UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549









FORM
10-Q









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




For the
quarterly period ended June 30, 2010




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




For the
transition period from ________ to ________




Commission
file number   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 mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934,
during the past 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes x    Noo




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).       Yeso    Noo





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 filer  o
            Accelerated
      filer x
            Non-accelerated
      filer oSmaller
      reporting company o





Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes  oNo  x





APPLICABLE
ONLY TO CORPORATE ISSUERS





State the number of shares outstanding
of each of the issuer’s classes of common equity,
as of August 6, 2010:
31,067,471 shares of common stock, par value $0.00001 per
share.














TABLE
OF CONTENTS




PagePart
      I. Financial Information
              
              3Item
      1. Financial Statements
              
              3Consolidated
      Balance Sheets
                As
      of June 30, 2010 (Unaudited) and December 31, 2009
              
              3Consolidated
      Statements of Operations and Other Comprehensive Income
                For
      the Three Months and Six Months Ended June 30, 2010 and 2009
      (Unaudited)
              
              4Consolidated
      Statements of Changes in Equity (Unaudited)
              
              5Consolidated
      Statements of Cash Flows
                For
      the Six Months Ended June 30, 2010 and 2009 (Unaudited)
              
              6Notes
      to the Consolidated Financial Statements (Unaudited)
              
              7Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
              
              35Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
              
              44Item
      4. Controls and Procedures
              
              44Part
      II. Other Information
              
              44Item
      1. Legal Proceedings
              
              44Item
      1A. Risk Factors
              
              44Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
              
              49Item
      3. Defaults upon Senior Securities
              
              49Item
      4. Removed and Reserved
              
              49Item
      5. Other Information
              
              49Item
      6. Exhibits
              
              49Signatures
              
              50Index
      to Exhibits
              
              51




2




PART
I. FINANCIAL INFORMATION




Item
1. Financial Statements (Unaudited)




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





CONSOLIDATED
BALANCE SHEETS


AS OF
JUNE 30, 2010 (UNAUDITED) AND DECEMBER 31, 2009





June
      30,
                              
                              
                              December 31,2010
                              
                              
                              2009(Unaudited)ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                              
                              $
                              40,275,201
                              
                              
                              $
                              92,902,400Restricted
      cash
                              
                              
                              5,086,010
                              
                              
                              
                              3,522,009Notes
      receivable
                              
                              
                              317,814
                              
                              
                              
                              1,086,929Accounts
      receivable, net
                              
                              
                              95,484,435
                              
                              
                              
                              93,322,885Inventories,
      net
                              
                              
                              80,865,291
                              
                              
                              
                              74,913,877Other
      receivables & prepaid expenses
                              
                              
                              3,453,818
                              
                              
                              
                              5,828,453Advances
      on inventory purchases
                              
                              
                              13,255,272
                              
                              
                              
                              11,718,544Total
      current assets
                              
                              
                              238,737,841
                              
                              
                              
                              283,295,097PLANT
      AND EQUIPMENT, net
                              
                              
                              182,148,559
                              
                              
                              
                              156,364,548OTHER
      ASSETS:Debt
      issuance costs, net
                              
                              
                              77,319
                              
                              
                              
                              359,255Advance
      on non-current assets
                              
                              
                              24,167,429
                              
                              
                              
                              13,666,414Goodwill
      and other intangible assets, net
                              
                              
                              73,673,741
                              
                              
                              
                              75,546,225Other
      assets
                              
                              
                              1,216,471
                              
                              
                              
                              1,722,693Total
      other assets
                              
                              
                              99,134,960
                              
                              
                              
                              91,294,587Total
      assets
                              
                              $
                              520,021,360
                              
                              
                              $
                              530,954,232LIABILITIES AND SHAREHOLDERS'
      EQUITYCURRENT
      LIABILITIES:Notes
      payable - short term
                              
                              $
                              5,747,885
                              
                              
                              $
                              4,533,268Accounts
      payable
                              
                              
                              55,833,838
                              
                              
                              
                              47,099,135Short
      term loans
                              
                              
                              46,150,243
                              
                              
                              
                              44,439,629Customer
      deposits
                              
                              
                              15,136,028
                              
                              
                              
                              18,455,842Accrued
      liabilities and other payables
                              
                              
                              7,246,715
                              
                              
                              
