UNITED STATES SECURITIES AND EXCHANGE
COMMISSION
 Washington, D.C.
20549
  
  Form 10-Q
  
  x
              QUARTERLY REPORTPURSUANT TOSECTION 13 OR 15 (d) OF THE
      SECURITIES EXCHANGE ACT OF
1934
  For the quarterly period endedMarch 31,
2009
  o
              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  
000-51006
  HARBIN ELECTRIC,
INC.
 (Exact name of registrant as specified
in its charter)
  Nevada
              98-0403396(State or other jurisdiction
      of
                incorporation or
      organization)
              (I.R.S.
      Employer
                Identification
      Number)
   
  No. 9 Ha Ping Xi Lu,
Ha Ping Lu Ji Zhong Qu
 Harbin Kai Fa Qu, Harbin,
People’s Republic of China
150060
 (Address of principal executive
offices)
  Telephone:
86-451-86116757
 (Issuer’s telephone
number)
  
 Indicate by check markwhether theregistrant(1)hasfiled all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934, during
thepast 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.
YesxNoo
  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).YesoNoo
 
 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 definition of“large accelerated filer,”“accelerated filer”and“smaller reporting company”in Rule 12b-2 of the Exchange
Act.
 
 Large accelerated
      filero
              Accelerated
      filerx
              Non-accelerated
      filero
 Smaller
reporting company o
 
 
 Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).
 YesoNox
 APPLICABLE ONLY TO CORPORATE
ISSUERS
  State the number of shares outstanding
of each of theissuer’s classes of common equity, as ofMay1, 2009: 22,102,078 shares of common stock, par
value $0.00001 per share.
  
 
 TABLE OF CONTENTS
  PagePart I. Financial
      InformationItem 1. Financial
      Statements
              1Consolidated Balance
      Sheets
                As ofMarch 31, 2009(Unaudited) and December 31,
      2008
              1Consolidated Statements of Income
      and Other Comprehensive Income
                For the Three Months EndedMarch31, 2009 and 2008(Unaudited)
              2Consolidated Statements of Shareholders’Equity
      (Unaudited)
              3Consolidated Statements of Cash
      Flows
                For theThreeMonths EndedMarch 31,2009and 2008(Unaudited)
              4Notes to the Consolidated
      Financial Statements (Unaudited)
              5Item 2. Management’s Discussion and Analysis of
      Financial Condition and Results of Operations
              33Item 3. Quantitative and
      Qualitative Disclosures About Market Risk
              39Item 4. Controls and
      Procedures
              39Part II. Other
      InformationItem 1. LegalProceedings
              39Item 1A. Risk
      Factors
              39Item 2. Unregistered Sales of
      Equity Securities and Use of Proceeds
              43Item 3. Defaults upon Senior
      Securities
              43Item 4. Submission of Matters to a
      Vote of Securities Holders
              43Item 5. Other
      Information
              44Item 6.
      Exhibits
              44Signatures
              45Index to
      Exhibits
              46







PART I. FINANCIAL INFORMATION
  Item 1. Financial Statements
(Unaudited)




HARBIN ELECTRIC, INC. AND SUBSIDIARIES








CONSOLIDATED
BALANCE SHEETS


AS OF
MARCH 31, 2009 AND DECEMBER 31, 2008





March
      31,
            
            
            December
      31,2009
            
            
            2008(Unaudited)ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
            
            $
            63,570,781
            
            
            $
            48,412,263Restricted
      cash
            
            
            -
            
            
            
            513,450Notes
      receivable
            
            
            95,642
            
            
            
            1,451,977Accounts
      receivable, net of allowance for doubtful accounts of
    $152,946and
      $153,155 as of March 31, 2009 and December 31, 2008,
      respectively
            
            
            20,132,666
            
            
            
            30,284,080Inventories
            
            
            18,679,403
            
            
            
            21,960,084Other
      receivables
            
            
            1,627,799
            
            
            
            248,552Advances
      on inventory purchases
            
            
            3,426,740
            
            
            
            3,529,607Total
      current assets
            
            
            107,533,031
            
            
            
            106,400,013PLANT
      AND EQUIPMENT, net
            
            
            97,670,800
            
            
            
            94,931,999OTHER
      ASSETS:Debt
      issuance costs, net
            
            
            1,536,669
            
            
            
            1,672,279Advances
      on equipment purchases
            
            
            10,401,987
            
            
            
            10,416,187Advances
      on intangible assets
            
            
            3,123,380
            
            
            
            1,892,430Goodwill
            
            
            12,273,778
            
            
            
            12,273,778Other
      intangible assets, net of accumulated amortization
            
            
            6,159,277
            
            
            
            6,430,397Other
      assets
            
            
            508,498
            
            
            
            471,220Deposit
      in derivative hedge
            
            
            1,000,000
            
            
            
            1,000,000Total
      other assets
            
            
            35,003,589
            
            
            
            34,156,291Total
      assets
            
            $
            240,207,420
            
            
            $
            235,488,303LIABILITIES AND
      SHAREHOLDERS' EQUITYCURRENT
      LIABILITIES:Notes
      payable - short term
            
            $
            -
            
            
            $
            1,026,900Accounts
      payable
            
            
            8,107,130
            
            
            
            8,415,919Short
      term loan - bank
            
            
            4,175,250
            
            
            
            4,180,950Other
      payables & accrued liabilities
            
            
            1,732,481
            
            
            
            2,789,792Customer
      deposits
            
            
            3,108,330
            
            
            
            1,244,622Taxes
      payable
            
            
            2,764,566
            
            
            
            2,096,521Interest
      payable
            
            
            195,970
            
            
            
            800,954Cross
      currency hedge payable
            
            
            108,513
            
            
            
            175,986Total
      current liabilities
            
            
            20,192,240
            
            
            
            20,731,644LONG
      TERM LIABILITIES:Amounts
      due to original shareholder
            
            
            732,500
            
            
            
            733,500Notes
      payable, net of debt discount of $11,266,520 and $12,389,135 as
      ofMarch
      31, 2009 and December 31, 2008, respectively
            
            
            32,733,480
            
            
            
            33,610,866Fair
      value of derivative instrument
            
            
            8,292,034
            
            
            
            5,762,958Warrant
      liabilities
            
            
            4,898,017
            
            
            
            -Total
      liabilities
            
            
            66,848,271
            
            
            
            60,838,968COMMITMENTS
      AND CONTINGENCIESSHAREHOLDERS'
      EQUITY:Common
      Stock, $0.00001 par value, 100,000,000 shares authorized,22,102,078
      and 22,102,078 shares issued and outstandingas
      of March 31, 2009 and December 31, 2008, respectively
            
            
            220
            
            
            
            220Paid-in-capital
            
            
            81,756,934
            
            
            
            95,029,290Retained
      earnings
            
            
            65,647,535
            
            
            
            52,100,479Statutory
      reserves
            
            
            15,823,552
            
            
            
            14,573,994Accumulated
      other comprehensive income
            
            
            10,130,908
            
            
            
            12,945,352Total
      shareholders' equity
            
            
            173,359,149
            
            
            
            174,649,335Total
      liabilities and shareholders' equity
            
            $
            240,207,420
            
            
            $
            235,488,303


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




-1-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME
 FOR THE
THREE MONTHS ENDED MARCH 31, 2009 AND 2008
 (Unaudited)
 
 Three
      Months Ended March 31,2009
              
              
              2008REVENUES
              
              $
              30,724,893
              
              
              $
              22,458,185COST
      OF SALES
              
              
              19,801,115
              
              
              
              11,698,708GROSS
      PROFIT
              
              
              10,923,778
              
              
              
              10,759,477RESEARCH
      AND DEVELOPMENT EXPENSE
              
              
              393,282
              
              
              
              97,695SELLING,
      GENERAL AND  ADMINISTRATIVE EXPENSES
              
              
              2,504,904
              
              
              
              2,025,959INCOME
      FROM OPERATIONS
              
              
              8,025,592
              
              
              
              8,635,823OTHER
      (INCOME) EXPENSE,
      NETOther
      (income) expenses, net
              
              
              (539,379
              )
              
              
              9,190Interest
      expense, net
              
              
              1,441,384
              
              
              
              2,282,780Change
      in fair value of warrants
              
              
              (2,573,421
              )
              
              
              -Total
      other (income) expense,  net
              
              
              (1,671,416
              )
              
              
              2,291,970INCOME
      BEFORE PROVISION FOR INCOME TAXES
              
              
              9,697,008
              
              
              
              6,343,853PROVISION
      FOR INCOME TAXES
              
              
              1,042,674
              
              
              
              990,617NET
      INCOME
              
              
              8,654,334
              
              
              
              5,353,236OTHER
      COMPREHENSIVE INCOME (LOSS)Foreign
      currency translation adjustment
              
              
              (285,368
              )
              
              
              5,307,825Change
      in fair value of derivative instrument
              
              
              (2,529,076
              )
              
              
              (4,493,886
              )COMPREHENSIVE
      INCOME
              
              $
              5,839,890
              
              
              $
              6,167,175EARNINGS
      PER SHARE:Basic
              
              $
              0.39
              
              
              $
              0.29Diluted
              
              $
              0.39
              
              
              $
              0.27WEIGHTED
      AVERAGE NUMBER OF SHARESBasic
              
              
              22,102,078
              
              
              
              18,209,978Diluted
              
              
              22,158,573
              
              
              
              19,952,721
  The
accompanying notes are an integral part of these consolidated
statements.
  -2-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF SHAREHOLDERS' EQUITY
 
 Common
      stock
              
              
              Additional
              
              
              Retained
      earnings
              
              
              Accumulated
      otherNumber
      of
              
              
              Par
              
              
              paid-in
              
              
              Unrestricted
              
              
              Statutory
              
              
              comprehensiveShares
              
              
              value
              
              
              capital
              
              
              earnings
              
              
              reserves
              
              
              income
      (loss)
              
              
              TotalBALANCE,
      January 1, 2008
              
              
              18,143,156
              
              
              $
              181
              
              
              $
              44,970,589
              
              
              $
              32,281,312
              
              
              $
              9,014,462
              
              
              $
              (1,649,969
              )
              
              $
              84,616,575Exercise
      of stock warrants at $3.50
              
              
              202,300
              
              
              
              2
              
              
              
              708,048
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              708,050Exercise
      of stock warrants at $3.10
              
              
              25,000
              
              
              
              -
              
              
              
              77,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              77,500Share-based
      compensation
              
              
              
              
              
              
              
              
              
              
              456,232
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              456,232Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,353,236
              
              
              
              
              
              
              
              
              
              
              
              5,353,236Adjustment
      to statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (990,617
              )
              
              
              990,617
              
              
              
              
              
              
              
              -Foreign
      currency translation gain
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,307,825
              
              
              
              5,307,825Net
      change related to cash flow hedge
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (4,493,886
              )
              
              
              (4,493,886
              )BALANCE,
      March 31, 2008 (Unaudited)
              
              
              18,370,456
              
              
              
              183
              
              
              
              46,212,369
              
              
              
              36,643,931
              
              
              
              10,005,079
              
              
              
              (836,030
              )
              
              
              92,025,532Exercise
      of stock warrants at $3.50
              
              
              119,998
              
              
              
              1
              
              
              
              419,992
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              419,993Non-cash
      exercise of stock options at $3.10
              
              
              11,624
              
              
              
              -
              
              
              
              -
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Exercise
      of stock warrants at $7.80
              
              
              100,000
              
              
              
              1
              
              
              
              779,999
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              780,000Stock
      issuance for cash at $14.13
              
              
              3,500,000
              
              
              
              35
              
              
              
              46,290,708
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              46,290,743Share-based
      compensation
              
              
              
              
              
              
              
              
              
              
              1,326,222
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,326,222Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              20,025,463
              
              
              
              
              
              
              
              
              
              
              
              20,025,463Adjustment
      to statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (4,568,915
              )
              
              
              4,568,915
              
              
              
              
              
              
              
              -Foreign
      currency translation gain
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,206,082
              
              
              
              4,206,082Net
      change related to cash flow hedge
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              9,575,300
              
              
              
              9,575,300BALANCE,
      December 31, 2008, as previously reported
              
              
              22,102,078
              
              
              
              220
              
              
              
              95,029,290
              
              
              
              52,100,479
              
              
              
              14,573,994
              
              
              
              12,945,352
              
              
              
              174,649,335Cumulative
      effect of reclassification of warrants
              
              
              
              
              
              
              
              
              
              
              (13,613,718
              )
              
              
              6,142,280
              
              
              
              
              
              
              
              
              
              
              
              (7,471,438
              )BALANCE,
      January 1, 2009, as adjusted
              
              
              22,102,078
              
              
              
              220
              
              
              
              81,415,572
              
              
              
              58,242,759
              
              
              
              14,573,994
              
              
              
              12,945,352
              
              
              
              167,177,897Share-based
      compensation
              
              
              
              
              
              
              
              
              
              
              341,362
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              341,362Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,654,334
              
              
              
              
              
              
              
              
              
              
              
              8,654,334Adjustment
      to statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,249,558
              )
              
              
              1,249,558
              
              
              
              
              
              
              
              -Foreign
      currency translation loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (285,368
              )
              
              
              (285,368
              )Net
      change related to cash flow hedge
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,529,076
              )
              
              
              (2,529,076
              )BALANCE,
      March 31, 2009 (Unaudited)
              
              
              22,102,078
              
              
              $
              220
              
              
              $
              81,756,934
              
              
              $
              65,647,535
              
              
              $
              15,823,552
              
              
              $
              10,130,908
              
              
              $
              173,359,149


-3-




HARBIN ELECTRIC, INC. AND SUBSIDIARIES
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 FOR THE
THREE MONTHS ENDED MARCH 31, 2009 AND 2008
 (Unaudited)
 
 Three
      Months Ended March 31,2009
              
              
              2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
              
              $
              8,654,334
              
              
              $
              5,353,236Adjustments
      to reconcile net income to cashprovided
      by (used in) operating activities:Depreciation
              
              
              667,780
              
              
              
              211,710Amortization
      of intangible assets
              
              
              292,927
              
              
              
              242,303Amortization
      of debt issuance costs
              
              
              135,610
              
              
              
              228,181Amortization
      of debt discount
              
              
              1,122,614
              
              
              
              1,343,929Loss
      (gain) on derivative instrument
              
              
              219,188
              
              
              
              (168,214
              )Share-based
      compensation
              
              
              341,362
              
              
              
              456,232Change
      in fair value of warrants
              
              
              (2,573,421
              )
              
              
              -Change
      in operating assets and liabilitiesNotes
      receivable
              
              
              1,354,449
              
              
              
              -Accounts
      receivable
              
              
              10,111,075
              
              
              
              (5,286,259
              )Inventories
              
              
              3,250,970
              
              
              
              120,299Other
      receivables
              
              
              (1,379,675
              )
              
              
              (815,265
              )Advances
      on inventory purchases
              
              
              98,070
              
              
              
              (877,424
              )Other
      assets
              
              
              (37,918
              )
              
              
              -Accounts
      payable
              
              
              (298,129
              )
              
              
              (139,993
              )Other
      payables & accrued liabilities
              
              
              (1,053,384
              )
              
              
              (1,191,355
              )Other
      payables - related party
              
              
              -
              
              
              
              (46,377
              )Customer
      deposits
              
              
              1,865,532
              
              
              
              (1,896
              )Taxes
      payable
              
              
              670,942
              
              
              
              879,686Interest
      payable
              
              
              (559,618
              )
              
              
              (868,177
              )Net
      cash provided by (used in) operating activities
              
              
              22,882,708
              
              
              
              (559,384
              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Cash
      deposit on acquisition
              
              
              -
              
              
              
              (698,850
              )Payment
      for advances on intangible assets
              
              
              (1,233,614
              )
              
              
              -Payment
      for advances on equipment purchases
              
              
              -
              
              
              
              (5,813,976
              )Purchase
      of intangible assets
              
              
              (30,555
              )
              
              
              (697,544
              )Purchases
      of plant and equipment
              
              
              (175,791
              )
              
              
              (2,164,933
              )Additions
      to construction in progress
              
              
              (3,360,011
              )
              
              
              -Net
      cash used in investing activities
              
              
              (4,799,971
              )
              
              
              (9,375,303
              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Decrease
      in restricted cash
              
              
              512,785
              
              
              
              -Proceeds
      received from conversion of warrants and options
              
              
              -
              
              
              
              785,548Payment
      of cross currency hedge
              
              
              (332,027
              )
              
              
              -Payment
      on notes payable
              
              
              (2,000,000
              )
              
              
              (2,000,000
              )Decrease
      of notes payable-short term
              
              
              (1,025,570
              )
              
              
              -Net
      cash used in financing activities
              
              
              (2,844,812
              )
              
              
              (1,214,452
              )EFFECTS
      OF EXCHANGE RATE CHANGE ON CASH
              
              
              (79,407
              )
              
              
              2,519,430INCREASE
      (DECREASE) IN CASH
              
              
              15,158,518
              
              
              
              (8,629,709
              )CASH
      AND CASH EQUIVALENTS, beginning of period
              
              
              48,412,263
              
              
              
              45,533,893CASH
      AND CASH EQUIVALENTS, end of period
              
              $
              63,570,781
              
              
              $
              36,904,184
 The
accompanying notes are an integral part of these consolidated
statements.




