity’s own
stock.  This accounting standard specifies that a contract that would
otherwise meet the definition of a derivative but is both (a) indexed to the
Company’s own stock and (b) classified in stockholders’ equity in the statement
of financial position would not be considered a derivative financial
instrument.  This FASB accounting standard provides a new two-step
model to be applied in determining whether a financial instrument or an embedded
feature is indexed to an issuer’s own stock and thus able to qualify for the
scope exception.





As a
result of adopting this FASB accounting standard, warrants previously treated as
equity pursuant to the derivative treatment exemption are no longer afforded
equity treatment because the warrants have a downward ratchet provision on the
exercise price. As a result, the warrants are not considered indexed to the
Company’s own stock, and as such, all future changes in the fair value of these
warrants will be recognized currently in earnings until such time as the
warrants are exercised or expired.





On August
20, 2008, the fair value of the 13,001,608 warrants issued with the Series A
Convertible Preferred Stock to China Hand was $1.97 MM and the fair value of
6,500,804 warrants issued to Kuhns Brothers was $0.98 MM. The fair value was
computed using the Cox-Ross-Rubinstein (“CRR”) Binomial Model under the
following assumptions: (1) expected life of 5 years, (2) volatility of 90%,
(3) risk free interest rate of 3% and dividend rate of 0%.





On May 1,
2009, the fair value of the 7,814,719 warrants issued with the Series B
Convertible Preferred Stock to China Hand was $3.25 MM and the fair value of
3,907,358 warrants issued to Kuhns Brothers was $1.62 MM. The fair value was
computed using the Cox-Ross-Rubinstein (“CRR”) Binomial Model under the
following assumptions: (1) expected life of 5 years, (2) volatility of 90%, (3)
risk free interest rate of 2.03% and dividend rate of 0%.





As of
September 30, 2010, the fair value of the warrants was $4.82 MM, derivative
financial instruments – call options related to Series D Convertible
Preferred Stock was 43.67 MM and derivative assets- -put options was 1.60MM.
 Therefore, the Company recognized a $8.32 MM loss from the change in fair
value for the three months ended September 30, 2010 and a $6.04 MM gain
from the change in fair value during the same period in
2009.





Income (loss)From Continuing Operations, Before
Income Tax.Our loss
from continuing operations before income tax increased by $18.12 MM to $11.51 MM
for the nine months ended  September 30, 2010 from a gain of $6.62 MM
during the same period in 2009.  Such increase was mainly due to: (1)
an increase in operating expenses by $1.43 MM; (2) the change in fair value
of derivative financial instruments was recorded as other expenses of
$8.03 MM while it resulted in other income of $8.02 MM for the same
period of 2009; and (3) the value of Series Preferred Stock C was $1.03 MM,
which was issued in payment of interest.





13




Income
(Loss) From Discontinued Operations





Disposal of Yingkou
Zhongneng Gas Development Co.,Ltd in 2010 – completed in
2010





On March
17, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Hunan Zhongyouzhiyuan Gas Co., Ltd. (the“Purchaser").
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). On March 31, 2010, the agreement was
terminated.





On April
2, 2010, SingOcean, our PRC 99%-owned subsidiary, entered into an Equity
Transfer Agreement with Changsha Yuedu Steel Co., Ltd. (the “Purchaser”).
Pursuant to the Agreement, SingOcean agreed to sell to the Purchaser its 100%
equity interest in Yingkou Zhongneng, for a cash purchase price of approximately
$3,200,000 (RMB21,900,000). As of September 30, 2010, the Group received part of
the downpayment of $l,045,072 (RMB7,000,000) and recorded it under Deposits
receipt for disposal of current liabilities.





As of
September 30, 2010, the legal procedures for the transfer of the ownership of
Yingkou have not been completed and the control of Yingkou still remains in the
Group; therefore, the Group recorded all the assets and liabilities of Yingkou
under the caption of “Current Assets Held for Sale”, “Non-current Assets Held
for Sale” and “Liabilities Held for Sale”. The oprating activity of Yingkou was
recorded under the discontinued operations for the nine months ended September
30, 2010 and 2009.





The
following table displays summarized operating activity for the discontinued
operations of Yingkou for the nine months ended September 30, 2010 and Yingkou
and Acheng for the nine months ended September 30, 2009.