                              12,329,394Taxes
      payable
                              
                              
                              9,012,807
                              
                              
                              
                              8,233,862Amounts
      due to original shareholders
                              
                              
                              736,500
                              
                              
                              
                              28,681,976Current
      portion of notes payable, net
                              
                              
                              5,083,486
                              
                              
                              
                              7,660,210Total
      current liabilities
                              
                              
                              144,947,502
                              
                              
                              
                              171,433,316LONG
      TERM LIABILITIES:Long
      term bank loans
                              
                              
                              -
                              
                              
                              
                              4,401,000Warrant
      liability
                              
                              
                              3,200,179
                              
                              
                              
                              4,623,558Total
      liabilities
                              
                              
                              148,147,681
                              
                              
                              
                              180,457,874COMMITMENTS
      AND CONTINGENCIESSHAREHOLDERS'
      EQUITY:Common
      Stock, $0.00001 par value, 100,000,000 shares authorized,31,067,471
      and 31,067,471 shares issued and outstandingas
      of June 30, 2010 and December 31, 2009, respectively
                              
                              
                              310
                              
                              
                              
                              310Paid-in-capital
                              
                              
                              213,216,504
                              
                              
                              
                              218,094,374Retained
      earnings
                              
                              
                              110,778,315
                              
                              
                              
                              69,594,111Statutory
      reserves
                              
                              
                              27,913,711
                              
                              
                              
                              22,869,423Accumulated
      other comprehensive income
                              
                              
                              20,051,102
                              
                              
                              
                              18,638,299Total
      shareholders' equity
                              
                              
                              371,959,942
                              
                              
                              
                              329,196,517NONCONTROLLING
      INTERESTS
                              
                              
                              (86,263
                              )
                              
                              
                              21,299,841Total
      liabilities and shareholders' equity
                              
                              $
                              520,021,360
                              
                              
                              $
                              530,954,232




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


3




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME


FOR THE
THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2010 AND 2009


(Unaudited)





Three Months Ended June 30
                    
                    
                    Six Months Ended June 302010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009REVENUES
                    
                    $
                    105,435,970
                    
                    
                    $
                    38,363,484
                    
                    
                    $
                    210,921,127
                    
                    
                    $
                    69,088,377COST
      OF SALES
                    
                    
                    70,103,783
                    
                    
                    
                    25,500,208
                    
                    
                    
                    139,846,870
                    
                    
                    
                    45,301,323GROSS
      PROFIT
                    
                    
                    35,332,187
                    
                    
                    
                    12,863,276
                    
                    
                    
                    71,074,257
                    
                    
                    
                    23,787,054RESEARCH
      AND DEVELOPMENT EXPENSE
                    
                    
                    362,783
                    
                    
                    
                    408,520
                    
                    
                    
                    956,978
                    
                    
                    
                    801,802SELLING,
      GENERAL AND  ADMINISTRATIVE EXPENSES
                    
                    
                    6,886,054
                    
                    
                    
                    3,638,936
                    
                    
                    
                    14,302,812
                    
                    
                    
                    6,143,840INCOME
      FROM OPERATIONS
                    
                    
                    28,083,350
                    
                    
                    
                    8,815,820
                    
                    
                    
                    55,814,467
                    
                    
                    
                    16,841,412OTHER
      EXPENSE (INCOME), NETOther
      income, net
                    
                    
                    (1,326,675
                    )
                    
                    
                    (2,100,885
                    )
                    
                    
                    (2,445,961
                    )
                    
                    
                    (2,640,264
                    )Interest
      expense, net
                    
                    
                    977,858
                    
                    
                    
                    842,528
                    
                    
                    
                    2,624,781
                    
                    
                    
                    2,283,912Loss
      from disposal of subdivision
                    
                    
                    623,158
                    
                    
                    
                    -
                    
                    
                    
                    623,158
                    
                    
                    
                    -Change
      in fair value of warrants
                    
                    
                    (1,657,457
                    )
                    
                    
                    14,014,790
                    
                    
                    
                    (1,423,379
                    )
                    
                    
                    11,441,369Total
      other (income) expense, net
                    
                    
                    (1,383,116
                    )
                    
                    
                    12,756,433
                    
                    
                    
                    (621,401
                    )
                    