-4-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)




Note
1 – Organization and description of business


Harbin
Electric, Inc., (the “Company”), was incorporated in Nevada on July 9, 2003. The
Company through its indirect wholly-owned subsidiaries, Harbin Tech Full
Electric Co., Ltd. (“HTFE”) and Weihai Hengda Electric Motor (Group) Co., Ltd.
(“Hengda”), designs, develops, engineers, manufactures, sells and services a
wide array of electric motors including linear motors, specialty micro-motors,
and industrial rotary motors, with focus on innovation, creativity, and
value-added products. Products are sold in China and to the United States as
discussed further in Note 10.
 
 In
December 2006, the Company formed Shanghai Tech Full Electric Co., Ltd.
(“Shanghai Tech Full”), a wholly-owned subsidiary, to develop and manufacture
specialty micro-motors and their components and accessories.
  In April
2007, the Company entered into an Agreement with Shelton Technology, LLC
(“Shelton”), whereby the Company and Shelton agreed to work together
through  the Company’s newly formed, wholly-owned subsidiary, Advanced
Automation Group, LLC (“AAG”) to design, develop and manufacture custom
industrial automation controllers. The Company is required to invest a total of
$3 million in AAG while Shelton contributes an exclusive worldwide royalty-free
license for motorized automation technology. As of March 31, 2009, the Company
has contributed a total of $2.5 million to AAG. The remaining $500,000
contribution to AAG is to be made before June 30, 2009 pursuant to an amended
agreement between the Company and Shelton dated April 21, 2009.
 In July
2008, the Company’s subsidiary HTFE acquired Hengda for an aggregate price
of approximately $54.7 million (RMB 375 million) payable in cash. On March
27, 2008, HTFE deposited approximately $0.7 million (RMB 5 million)
toward the purchase price. The Company paid approximately $54.0 million (RMB 370
million) in 2008 and expects to pay the remaining investment balance of
$0.7 million (RMB 5 million) within two years from the Agreement (see Note
14).  Hengda manufactures and distributes various industrial rotary
motors such as high/low voltage motors, AC/DC motors and speed control
motors.
 In
October 2008, the Company, through AAG, formed Advanced Automation Group
Shanghai, Ltd. (“AAG Shanghai”), a wholly-owned subsidiary in China, to design,
develop, manufacture, sell and service custom industrial automation controllers
for linear motors. The registered capital is $1 million. The Company has
invested $500,000 in AAG Shanghai through March 31, 2009.
 
 Note
2 – Accounting policies
 
 Use of
estimates
 
 The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. For
example, the Company estimates the fair value of its derivative instrument using
the discounted cash flow method. The Company also estimates the fair value of
options using subjective assumptions including estimated length of time
employees will retain their options before exercising them, forfeitures, and
expected volatility of Company’s stock price over the expected term. Changes in
these assumptions materially affect the estimated fair value and the resulting
expense. Actual results could differ from management’s estimates.
  -5-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Management
has included all adjustments, consisting only of normal recurring adjustments,
considered necessary to give a fair presentation of operating results for the
periods presented. Interim results are not necessarily indicative of results for
a full year. The information included in this Form 10-Q should be read in
conjunction with information included in the 2008 annual report filed on Form
10-K.
 
 Basis of
presentation
 
 The
consolidated financial statements of Harbin Electric Inc. reflect the activities
of the following subsidiaries:
  Place
      incorporated
              Ownership
                percentageAdvanced
      Electric Motors, Inc. (“AEM”)
              Delaware,
      USA
              100%Harbin
      Tech Full Electric Co., Ltd.
              Harbin,
      China
              100%Advanced
      Automation Group, LLC
              Delaware,
      USA
              100%Advanced
      Automation Group Shanghai Co., Ltd.
              Shanghai,
      China
              100%Shanghai
      Tech Full Electric Co., Ltd.
              Shanghai,
      China
              100%Weihai
      Hengda Electric Motor (Group) Co. Ltd.
              Weihai,
      China
              100%
 
 The
accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of
America.  All material intercompany transactions and balances have
been eliminated in the consolidation.
  Since
Hengda was acquired in July 2008, its operating results are reflected in the
consolidated financial statements for the three months ended March 31, 2009 and
in the consolidated balance sheets as of December 31, 2008.
 
 Concentration of
risks
 
 The Company considers all highly liquid
investments with original maturities ofthree months or less at the time of
purchase to be cash equivalents, for cash flow statement
purposes.  Cash includes cash on hand and demand deposits in accounts
maintained with state owned banks within the People’s Republic of China (“PRC”) and the United States. The Company maintains
balances at financial institutions which, from time to time, may exceed Federal
Deposit Insurance Corporation insured limits for the banks located in the Unites
States. Balances at financial institutions or state owned banks within the PRC are not insured. As ofMarch 31, 2009
andDecember 31,2008, the Company had deposits in excess of
federally insured limits totaling$61,451,327and $47,783,767, respectively. The Company has not
experienced any losses in such accounts andbelieves it is not exposed to any
significant risks on its cash in bank accounts.
  -6-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 
 Three major customers accounted for
approximately38% of the net revenue for thethree monthsendedMarch 31, 2009, with each customer individually
accounting for15%,12%and11%, respectively.    AtMarch 31, 2009, the total receivable balance due from
these customers was $8,876,293, representing44% of total accounts
receivable.Five major
customers accounted for73% of the net revenue for thethree monthsendedMarch 31,2008, with each customer individually
accounting for22%,18%,16%,10% and7%, respectively. AtMarch 31, 2008, the total receivable balance due from
these customers was $24,204,386, representing82% of total accounts
receivable.
 
 Two major vendors provided approximately25% of the Company’s purchases of raw materials for thethree monthsendedMarch31, 2009, with each vendor individually
accounting for17% and8%, respectively. Fivemajorvendors provided79% of the Company’s purchase of raw materials
for thethree monthsendedMarch 31, 2008, with each vendor individually
accountingfor28%,22%,12%,10% and7%, respectively. The Company’s accounts payable to these
vendorswas $0and $0atMarch 31, 2009 and 2008, respectively.
 
 The Company's operations are carried out in the PRC.
Accordingly, the Company's business, financial condition and results of
operations may be influenced by the political, economic and legal environment in
the PRC, and by the general state of the PRC's economy. The Company's
operations in the PRC are subject to
specific considerations and significant risks not typically associated with
companies in the North America and Western Europe. These include risks
associated with, among others, the political, economic and legal
environments and foreign currency exchange. The
Company'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 other
things.
  Restricted
cash
 
 Restricted cash represent amounts set
aside by the Company in accordance with the Company’s debt agreements with certain financial
institutions.  These cash amounts are designated for the purpose of
paying downthe principal
amounts owed to the financial institutions, and these amounts are held at the
same financial institutions with which the Company has debt agreements in the
PRC.  Due to the short-term nature of the Company’s debt obligations to these banks,the corresponding restricted cash
balances have been classified as current in the consolidated balance
sheets.
  -7-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Accounts
receivable
 
 The Company’s business operations are conducted in
the PRC.  During the normal course of business, the Company extends
unsecured credit to its
customers.  Management reviews the composition of accounts
receivable and analyzes historical bad debts, customer concentrations, customer
credit worthiness, current economic trends and changes in customer payment
patterns to determineif the allowance for doubtful accounts is
adequate.  An estimate for doubtful accounts is made when collection
of the full amount is no longer probable.  Delinquent account balances
are written-offagainst allowance for doubtful accountsafter management
has determined that the
likelihood of collection is not probable.
 
 Inventories
 
 Inventory is composed of raw
materialsfor manufacturing electrical motors,
work in process and finished goods. Inventory is valued at the lower of cost or
market value using theweighted average method. Management compares the cost of inventory with the
market value and an allowance is made for writing down the inventory to its
market value, if lower than cost.
 
 Plant and
equipment
 
 Plant and equipment are
stated at cost. Expenditures for maintenance
and repairs are charged to earnings as incurred; additions, renewals and
betterments are capitalized. When assets are retired or otherwise disposed of,
the related cost and accumulated depreciation are removed from the respective
accounts, and any gain or
loss is included in operations. Depreciation of plant and equipment is provided
using the straight-line method for substantially all assets with estimated lives
as follows:
 
 Estimated Useful
      LifeBuildings
              20 yearsVehicle
              5 yearsOffice
      equipment
              5 yearsProduction
      equipment
              10
  years
 
 Construction in progress represents the
costs incurred in connection with the construction of buildings or new additions
to the Company’s plant facilities. No depreciation is
provided for construction
in progress until such time as the assets are completed and are placed into
service. Maintenance, repairs and minor renewals are charged directly to expense
as incurred. Major additions and betterment to buildings and equipment are
capitalized. Interest incurred during construction is
capitalized into construction in progress. All other interest is expensed as
incurred.
  -8-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
  The Company evaluates the carrying value
of long-lived assets in accordance with FAS 144 “Accounting for Impairment or Disposal of
Long Lived
Assets.”When estimated
cash flows generated by those assets are less than the carrying amounts of the
asset, the Company recognizes an impairment loss. Based on its review, the
Company believes that, as ofMarch31,2009there were no impairmentsof its long-lived
assets.
 
 Goodwill and other
intangible assets
 
 Goodwill–the excess of the cost of an acquired
entity over the net of the amounts assigned to assets acquired and liabilities
assumed shall be recognized as goodwill. In accordance with FAS 142, “Goodwill and Other Intangible
Assets”, goodwill is not
amortized.
 
 Land use rights - all land in the
People’s Republic of China is government
owned.However,
the government grants “land
use rights”.  The
Company has the right to use the land for 50 years and amortizes theright on a straight line basis over 50
years.
 
 Patents–capitalized patent costs represent
legal costs incurred to establish patents and the portion of the acquisition
price paid attributed to patents upon the assets acquisitiondate. Capitalized patent costs are amortized
on a straight-linebasisover the related patent terms generally
6 to 10 years.
 
 The Company evaluates intangible assets
for impairment, at least annually and whenever events or changes in
circumstances indicatethat
the carrying value may not be recoverable from its estimated future cash flows.
Recoverability of intangible assets, other long-lived assets, and goodwill is
measured by comparing their net book value to the related projected undiscounted
cash flowsfrom these assets, considering a number
of factors including past operating results, budgets, economic projections,
market trends and product development cycles. If the net book value of the asset
exceeds the related undiscounted cash flows, the asset isconsidered impaired, and a second test is
performed to measure the amount of impairment loss. As ofMarch 31,2009, management believes there was no
impairment.
 
 Stock-based
compensation
 
 The Company records stock-based compensation expense pursuant to
FAS 123R, “Accounting for Stock-Based
Compensation.”The Company estimates the fair value of
the award using the Black-Scholes Option Pricing Model. Under FAS 123R, the
Company’s expected volatility assumption is
based on the historical volatility of Company’s stock. The expected life assumption is
primarily based on the simplified method of the terms of the options. The
risk-free interest rate for the expected term of the option is based on the U.S.
Treasury yield curve in effect at the time of grant.
  -9-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The Company accounts for equity instruments
issued in exchange for the receipt of goods or services from other than
employees in accordance with SFAS 123R and the conclusions reached by EITF
96-18, “Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring or in
Conjunction with Selling Goods or Services.”Costs are measured at the estimated
fair market value of the consideration received or the estimated fair value of
the equity instruments issued, whichever is more reliably determinable. The value of equity instruments
issued for consideration other than employee services is determined on the
earlier of a performance commitment or completion of performance by the provider
of goods or services as defined by EITF 96-18.
 
 Stock compensation expense is recognized based on
awards expected to vest, and there were no estimated forfeitures as the Company
has a short history of issuing options. FAS 123R requires forfeitures to be
estimated at the time of grant and revised in subsequent periods, if necessary, if actual forfeitures
differ from those estimates.
 
 Revenue
recognition
 
 The Company's revenue recognition
policies are in accordance with Staff Accounting Bulletin (“SAB”) 104. Sales revenue is recognized at
the date of shipment to customers when a formal arrangement exists,
the price is fixed or determinable, the delivery is completed, no other
significant obligations of the Company exist and collectability is reasonably
assured. For products that are required to be examined by customers, sales revenue is recognized after the
customer examination is passed. Payments received before all of the relevant
criteria for revenue recognition are recorded as customer
deposits.
 
 In addition, revenue recognition could
be negatively impacted by returns. For linear motor and specialty
micro-motor businesses,products are custom products which are
customer specific, and no returns are allowed.The Companywarrantstheirproduct for repair, only in the event
of defects for two years from the date of shipmentandsuch costsare chargedto cost of goods sold. Forthenewly acquiredHengda’srotary motor business,theirproducts are standardized products and
returns are allowed within three days upon receipt of products by customers.Hengdaprovidesproductwarranty for repair one year from the
date of shipment.The returns and defects have not been
material. Should returns increase in the future it would be necessary to adjust
the estimates, in which case,recognition of revenues could be
delayed.
 
 Shippingand handling costs are included in
selling, general and administrative costs and totaled $464,363and $230,426for thethree monthsendedMarch31,2009and2008, respectively.
  -10-
 
 HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Income
taxes
 
 The Company reports income taxes
pursuant to FAS 109, "Accounting for Income Taxes," which
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been included in the financial
statements or tax returns. A tax position is recognized as a benefit only if it is “more likely than not”that the tax position would be
sustained in a tax examination, with a tax examination being presumed to occur.
The amount recognized is the largest amount of tax benefit that is greater than
50% likely of being realized on examination. For tax positions
not meeting the “more
likely than not”test, no
tax benefit is recorded.
 
 Under this method, deferred income taxes
are recognized for the tax consequences in future years of differences between
the tax bases of assetsand
liabilities and their financial reporting amounts at each period end based on
enacted tax laws and statutory tax rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established, whennecessary, to reduce deferred tax
assets to the amount expected to be realized.  There are no deferred
tax amounts atMarch31,2009, andDecember 31,2008, respectively.
 
 The charge for taxation is based on the
results for the reporting period as adjusted for items, which are non-assessable or
disallowed.  It is calculated using tax rates that have been enacted
or substantively enacted by the balance sheet date.
 
 The new Chinese Enterprise Income Tax
(“EIT”) law was effective on January 1, 2008.
Under thenew Income Tax
Laws of PRC, a company is generally subject to income tax at an effective rate
of 25% on income reported in the statutory financial statements after
appropriated tax adjustments. HTFE is located in a specially designated region
where HTFEis subject to a 10% EIT rate.Hengda is currently at a 25% income tax
rate.
 
 The Company’s subsidiaries were paying the following
tax rate for thethree
months ended:
 
 March
      31, 2009
                (Unaudited)
              
              
              March
      31, 2008
                (Unaudited)Subsidiaries
              
              Income
      Tax Exemption
              
              
              Effective
      Income Tax Rate
              
              
              Income
      Tax Exemption
              
              
              Effective
      Income Tax RateHarbin
      Tech Full Electric Co., Ltd.
              
              
              15
              %
              
              
              10
              %
              
              
              15
              %
              
              
              10
              %Weihai
      Hengda Electric Motor (Group) Co. Ltd.
              
              
              -
              %
              
              
              25
              %
              
              
              N/A
              (a)
              
              
              N/A
              (a)
 
 (a)
Hengda was acquired in July 2008 and its results of operations are not included
in the consolidated financial statements for the three months ended March 31,
2008.
  -11-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The following table reconciles the U.S.
statutory rates to the Company’s effective tax rate for thethree monthsended:
  March 31, 2009
              
              
              March 31,
    2008(Unaudited)
              
              
              (Unaudited)U.S. Statutory
      rates
              
              
              34.0
              %
              
              
              34.0
              %Foreign income not recognized in
      USA
              
              
              (34.0
              )
              
              
              (34.0
              )China income
      taxes
              
              
              25.0
              
              
              
              25.0China income tax
      exemption
              
              
              (14.1
              )
              
              
              (15.0
              )Other item (b)
              
              
              (0.1
              )
              
              
              5.6Effective income
      taxes
              
              
              10.8
              %
              
              
              15.6
              %
 
 (b)  The
(0.1) % and 5.6%  represents the ($131,072) and $3,537,382 of (income)
and expenses incurred by the Company, and its subsidiaries AEM and AAG that are
not subject to PRC income tax for the three months ended March 31, 2009 and
2008, respectively.
 
 The estimated tax savings for thethree months ended March
31, 2009 and2008amounted to $1,305,422and $1,485,926, respectively. The net effect on
earnings per share had the
income tax been applied would decreasebasicearnings per shareand diluted earnings per share by $0.06
and $0.06, respectively,for the three months ended March 31,
2009. For the three months ended March 31, 2008, the net effect on earnings per share had the income tax
been applied would decrease basic earnings per share and diluted earnings per
share by $0.08 and $0.07, respectively.
 