For
      the nine months endedSeptember,302010
                                            
                                            
                                            2009(Unaudited)
                                            
                                            
                                            (Unaudited)Revenue
                                            
                                            $
                                            201,739
                                            
                                            
                                            $
                                            4,120,898Operating
      (loss) profit
                                            
                                            $
                                            (85,877
                                            )
                                            
                                            $
                                            2,712,980(Loss)
      Profit before income taxes
                                            
                                            $
                                            (85,877
                                            )
                                            
                                            $
                                            2,535,350Income
      tax expense
                                            
                                            $
                                            -
                                            
                                            
                                            $
                                            640,807(Loss)
      Profit from discontinued operations, net of tax
                                            
                                            $
                                            (85,877
                                            )
                                            
                                            $
                                            1,894,543





NetIncome
(Loss). Net
loss increased by $20.30 MM to a net loss of $11.98 MM for
the nine months ended September 30, 2010, from net income of $8.32 MM
for the same period of 2009, which is mainly due to: (1) the change in fair
value of derivative financial instruments was recorded as other expenses of
$8.03 MM while it resulted in other income of $8.02 MM for the same
period of 2009; (2) an increase in operating expenses by $1.43MM,
and (3) the value of Series Preferred Stock C was $1.03 MM, which recorded as
accrued interest.




14





Liquidity
and Capital Resources





As of
September 30, 2010, we had cash and cash equivalents of approximately
$0.59 million.  The following table provides detailed information
about our net cash flow for all financial statement periods presented in this
report.





Cash
Flow


(All
amounts in thousands of U.S. dollars)





For
      the nine months endedSeptember
      30,2010
                            
                            
                            2009Net
      cash provided by (used in) operating activities
                            
                            
                            (487
                            )
                            
                            
                            (915
                            )Net
      cash used in investing activities
                            
                            
                            (20,043
                            )
                            
                            
                            (5,031
                            )Net
      cash flows provided by financing activities
                            
                            
                            18,361
                            
                            
                            
                            5,215Effect
      of exchange rate changes in cash and cash equivalents
                            
                            
                            77
                            
                            
                            
                            (2
                            )Net
      increase (decrease) in cash and cash equivalents
                            
                            
                            (2,092
                            )
                            
                            
                            (734
                            )




Operating
Activities





Net cash
used in operating activities was $0.49 MM for the nine months ended
September 30, 2010, compared to net cash used in operating activities of $0.92
MM during the same period of 2009. This increase in funds used in our
operating activities was primarily due to an increase in net loss and a
decrease in accruals and other payables.





Investing
Activities





Our main
use of cash in investing activities was mainly for the construction of gas
pipelines and acquisition of assets.





Net cash
used in investing activities for the nine months ended September 30, 2010
was $20.04 MM, which was an increase of $15.01 MM from net cash
used of $5.03 MM for the same period of 2009.  This increase was
due to increased cash deposited into a mutually managed account for
the first installment of the acquisition of Century Dadi and Zhuolu
Dadi.




Financing
Activities




Net cash
provided by financing activities for the nine months ended September 30, 2010
was $18.36 MM, which is an increase of $13.14 MM from $5.22 MM during the
same period of 2009. This decrease was mainly due to the contribution
from the private placement consummated on September 14, 2010.





On
September 14, 2010, the Company entered into and consummated the sale of
securities pursuant to a Series C and Series D Convertible Preferred Stock
Securities Purchase Agreement (the “Securities Purchase Agreement”) with China
Hand Fund I, LLC (“China Hand”), providing for the sale to China Hand of (i)
18.73 shares of the Company’s Series C Convertible Preferred Stock (“Series C
Preferred Stock”), and (ii) 4 shares of the Company’s Series D Convertible
Preferred Stock (“Series D Preferred Stock”) for an aggregate purchase price of
$15,000,000 (the “Private Placement”). The proceeds of the Private Placement
will be used to finance the first installment of the purchase price due for the
acquisition by a wholly-owned subsidiary of the Company of (i) a 70% equity
interest in each of Beijing Century Dadi Gas Engineering Co., Ltd., a PRC
limited liability company (“Century Dadi”) and (ii) Zhoulu Dadi Gas Co. Ltd., a
PRC limited liability company (“Zhoulu Dadi”).


15




On
September 14, 2010, the Company entered into and consummated the sale to certain
accredited investors pursuant to Note Purchase Agreements (the “Note Purchase
Agreements”) of Convertible Notes due October 15, 2010 (the “Notes”) in the
aggregate principal amount of $3,000,000. The Notes pay no interest and in lieu
thereof, the Company will issue a total of 1.67 shares of Series C Preferred
Stock if the Notes are repaid before the maturity date of October 15, 2010 and
the value of Series Preferred Stock C was $1,034,314 and recorded as accrued
interest.  Such shares of Series C Preferred Stock would be
convertible into 9,430,508 shares of Common Stock. On October 15, 2010, the
Company agreed with the investors to extend the maturity date to December 31,
2010. If the Notes are not paid at maturity, they will convert automatically
into a total of 3.75 shares of Series C Preferred Stock. Such shares of Series C
Preferred Stock would be convertible into 21,176,291 shares of Common Stock. The
number of shares of Series C Preferred Stock issuable upon conversion of the
Notes is subject to adjustment for stock splits and similar events.