                    
                    11,085,017INCOME
      BEFORE PROVISION FOR INCOME TAXES
                    
                    
                    29,466,466
                    
                    
                    
                    (3,940,613
                    )
                    
                    
                    56,435,868
                    
                    
                    
                    5,756,395PROVISION
      FOR INCOME TAXES
                    
                    
                    3,790,892
                    
                    
                    
                    1,478,751
                    
                    
                    
                    7,854,253
                    
                    
                    
                    2,521,425NET
      INCOME BEFORE NONCONTROLLING INTEREST
                    
                    
                    25,675,574
                    
                    
                    
                    (5,419,364
                    )
                    
                    
                    48,581,615
                    
                    
                    
                    3,234,970LESS:
      NET INCOME ATTRIBUTABLE TO NONCONTROLLING INTEREST
                    
                    
                    770
                    
                    
                    
                    -
                    
                    
                    
                    2,353,123
                    
                    
                    
                    -NET
      INCOME ATTRIBUTABLE TO CONTROLLING INTEREST
                    
                    
                    25,674,804
                    
                    
                    
                    (5,419,364
                    )
                    
                    
                    46,228,492
                    
                    
                    
                    3,234,970OTHER
      COMPREHENSIVE INCOME (LOSS)Foreign
      currency translation adjustment
                    
                    
                    1,320,473
                    
                    
                    
                    (9,110
                    )
                    
                    
                    1,412,069
                    
                    
                    
                    (294,478
                    )Foreign
      currency translation adjustment attributable to noncontrolling
      interest
                    
                    
                    611
                    
                    
                    
                    -
                    
                    
                    
                    (191
                    )
                    
                    
                    -Change
      in fair value of derivative instrument
                    
                    
                    -
                    
                    
                    
                    (711,288
                    )
                    
                    
                    -
                    
                    
                    
                    (3,240,364
                    )COMPREHENSIVE
      INCOME
                    
                    $
                    26,995,888
                    
                    
                    $
                    (6,139,762
                    )
                    
                    $
                    47,640,370
                    
                    
                    $
                    (299,872
                    )EARNINGS
      PER SHAREBasicWeighted
      average number of shares
                    
                    
                    31,067,471
                    
                    
                    
                    22,140,568
                    
                    
                    
                    31,067,471
                    
                    
                    
                    22,121,746Earnings
      per share before noncontrolling interest
                    
                    $
                    0.83
                    
                    
                    $
                    (0.24
                    )
                    
                    $
                    1.56
                    
                    
                    $
                    0.15Earnings
      per share attributable to controlling interest
                    
                    $
                    0.83
                    
                    
                    $
                    (0.24
                    )
                    
                    $
                    1.49
                    
                    
                    $
                    0.15Earnings
      per share attributable to noncontrolling interest
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    (0.08
                    )
                    
                    $
                    -DilutedWeighted
      average number of shares
                    
                    
                    31,343,306
                    
                    
                    
                    22,140,568
                    
                    
                    
                    31,348,563
                    
                    
                    
                    22,350,126Earnings
      per share before noncontrolling interest
                    
                    $
                    0.82
                    
                    
                    $
                    (0.24
                    )
                    
                    $
                    1.55
                    
                    
                    $
                    0.14Earnings
      per share attributable to controlling interest
                    
                    $
                    0.82
                    
                    
                    $
                    (0.24
                    )
                    
                    $
                    1.47
                    
                    
                    $
                    0.14Earnings
      per share attributable to noncontrolling interest
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    (0.08
                    )
                    
                    $
                    -




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


4




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF CHANGES IN EQUITY


(Unaudited)




Common stock
                        
                        
                        Additional
                        
                        
                        Retained earnings
                        
                        
                        Accumulated otherPar
                        
                        
                        paid-in
                        
                        
                        Unrestricted
                        
                        
                        Statutory
                        
                        
                        comprehensive
                        
                        
                        NoncontrollingShares
                        
                        
                        value
                        
                        
                        capital
                        
                        
                        earnings
                        
                        
                        reserves
                        
                        
                        income (loss)
                        
                        
                        interest
                        
                        
                        TotalBALANCE,
      January 1, 2009
                        
                        
                        22,102,078
                        
                        
                        $
                        220
                        
                        
                        $
                        95,029,290
                        
                        
                        $
                        52,100,479
                        
                        
                        $
                        14,573,994
                        
                        
                        $
                        12,945,352
                        
                        
                        