 Harbin Electric, Inc., Advanced Electric
Motors, Inc. and Advanced Automation Group, LLC wereorganizedin the United States and have incurred
net operating losses for income tax purposes for thethree monthsendedMarch31, 2009.  The net operating loss
carry forwards for United States income taxes amounted to $24,246,237 as of March 31,
2009which maybe available to reduce future
years’taxable income.  These carry
forwards will expire, if not utilized,beginning2024through 2029.  Management believes that
the realization of the benefits from these losses appears uncertain due to the
Company’s limitedoperating history and continuing losses
for United States income tax purposes.  Accordingly, the Company has
provided a 100% valuation allowance on the deferred tax asset benefit to reduce
the asset to zero.  The net change in the valuation allowance
forthethree monthsendedMarch31, 2009was an increase of approximately
$286,540. Management will review this valuation
allowance periodically and make adjustments accordingly.
 
 Value added
tax
 
 Sales revenue represents the invoiced
value of goods, net of avalue-added tax (“VAT”). All of the Company’s products that are sold in the PRC are
subject to a ChineseVATat a rate of 17% of the gross sales
price. This VAT may be offset by VAT paid by the Company on raw materials and
other materials included in thecost of producing their finished
product. The Company recorded VAT Payable and VAT receivable net of payments in
the financial statements. The VAT tax return is filed offsetting the payables
against the receivables.
  -12-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 VAT on sales and VAT on purchases
amounted to $5,986,746and $3,669,570for thethree monthsendedMarch31, 2009 and$3,213,074 and $1,800,380for the same period of 2008,respectively. Sales and purchases are
recorded net of VAT collected and paid as the Company acts as an agent for the
government.
 
 Taxes payable consisted of the
following:
 
 March 31,2009
              
              
              December 31, 2008(Unaudited)VAT tax
    payable
              
              $
              1,632,499
              
              
              $
              1,019,771Individual income tax
      payable
              
              
              5,035
              
              
              
              4,281Corporation income tax
      payable
              
              
              999,889
              
              
              
              956,583Others misc. tax
      payable
              
              
              127,143
              
              
              
              115,886Total
              
              $
              2,764,566
              
              
              $
              2,096,521
 
 Advertising
costs
 
 The Company expenses the cost of
advertising as incurred in selling, general and administrative costs. The
Company incurred $3,616 and
$0 for the three months ended March 31, 2009 and 2008,
respectively.
 
 Fair value of financial
instruments
 
 FAS 107, “DisclosuresAboutFair Value of Financial
Instruments”defines
financial instruments and requires fair value disclosureof applicable financial
instrumentsFAS 157,
“Fair Value
Measurements,”adopted January 1, 2008,defines fair value, establishes a
three-level valuation hierarchy for disclosures of fair value measurement and
enhances disclosure requirements for fair valuemeasures. The carrying amounts reported
in the balance sheets for currentreceivablesandpayablesqualify as financial
instruments.  Management concluded the
carrying valuesare a
reasonable estimate of fair value because of the short period of time
between the origination of
such instruments and their expected realization andif applicable,theirstated interest rate approximatescurrent ratesavailable. The three levels are defined as
follows:
 
 ·
              Level 1
              inputs to the valuation
      methodology are quoted prices (unadjusted) for identical
      assets or liabilities in active
markets.
 
 ·
              Level 2
              inputs to the valuation
      methodology include quoted prices for similar assets and liabilities in
      active markets, and inputs that are observable for the assets or
      liability, either
      directly or indirectly, for substantially the full term of the financial
      instruments.
 
 ·
              Level 3
              inputs to the valuation
      methodology are unobservable and significant to the fair
      value.
  -13-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The Company analyzes all financial
instruments with features of both liabilities and equity under FAS 150,
“Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and
Equity,”FAS 133,
“Accounting for Derivative
Instruments and Hedging Activities”and EITF 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock.”As ofMarch31, 2009, the outstanding principal on the
Company’s note payable, evaluated under these
accounting standards, amounted to $32,733,480.Management concluded thecarrying value of the note
isa reasonable estimate of
fair value becausethestated interest rate approximatescurrent ratesavailable.
 
 Effective January 1,
2009, theCompanyadopted the provisions of EITF 07-5,
"Determining Whether an Instrument (or Embedded Feature) is Indexed to an
Entity’s Own Stock”,which is effective for financial
statements for fiscal years beginning after December 15, 2008 and which replaced
the previous guidance on this topic in EITF 01-6.  Paragraph 11(a) of
FAS 133 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.  EITF 07-5 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 FAS 133 paragraph 11(a) scope exception.
 
 As a resultof adopting EITF 07-5, 2,030,158
warrants previously treated as equity pursuant to the derivative treatment
exemptionareno longer afforded equity
treatmentbecause
the strike price of the
warrants is denominated in US dollar, a currency other than the Company’s functional currency, the Chinese
Renminbi.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.
 
 As such, effective January 1, 2009,the Companyreclassified the fair value of these
warrants from equity to liability,as if these warrants were treated as a
derivative liability since their issuancein August2006. On January 1, 2009,the Companyreclassified from additional paid-in
capital, as a cumulative effect adjustment, $6.1million to beginningretained earnings and $7.5million to warrant liabilities to
recognize the fair value of such warrants.Thefair value of thewarrantswas$4.9million on March 31,
2009.Therefore,
the Companyrecognized a
$2.6million gain from the change in fair
value of these warrants for the three months ended March 31,
2009.
  -14-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 These common stock purchase warrants do
not trade in an active securities market, and as such, we
estimate the fair value of these warrants using the Black-ScholesOptionPricingModel using the following
assumptions:
 
 March 31,
    2009
              
              
              January 1,
    2009(Unaudited)Annual dividend
      yield
              
              
              -
              
              
              
              -Expected life (years)
              
              
              3.07
              
              
              
              3.32Risk-free interest
      rate
              
              
              1.2%
              
              
              
              1.1%Expected
      volatility
              
              
              74%
              
              
              
              69%
 
 Expected volatility is based primarily
on historical volatility. Historical volatility was computed using daily pricing
observations for recent periods that correspondto the term of the warrants. We believe
this method produces an estimate that is representative of our expectations of
future volatility over the expected term of these warrants. We have no reason to
believe future volatility over the expected remaining life of these warrants likely to differ
materially from historical volatility. The expected life is based on the
remaining term of the warrants. The risk-free interest rate is based on U.S.
Treasury securities according to the remaining term of the warrants.
 
 As ofMarch31, 2009, the Companycarries aderivative instrumentvalued at $8.3million. Management obtains the fair value of
the derivative instrument from a financial institution using Level 3 inputs
since there is no observable market price.
 
 Carrying
      Value as of
                March
      31, 2009
              
              Fair
      Value Measurements at March 31, 2009 Using Fair Value
      Hierarchy(Unaudited)
              
              Level
      1
              
              Level
      2
              
              
              Level
      3Derivative
      Hedge
              
              $
              8,292,034
              
              
              
              
              
              
              $
              8,292,034Fair
      value of warrant liabilities
              
              $
              4,898,017
              
              
              
              $
              4,898,017
 
 A discussion of the valuation techniques used to
measure fair value for the liabilities listed above and activity for these
liabilities for the three months ended March 31, 2009 is provided elsewhere in
this footnote and in Note 2 and Note 12.Other than the derivative instruments, the Company did not identify any
assets and liabilities that are required to be presented on the balance sheet at
fair value in accordance with FAS 157.
 
 Derivative
instrument
 
 Effective
January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, and amendment of FASB No. 133” (“SFAS 161”),
which amends and expands the disclosure requirements of SFAS 133 (“SFAS 133”).
SFAS 161 requires qualitative disclosures about objectives and strategies
for using derivatives and quantitative disclosures about the fair value of and
gains and losses on derivative instruments.
  The Company uses a cross currency
interest rate swap, a derivative financial instrument, to hedge
the risk of rising interest rates on their variable interest rate
debt.  This type of derivative financial instrument is known as a cash
flow hedge.  The Company accounts for this interest rate swap in
accordance withFAS 133 which requires the derivative
to be carried on the balance sheet at fair value and to meet certain documentary
and analytical requirements to qualify for hedge accounting treatment. The above
derivative qualifies for hedge accounting under FAS 133and, accordingly, changes in the fair
value is reported in accumulated other comprehensive income, net of related
income tax effects.  Amounts included in accumulated other
comprehensive income are reclassified into earnings when the hedged transaction
effects earnings.
  At the inception of the transaction, the
Company documents the relationship between hedging instruments and hedged items,
as well as its risk management objective and the strategy for undertaking
various hedge transactions. This process includes linking all derivatives
designated to specific firm commitments of forecast transactions. The Company
also documents its assessment, both at inception and on an ongoing basis, of
whether the derivative financial instruments that are used in hedgingtransactions are highly effective in
offsetting changes in fair values or cash f lows of hedged items. Any portion deemed
ineffective is recorded in earnings with the effective portion reflected in
accumulated other comprehensive.
  -15-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 
 Foreign currency
transactions
 
 The reporting currency of the Company is
the US dollar.  The functional currency is the Chinese Renminbi. The
financial statements of PRC subsidiaries are translated to United States dollars
using quarter-end exchange rates as to assets and liabilities and average exchange rates as to
revenues, expenses and cash flows.  Capital accounts are translated at
their historical exchange rates when the capital transaction
occurred.  Translation adjustments resulting from this process are
included in accumulated other comprehensive income in the
statement of shareholders’equity.  Transaction gains
and losses that arise from exchange rate fluctuations on transactions
denominated in a currency other than the functional currency are included in the
results ofoperations as
incurred.
 
 Translation adjustments resulting from
this process amounted toaloss of$285,368andagain of$5,307,825for thethree monthsendedMarch31, 2009 and2008, respectively.  The balance
sheet amounts with the exception of equity atMarch31, 2009were translated6.8259RMB to $1.00 as compared to7RMBatMarch31, 2008.  The equity accounts were
stated at their historical exchange rate.  The average translation
rates applied to the income and cash flow statement amounts for thethree monthsendedMarch31, 2009 and2008were6.8255RMBand7.10RMB to $1.00,
respectively.
  Transaction gains and losses that arise
from exchange rate fluctuations on transactions denominated in a currency other
than the functional currency are included in the results of operations as
incurred. Transaction loss of$292,309and $29,562were recognized duringthree monthsendedMarch31, 2009 and 2008. The amount has recorded in the
statement of operations during the period.
  -16-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Recent accounting
pronouncements
  In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". SFAS 162 is intended to improve financial reporting by identifying
a consistent framework, or hierarchy, for selecting accounting principles to be
used in preparing financial statements that are presented in conformity with
U.S. GAAP for nongovernmental entities. SFAS 162 is effective 60 days following
the SEC's approval of the Public Company Accounting Oversight Board amendments
to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles." The Company is in the process of evaluating the
impact of adoption of this statement on the results of operations, financial
position or cash flows.
 
 In June
2008, FASB issued EITF 08-4, “Transition Guidance for Conforming Changes to
Issue No. 98-5”. The objective of EITF 08-4 is to provide transition
guidance for conforming changes made to EITF 98-5, “Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios”, that result from EITF 00-27 “Application of Issue No. 98-5
to Certain Convertible Instruments”, and SFAS 150, “Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity”. This
Issue is effective for financial statements issued for fiscal years ending after
December 15, 2008. The adoption of EITF 08-4 did not have a material impact on
our financial position or results.
 
 On
October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” which clarifies
the application of SFAS 157 in a market that is not active and provides an
example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not active. FSP
157-3 became effective on October 10, 2008, and its adoption did not have a
material impact on our financial position or results.
 
 In April 2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume
and Level of Activity for the Asset or Liability Have Significantly Decreased
and Identifying Transactions That Are Not Orderly”(FSP FAS 157-4). FSP FAS 157-4 amends
SFAS 157 and provides additional guidance for estimating fair
value in accordance with SFAS 157 when the volume and level of activity for the
asset or liability have significantly decreased and also includes guidance on
identifying circumstances that indicate a transaction is notorderly for fair value measurements.
This FSP shall be applied prospectively with retrospective application not
permitted. This FSP shall be effective for interim and annual periods ending
after June 15, 2009, with early adoption permitted for periods
ending after March15, 2009. An entity early adopting this
FSP must also early adopt FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of
Other-Than-Temporary Impairments”(FSP FAS 115-2 and FAS 124-2).
Additionally, if an entity elects to early adopteither FSP FAS 107-1 and APB 28-1,
“Interim Disclosures about
Fair Value of Financial Instruments”(FSP FAS 107-1 and APB 28-1) or FSP FAS
115-2 and FAS 124-2, it must also elect to early adopt this FSP. We are
currently evaluating this new FSP but do notbelieve that it will have a significant
impact on the determination or reporting of our financial
results.
  -17-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 In April 2009, the FASB issued FSP FAS
115-2 and FAS 124-2. This FSP amends SFAS 115, “Accounting for Certain Investments in
Debt and Equity Securities,”SFAS 124, “Accounting for Certain Investments Held
by Not-for-Profit Organizations,”and EITF Issue No.99-20, “Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial
Assets,”to make the
other-than-temporary impairments guidance more operational and to improve the
presentation of other-than-temporary impairments in the financial statements.
This FSP will replace the existing requirement that the entity’s management assert it has both the
intent and ability to hold an impaired debt security until recovery with a
requirement that management assert it does not have the intent to sell the
security, and it is more likely than not it will nothave to sell the security before
recovery of its cost basis. This FSP provides increased disclosure about the
credit and noncredit components of impaired debt securities that are not
expected to be sold and also requires increased and more frequent
disclosures regarding expected cash flows,
credit losses, and an aging of securities with unrealized losses. Although this
FSP does not result in a change in the carrying amount of debt securities, it
does require that the portion of an other-than-temporary impairment not related to a credit loss for
a held-to-maturity security be recognized in a new category of other
comprehensive income and be amortized over the remaining life of the debt
security as an increase in the carrying value of the security. This FSPshall be effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for
periods ending after March 15, 2009. An entity may early adopt this FSP
only if it also elects to early adopt FSP FAS 157-4. Also, if an entityelects to early adopt either FSP FAS
157-4 or FSP FAS 107-1 and APB 28-1, the entity also is required to early adopt
this FSP. We are currently evaluating this new FSP but do not believe that it
will have a significant impact on the determination or reporting of our financial
results.
 
 In April 2009, the FASB issued FSP FAS
107-1 and APB 28-1. This FSP amends SFAS No.107, “Disclosures about Fair Value of
Financial Instruments,”to
require disclosures about fair value of financial instruments not measured
onthe balance sheet at
fair value in interim financial statements as well as in annual financial
statements. Prior to this FSP, fair values for these assets and liabilities were
only disclosed annually. This FSP applies to all financial instruments withinthe scope of SFAS 107 and requires all
entities to disclose the method(s) and significant assumptions used to estimate
the fair value of financial instruments. This FSP shall be effective for interim
periods ending after June 15, 2009, with early adoptionpermitted for periods ending after
March 15, 2009. An entity may early adopt this FSP only if it also elects
to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS 124-2. This FSP does not
require disclosures for earlier periods presented for comparative purposes at initial adoption. In periods
after initial adoption, this FSP requires comparative disclosures only for
periods ending after initial adoption. We are currently evaluating the
disclosure requirements of this new FSP.
  -18-
   HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Note
3 – Accounts receivable
 
 Accounts receivable consisted of the
followingat:
 
 March 31,2009
              
              
              December 31,2008(Unaudited)Trade accounts
      receivable
              
              $
              20,285,612
              
              
              $
              30,437,235Allowance for bad
      debts
              
              
              (152,946
              )
              
              
              (153,155
              )Trade accounts
      receivable,
      net
              
              $
              20,132,666
              
              
              $
              30,284,080
  The following table consists of
allowance for doubtful accounts.
  Allowance for doubtful accounts atJanuary1, 2008
              
              $
              116,238Additional
      reserves
              
              
              -Accounts receivable write
      off
              
              
              -Effect of foreign currency
      translation
              
              
              4,833Allowance for doubtful accounts atMarch31, 2008(Unaudited)
              
              
              121,071Additional
      reserves
              
              
              -Accounts receivable write
      off
              
              
              -Increase in allowance from
      acquisition of Hengda
              
              
              30,735Effect of foreign currency
      translation
              
              
              1,349Allowance for doubtful accounts at
      December 31, 2008
              
              
              153,155Additionalreserves
              
              
              -Accounts receivable write
      off
              
              
              -Effect of foreign currency
      translation
              
              
              (209
              )Allowance for doubtful accounts atMarch31, 2009(Unaudited)
              
              $
              152,946
 
 Note
4 – Inventories
 
 Inventories consist of the
followingat:
 
 March31,
              
              
              December31,2009
              
              
              2008(Unaudited)Raw and packing materials
              
              $
              2,719,747
              
              
              $
              2,702,417Work in
    process
              
              
              7,622,816
              
              
              
              7,978,350Finished
    goods
              
              
              8,336,840
              
              
              
              11,279,317Total
              
              $
              18,679,403
              
              
              $
              21,960,084
  -19-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Note
5 – Plant and equipment
 
 Plant and equipment consist of the
following
at:
 
 March 31,
              
              
              December
31,2009
              
              
              2008(Unaudited)Buildings
              
              $
              26,404,194
              
              
              $
              26,440,241Office
      equipment
              
              
              946,025
              
              
              
              925,372Production
      equipment
              
              
              8,037,600
              
              
              
              7,908,020Vehicles
              
              
              1,484,490
              
              
              
              1,472,593Construction in
      progress
              
              
              64,372,238
              
              
              
              61,095,712Total
              
              
              101,244,547
              
              
              
              97,841,938Less: accumulated
      depreciation
              
              
              (3,573,747
              )
              
              
              (2,909,939
              )Property and equipment,
      net
              
              $
              97,670,800
              
              
              $
              94,931,999
 
 Construction in progress represents
labor costs, material, capitalized interest incurred in connection with the
construction of the new plant facility in Shanghai and the construction and
installation of manufacturing equipment in Harbin(HTFE)manufactureplant.
  Depreciation expense for thethree monthsendedMarch31, 2009 and2008amounted to $667,780and $211,710, respectively.
 