Capital
Expenditures, Contractual Obligations, Commitments and Contingences





For the
nine months ended September 30, 2010, the company spent about $38.35 MM in
capital expenditures which was mainly for the construction of gas pipelines, gas
station and acquisition. The company settled the payments according to the terms
of the contract and fulfilled its contractual obligations.  Other than
the operating leases stated in Note 24 to Unaudited Condensed Consolidated
Financial Statements, we have no other commitments and contingencies. As
disclosed in Note 24, the Company is obligated under operating leases to pay
minimum lease payments of approximately $0.23 MM.




Seasonality





Our
pipeline distribution networks are primarily located in northeastern China,
which is extremely cold during the winter months. Additionally, gas consumption
by residential customers is higher in the winter months for heating purposes,
and there is a corresponding increase in usage during winter. However, due to
the cold weather we are unable to construct primary gas pipelines.  If
a primary pipeline is already in place, we are able to connect new customers to
our distribution network during this time.





Effects
of Inflation





Our
business, revenues and operating results have not been affected in any material
way by inflation.





Off
Balance Sheet Arrangements





The
Company evaluated subsequent events through the time of filing this Quarterly
Report on Form 10-Q. No significant events occurred subsequent to the balance
sheet date but prior to the filing of this report that would have a material
impact on our Condensed Consolidated Financial Statements.




16





ITEM
3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK.





Not
Applicable.




ITEM
4.     CONTROLS AND PROCEDURES.





Evaluation of
Disclosure Controls and Procedures.





We
maintain “disclosure controls and procedures” (as defined in Rule 13a-15(e)
under the Exchange Act) that are designed to ensure that information that would
be required to be disclosed in Exchange Act reports is recorded, processed,
summarized and reported within the time period specified in the SEC’s rules and
forms, and that such information is accumulated and communicated to our
management, including to our Chief Executive Officer and Chief Financial
Officer, as appropriate, to allow timely decisions regarding required
disclosure.




As
required by Rule 13a-15 under the Exchange Act, our management, including Mr.
Yangkan Chong, our Chief Executive Officer and Mr. Eric Yu, our Chief Financial
Officer, evaluated the effectiveness of the design and operation of our
disclosure controls and procedures as of September 30, 2010.  Based on
that evaluation, Mr. Chong and Mr. Yu concluded that as of September 30, 2010,
and as of the date that the evaluation of the effectiveness of our disclosure
controls and procedures was completed, our disclosure controls and procedures
were effective and the following measurements have been deployed.





·
            We continue to arrange necessary
      training for our accounting department
  staff;





·
            We continue to engage external
      professional accounting or consultancy firms to assist us in the
      preparation of the US GAAP
accounts;





·
            We have established an effective
      internal audit function; through allocating financial and human resources
      to strengthen the internal control structure and we have been actively
      working with external consultants to assess our data collection, financial
      reporting, and control procedures and to strengthen our internal controls
      over financial reporting.




We
believe that the foregoing steps will strengthen our disclosure controls and
procedures, and we will continue to monitor the effectiveness of these steps and
make any changes that our management deems appropriate.




Changes
in Internal Controls.




Except as
described abovethere
were no changes in our internal control over financial reporting that occurred
during the fiscal quarter covered by this report that have materially affected,
or are reasonably likely to materially affect, our internal control over
financial reporting.




PART
II


OTHER
INFORMATION





ITEM
1.     LEGAL PROCEEDINGS.





From time
to time, we may become involved in various lawsuits and legal proceedings, which
arise, in the ordinary course of business. We are currently not aware of any
such legal proceedings or claims that we believe will have a material adverse
affect on our business, financial condition or operating results. However,
litigation is subject to inherent uncertainties, and an adverse result in these,
or other matters, may arise from time to time that may harm our
business.


17





ITEM
1A:  RISK FACTORS





Not
applicable.





ITEM
2:     UNREGISTERED SALES OF EQUITY SECURITIES
AND USE OF PROCEEDS





Not
applicable.





ITEM
3:     DEFAULTS UPON SENIOR
SECURITIES





Not
applicable.





ITEM
5:     OTHER INFORMATION





Not
applicable.





ITEM
6.     EXHIBITS.





The
following exhibits are filed as part of this report or incorporated by
reference:





Exhibit
      No.
                
                Description31.1
                
                Certifications
      of Principal Executive Officer filed pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
                
                Certifications
      of Principal Financial Officer filed pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32.1
                
                Certifications
      of Principal Executive Officer furnished pursuant to 18 U.S.C. Section
      1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.32.2
                
                Certifications
      of Principal Financial Officer furnished pursuant to 18 U.S.C. Section
      1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002.




18




SIGNATURES





In
accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.




Date:
      November 22, 2010
                  CHINA
      NEW ENERGY GROUP COMPANYBy:
                  /s/
      Yangkan ChongYangkan
      Chong, Chief Executive Officer(Principal
      Executive Officer)By:
                  /s/ Eric
      YuEric
      Yu, Chief Financial Officer(Principal
      Financial Officer and Principal
                    Accounting
      Officer)




19