                        -
                        
                        
                        $
                        174,649,335Reclassification
      of warrant liabilities to equity
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (13,613,718
                        )
                        
                        
                        6,142,280
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (7,471,438
                        )Amortization
      of stock compensation
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        584,290
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        584,290Non
      cash exercise of warrant at $12.25
                        
                        
                        85,227
                        
                        
                        
                        1
                        
                        
                        
                        1,055,266
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        1,055,267Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3,234,970
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3,234,970Adjustment
      to statutory reserve
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (1,994,565
                        )
                        
                        
                        1,994,565
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Foreign
      currency translation gain
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (294,478
                        )
                        
                        
                        
                        
                        
                        
                        (294,478
                        )Net
      change related to cash flow hedge
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (3,240,364
                        )
                        
                        
                        
                        
                        
                        
                        (3,240,364
                        )BALANCE,
      June 30, 2009 (Unaudited)
                        
                        
                        22,187,305
                        
                        
                        
                        221
                        
                        
                        
                        83,055,128
                        
                        
                        
                        59,483,164
                        
                        
                        
                        16,568,559
                        
                        
                        
                        9,410,510
                        
                        
                        
                        -
                        
                        
                        
                        168,517,582Exercise
      of stock warrants at $7.80
                        
                        
                        1,428,846
                        
                        
                        
                        14
                        
                        
                        
                        26,122,124
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        26,122,138Amortization
      of stock compensation
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        626,747
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        626,747Stock
      issuance for cash at $16
                        
                        
                        7,187,500
                        
                        
                        
                        72
                        
                        
                        
                        107,521,878
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        107,521,950Noncontrolling
      interest in acquiree
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        17,957,815
                        
                        
                        
                        17,957,815Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        16,411,811
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3,491,414
                        
                        
                        
                        19,903,225Exercise
      of stock options at $3.10
                        
                        
                        65,000
                        
                        
                        
                        1
                        
                        
                        
                        201,499
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        201,500Exercise
      of stock options at $8.10
                        
                        
                        70,000
                        
                        
                        
                        1
                        
                        
                        
                        566,999
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        567,000Cashless
      exercise of options
                        
                        
                        128,820
                        
                        
                        
                        1
                        
                        
                        
                        (1
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Adjustment
      to statutory reserve
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (6,300,864
                        )
                        
                        
                        6,300,864
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Dividend
      distribution
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (150,071
                        )
                        
                        
                        (150,071
                        )Foreign
      currency translation gain
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        224,467
                        
                        
                        
                        683
                        
                        
                        
                        225,150Net
      change related to cash flow hedge
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3,322
                        
                        
                        
                        
                        
                        
                        
                        3,322Reclassification
      of change in cash flow hedge to earnings
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        9,000,000
                        
                        
                        
                        
                        
                        
                        
                        9,000,000BALANCE,
      December 31, 2009
                        
                        
                        31,067,471
                        
                        
                        
                        310
                        
                        
                        
                        218,094,374
                        
                        
                        
                        69,594,111
                        
                        
                        
                        22,869,423
                        
                        
                        
                        18,638,299
                        
                        
                        
                        21,299,841
                        
                        
                        
                        350,496,358Amortization
      of stock compensation
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        509,338
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        509,338Net
      income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        46,228,492
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2,353,123
                        
                        
                        
                        48,581,615Adjustment
      to statutory reserve
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,044,288
                        )
                        
                        
                        5,044,288
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        -Deconsolidation
      of subsidiaries
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        23
                        
                        
                        
                        (1,604,613
                        )
                        
                        
                        (1,604,590
                        )Acquisition
      of noncontrolling interest
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (5,387,208
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        711
                        
                        
                        
                        (22,134,423
                        )
                        
                        
                        (27,520,920
                        )Foreign
      currency translation gain
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        1,412,069
                        
                        
                        
                        (191
                        )
                        
                        
                        1,411,878BALANCE,
      June 30, 2010 (Unaudited)
                        
                        
                        31,067,471
                        
                        
                        $
                        310
                        
                        
                        $
                        213,216,504
                        
                        
                        $
                        110,778,315
                        
                        
                        $
                        27,913,711
                        
                        
                        $
                        20,051,102
                        
                        
                        