 As ofMarch31, 2009andDecember 31, 2008, a total of $4,835,958and $3,634,014,of interest was capitalized into
construction in progress,
respectively.
  Note
6 – Goodwill and other intangible assets
 
 Net intangible assets consist of the
following at:
 
 March 31,
                2009
              
              
              December31,2008(Unaudited)Goodwill
              
              $
              12,273,778
              
              
              $
              12,273,778Land use rights
              
              
              1,541,102
              
              
              
              1,531,202Patents
              
              
              6,619,991
              
              
              
              6,629,028Less: accumulated
      amortization
              
              
              (2,001,816
              )
              
              
              (1,729,833
              )Intangible assets,
      net
              
              $
              18,433,055
              
              
              $
              18,704,175
 
 Amortization expense for thethree monthsendedMarch31, 2009 and2008amounted to $292,927and $242,303, respectively.
 
 Note
7 – Advance for intangible assets
 
 The advances for intangible assets
consisted of land use right prepayment. As ofMarch31, 2009 andDecember 31,2008, advances for intangible assets amounted to $3,123,380and $1,892,430, respectively.
 
 On September 8, 2006, HTFE entered into
an agreement ("Land Use Agreement") with Shanghai Lingang Investment and
Development Company Limited ("Shanghai Lingang") with respect to
HTFE’s use of 40,800 square meters of State-owned land in
the Shanghai Zhuqiao Airport Industrial Zone (the "Site").
  -20-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The term of the land use agreement is 50
years and the aggregate amount HTFE shall pay to Shanghai Lingang is
approximately $2.74 million ("Fee"),92% or $2,713,180has been paid with the balance payable
upon Shanghai Lingang's completion of certain regulatory applications on behalf
of HTFE. The balance of the Fee is payable within seven daysof receipt of a regulatory permit for
work commencement. The Site will be used for industrial purposes. The
Land Use Agreement requires HTFE to invest approximately $16.5 million in the
site through December 2008. This investment amount includes fees, improvement
costs, constructing a factory building and installing necessary equipment. HTFE shall register a
Sino-foreign joint venture company at the location of Shanghai Lingang, with
taxes payable at the same location. HTFE has agreed to compensate Shanghai
Lingang for certain local taxes due to the local tax authority inconnection with applicable tax generation
requirements. As ofMarch31, 2009, the applicationforthe regulatory permit for the land use
is still in process.
 
 Note
8 – Advances to suppliers
 
 The Company makes advances to certain
vendors for inventory purchases and construction projects. The
advances on inventory purchases were $3,426,740and $3,529,607as ofMarch31, 2009 andDecember 31,2008,respectively. Additionally, the Company
made advances on equipment purchases amounted to $10,401,987and $10,416,187as ofMarch31, 2009 andDecember 31,2008,respectively.
 
 Note
9 – Other assets
 
 Other assets consist of the
followingat:
 
 March 31,2009
              
              
              December31,2008(Unaudited)Research and development
      prepayment
              
              $
              406,860
              
              
              $
              407,415Deferred expenses & other
      assets
              
              
              101,638
              
              
              
              63,805Total
              
              $
              508,498
              
              
              $
              471,220
 
 On August 21, 2006, HTFE entered into a
joint research and development agreement (the “R&D Agreement”) with the Institute of Electrical
Engineering of the Chinese
Academy of Sciences (“IEECAS”) to produce a train system to be tested
at the Beijing Airport railway line in the People’s Republic of China (“PRC”) in 2009. The Agreement provides that
the term of the project shall commence on August 2006 and terminate in the second half of
2009.
 
 The R&D Agreement provides for a
budget of approximately $3.65 million (RMB 25 million), consisting of $2.19
million (RMB 15 million) to be invested by HTFE and the remainder to be invested
by IEECAS.Of
this amount, approximately
$1.46 million (RMB 10 million) has been invested to date by HTFE. The balance of
approximately $0.73 million (RMB 5 million) will be invested in 2009 as testing
and evaluation occurs. The Company has started to amortize the R&D
prepayment based onthe progress of the project. A total of
$1,058,140has been amortized and netted with
R&D prepayment to the amount of $406,860.
  -21-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 
 The research and development prepayment
is being expensed based on the service incurred pursuant to FAS 2 and EITF 07-3.
A total of $393,282and $97,695have been expensed as research and
development for thethree
monthsendedMarch31, 2009 and2008, respectively.
 
 Note
10 – Additional product sales information
 
 The Company has a single operating
segment. The majority of the Company’s revenuewas generated from local sales.
Summarized financial information concerning the Company’s revenues based on geographic areas for
thethree
monthsendedis as follows:
 
 March 31,2009
              
              
              March 31,2008(Unaudited)
              
              
              (Unaudited)Geographic AreaChina
              
              $
              27,463,006
              
              
              $
              18,653,559International
              
              
              3,261,887
              
              
              
              3,804,626Total sales
              
              
              30,724,893
              
              
              
              22,458,185Cost of sales -
      China
              
              
              18,001,310
              
              
              
              9,805,358Cost of sales -
      International
              
              
              1,799,805
              
              
              
              1,893,350Total cost of
      sales
              
              
              19,801,115
              
              
              
              11,698,708Gross
profit
              
              $
              10,923,778
              
              
              $
              10,759,477
 
 Note
11 – Financing
 
 On August 29, 2006, the Company, Citadel
Equity Fund Ltd. (“Citadel”) and Merrill Lynch International (“Merrill Lynch”and, together with Citadel, the
“Investors”) entered a purchase agreement (the
“Purchase
Agreement”) relating to the
purchase and sale of (a) $50 million aggregate principal amount of the Company's
Guaranteed Senior SecuredFloating Rate Notes (collectively, the
“Notes”) and (b) fully detachable warrants (the
“Warrants”) to purchase an aggregate of 3,487,368
shares of our common stock. The transaction closed on August 30,
2006.
 
 The Notes are governed by an indenture,
datedAugust 30, 2006,
entered into among the Company,AEMas guarantor, and The Bank of New York,
as trustee for the Notes (the “Indenture”). Of the $50 million aggregate
principal amount of the Notes, Citadel subscribed to $38 million of the
principal amount of the
Notes, which mature on September 1, 2012 (the “2012 Notes”), and Merrill Lynch subscribed to $12
million of the principal amount of the Notes, which mature on September 1, 2010
(the “2010
Notes”). Pursuant to the
indenture, AEM has agreed, and all ofthe Company’s other existing and future subsidiaries
(other than subsidiaries domiciled in the People's Republic of China) are
obligated, to guarantee, on a senior secured basis, to the Investors and to the
trustee the payment and performance of our obligationsunder the Notes.
  -22-
 
 The 2010 Notes bear interest, payable
semi-annually in arrears commencing March 1, 2007, at a rate equal to LIBOR
(approximately1.80%atMarch 31, 2009 and3.11%atDecember 31, 2008), plus 4.75%. The 2010
Notes bear an additional 4%
interest on any overdue principal and premium, if any, including interest on
overdue interest, to the extent permitted by law.
  The 2010 Notes are redeemable at the
option of the Company, in whole but not in part, at any time after September 1,
2007, initially at 106% of
the principal amount thereof and declining to 100% of the principal amount on
September 1, 2009. The 2010 Notes are subject to mandatory redemption
semi-annually commencing March 1, 2008 in the principal amount of $2,000,000 at
a price equal to 100% of such principal
amount.
 
 The 2012 Notes bear interest, payable
semi-annually in arrears commencing March 1, 2007, at a rate equal to LIBOR plus
3.35%. See below for discussion of swap agreement changing the variable interest
to a 7.2% RMB fixed rate.
The 2012 Notes bear an additional 4% interest on any overdue principal and
premium, if any, including interest on overdue interest, to the extent permitted
by law. The 2012 Notes are redeemable at the option of the Company, in whole but
notin part, at any time after September 1,
2007, initially at 106% of the principal amount thereof and declining to 100% of
the principal amount on September 1, 2011. The 2012 Notes are subject to
mandatory redemption semi-annually commencing September 1, 2009 in the principal amount $2,400,000 on
September 1, 2009, $3,800,000 on March 1, 2010, $9,900,000 on September 1, 2010
and March 1, 2011, and $4,000,000 on September 1, 2011, March 1, 2012 and
September 1, 2012, in each instance at a price equal to 100%of such principal amount. Holders of the
2012 Notes may require the Company to repurchase such Notes at 100% of the
principal amount thereof at any time after September 1,
2011.
 
 Upon a Change of Control (as defined in
the indenture), holders of the Notes may require the Company to repurchase any
or all such Notes at a price equal to 102.5% of the principal amount thereof.
The Company is required to offer to purchase Notes at a price equal to 100% of
the principal amount thereof with the proceeds of certainasset sales. As security for the Notes,
the Company and The Bank of New York, as collateral agent, entered into a share
pledge agreement, dated August 30, 2006, to secure the Notes with all of the
shares of AEM common stock held by the Company as collateral.
 
 The following table disclosed the
combined aggregate amounts of maturities for all long-term borrowings disclosed
for each of the five years followingMarch31, 2009:
 
 Contractual
      Obligations
              
              2012 Notes
              
              
              2010 Notes
              
              
              Total2009
              
              $
              2,400,000
              
              
              $
              2,000,000
              
              
              $
              4,400,0002010
              
              
              13,700,000
              
              
              
              4,000,000
              
              
              
              17,700,0002011
              
              
              13,900,000
              
              
              
              -
              
              
              
              13,900,0002012
              
              
              8,000,000
              
              
              
              -
              
              
              
              8,000,000Thereafter
              
              
              -
              
              
              
              -
              
              
              
              -Total
              
              $
              38,000,000
              
              
              $
              6,000,000
              
              
              $
              44,000,000
  -23-
 HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 
 The Warrants are governed by a warrant
agreement, dated August 30, 2006, between AEM and The Bank of New York, as
warrant agent. The Warrants consist of (i) six-year warrants to purchase an
aggregate of 2,192,308 shares of our common stock, at an exercise price of $7.80
per share (the “First
Tranche 2012 Warrants”),
(ii) six-year warrants to purchase an aggregate of 525,830 shares of our common
stock at an exercise price of $10.84 per share (the “Second Tranche 2012
Warrants”) and(iii) three-year warrants to purchase an
aggregate of 769,230 shares of our common stock at an exercise price of $7.80
per share (the “2009
Warrants”).
 
 The First Tranche 2012 Warrants and the
Second Tranche 2012 Warrants were issued to Citadel, and the 2009 Warrants were issued to
MerrillLynch. Each Warrant is exercisable at the
option of the Warrant holder at any time through the maturity date of such
Warrant.
 
 The warrant agreements contain a
cashless exercise provision.  During thethree monthsendedMarch31, 2009and 2008, no warrants were converted to common
stock by cashless transaction.
 
 The fair value of the warrants upon
issuance totaled $22,921,113, was treated as a discount on the carrying value of
the debt, and is being amortized over the lifeof the loan using the effective
interest method.A total of$1,122,614 and $1,343,929were amortized to interest expense for
thethree
monthsendedMarch31, 2009 and2008, respectively. The carrying value of
the debt is as follows at:
 March 31,2009
              
              
              December31,2008(Unaudited)Principal
      amount
              
              $
              44,000,000
              
              
              
              46,000,000Less unamortized
      discount
              
              
              (11,266,520
              )
              $
              
              (12,389,134
              )Long-term debt, net of unamortized
      discount
              
              $
              32,733,480
              
              $
              
              33,610,866
 
 Debt issuancecosts, initially $2,954,625, are carried
in other assets and are amortized over the life of the loan using the effective
interest method. $135,610and $228,181were amortized to interest expense for
thethree
monthsendedMarch31, 2009 and2008, respectively. As ofMarch31, 2009andDecember 31,2008, unamortized debt issuance costs
totaled $1,536,669and $1,672,279, respectively.
  -24-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
  The Company has short term loan which is
purchased during acquisition of new subsidiary Hengda,amountingas followsat:
  March31, 2009
              
              
              December31, 2008(Unaudited)Loan from Agriculture Bank in city
      of Wendeng, due October 2009. Monthly interest-only payments at 8.360% per
      annum, secured by buildings
              
              $
              3,003,250
              
              
              $
              3,007,350Loan from Commercial Bank in city of Wendeng, due
      September 2009. Monthly interest-only payments at 8.964% per annum,
      secured by buildings
              
              
              1,172,000
              
              
              
              1,173,600Short term loan -
      bank
              
              $
              4,175,250
              
              
              $
              4,180,950
  Net interest expense for thethree monthsendedMarch31, 2009 and2008was comprised of the
following:
 
 2009
              
              
              2008(Unaudited)
              
              
              (Unaudited)Amortization of debt
      discount
              
              $
              1,122,614
              
              
              $
              1,343,929Amortization of debt issuance
      costs
              
              
              135,610
              
              
              
              228,181Interest expense
              
              
              203,858
              
              
              
              1,093,629Interest earned on cash
      deposits
              
              
              (198,847
              )
              
              
              (214,745
              )Interest expense (income) on
      derivative instrument
              
              
              178,149
              
              
              
              (168,214
              )Interest expense,
      net
              
              $
              1,441,384
              
              
              $
              2,282,780
 
 Note
12 – Derivative instrument
 
 The Company's operations are exposed to
a variety of global market risks, including the effect of changing currency
exchange ratesand interest rates.
These exposures are managed, in part, with the use of a financial
derivative. The Company
uses financial derivatives only to hedge exposures in the ordinary course of
business and dose not invest in derivative instruments for speculative
purposes.
 
 Effective April 17, 2007, the Company
entered into a cross currency interest rate swap agreement with Merrill Lynch exchanging the
LIBOR plus 3.35% variable rate interest payable on the $38 million principle
amount or 2012 Notes for a 7.2% (3.6% semi-annually) RMB fixed rate
interest.  The agreement requires semi-annual payments on March 1
andSeptember 1 through the maturity of the
agreement on September 1, 2012.  Merrill Lynch required the Company to
deposit $1,000,000 with them to secure the agreement.  The deposit may
be increased to $2,500,000 if the exchange rate for Renminbi to USD
fallsbelow 6.5, and to $4,000,000 if the
exchange rate falls below 5.5. This swap is designated and qualified as a cash
flow hedge.
 
 The fair value of this swap agreementatApril 02, 2007 (inception date) was a
payable of $5,387,487, and atMarch31, 2009andDecember 31,2008, was a payable of $8,292,034and $5,762,958, respectively.Changes in the fair values of derivative
instruments accounted for as cash flow hedges, to the extent they qualify for
hedge accounting, are recorded in accumulated other comprehensive income.For the three months ended March 31,
2009 and 2008, there were no amounts recorded in the consolidated statements of
income in relation to ineffectiveness of this interest swap. Accordingly,
for thethree monthsendedMarch31, 2009 and2008,$2,529,076 and $4,493,886was recorded aslosson the derivative instrument,
respectively, in other comprehensive income (loss).
  -25-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 
 During thethree monthsendedMarch31, 2009, the Company paid $110,676as hedging payment and Company
recognized $178,149,which was recorded as a loss from
derivative transactions.During thethree monthsendedMarch31, 2008, the Company recognized $168,214, which was recorded as a gain from
derivative transactions.
 