                        (86,263
                        )
                        
                        $
                        371,873,679




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


5




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR THE
SIX MONTHS ENDED JUNE 30, 2010 AND 2009


(Unaudited)





Six Months Ended June 30,2010
                        
                        
                        2009CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income attibutable to noncontrolling interest
                        
                        $
                        2,353,123
                        
                        
                        $
                        -Net
      income attibutable to controlling interest
                        
                        
                        46,228,492
                        
                        
                        
                        3,234,970Consolidated
      net income
                        
                        
                        48,581,615
                        
                        
                        
                        3,234,970Adjustments
      to reconcile net income to cashprovided
      by (used in) operating activities:Depreciation
                        
                        
                        3,829,181
                        
                        
                        
                        1,287,510Amortization
      of intangible assets
                        
                        
                        753,764
                        
                        
                        
                        524,960Amortization
      of debt issuance costs
                        
                        
                        281,936
                        
                        
                        
                        271,220Amortization
      of debt discount
                        
                        
                        1,223,276
                        
                        
                        
                        2,007,648(Recovery
      of) provision for accounts receivable
                        
                        
                        (29,116
                        )
                        
                        
                        647,729(Recovery
      of) inventory reserve
                        
                        
                        (387,200
                        )
                        
                        
                        -Share-based
      compensation
                        
                        
                        509,338
                        
                        
                        
                        584,290Loss
      on disposal of equipment
                        
                        
                        69,119
                        
                        
                        
                        -Gain
      on cashless conversion of warrants
                        
                        
                        -
                        
                        
                        
                        (11,595
                        )Change
      in fair value of warrants
                        
                        
                        (1,423,379
                        )
                        
                        
                        11,441,369Loss
      from disposal of subdivision
                        
                        
                        623,158
                        
                        
                        
                        -Change
      in operating assets and liabilitiesNotes
      receivable
                        
                        
                        770,358
                        
                        
                        
                        964,911Accounts
      receivable
                        
                        
                        (2,750,252
                        )
                        
                        
                        4,816,100Inventories
                        
                        
                        (6,358,437
                        )
                        
                        
                        6,776,920Other
      receivables & prepaid expenses
                        
                        
                        2,328,104
                        
                        
                        
                        24,422Advances
      on inventory purchases
                        
                        
                        (1,498,028
                        )
                        
                        
                        (264,438
                        )Other
      assets
                        
                        
                        125,988
                        
                        
                        
                        (343,857
                        )Accounts
      payable
                        
                        
                        9,370,961
                        
                        
                        
                        (384,241
                        )Customer
      deposits
                        
                        
                        (2,803,473
                        )
                        
                        
                        (42,712
                        )Accrued
      liabilities & other payables
                        
                        
                        (4,798,093
                        )
                        
                        
                        (958,470
                        )Taxes
      payable
                        
                        
                        719,344
                        
                        
                        
                        461,321Net
      cash  provided by operating activities
                        
                        
                        49,138,164
                        
                        
                        
                        31,038,057CASH
      FLOWS FROM INVESTING ACTIVITIES:Payment
      for advances on intangible assets
                        
                        
                        -
                        
                        
                        
                        (1,234,119
                        )Payment
      for advances on equipment purchases
                        
                        
                        (10,386,470
                        )
                        
                        
                        -Purchase
      of intangible assets
                        
                        
                        (110,507
                        )
                        
                        
                        -Purchase
      of plant and equipment
                        
                        
                        (1,637,564
                        )
                        
                        
                        (268,408
                        )Proceeds
      from sale of equipments and vehicles
                        
                        
                        90,892Additions
      to construction-in-progress
                        
                        
                        (28,558,099
                        )
                        
                        
                        (4,057,555
                        )Addition
      to loan receivable - related party
                        
                        
                        -
                        
                        
                        
                        (4,250,530
                        )Payment
      to original shareholders for acquisition
                        
                        
                        (27,946,571
                        )
                        
                        
                        -Payment
      to acquire noncontrolling interests
                        
                        
                        (26,550,890
                        )
                        
                        
                        -Deconsolidation
      of cash held in disposed subdivisions
                        
                        
                        (602,948
                        )
                        
                        
                        -Proceeds
      from sale of controlling interests in subsidiaries
                        
                        
                        718,781
                        
                        
                        
                        -Net
      cash used in investing activities
                        
                        
                        (94,983,376
                        )
                        
                        
                        (9,810,612
                        )CASH
      FLOWS FROM FINANCING ACTIVITIES:Decrease
      in restricted cash
                        
                        
                        (1,543,179
                        )
                        
                        
                        (510,064
                        )Payment
      on cross currency hedge
                        
                        
                        -
                        
                        
                        
                        (332,027
                        )Payment
      on notes payable
                        
                        
                        (3,800,000
                        )
                        
                        
                        (2,000,000
                        )Proceeds
      from notes payable-short term
                        
                        
                        4,271,647
                        
                        
                        
                        1,020,127Payment
      on notes payable-short term
                        
                        
                        (3,080,524
                        )
                        
                        
                        -Proceeds
      from short term loans
                        
                        
                        6,307,670
                        
                        
                        
                        3,077,970Repayment
      of short term loans
                        
                        
                        (9,094,780
                        )
                        
                        
                        (3,004,685
                        )Net
      cash used in financing activities
                        
                        
                        (6,939,166
                        )
                        
                        
                        (1,748,679
                        )EFFECTS
      OF EXCHANGE RATE CHANGE ON CASH
                        
                        
                        157,179
                        
                        
                        
                        (89,705
                        )(DECREASE)
      INCREASE IN CASH
                        
                        
                        (52,627,199
                        )
                        
                        
                        19,389,061Cash
      and cash equivalents, beginning of period
                        
                        
                        92,902,400
                        
                        
                        
                        48,412,263Cash
      and cash equivalents, end of period
                        
                        $
                        40,275,201
                        
                        
                        $
                        67,801,324





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


6




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30,
2010


(UNAUDITED)




Note
1 - Nature of Business
 
 Harbin
Electric, Inc. (the “Company” or “Harbin Electric”) is a Nevada Corporation,
incorporated on July 9, 2003. Through its subsidiaries, the Company 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 certain international
markets.
 
 Recent
development
 
 In
October 2009, Harbin Electric acquired 100% of Xi’an Tech Full Simo Motor Co.,
Ltd. (“Simo Motor”). Simo Motor formerly known as Xi’an Simo Motor Incorporation
(Group), was initially established in 1955 as a State-Owned Enterprise and one
of the major backbone companies of China’s electric motor industry. In January
2004, Simo Motor was privatized as a shareholding company from the former Xi’an
Electric Motor Works under the corporate laws of the People’s Republic of China
(“PRC”). Simo Motor develops and manufactures various industrial motors. Simo
Motor sells its products primarily in China and also in certain international
markets. Simo Motor has been developed to a large enterprise group which
consisted of 15 wholly-owned and 8 majority-owned subsidiaries mainly engaged in
manufacturing and selling of electric motors. As a result, Simo Motor’s
ownership to all subsidiaries averaged to 87.2%. Subsequently, Simo Motor
acquired 4 of the 8 majority-owned subsidiaries and sold 3 of the 8
majority-owned subsidiaries, effective April 1, 2010, as described
below.
 
 On June
3, 2010, Simo Motor entered into four Share Purchase Agreements with
certain shareholders of four subsidiaries of Simo Motor pursuant to which Simo
Motor agreed to acquire all of the equity interests of these subsidiaries that
are not currently held by Simo Motor.  Pursuant to these Share
Purchase Agreements, effective April 1, 2010, Simo Motor would own 100% of the
outstanding equity of Xi’an Tech Full Lamination Co., Ltd. (“Lamination”), Xi’an
Simo A’Da Motor Co., Ltd. (“A’Da Motor”), Xi’an Tech Full Simo Moulds Co., Ltd.
(“Moulds”), and Xi’an Tech Full Simo Transportation Co., Ltd.
(“Transportation”).  See Note 4 for further discussion. These
transactions were closed in the months of June and July 2010. The aggregate
purchase price for these equity interests in Lamination, A’Da Motor, Moulds, and
Transportation is RMB188.2 million ($27.60 million), of which $26.50 million was
paid in the months of May and June 2010 with the remaining $1.10 million paid in
July 2010.
 