 Changes of cross currency hedge are as
follows:
 
 Crosscurrency hedgepayablebalance atDecember31, 2008
              
              $
              175,986Proceeds from cross currency
      hedge
              
              
              -Payments for cross currency
      hedge
              
              
              110,676Loss from derivative
      transactions
              
              
              (178,149
              )Cross currency hedge payable
      balance atMarch31, 2009(Unaudited)
              
              $
              108,513
 
 Note
13 – Other expenses and income, net
 
 Other income and expense consist of the
following:
  For the three months
      ended
              
              March 31,2009
              
              
              March 31,2008(Unaudited)
              
              
              (Unaudited)Interest
      expense
              
              $
              89,698
              
              
              $
              1,064,067Interest
    income
              
              
              (198,847
              )
              
              
              (382,959
              )Amortization of debt
      discount
              
              
              1,122,614
              
              
              
              1,343,929Amortization of debt issuance
      cost
              
              
              135,610
              
              
              
              228,181Other non-operating
      income
              
              
              (579,691
              )
              
              
              (21,606
              )Other non-operating
      expense
              
              
              40,312
              
              
              
              30,796Change in fair value of
      warrants
              
              
              (2,573,421
              )
              
              
              -Foreign currency transaction
      loss
              
              
              292,309
              
              
              
              29,562Total other(income)expense,
net
              
              $
              (1,671,416
              )
              
              $
              2,291,970
 
 Note
14 – Business combinations
 
 On July 10, 2008, the
Company’s subsidiary HTFE entered into an Equity
and Assets Transfer Agreement (the “Agreement”) with respect to the acquisition by
HTFE of Weihai Hengda Electric Motor (Group) Co. Ltd., a PRC corporation (“Hengda”) for an aggregate price of
approximately $54.7 million (RMB 375 million),payable in cash. The results of
operations of the acquired companies are included in the consolidated statement
of incomefor the three
monthsendedMarch31, 2009.
 
 Amounts due to original shareholders
represent the unpaid portion for the acquisition of Hengda (see Note 1 for the
acquisition). As ofMarch31, 2009, HTFE had payables of $732,500 (RMB 5 million), which will be paid
within two years from the acquisition date.
  -26-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The following table summarizes the net
book value and the fair value of the assets acquired and liabilities assumed at
the date of acquisition:
 
 Net Book
              
              
              Fair ValueCurrent
    assets
              
              $
              43,572,481
              
              
              $
              43,572,481Property,plant and equipment,
      net
              
              
              22,350,703
              
              
              
              22,350,703Other non current
      assets
              
              
              1,201,828
              
              
              
              1,201,828Goodwill
              
              
              -
              
              
              
              12,273,778Total
assets
              
              
              67,125,012
              
              
              
              79,398,790Total
      liabilities
              
              
              24,590,248
              
              
              
              24,590,248Net assets
              
              $
              42,534,764
              
              
              $
              54,808,542
 
 Based on an evaluation by an independent
appraisal and final asset evaluation by the management, the purchase price exceeded the fair
value of Hengda’s net assets by $12.3 million, which was
recognized as goodwill,
pursuant to FAS
141.
 
 Pro Forma
 
 The following unaudited pro forma
condensed income statement for thethree monthsendedMarch31,2008,wasprepared under generally accepted
accounting principles,as if the acquisition of Hengda had
occurredthe
first day of the respective
periods.The consolidated income statement for
the three months ended March 31, 2009 already includes the results from
Hengdasince the
acquisition closed in July 2008.The pro forma information may not be
indicative of the resultsthat actually would have occurred if the
acquisition had been in effect from and on the date
indicated.
  March 31,2009
              
              
              March 31,2008(Unaudited)
              
              
              (Unaudited)Sales
              
              $
              30,724,893
              
              
              $
              33,056,581Cost of Goods
      Sold
              
              
              19,801,115
              
              
              
              20,716,313Gross
Profit
              
              
              10,923,778
              
              
              
              12,340,268Operating
      Expenses
              
              
              2,898,186
              
              
              
              2,491,104Income from
      Operations
              
              
              8,025,592
              
              
              
              9,849,164Other expense(Income), net
              
              
              (1,671,416
              )
              
              
              1,987,170Income Tax
              
              
              1,042,674
              
              
              
              1,370,875Net Income
              
              $
              8,654,334
              
              
              $
              6,491,119
 
 Note
15 – Commitments and contingencies
 
 The Company enters into non-cancelable
purchase commitments with its vendors. As ofMarch31, 2009 andDecember 31,2008, the Company was obligated under the
non-cancelable commitments to purchase
materials totaling to
$1,341,274and $305,100, respectively.  These
commitments are short-term and expire within one year.  The Company
has experienced no losses on these purchase commitments over the
years.
  As discussed in more detail in Note 1,
the Company entered into an
agreement with Shelton Technology, LLC on April 9, 2007.  Under the
terms of the agreement, the Companyis required to contribute a total of $3
million in installments to AAG by March 31, 2009.  The Company has
invested a total of $2.5 million to AAG as of March 31, 2009 andhastheremaining $500,000to be invested.  Based upon a
mutual agreement, the Company will contribute the remaining $500,000 to AAGat alaterdateaccording toactual needs.
  -27-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 As discussed in Note 12, the Company entered into a swap agreement that required
a $1,000,000 deposit to secure the transaction.  If the exchange rate
for Renminbi to US Dollars drops below certain levels, the Company will be
required to deposit up to $4,000,000.
 
 As discussed in Note 11, the 2010 Notes are subject to mandatory
redemption semi-annually commencing March 1, 2008 in the principal amount
$2,000,000 at price equal to 100% of such principal amount. The 2012 Notes are
subject to mandatory redemption semi-annually commencing September 1,2009 in the principal amount $2,400,000
on September 1, 2009, $3,800,000 on March 1, 2010, $9,900,000 on September 1,
2010 and March 1, 2011, and $4,000,000 on September 1, 2011, March 1, 2012 and
September 1, 2012, in each instance at price equal to 100%of such principal amount. Holders of
the 2012 Notes may require the Company to repurchase such Notes at 100% of the
principal amount thereof at any time after September 1,
2011.
 
 On September 8, 2006, HTFE entered into
an agreement (“Land Use
Agreement”)with Shanghai Lingang Investment and
Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters
of State-owned land in the Shanghai Zhuqiao Airport Industrial Zone (the
“Site”). The term of the Land Use
Agreement is 50 years and totaled
$2.96million (RMB 20.2 million of“Fee”),92% or $2.7million (RMB18.5million) of which has been paid with
the balance payable upon Shanghai Lingang’s completion of certain regulatory
applications on behalf of HTFE. The amount paid is recorded as advances on
intangible assets for $2,713,180and $1,481,670as ofMarch31,2009andDecember 31, 2008, respectively. Theremainingbalance of the Fee is payable within
seven days of receipt of a regulatory permit for work commencement. As ofMarch31,2009, the application of the regulatory
permit for the land use is still in process.
  -28-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 Note
16 – Earnings per share
 
 The Company reports earnings per share
in accordance with the provisions of FAS 128, “Earnings Per
Share.”FAS 128
requires presentation of
basic and diluted earnings per share in conjunction with the disclosure of the
methodology used in computing such earnings per share.  Basic earnings
per share excludes dilution and is computed by dividing income available to
commonstockholders by the weighted average
common shares outstanding during the period. Diluted earnings per share takes
into account the potential dilution that could occur if securities or other
contracts to issue common stock were exercised and converted into common stock. The following is a
reconciliation of the basic and diluted earnings per share
computations:
 
 For theThree MonthsendedMarch31:
              
              2009
              
              
              2008(Unaudited)
              
              
              (Unaudited)Net income for basic and
      diluted   earnings per share
              
              $
              8,654,334
              
              
              $
              5,353,236Weighted average shares used in
      basic computation
              
              
              22,102,078
              
              
              
              18,209,978Diluted effect of stock options
      and warrants
              
              
              56,495
              
              
              
              1,742,743Weighted average shares used in
      diluted computation
              
              
              22,158,573
              
              
              
              19,952,721Earnings per
      share:Basic
              
              $
              0.39
              
              
              $
              0.29Diluted
              
              $
              0.39
              
              
              $
              0.27
 
 AtMarch31, 2009, a total of559,583 options and 2,030,158 warrantswere excluded fromdiluted earnings per share due to the
anti-dilutive effect. All other stock options and warrants have been included in
the diluted earnings per share calculation for thethree monthsendedMarch31,2009.At March 31, 2008, all outstanding
stock options and warrants
have been included in the diluted earnings per share calculation for the three
months ended March 31, 2008.
 
 Note
17 – Shareholders’ equity
 
 Statutory
reserves
 
 The laws and regulations of the
People’s Republic of China require that before
aSino-foreign cooperative
joint venture enterprise distributes profits to its partners, it must first
satisfy all tax liabilities, provide for losses in previous years, and make
allocations in proportions determined at the discretion of the board of
directors, after the statutory
reserve.
 
 Surplus
reserve fund
 
 The Company is required to transfer 10%
of its net income, as determined in accordance with the PRC accounting rules and
regulations, to a statutory surplus reserve fund until such reserve balance
reaches 50% of the
Company’s registered capital.The transfer to this reserve must be
made before distribution of any dividend to shareholders. TheCompanywill transfer at year end 10% of the
year’s net income determined in accordance
with PRC accounting rules
and regulations.
 
 For thethree months ended March31, 2009, the Company transferred $1,249,558representing10% of thecurrent quarter’snet incomegenerated by the Company’s subsidiaries located within
PRCdetermined in
accordance with PRC accounting rulesand regulations, to this
reserve.Theremaining reserve to fulfill the 50%
registered capital requirement amounted to approximately $24.1 million and $25.4
millionas of March 31,
2009 and December 31, 2008,
respectively.
  -29-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
 The surplus reserve fund is
non-distributable other
than during liquidation and can be used to fund previous years’losses, if any, and may be utilized for
business expansion or converted into share capital by issuing new shares to
existing shareholders in proportion to their shareholding or by
increasing the par value of the shares currently
held by them, provided that the remaining reserve balance after such issue is
not less than 25% of the registered capital.
  Warrants
 
 Following is a summary of warrant
activity:
 
 Outstanding as of January 1,
      2008
              
              
              2,454,960Granted
              
              
              -Forfeited
              
              
              -Exercised
              
              
              (202,300
              )Outstanding as ofMarch31, 2008(Unaudited)
              
              
              2,252,660Granted
              
              
              -Forfeited
              
              
              (2,504
              )Exercised
              
              
              (219,998
              )Outstanding as of December 31,
      2008
              
              
              2,030,158Granted
              
              
              -Forfeited
              
              
              -Exercised
              
              
              -Outstanding as ofMarch31, 2009(Unaudited)
              
              
              2,030,158
 
 Following is a summary of the status of
warrants outstanding atMarch31, 2009(Unaudited):
  Outstanding
      Warrants
              
              
              Exercisable WarrantsExercise
    Price
              
              
              Numberof Shares
              
              
              Average Remaining Contractual
      Life
              
              
              Average
                Exercise
    Price
              
              
              Numberof Shares
              
              
              Average Remaining Contractual
      Life$
              10.84
              
              
              
              366,697
              
              
              
              3.42
              
              
              $
              10.84
              
              
              
              366,697
              
              
              
              3.42$
              7.80
              
              
              
              1,428,846
              
              
              
              3.42
              
              
              $
              7.80
              
              
              
              1,428,846
              
              
              
              3.42$
              7.80
              
              
              
              234,615
              
              
              
              0.42
              
              
              $
              7.80
              
              
              
              234,615
              
              
              
              0.42Total
              
              
              
              2,030,158
              
              
              
              
              
              
              
              
              
              
              
              2,030,158
  -30-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
  Options
 
 Following is a summary of stock
option
activity:
 
 Options
      Outstanding
              
              
              Weighted Average Exercise
      Price
              
              
              Aggregate Intrinsic
      ValueOutstanding as of January 1,
      2008
              
              
              761,250
              
              
              $
              9.82
              
              
              $
              12,370,313Granted
              
              
              -
              
              
              
              -
              
              
              
              -Forfeited
              
              
              -
              
              
              
              -
              
              
              
              -Exercised
              
              
              (25,000
              )
              
              
              3.10
              
              
              
              -Outstanding as ofMarch31, 2008(Unaudited)
              
              
              736,250
              
              
              $
              10.05
              
              
              $
              2,245,563Granted
              
              
              -
              
              
              
              
              
              
              
              -Forfeited
              
              
              (26,667
              )
              
              
              8.10
              
              
              
              -Exercised
              
              
              (15,000
              )
              
              
              3.10
              
              
              
              -Outstanding as of December 31,
      2008
              
              
              694,583
              
              
              $
              10.27
              
              
              $
              -Granted
              
              
              -
              
              
              
              -
              
              
              
              -Forfeited
              
              
              (25,000
              )
              
              
              12.40
              
              
              
              -Exercised
              
              
              -
              
              
              
              -
              
              
              
              -Outstanding as ofMarch31, 2009(Unaudited)
              
              
              669,583
              
              
              $
              10.19
              
              
              $
              -
 
 Following is a summary of the status of
options outstanding atMarch31, 2009(Unaudited):
 
 Outstanding
      Options
              
              
              Exercisable
      OptionsExercise
    Price
              
              
              Number
              
              
              Average Remaining Contractual
      Life
              
              
              Average Exercise
      Price
              
              
              Number
              
              
              Average Remaining Contractual
      Life$
              3.10
              
              
              
              110,000
              
              
              
              0.83
              
              
              $
              3.10
              
              
              
              110,000
              
              
              
              0.83$
              8.10
              
              
              
              299,583
              
              
              
              1.83
              
              
              $
              8.10
              
              
              
              299,583
              
              
              
              1.83$
              15.60
              
              
              
              260,000
              
              
              
              1.72
              
              
              $
              15.60
              
              
              
              121,333
              
              
              
              1.72Total
              
              
              
              669,583
              
              
              
              
              
              
              
              
              
              
              
              530,916
 
 On July 12, 2007, the
Company’s CEO transferred 280,000 of his own
shares to the Company employees and consultants. The shares vest over 5 to 10
years starting July 12, 2007. The Company valued theshares at $13.73 per share, based on
the average price for the immediately proceeding fifteen consecutive trading
days before June 16, 2007, the date when the Company and HTFE entered into the
asset purchase agreement with Harbin Taifu Auto Electric Co.,Ltd, the trading price of the stock on
the date of transfer, as a capital contribution totaling $3,844,904 by the CEO,
the value was amortized over the vesting period.  For thethree monthsendedMarch31, 2009 and 2008, respectively, a total of $99,556and $99,556 has been expensed and included
in the share based compensation expenses.
 
 For three monthsendedMarch31, 2009 and2008, share basedcompensation expenseamounted to$341,362 and$456,232, respectively.
 
 Note
18 – Supplemental disclosure of cash flows
 
 The Company prepares its statements of
cash flows using the indirect method as defined under the FAS 95. The following
information relates to non-cash investing and financing activities for
2009 and 2008.
 
 Total interest paid amounted to
$1,963,110and $2,312,668for thethree monthsendedMarch31, 2009and 2008, respectively.
 
 Total income tax paid amounted to
$1,042,674and $0for thethree monthsendedMarch31, 2009and 2008, respectively.
  -31-
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31,
2009
 (UNAUDITED)
  Note19–Employee
pension
 
 Regulations in thePRCrequire the Company to contribute to a
defined contribution retirement plan for all employees. All Joint Venture
employees are entitled to a retirement pension amount calculated based upon
their salary at their date of retirement and their length of servicein accordance with a government managed
pension plan. The PRC government is responsible for the pension liability to the
retired staff. The employee pension in Harbin generally includes two parts: the
first part to be paid by the Company is 20% of the employees’actual salary in the prior year. If the
average salary falls below $1,165 for each individual, $1,165 will be used as
the basis. The other part, paid by the employees, is 8% of actual salary with
the same minimum requirement. The Company made contributionstoemployment benefits, including
pension,of$23,776and $8,376for thethree monthsendedMarch31, 2009 and 2008, respectively.
  -32-




Item 2.Management’s Discussion and
Analysis of Financial Condition and Results of Operations


INFORMATION REGARDING FORWARD LOOKING
STATEMENTS
 
 The following is management’s discussion and analysis of certain
significant factors that have affected aspects of our financial position and
results of operations during the periods included in the accompanying unaudited
financial statements. You should read this in conjunction with the
discussion under “Management’s Discussion and Analysis of Financial
Condition and Results of Operations”and the audited financial statements
for the year ended December 31, 2008 included in our Annual Report on Form
10-K andthe unaudited consolidated financial
statements and notes thereto set forth in Item 1 of this Quarterly Report. In
addition to historical information, this discussion and analysis contains
forward-looking statements that relate to future events and expectations and, as such, constitute
forward-looking statements. Forward-looking statements include those containing
such words as”anticipates,”“believes,”“estimates,”“expects,”“hopes,”“targets,”“should,”will,”“will likely result,”“forecast,”“outlook,”“projects”or similar expressions. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause actual results, performance or achievements of the
Company to be materially different from those expressed or implied in the forward-looking
statements.
  OVERVIEW
  We were incorporated under the laws of
the state of Nevada and, along with our wholly-owned subsidiaries, are
headquartered in Harbin, China. We design, develop, manufacture, supply, and
service a wide range of
electric motors, with a focus on innovation, creativity, and value-added
products. Our major product lines include linear motors, specialty micro-motors,
and industrial rotary motors. Our products are purchased by a broad range of
customers including those customers in the
oil services, factory automation, food processing, packaging industries,
logistic systems, mass transportation systems, petrochemical, metallurgical,
mining, textile, and agricultural industries. We sell our productsprincipally in China, but also
internationally in North America, and to a lesser degree in Southeast Asia and
Africa.
  We are subject to risks common to
companies operating in China, including risks inherent in our distribution and
commercialization efforts,
uncertainty of foreign regulatory and marketing approvals and laws, reliance on
key customers, enforcement of patent and proprietary rights, the need for future
capital and retention of key employees. We cannot provide assurance that we will
generate revenues or achieve and sustain
profitability in the future.
  CRITICAL ACCOUNTING POLICIES AND
ESTIMATES
 
 We believe that the application of the
following accounting policies, which are important to our financial position and
results of operations, requiresignificant judgments and estimates on
the part of management. Our critical accounting policies and estimates present
an analysis of the uncertainties involved in applying a principle, while the
accounting policies note to the financial statements (Note 2)describe the method used to apply the
accounting principle.
 