 In
addition, Simo Motor also entered into three Share Purchase Agreements,
each dated as of June 3, 2010 with certain shareholders of three subsidiaries of
Simo Motor pursuant to which Simo Motor agreed to sell its equity interests in
such subsidiaries to these shareholders.  Pursuant to these three
Share Purchase Agreements, effective April 1, 2010, Simo Motor would no longer
own any of the outstanding equity of Tianjin Simo Electric Co., Ltd. (“Tianjin
Simo”), Xi’an Simo Science and Technology Development Co., Ltd. (“Science and
Technology”), and Xi’an Simo Imports and Exports Co., Ltd. (“Imports and
Exports”).  See Note 3 for further discussion. These transactions were
closed in the months of June and July 2010. The aggregate sales price to be
received by Simo Motor for these equity interests in Tianjin Simo, Science and
Technology, and Imports and Exports is RMB12.55 million ($1.84 million). The
Company received $0.72 million in June 2010 with the remaining $1.12 received in
July 2010.
 
 Note
2 - Summary of Significant Accounting Policies
 
 Basis of
presentation
 
 The
consolidated financial statements of Harbin Electric Inc. reflect the activities
of the following subsidiaries.  All material intercompany transactions
have been eliminated.
  Place incorporated
                          
                          Ownership
                            percentageAdvanced
      Electric Motors, Inc. (“AEM”)
                          
                          Delaware,
      USA
                          
                          
                          100
                          %Harbin
      Tech Full Electric Co., Ltd. (“HTFE”)
                          
                          Harbin,
      China
                          
                          
                          100
                          %Advanced
      Automation Group, LLC (“AAG”)
                          
                          Delaware,
      USA
                          
                          
                          100
                          %Advanced
      Automation Group Shanghai Co., Ltd. (“SAAG”)
                          
                          Shanghai,
      China
                          
                          
                          100
                          %Shanghai
      Tech Full Electric Co., Ltd. (“STFE”)
                          
                          Shanghai,
      China
                          
                          
                          100
                          %Weihai
      Tech Full Simo Motor Co., Ltd. (“Weihai”)
                          
                          Weihai,
      China
                          
                          
                          100
                          %Xi’an
      Tech Full Simo Motor Co., Ltd. (“Simo Motor”)
                          
                          Xi’an,
      China
                          
                          
                          100
                          %
  7
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 The
accompanying consolidated financial statements include the accounts of all
directly and indirectly owned subsidiaries listed above.
 
 The
interim unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States,
or GAAP, for interim financial information and with the instructions to
Securities and Exchange Commission, or SEC, Form 10-Q and Article 10 of SEC
Regulation S-X and consistent with the accounting policies stated in the
Company’s 2009 Annual Report on Form 10-K. Certain information and note
disclosures normally included in financial statements prepared in accordance
with GAAP have been condensed or omitted pursuant to such rules and regulations.
Therefore, these financial statements should be read in conjunction with our
audited consolidated financial statements and notes thereto for the year ended
December 31, 2009, included in our Annual Report on Form 10-K filed with the
SEC.
 
 The
interim consolidated financial statements included herein are unaudited;
however, they contain all normal recurring accruals and adjustments that, in the
opinion of management, are necessary to present fairly our consolidated
financial position as of June 30, 2010, our consolidated results of operations
for the three months and six months ended June 30, 2010 and 2009, and our
consolidated results of cash flows for the six months ended June 30, 2010 and
2009. The results of operations for the three months and six months ended June
30, 2010 are not necessarily indicative of the results to be expected for future
quarters or the full year.
 
 Use of
estimates
 
 The
preparation of financial statements in conformity with generally accepted
accounting principles in the United States of America requires management to
make estimates and assumptions about future events. These estimates and the
underlying assumptions affect the reported amounts of assets, liabilities,
revenue and expenses, and disclosures about contingent assets and liabilities.
Such estimates and assumptions by management affect accrued expenses, the
valuation of accounts receivable, inventories, and long-lived assets, legal
contingencies, lives of plant and equipment, lives of intangible assets,
business combinations, goodwill, calculation of warranty accruals, taxes,
share-based compensation and others.
 
 Although
the Company regularly assesses these estimates, actual results could materially
differ. The Company bases its estimates on historical experience and various
other assumptions that it believes to be reasonable under the
circumstances.
 