 Accounts Receivable
 
 We use estimates in determining our
allowance for bad debts that are based on our historical collection experience,
current trends, credit policy and a percentage of our accounts receivable by aging category. In
determining these percentages, we review historical write-offs in our
receivables. In determining the appropriate reserve percentages, we also review
current trends in the credit quality of our customers, as well aschanges in our internal credit
policies.
 
 We maintain reserves for potential
credit losses on accounts receivable. Management reviews the composition of
accounts receivable and analyzes historical bad debts, customer concentrations,
customer credit worthiness,
current economic trends and changes in customer payment patterns to evaluate the
adequacy of these reserves. Reserves are recorded primarily on a specific
identification basis. Additional allowances for doubtful accounts may be
required if there is deterioration in past due balances, if
economic conditions are less favorable than anticipated, or for
customer-specific circumstances, such as financial difficulty. Delinquent
account balances are written-off after management has determined that the
likelihood of collection is not probable, known
bad debts are written off against allowance for doubtful accounts when
identified.
 
 Inventories
  Inventory levels are based on
projections of future demand and market conditions. Inventories are stated at
cost, not in excess of
market using the weighted average cost method. Any sudden decline in demand
and/or rapid product improvements and technological changes can result in excess
and/or obsolete inventories. Because most of our products are customized and
uniqueto a particular customer, there is a
risk that we will forecast inventory needs incorrectly and purchase or produce
excess inventory. As a result, actual demand may differ from forecasts, and such
differences, if not managed, may have a material adverse effect on future results of operations due
to required write-offs of excess or obsolete inventory. To mitigate such
exposure, we require a binding purchase order or a signed agreement by our
customer agreeing to pay for and take possession of finished goodsinventory parts for the duration of the
agreement.
  -33-
 
 On an ongoing basis, inventories are
reviewed for potential write-down for estimated obsolescence or unmarketable
inventories equal to the difference between the costs of inventories and the
estimated netrealizable
value based upon forecasts for future demand and market conditions. To the
extent we increase our reserves for future periods, operating income will be
reduced.
 
 Revenue Recognition
  Our revenue recognition policies comply
with Staff Accounting
Bulletin (SAB) 104 and SFAS 48. SAB 104 requires that revenue can only be
recognized when it is realized or realizable and earned. Revenue generally is
realized or realizable and earned when all four of the following criteria have
been met: (1) persuasive evidence of an arrangement exists;
(2) delivery has occurred or services rendered; (3) the price is fixed and
determinable; and (4) collectability is reasonably assured. For products that
are required to be examined by customers upon receiving shipments, sales revenue is recognized after the
customer examination is passed.
 
 In addition, our revenue recognition
could be negatively impacted by returns. For our linear motor and specialty
micro-motor businesses, our products are custom products which are
customer specific, and no
returns are allowed. We warrant our product for repair, only in the event of
defects for two years from the date of shipment. We charge such costs to cost of
goods sold. For our newly acquired rotary motor business, our products
arestandardized products and returns are
allowed within three days upon receipt of products by customers. We provide
product warranty for repair one year from the date of shipment. Historically,
the returns and defects have not been material.
 
 Stock-Based Compensation
  The Company accounts for stock-based
compensation in accordance with the fair value recognition provisions of SFAS
123R. The Company uses the Black-Scholes-Merton option-pricing model which
requires the input of highly subjective assumptions. These assumptions include estimating the
length of time employees will retain their stock options before exercising them
(“expected
term”), the estimated
volatility of the Company’s common stock price over the expected
term and the number of options that will ultimately not complete their vesting
requirements (“forfeitures”). Changes in the subjective assumptions
can materially affect the estimate of fair value of stock-based compensation and
consequently, the related amount recognized on the consolidated statements of
earnings.
 
 The Company accounts for equity
instruments issued in exchange for the receipt of goods or services from other
than employees in accordance with SFAS 123R and the conclusions reached by EITF
96-18, “Accounting for
Equity InstrumentsThat Are
Issued to Other Than Employees for Acquiring or in Conjunction with Selling
Goods or Services.”Costs
are measured at the estimated fair market value of the consideration received or
the estimated fair value of the equity instruments issued, whichever is more reliably determinable. The
value of equity instruments issued for consideration other than employee
services is determined on the earlier of a performance commitment or completion
of performance by the provider of goods or services as definedby EITF 96-18.
 
 Stock compensation expense is recognized
based on awards expected to vest, and there were no estimated forfeitures as the
Company has a short history of issuing options. FAS 123R requires forfeitures to
be estimated at the time of grant andrevised in subsequent periods, if
necessary, if actual forfeitures differ from those
estimates.
 
 Derivative Financial
Instruments
 
 The Company uses a cross-currency
interest rate swap to hedge its exposure under the 2012 Notes. The derivative is
initially recognized in the
balance sheet at cost and subsequently re-measured at fair value each reporting
period. Changes in the fair values of derivatives accounted for as cash flow
hedges, to the extent they qualify for hedge accounting, are recorded in
accumulated other comprehensive income, net of
deferred taxes; changes in fair values of derivative financial instruments not
qualifying as hedges are reported in income.
 
 At the inception of a hedge transaction,
the Company documents the relationship between hedging instruments and hedged items, as
well as its risk management objective and the strategy for undertaking the
hedge. This process includes linking all derivatives designated to specific firm
commitments of forecast transactions. The Company also documents its assessment, both at inception
and on an ongoing basis, of whether the derivative financial instruments that
are used to hedge are highly effective in offsetting changes in fair values or
cash flows of hedged items.
 
 Fair Value of Financial
Instruments
 
 FAS 107, “Disclosures About Fair Value of
Financial Instruments”defines financial instruments and requires fair value disclosure of applicable
financial instruments FAS 157, “Fair Value Measurements,”adopted January 1, 2008, defines fair
value, establishes a
three-level valuation hierarchy for disclosures of fair value measurement and
enhances disclosure requirements for fair value measures. The carrying amounts
reported in the balance sheets for current receivables and payables qualify as
financialinstruments.  Management
concluded the carrying values are a reasonable estimate of fair value because of
the short period of time between the origination of such instruments and their
expected realization and if applicable, their stated interest rate
approximates current rates available. The
three levels are defined as follows:
 
 ·
              Level 1
              inputs to the valuation
      methodology are quoted prices (unadjusted) for identical assets or
      liabilities in active
markets.
  -34-
  ·
              Level 2
              inputs to the valuation
      methodology include
      quoted prices for similar assets and liabilities in active markets, and
      inputs that are observable for the assets or liability, either directly or
      indirectly, for substantially the full term of the financial
      instruments.
 
 ·
              Level 3
              inputs to the
      valuationmethodology
      are unobservable and significant to the fair
  value.
 
 Newaccounting pronouncementsadopted
 
 Effective
January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, and amendment of FASB No. 133” (“SFAS 161”),
which amends and expands the disclosure requirements of SFAS 133 (“SFAS 133”).
SFAS 161 requires qualitative disclosures about objectives and strategies
for using derivatives and quantitative disclosures about the fair value of and
gains and losses on derivative instruments.
  Effective January 1, 2009, the
Company adopted the provisions of EITF 07-5, "Determining Whether an Instrument
(or Embedded Feature) is Indexed to an Entity’s Own Stock”, which is effective for financial
statements for fiscal years beginning after December 15, 2008 and which replaced
the previous guidance on this topic in EITF 01-6.  Paragraph 11(a) of
FAS 133 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.  EITF 07-5 provides a newtwo-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 FAS 133 paragraph 11(a) scope exception.
 
 As a result of adopting EITF 07-5,
2,030,158warrants
previously treated as equity pursuant to the derivative treatment exemption are
no longer afforded equity treatment because the strike price of the warrants is
denominated in US dollar, a currency other than the Company’s functional currency, theChinese Renminbi.  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 exercisedor expired.
 
 As such, effective January 1, 2009, the
Company reclassified the fair value of these warrants from equity to liability,
as if these warrants were treated as a derivative liability since their issuance
in August 2006. On January 1, 2009, the Company reclassified from additional
paid-in capital, as a cumulative effect adjustment, $6.1 million to
beginning retained earnings and $7.5 million to warrant liabilities to recognize
the fair value of such warrants. The fair value of the warrants was
$4.9million on March 31,
2009.  Therefore, the Company recognized a $2.6 million gain from
the change in fair value of these warrants for the three months ended
March 31, 2009.The Company uses the Black-Scholes
Option Pricing Model to value its options and warrants, and considering certain key input, including
the trading price on reporting date, volatility of its stock, conversion price,
remaining term of the warrants , dividend rate , and the risk-free interest rate
for the warrant life.
 
 Recent Accounting
Pronouncements
 
 In April 2009, the FASB issued FSP FAS
157-4, “Determining Fair
Value When the Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions That Are Not
Orderly”(FSP FAS 157-4).
FSP FAS 157-4 amends SFAS
157 and provides additional guidance for estimating fair value in accordance
with SFAS 157 when the volume and level of activity for the asset or liability
have significantly decreased and also includes guidance on identifying
circumstances that indicate a transaction is not orderly for fair
value measurements. This FSP shall be applied prospectively with retrospective
application not permitted. This FSP shall be effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for periods ending after
March15, 2009. An
entity early adopting this FSP must also early adopt FSP FAS 115-2 and FAS
124-2, “Recognition and
Presentation of Other-Than-Temporary Impairments”(FSP FAS 115-2 and FAS 124-2).
Additionally, if an entity elects to early adopt either FSP FAS
107-1 and APB 28-1, “Interim Disclosures about Fair Value of
Financial Instruments”(FSP
FAS 107-1 and APB 28-1) or FSP FAS 115-2 and FAS 124-2, it must also elect to
early adopt this FSP. We are currently evaluatingthis new FSP but do not believe that it
will have a significant impact on the determination or reporting of our
financial results.
 
 In April 2009, the FASB issued FSP FAS
115-2 and FAS 124-2. This FSP amends SFAS 115, “Accounting for Certain Investments
inDebt and Equity
Securities,”SFAS 124,
“Accounting for Certain
Investments Held by Not-for-Profit Organizations,”and EITF Issue No.99-20, “Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in
Securitized Financial Assets,”to make the other-than-temporary
impairments guidance more operational and to improve the presentation of
other-than-temporary impairments in the financial statements. This FSP will
replacethe existing requirement that the
entity’s management assert it has both the
intent and ability to hold an impaired debt security until recovery with a
requirement that management assert it does not have the intent to sell the
security, and it is more likely than not it will not have to sell the
security before recovery of its cost basis. This FSP provides increased
disclosure about the credit and noncredit components of impaired debt securities
that are not expected to be sold and also requires increasedand more frequent disclosures regarding
expected cash flows, credit losses, and an aging of securities with unrealized
losses. Although this FSP does not result in a change in the carrying amount of
debt securities, it does require that the portion of an other-than-temporary impairment not
related to a credit loss for a held-to-maturity security be recognized in a new
category of other comprehensive income and be amortized over the remaining life
of the debt security as an increase in the carrying value ofthe security. This FSP shall be effective
for interim and annual periods ending after June 15, 2009, with early
adoption permitted for periods ending after March 15, 2009. An entity may
early adopt this FSP only if it also elects to early adopt FSP FAS
157-4. Also, if an entity elects to early
adopt either FSP FAS 157-4 or FSP FAS 107-1 and APB 28-1, the entity also is
required to early adopt this FSP. We are currently evaluating this new FSP but
do not believe that it will have a significant impact on thedetermination or reporting of our
financial results.
  -35-
 
 In April 2009, the FASB issued FSP FAS
107-1 and APB 28-1. This FSP amends SFAS No.107, “Disclosures about Fair Value of
Financial Instruments,”to
require disclosures about fair value of financial instruments not measured on the balance
sheet at fair value in interim financial statements as well as in annual
financial statements. Prior to this FSP, fair values for these assets and
liabilities were only disclosed annually. This FSP applies to all
financial instruments within the scope of SFAS
107 and requires all entities to disclose the method(s) and significant
assumptions used to estimate the fair value of financial instruments. This FSP
shall be effective for interim periods ending after June 15,
2009, with early adoption permitted for
periods ending after March 15, 2009. An entity may early adopt this FSP
only if it also elects to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS
124-2. This FSP does not require disclosures for earlier periods
presented for comparative purposes at initial
adoption. In periods after initial adoption, this FSP requires comparative
disclosures only for periods ending after initial adoption. We are currently
evaluating the disclosure requirements of this new FSP.
 
 In December 2007, the FASB issued SFAS 141R,
“Business
Combinations”(“FAS 141R”). FAS 141R changes the accounting for
business combinations in several areas including contingent consideration,
acquisition-related costs, restructuring costs and deferred incometaxes. Acquisition costs will generally
be expensed as incurred. Restructuring costs associated with a business
combination will generally be expensed subsequent to the acquisition date.
Changes in deferred tax asset valuation allowances and uncertain taxpositions after the acquisition date will
generally impact income tax expense. FAS 141R is effective for fiscal years
beginning after December 15, 2008 on a prospective basis. The adoption of SFAS
No. 141R did not have a significant impact on the Company'sfinancial statements for the three
months ended March 31, 2009.
  RESULTS OF
OPERATIONS
  Results of
Operations
 
 For thefirst quarter of 2009, Harbin Electric
reportedtotal revenues of
$30.72 million,compared
with $22.46 million in the first quarter of2008.The37%sales growth was primarily
attributable to the
$10.85million sales from
our industrial rotary motor business acquired in July
2008.Linear
motor sales also increased 5% from thefirst quarter of2008due to higher sales of our tower type
oil pump(60 units for the first quarter of 2009
versus 39 units for the first quarter of 2008)and other linear motors.Excluding acquisition, organicrevenuesfor the quarterwere$19.87million,reflecting weaker sales primarily in specialty
micro-motors.
 
 International sales totaled $3.26 million or
10.6% of total salesfor the quarter,down 14%compared withinternational sales of $3.80million inthe first quarter of 2008, reflecting
weaker export sales in our specialty micro-motor business.
 
 The following table shows the revenue
contribution bypercentageforeach major product line andthecorresponding average gross profit
margin for thefirst
quartersended March 31, 2009 and
2008,
respectively. The declineinoverall gross profit margin was
primarily due to changes in
product mixandthe lower gross margininthe rotary motor
business.
  
 Three Months EndedMarch31, 2009
              
              
              Three Months EndedMarch31, 2008Product
Line
              
              % of Total
      Revenues
              
              
              Gross Profit
      Margin
              
              
              % of Total
      Revenues
              
              
              Gross Profit MarginLinear Motors and Related
      Systems
              
              
              40.3
              %
              
              
              54.1
              %
              
              
              50.6
              %
              
              
              53.5
              %Specialty
      Micro-Motors
              
              
              19.9
              %
              
              
              40.1
              %
              
              
              38.1
              %
              
              
              42.2
              %Rotary
    Motors
              
              
              35.3
              %
              
              
              10.1
              %
              
              NA
              
              
              NAOthers
              
              
              4.5
              %
              
              
              49.3
              %
              
              
              11.3
              %
              
              
              45.2
              %Total
              
              
              100
              %
              
              
              35.6
              %
              
              
              100
              %
              
              
              47.9
              %
  
 Operating profitof$8.03million in thefirst quarter of 2009 decreased by 7%
from $8.64million in thefirst quarter of
2008. Operating margin
declined to 26.1% from 38.5% for the same quarterin 2008, mainly due to lower grossmarginintheindustrial rotary motor
businessand higher
research and development expenses as well as higherselling, general and
administrative
expenses.
 
 Selling, general and administrative
expenses (“SG&A”) were $2.50million for the quarterended March 31, 2009, compared to $2.03million for the same quarterended2008. The increase in SG&A was primarilyassociated with the newly
acquired company,the start-up oftheShanghaifacility, higher shipping and handling costs,and higher depreciation expenses. As a percentage of total sales, the
Company’s total SG&A expenses declined to 8.2% in
this quarter from 9.0% in
the same quarter last year.
 
 Net income for the quarterended March 31, 2009totaled$8.65million, compared to $5.35million for thesamequarterof last year,representinga 62% increase.  Net income for the quarter
benefitedfrom$2.57millionchange infair valueofwarrantsdue toadopting EITF 07-5 atJanuary 1, 2009(see Note 2). Additionally, higher other income and
lower interest expense including lower amortization expense of debt discount
contributed to higher net income.  Excluding the adjustment due to theadoption of the new
accounting pronouncement,
net income totaled$6.08
million for the quarter,
representing a 14% increase over the same quarter last
year.
  -36-
 
 Earnings per diluted share increased to $0.39from $0.27in thefirst quarter of 2008, with an
additional 2.2million
weighted average number of shares.Excluding the accounting
adjustment, earnings per
sharewasflat.
 
 Interest expense
 
 Net interest expense was $1.44million and $2.28million for thefirst quarter of 2009 and2008,respectively. Non-cash amortization
expense of debt discount anddebt issuance cost totaled $1.26
million and $1.57million for thetwo periods,
respectively.  The lower interest expense was mainly due tocombined factorsincludinglower interest rate, lower debt amount,
andhighercapitalization of interest
expense.
  Liquidity and Capital
Resources
 
 A major factor of the Company’s liquidity and capital resource
planning is its generation of operating cash flow, which is strongly dependent
on the demand for our products.  This is supplemented by our financing
activities inthecapital marketsincluding potentially debt and equity, which supports major acquisitions and
capital investments for business growth.
 
 Our liquidity position remains strong,
supported by approximately $63.57 million in cash and cash equivalents as of
March 31, 2009, compared to $48.41million as of December 31, 2008.The increase in cash and
cash equivalents was mainly driven by cash generated from
operations.Cash
provided byoperating
activitiestotaled
$22.88 million during the
quarter, primarily
attributable to our solid net earnings,a significant improvementinaccounts receivables, and a reduction of
inventories.This compares
very favorably withthe
same quarter in 2008whenoperating activities used$0.56 millioncash.
 
 On August 29, 2006, the Company,Advanced Electric
Motors, Inc.(“AEM”), Citadel Equity Fund Ltd.
(“Citadel”) and Merrill Lynch International
(“Merrill
Lynch”and, together with
Citadel, the “Investors”) entered into a purchase agreement (the
“Purchase
Agreement”) relating to the
purchase and sale of (a) $50.0 million aggregate principal amount of the
Company’s Guaranteed Senior Secured Floating
Rate Notes (collectively, the “Notes”) and (b) fully detachable warrants (the
“Warrants”) to purchase an aggregate of 3,487,368
shares of our common stock. The transaction closed on August 30, 2006. Interest
on the Notes is payable semi-annually in arrears, commencing March 1,
2007.
 
 The Notes are governed by an indenture,
dated August 30, 2006, entered among the Company, AEM, as guarantor, and The
Bank of New York, as trusteefor the Notes. Of the $50.0 million
aggregate principal amount of the Notes, Citadel subscribed to $38.0 million of
the principal amount of the Notes, which mature on September 1, 2012 (the
“2012 Notes”), and Merrill Lynch subscribed to $12.0
million ofthe principal amount of the Notes, which
mature on September 1, 2010 (the “2010 Notes”). Pursuant to the indenture, AEM has
agreed, and all of our other existing and future subsidiaries (other than
subsidiaries domiciled in the People’s Republic of China)are obligated, to guarantee, on a senior
secured basis, to the Investors and to the trustee the payment and performance
of our obligations.
 
 As security for the Notes, we and The
Bank of New York, as collateral agent, enteredintoa share pledge agreement,dated August 30, 2006, to secure the
Notes by pledgingall the shares of AEM common stock held
by us.
 
 The 2010 Notes bear interest, payable
semi-annually in arrears, commencing March 1, 2007, at a rate equal to LIBOR
plus 4.75%. The six month LIBOR rate was1.80375% as of March 2, 2009 compared to3.1125% as of September 1,
2008. The 2010 Notes are subject to mandatory redemption semi-annually
commencing March 1, 2008 in the principal amount $2,000,000 at a price equal to
100% of such principal amount.  Wemade $4millioninprincipal paymentsin 2008 and another $2 millioninprincipal paymentsin March 2009 for the 2010
Notes.
 
 The 2012 Notes bear interest, payable
semi-annually in arrears, commencing March 1, 2007, at a rate equal to LIBOR
plus 3.35%. The 2012 Notes
are subject to mandatory redemption semi-annually commencing September 1, 2009
in the principal amounts of $2,400,000 on September 1, 2009, $3,800,000 on March
1, 2010, $9,900,000 on September 1, 2010 and March 1, 2011, and $4,000,000 on
September 1, 2011, March 1, 2012 and
September 1, 2012, in each instance at price equal to 100% of such principal
amount.
 
 The Warrants are governed by a warrant
agreement, dated August 30, 2006, between us and The Bank of New York, as
warrant agent. The Warrants
consist of (i) six-year warrants to purchase an aggregate of 2,192,308 shares of
our common stock, at an exercise price of $7.80 per share (the “First Tranche 2012 Warrants”), (ii) six-year warrants to purchase an
aggregate of 525,830 shares of our common stock at an exercise price of $10.84
per share (the “Second
Tranche 2012 Warrants”) and
(iii) three-year warrants to purchase an aggregate of 769,230 shares of our
common stock at an exercise price of $7.80 per share (the “2009 Warrants”). The First Tranche 2012 Warrants and the Second
Tranche 2012 Warrants were issued to Citadel, and the 2009 Warrants were issued
to Merrill. Each Warrant is exercisable at the option of the Warrant holder at
any time through the maturity date of such Warrant.
 
 In August2006 the Company’s subsidiary Harbin Tech Full signed an
R&D Agreement withthe
Institute of Electrical Engineering of the Chinese Academy of Sciences
(“IEECAS”). Under the R&D Agreement with
IEECAS, Harbin Tech Full is obligated to invest approximately $2.19 million(RMB 15 million). Ofthis amount,approximately $1.46 million(RMB 10 million)has been invested to date with the balance to
be invested in2009.
 
 InSeptember 2006 the Company’s subsidiary Harbin Tech Full signed a
Land Use Agreement for a plot of land in Shanghai. Harbin Tech Full
is obligated toinvestapproximately $2.74million. Of this amount, 92% or $2.70million has been paid with the balance
payableupon completion of
certain regulatory applications andreceipt of a regulatory
permit.
  -37-
 
 In October 2008, the Company, through
its wholly-owned subsidiary Advanced Automation Group, LLC (“AAG”), formed Advanced Automation Group
Shanghai, Ltd. (“AAG
Shanghai”), a wholly-owned
subsidiary in China, to design, develop, manufacture, sell and service custom industrial automation
controllers for linear motors. The registered capital is $1 million. The Company
has invested $500,000inAAG Shanghai through March 31,
2009.
 
 Pursuant to the original agreement
(“Original
Agreement”) signed in April
2007between the Company
and Shelton Technology, LLC (“Shelton”), whereby the Company and Shelton
agreed to work together through AAG to design, develop and manufacture custom
industrial automation controllers, the Company is required to invest a total of
$3 millioninAAG while Shelton contributes an
exclusive worldwide royalty-free license for motorized automation technology.
Shelton is entitled to receive 49% of any profits earned by AAG through the
initial term of the Agreement which ended August 31, 2008. TheCompany andSheltonentered into a first amendment to the
Original Agreement on December 11, 2008 to extend theterm of theOriginal Agreementfrom August 31, 2008 to December 31,
2008. On April 21, 2009,
the Company and Shelton enteredinto a second amendment to the Original Agreement tofurtherextend the term toJune 30, 2009.Including the $500,000 invested in AAG
Shanghai, the Company has contributed a total of $2.5 million to AAG as of March
31, 2009. The remaining $500,000 contribution to AAG isto be made at a later date to be decided
mutually.
 
 Cross-currency interest rate
hedge
 
 The Company's operations are exposed to
a variety of global market risks, including changes in foreign currency exchange
rates and interest rates. These exposures are managed, in part, with the use of a
financial derivative. The Company uses financial derivatives only to hedge
exposures in the ordinary course of business and does not invest in derivative
instruments for speculative purposes.
 
 Effective April 17, 2007, the Company entered a cross-currency
interest rate swap agreement with Merrill Lynch, effectively exchanging the
LIBOR plus 3.35% variable rate interest payable on the $38 million principal
amount of 2012 Notes for a 7.2% RMB fixed interest rate. The agreement requires semi-annual payments on
March 1 and September 1 through the maturity of the agreement on September 1,
2012. Merrill Lynch required the Company to deposit $1,000,000 to secure the
agreement. The deposit may be increased to $2,500,000, if the exchange rate for Renminbi to USD falls
below 6.5, and to $4,000,000, if the exchange rate falls below 5.5. This swap is
designated and qualified as a cash flow hedge.
 
 The fair value of this swapagreement was a payable of$8.29million onMarch 31, 2009and$5.76million on December 31, 2008. From the
December 31, 2008toMarch 31, 2009, changes in fair value of the swap
resulted inother
comprehensive loss of $2.53million and anincreasein liabilities.
 
 The Company accounts for this swap in
accordance with FAS 133,
“Accounting for Derivatives
Instruments and Hedging Activity,”which requires all derivatives to be
carried on the balance sheet at fair value and to meet certain documentary and
analytical requirements to qualify for hedge accounting treatment. Accordingly, changes in the fair value
are reported in accumulated other comprehensive income, net of related income
tax effects.
 
 Contractual
Obligations
 
 The Company enters into non-cancelable
purchase commitments with its investors. As ofMarch 31, 2009, and December 31, 2008, the Company was obligated under the
non-cancelable commitments to purchase materials totaling to $1,341,274and $305,100, respectively. These commitments are
short-term and expire within one year. The Company has experienced no
losses on these purchase
commitments over the years.
  As discussed in more detail in Note 1,
the Company entered into an agreement with Shelton Technology, LLC on April 9,
2007.  Under the terms of the agreement, the Company is required to
contribute a total of $3
million in installments in AAG by March 31, 2009.  The Company
has invested a total of $2.5 million to AAG as of March 31, 2009 and has the
remaining $500,000 to be invested.  Based upon a mutual agreement, the
Company will contribute the remaining $500,000 to AAG at a later date
according to actual needs.
 
 As discussed in Note 12, the Company
entered into a swap agreement that required a $1,000,000 deposit to secure the
transaction.  If the exchange rate for Renminbi to US Dollars drops
below certain levels, the
Company will be required to deposit up to $4,000,000.
 
 As discussed in Note 11, the 2010 Notes
are subject to mandatory redemption semi-annually commencing March 1, 2008 in
the principal amount $2,000,000 at price equal to 100% of such principal amount. The 2012 Notes are
subject to mandatory redemption semi-annually commencing September 1, 2009 in
the principal amount $2,400,000 on September 1, 2009, $3,800,000 on March 1,
2010, $9,900,000 on September 1, 2010 and March 1, 2011, and $4,000,000 on September 1, 2011, March 1, 2012
and September 1, 2012, in each instance at price equal to 100% of such principal
amount. Holders of the 2012 Notes may require the Company to repurchase such
Notes at 100% of the principal amount thereof at any timeafter September 1,
2011.
 
 On September 8, 2006, HTFE entered into
an agreement (“Land Use
Agreement”) with Shanghai
Lingang Investment and Development Company Limited (“Shanghai Lingang”) with respect to HTFE’s lease and use of 40,800 square meters
of State-owned land in the
Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The term of the Land Use Agreement is
50 years and totaled $2.96 million (RMB 20.2 million of “Fee”), 92% or $2.7 million (RMB 18.5
million) of which has been paid with the balancepayable upon Shanghai
Lingang’s completion of certain regulatory
applications on behalf of HTFE. The amount paid is recorded as advances on
intangible assets for $2,713,180 and $1,481,670 as of March 31, 2009 and
December 31, 2008, respectively. The remaining balance of the Fee is payable
within seven days of receipt of a regulatory permit for work commencement. As of
March 31, 2009, the application of the regulatory permit for the land use is
still in process.
  -38-
 
 Off-balance sheet
arrangement
 
 None.
 
 Item 3. Quantitative and Qualitative
Disclosures about Market Risk
 
 Information relating to quantitative and
qualitative disclosures about market risk is provided in the Company’s 2008annual report on Form 10-K, which
information is incorporated herein by reference. There have been no material
changes in the Company’s exposure to market risk since December 31,
2008.
 
 Item 4. Controls and
Procedures
 
 (a) Evaluation of Disclosure Controls
and Procedures
 
 We maintain disclosure controls and
procedures that are designed to ensure that information required
to be disclosed in our reports filed pursuant to the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the
SEC’s rules, regulations and related forms,
and that such information is accumulated and
communicated to our principal executive officer and principal financial officer,
as appropriate, to allow timely decisions regarding required
disclosure.
 
 Under the supervision and with the
participation of our management, including our principal executive officer
and principal financial officer, the Company conducted an evaluation of the
effectiveness of the design and operation of our disclosure controls and
procedures as of the end of the period covered by this report, as such term is defined in Exchange Act Rules
13a-15(e) and 15d-15(e). Based on this evaluation, our principal executive
officer and principal financial officer have concluded that during the period
covered by thisreport,the Company’s disclosure controls and procedures are effective as of such date
at a reasonable assurance level to ensure that information required to be
disclosed by us in our Exchange Act reports is recorded, processed, summarized,
and reported within the time periods specified in the SEC’s rules and forms, and that such
information is accumulated and communicated to our management, including our
principal executive officer and principal financial officer, as appropriate to
allow timely decisions regarding required disclosure.
  (b)Changes
inInternal
Control over Financial Reporting
 
 There have been no changes in our
internal control over financial reporting that occurred during thethreemonths endedMarch31, 2009that have materially affected, or are
reasonably likely to materially affect, the Company’s internal control over financial
reporting.
  PART II. OTHER
INFORMATION
  Item 1.Legal
Proceedings
  We are not currently a party to any
material legal proceedings. From time to time, however, we may become involved
in various lawsuitsand
legal proceedings which arise in the ordinary course of business.
  Item 1A. Risk
Factors
 
 An investment in our common stock is
very risky. You should carefully consider the risk factors described below
before making an investment decision. If any ofthe following risks actually occurs, our
business, financial condition or operating results could be materially and
adversely affected. In such case, the trading price of our common stock could
decline, and you may lose all or part of your investment. Additional risks and uncertainties not
currently foreseeable to us may also impair our business
operations.
  GENERAL RISKS RELATING TO OUR
BUSINESS
 
 Our rapid growth may strain our
resources.
  Our revenues increased by 85% for the
year ended December 31, 2008 versus the year ended December 31,
2007, and 62% in 2007 over 2006, however, it is unlikely that we will maintain
such growth in the long term and cannot assure any growth of our business for
any period. Our rapid expansion will place significant strainon our management and our operational,
accounting, and information systems. We expect that we will need to continue to
improve our financial controls, operating procedures, and management information
systems. We will also need to effectively train, motivate, and manage our employees. Our failure
to manage our growth could disrupt our operations and ultimately prevent us from
generating the profits we expect. Additionally, the current financial crisis has
made it more difficult for businesses to obtain financing from debt and capital markets. This
would limit our ability to maintain a rapid growth of our business due to
insufficient cash flow for operation or for
acquisitions.
  -39-
  Our debt may constrict our operations,
and cash flows and capital resources maybe insufficient to make required
payments on our substantial indebtedness and future
indebtedness.
 
 We have a substantial amount of debt. As
ofMarch31, 2009, we had approximately $44million outstanding under our
Guaranteed Senior Secured Floating RateNotes (the “Notes”) issued in August 2006, due in 2010 and
2012 (respectively, the “2010 Notes”and the “2012 Notes”). Our substantial debt could have
important consequences to you. For example, it could:
 
  ·
              reduce the availability of our
      cash flow to fund future working capital, capital expenditures,
      acquisitions and other general corporate
  purposes;
  ·
              limit our ability to obtain
      additional financing for working capital, capital expenditures, and other
      general corporate
      requirements;
  ·
              expose us to interest rate
      fluctuations because the interest rate for a portion of our debt is
      variable;
  ·
              increase our vulnerability to
      general adverse economic and industry
  conditions;
  ·
              require us to sell
      assetsto reduce
      indebtedness or influence our decisions about whether to do
      so;
  ·
              restrict us from making strategic
      acquisitions or pursuing business
  opportunities;
  ·
              limit our flexibility in planning
      for, or reacting to, changes in our business and the industry in which we
      operate;
  ·
              limit, along with the financial
      and other restrictive covenants in our indebtedness, among other things,
      our ability to borrow additional funds;
  and
  ·
              place us at a competitive
      disadvantage compared to competitors thatmay have proportionately less
      debt.
  In addition, our ability to make
scheduled payments or refinance our obligations depends on our successful
financial and operating performance, cash flows, and capital resources, which in
turn depend upon prevailing economic conditions and certain
financial, business, and other factors, many of which are beyond our control. If
our cash flows and capital resources are insufficient to fund our debt
obligations, we may be forced to reduce or delay capital expenditures,
sell material assets or operations, obtain
additional capital, restructure our debt, or declare bankruptcy. Furthermore,
our obligations under the Notes are secured by our shares of Advanced Electric
Motors, Inc., our Delaware subsidiary through which we ownour electric motor business. These
security interests could result in our loss of the business, if we default on
the Notes.
  To mitigate our exposure to volatility
in interest rates and foreign currency exchange rates fluctuation associated
with the $38million
principal amount of 2012 Notes, in April 2007, the Company entered a
cross-currency interest rate swap transaction with Merrill Lynch International.
The swap, in effect, converts the LIBOR plus 3.35% variable interest rate on the
2012 Notes to a 7.2% RMB fixed interest rate. The Company
uses this derivative instrument only to hedge exposures in the ordinary business
course and does not invest in derivative instruments for speculative
purposes.
 
 The Company management watches closely
and measures therisk of
the swap on a regular basis, which includes effectiveness analysis and pricing
model discussion with Merrill Lynch that provides market value pricing
quarterly. Harbin is aware that, under recently adopted Statement of Financial
Standards (“FAS”)No. 157,Fair
Value Measurements, there
is risk inherent in relying on only one technique to measure fair value of
financial derivative liability and risk inherent in the inputs to the valuation
technique.
 
 Covenants in our debt instruments
restrict or prohibit our
ability to engage in or enter into a variety of
transactions.
 
 The indenture governing our Notes
contains various covenants that may limit our discretion in operating our
business. In particular, we are limited in our ability to merge,
consolidate or transfer
substantially all of our assets, issue preferred stock of subsidiaries and
create liens on our assets to secure debt. In addition, if there is default, and
we do not maintain certain financial covenants or we do not maintain borrowing
availability in excess of certain
pre-determined levels, we may be unable to incur additional indebtedness, make
restricted payments (including paying cash dividends on our capital stock) or
redeem or repurchase our capital stock.
  The indenture governing ourNotes requires us to maintain certain
financial ratios and limits our ability to make capital expenditures. These
covenants and ratios could have an adverse effect on our business by limiting
our ability to take advantage of financing, merger and acquisition or other corporate opportunities and
to fund our operations.
  -40-
 
 Our success depends on our management
team and other key personnel, the loss of any of whom could disrupt our business
operations.
  Our future success will depend in
substantial part on thecontinued service of the members of our
senior management. The loss of the services of one or more of our key personnel
could impede implementation of our business plan and result in reduced
profitability. We do not carry key person life insurance on anyof our officers or employees. Our future
success will also depend on the continued ability to attract, retain and
motivate highly qualified technical sales and marketing customer
support.
  Because of the rapid growth of the
economy in China, competition for qualified personnel is intense. We
cannot assure you that we will be able to retain our key personnel or that we
will be able to attract, assimilate or retain qualified personnel in the
future.
 
 We depend on a few key customers, the
loss of any of whichcould
cause a significant decline in our revenues.
  Three major customers accounted forapproximately
38%of net revenuefor thethreemonths endedMarch 31, 2009. Fivemajor customers accounted for
73% of net revenue for thethreemonths endedMarch31,2008. The loss of any of our major
customers, or a significant reduction in sales to any such customers, would
adversely affect our profitability.
 
 We depend on the supply of raw materials
and key component parts, and any adverse changes in such supply orthe costs of raw materials may adversely
affect our operations.
  Two major vendors provided approximately 25% of the Company’s purchases of raw materials for thethreemonths endedMarch31, 2009. Five major vendors provided
approximately 79% of the Company’s purchases of raw materials for thethreemonths endedMarch 31, 2008. Any material change in the spot and
forward rates could have a material adverse effect on the cost of our raw
materials and on our operations. In addition, if we need alternative
sources for key component
parts for any reason, these component parts may not be immediately available to
us. If alternative suppliers are not immediately available, we will have to
identify and qualify alternative suppliers, and production of these
components may be delayed. We may not be able to
find an adequate alternative supplier in a reasonable time period or on
commercially acceptable terms, if at all. Shipments of affected products have
been limited or delayed as a result of such problems in the past,and similar problems could occur in the
future. An inability to obtain our key source supplies for the manufacture of
our products might require us to delay shipments of products, harm customer
relationships or force us to curtail or cease operations.
 
 Wemay experience material disruptions to
our manufacturing operation.
 
 We operate our facilities in compliance
with applicable rules and regulations and take measures to minimize
the risks of disruption at our facilities. A material disruption at one of
ourmanufacturing facilities could prevent us from meeting
customer demand, reduce our sales and/or negatively impact our
financial results. Any of our manufacturing facilities, or any of our
machines within an otherwise operational facility, could cease
operations unexpectedly due to a number
of events, including:
 
 ·
              unscheduled maintenance
      outages;
 
 ·
              prolonged power
      failures;
 
 ·
              an equipment
      failure;
 
 ·
              disruptions in the transportation
      infrastructure including roads, bridges, railroad
      tracks;
 
 ·
              fires, floods, earthquakes, or
      other catastrophes; and
 
 ·
              otheroperational
      problems.
 
 We may not be able to adequately protect
and maintain our intellectual property.
  Our success will depend on our ability
to continue to develop and market electric motor products. We have been granted
12 patents in China relating to linear motor and automobile specialty
micro-motor applications. No assurance can be given that such patents will not
be challenged, invalidated, infringed or circumvented, or that such intellectual
property rights will provide a competitive advantage tous. Also, litigation may be necessary to
enforce our intellectual property rights or determine the validity and scope of
the proprietary rights of others. The outcome of such potential litigation may
not be in our favor and any success in litigation may not be able to adequately protect our
rights. Such litigation may be costly and divert management attention away from
our business. An adverse determination in any such litigation would impair our
intellectual property rights and may harm our business, prospects and reputation. Enforcement of
judgments in China is uncertain and even if we are successful in such litigation
it may not provide us with an effective remedy.
 
 We do not anticipate
paying cash dividends on our common stock.
  We do not anticipate paying cash dividends in the foreseeable
future. Presently, we intend to retain all of our earnings, if any, to finance
development and expansion of our business. Debt covenants and PRC capital and
currency regulations may also limit our ability to pay dividends.
  -41-
 
 Our directors and officers control a
majority of our common stock and, as a result, they may exercise voting control
and be able to take actions that may be adverse to your
interests.
 
 Our directors and executive officers,
directly or through entities that they control, currently
beneficially own, as a group, approximately 50.27% of our issued and outstanding
common stock as of March 31, 2009. This significant concentration of share
ownership may adversely affect the trading price of our common stockbecause investors often perceive a
disadvantage in owning shares in a company with one or several controlling
stockholders. Furthermore, our directors and officers, as a group, have the
ability to significantly influence or control the outcome of all matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions, such as mergers, consolidations or the sale of substantially all
of our assets. This concentration of ownership may have the effectof delaying or preventing a change of
control, including a merger, consolidation or other business combination
involving us, or discouraging a potential acquirer from making a tender offer or
otherwise attempting to obtain control.
  RISKS RELATING TO DOING BUSINESS IN THE PEOPLE’S REPUBLIC OF CHINA
 
 China’s economic policies could adversely
affect our business.
 
 Substantially all of our assets are
located in China and substantially all of our revenues are derived from our
operations in China. Accordingly, our results of operations and
prospects are subject, to a significant extent, to economic, political and legal
developments in China.
 
 While China’s economy has experienced significant
growth in the past 30 years, it has been uneven, both geographicallyand among various sectors
of the economy. The Chinese government has implemented various measures to
encourage economic growth and guide the allocation of resources. Some of these
measures benefit the overall economy of China, but may also have a
negativeeffect on us. For example, our operating
results and financial condition may be adversely affected by government control
over capital investments or changes in tax regulations.
  The economy of China has been changing
from a planned economy to a more market-oriented economy. In recent years the
Chinese government has implemented measures emphasizing market forces for
economic reform, reduction of state ownership of productive assets, and
establishment of corporate governance in business enterprises;
however, a substantial portion of productive
assets in China are still owned by the Chinese government. In addition, the
Chinese government continues to play a significant role in regulating industry
development by imposing industrial policies. It also exercisessignificant control over
China’s economic growth through the allocation
of resources, controlling payment of foreign currency-denominated obligations,
setting monetary policy, and providing preferential treatment to particular
industries or companies.
 
 Ifpreferential tax concessions granted by
the PRC government change or expire, our financial results and results of
operations would be materially and adversely affected.
  Our results of operation may be
adversely affected by changes to or expiration of preferential tax concessions that one of
our Chinese subsidiaries, Harbin Tech Full currently enjoys. The statutory tax
rate generally applicable to domestic Chinese companies was 33% before January
1, 2008. On January 1, 2008, the new Chinese Enterprise Income Tax (“EIT”) law replaced the existing laws for
Domestic Enterprises (“DES”) and Foreign Invested Enterprises
(“FIEs”). The new standard EIT rate of 25% is
now applicable to both DES and FIEs. A reduced rate of 10% may be possible for
productive foreigninvestment enterprises in the Economic
and Technological Development Zones and for enterprises engaged in production or
business operations in the Special Economic Zones. As a result of preferential
tax rate incentives, our operations under Harbin Tech Full have been subject to relatively lower
tax liabilities. The estimated tax savings for the quarter ended March 31, 2009
and 2008 amounted to approximately $1.32 million and $1.49 million,
respectively.
 
 Tax laws in China are subject to
interpretations by relevant
tax authorities. The preferential tax treatment may not remain in effect or may
change, in which case we may be required to pay the higher income tax rate
generally applicable to Chinese companies, or such other rate as is required by
the laws ofChina.
 
 Fluctuations in the value of the RMB
could materially affect our financial condition and results of
operations.
  The value of RMB against the U.S. dollar
and other currencies may fluctuate and is affected by, among other things,
changes in political and
economic conditions. Our revenues and costs are mostly denominated in RMB. Any
significant fluctuation in value of RMB may materially and adversely affect our
cash flows, revenues, earnings and financial position, and the value of our
stock in U.S.dollars. For example, an appreciation of
RMB against the U.S. dollar would make any new RMB denominated investments or
expenditures more costly to us, to the extent that we need to convert U.S.
dollars into RMB for such purposes. In addition, the depreciation of significant U.S. dollar
denominated assets could result in a charge to our income statement and a
reduction in the value of these assets.
 
 We must comply with the Foreign Corrupt
Practices Act.
  We are required to comply with the
United States Foreign
Corrupt Practices Act, which prohibits U.S. companies from engaging in bribery
or other prohibited payments to foreign officials for the purpose of obtaining
or retaining business. Foreign companies, including some of our competitors, are
not subject tothese prohibitions. Corruption,
extortion, bribery, pay-offs, theft and other fraudulent practices occur from
time-to-time in mainland China. If our competitors engage in these practices,
they may receive preferential treatment from personnel of some companies, giving our competitors an
advantage in securing business or from government officials who might give them
priority in obtaining new licenses, which would put us at a disadvantage.
Although we inform our personnel that such practices are illegal, wecan not assure you that our employees or
other agents will not engage in such conduct for which we might be held
responsible. If our employees or other agents are found to have engaged in such
practices, we could suffer severe penalties.
  -42-
 
 The Chinese government exerts substantial influence over
the manner in which we must conduct our business activities.
 
 We are dependent on our relationship
with the local government in the province in which we operate our
business.  Chinese government has exercised and continues to exercise substantial control
over virtually every sector of the Chinese economy through regulation and state
ownership.  Our ability to operate in China may be harmed by changes
in its laws and regulations, including those relating to taxation,environmental regulations, land use
rights, property and other matters.  We believe that our operations in
China are in material compliance with all applicable legal and regulatory
requirements. However, the central or local governments of these
jurisdictions may impose new, stricter regulations
or interpretations of existing regulations that would require additional
expenditures and efforts on our part to ensure our compliance with such
regulations or interpretations.  Accordingly, government actions in
thefuture, including any decision not to
continue to support recent economic reforms and to return to a more centrally
planned economy or regional or local variations in the implementation of
economic policies, could have a significant effect on economic conditions in China or particular regions
thereof, and could require us to divest ourselves of any interest we then hold
in Chinese properties.
 
 We are subject to environmental laws and
regulations in the PRC.
  We are subject to environmental laws and
regulations in the PRC. Any
failure by us to comply fully with such laws and regulations will result in us
being subject to penalties and fines or being required to pay damages. Although
we believe we are currently in compliance with the environmental
regulations in all material respects, any change
in the regulations may require us to acquire equipment or incur additional
capital expenditure or costs in order to comply with such regulations. Our
profits will be adversely affected if we are unable to pass on suchadditional costs to our
customers.
  We may have difficulty establishing
adequate management, legal and financial controls in the
PRC.
 
 The PRC historically has been deficient
in Western style management and financial reporting concepts and practices, aswell as in modern banking,
computer and other control systems. We may have difficulty in hiring and
retaining a sufficient number of qualified employees to work in the PRC. As a
result of these factors, we may experience difficulty in establishing
management, legal and financial controls,
collecting financial data and preparing financial statements, books of account
and corporate records and instituting business practices that meet Western
standards.
 
 It will be extremely difficult to
acquire jurisdiction and
enforce liabilities against our officers, directors and assets based in the
PRC.
 
 Because most of our executive officers
and several of our directors, including our chairman of the Board of Directors,
are Chinese citizens, it may be difficult, if not impossible, to acquire jurisdiction over
these persons in the event a lawsuit is initiated against us and/or our officers
and directors by a stockholder or group of stockholders in the United States.
Also, because the majority of our assets are located in the PRC, it would also be extremely
difficult to access those assets to satisfy an award entered against us in the
U.S. court.
 
 The legal system in China has inherent
uncertainties that may limit the legal protections available in the event of any
claims or disputes with
third parties.
 
 The legal system in China is based on
written statutes. Prior court decisions may be cited for reference but have
limited precedential value. Since 1979, the central government has promulgated
laws and regulations dealing with economic matters such as foreign
investment, corporate organization and governance, commerce, taxation and trade.
As China’s foreign investment laws and
regulations are relatively new and the legal system is still evolving, the
interpretation of many laws, regulations and rules is not always
uniform and enforcement of these laws, regulations and rules involve
uncertainties, which may limit the remedies available in the event of any claims
or disputes with third parties. In addition, any litigation in China may be protracted and result in
substantial costs and diversion of resources and management
attention.
 
 Item 2.Unregistered Sales
of Equity Securities and Use of Proceeds
 
 None.
 
 Item 3.Defaults upon Senior
Securities
  None.
  Item 4.Submission
of
Matters to a Vote of Securities Holders
  None.
  -43-
 
 Item 5.Other
Information
  OnApril1, 2009,the Company entered into an amendment to
the Employment Agreement dated November 27, 2007 (the “Amendment”) between the
Company and Ms. Christy Young Shue, the Company’s Executive Vice President
ofFinance and Investor
Relations. Pursuant to the
terms of the Amendment, Ms. Shue’s base salary was increased from $100,000 to
$110,000 per year in recognition of the additional responsibility she has
assumed as the Corporate Secretary of the Company. All of the other terms and
conditions of the Employment Agreement remain the same.A copy of the Amendment is attached
hereto as Exhibit 10.1to
this Quarterly Report.
  Item 6.Exhibits.
 The exhibits listed on the
Exhibit Index are being
furnished with this report.
  -44-
  SIGNATURES
  Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
  HarbinElectric,
    Inc.Date:May 8, 2009
              By:
              /s/ Tianfu
      YangTianfu
  YangChief Executive Officer, Director
      and Chairman of the Board
                (Principal Executive
      Officer)
  Date:May 8, 2009
              By:
              /s/ Zedong
      XuZedong
XuChief Financial Officer
                (Principal Accounting
      Officer)
 
 -45-
  EXHIBIT INDEX
 
 Exhibits:
   Exhibit Number
                  
                  Description
                  
                  Method of Filing3.1
                  
                  Articles of Merger dated as of
      January 27, 2005 by
                    and betweenthe Companyand Torch Executive Services
      Ltd., aNevadacorporation.
                  
                  Filed herewith as Exhibit
      3.1.10.1
                  
                  Amendment toEmployment Agreement,datedApril 1, 2009by and between the Company and Ms.
      ChristyYoung Shue.
                  
                  Filed herewith as Exhibit
      10.1.10.2
                  
                  Amendment to Letter Agreement,dated as of April 21,
      2009 between the Company and Shelton Technology,
    LLC.
                  
                  Filed as Exhibit 10.1to the current report on Form 8-K
      filed with the Commission on April 24, 2009 and incorporated herein by
      reference.31.1
                  
                  Certification by theChief Executive Officer pursuant
      to Rule 13a-14(a) or 15d-14(a)
                  
                  Filed herewith as Exhibit
      31.1.31.2
                  
                  Certification by the Chief
      Financial Officer pursuant to Rule 13a-14(a) or
      15d-14(a)
                  
                  Filed herewith as Exhibit
      31.2.32.1
                  
                  Certification of the Chief
      Executive Officer and the Chief Financial Officer pursuant 18 U.S.C.
      Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
                  
                  Filed herewith as Exhibit
      32.1.99.1
                  
                  Press Release
      dated May 8, 2009 - announcing the Company’s results of operations
      for the first quarter of 2009.
                  
                  Filed herewith as Exhibit
      99.1.
  -46-