 Foreigncurrency
transactions
 
 Our
reporting currency is the US dollar.  The functional currency of PRC
subsidiaries is the Chinese Renminbi (“RMB”). Our results of operations and
financial position of the PRC subsidiaries are translated to United States
dollars using the end of period exchange rates as to assets and liabilities and
weighted average exchange rates as to revenues, expenses and cash flows. Capital
accounts are translated at their historical exchange rates when the capital
transaction occurred. The resulting currency translation adjustments are
recorded as a component of accumulated other comprehensive income (loss) within
stockholders’ equity.  As a result, translation adjustments amount
related to assets and liabilities reported on the consolidated statement of cash
flows will not necessarily agree with changes in the corresponding consolidated
balances on the balance sheet. 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.
  8
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Translation
adjustments resulting from this process amounted to a gain of $1,320,473 and a
loss of $9,110 for the three months ended June 30, 2010 and 2009, respectively.
Translation adjustments resulting from this process amounted to a gain of
$1,412,069 and a loss of $294,478 for the six months ended June 30, 2010 and
2009, respectively. The balance sheet amounts with the exception of equity at
June 30, 2010 and December 31, 2009 were translated at 6.789 RMB to $1.00 and
6.837 RMB to $1.00, respectively.  The equity accounts were stated at
their historical exchange rate.  The average translation rates applied
to the revenues, expenses and cash flows statement amounts for the six months
ended June 30, 2010 and 2009 were 6.817 RMB and 6.843 RMB to $1.00,
respectively.
  Transaction
loss of $35,796 and gain of $87,619 were recognized during the three months
ended June 30, 2010 and 2009, respectively. Transaction loss of $38,478 and
$204,690 were recognized during the six months ended June 30, 2010 and 2009,
respectively.
 
 Concentration of
risks
 
 The
Company considers all highly liquid investments with original maturities of
three 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 PRC and with
banks in 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 of June 30, 2010 and December 31, 2009, the Company had deposits in excess of
federally insured limits totaling $44,852,731 and $92,701,730, respectively. The
Company has not experienced any losses in such accounts and believes it is not
exposed to any significant risks on its cash in bank accounts.
 
 No
customer accounted for more than 10% of the net revenue for the three months
ended June 30, 2010. Two major customers accounted for approximately 27% of the
net revenue for the three months ended June 30, 2009, with each customer
individually accounting for 15% and 12%, respectively.
 
 No
customer accounted for more than 10% of the net revenue for the six months ended
June 30, 2010.  Two major customers accounted for approximately 27% of
the net revenue for the six months ended June 30, 2009, with each customer
individually accounting for 14% and 13%, respectively. At June 30, 2009,
the total receivable balance due from these customers was $11,002,527,
representing 43% of total accounts receivable.
 
 No vendor
accounted for more than 10% of the raw material purchases for the three months
ended June 30, 2010. One major vendor provided 13% of the Company’s purchase of
raw materials for the three months ended June 30, 2009.
 
 No vendor
accounted for more than 10% of the raw material purchases for the six months
ended June 30, 2010. One major vendor provided 25% of the Company’s purchase of
raw materials for the six months ended June 30, 2009. The Company’s accounts
payable to this vendor was $0 at June 30, 2009.
 
 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 environments 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.
  9
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 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 down the 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.
 
 Notes
receivable
 
 Notes
receivables arose from sale of goods and represented commercial drafts issued by
customers to the Company that are guaranteed by banks of the
customers.  Notes receivables are interest-free with maturity dates of
three or six months from date of issuance.
 
 Accounts
receivable
 
 Accounts
receivable are presented net of an allowance for bad debts account. The Company
maintains 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. The estimated loss rate is based on our
historical loss experience and also considerations of current market conditions.
Delinquent account balances are written-off after management has determined that
the likelihood of collection is not probable, and known bad debts are written
off against allowance for doubtful accounts when identified.
 
 Inventories
 
 Inventories
are valued at the lower of cost or market value, as determined on a first-in,
first-out basis, using the weighted average method. Management compares the cost
of inventories with the market value and an allowance is made for writing down
the inventory to its market value, if lower than cost. 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 net realizable value based upon forecasts for
future demand and market conditions. When inventories are written-down to
the lower of cost or market, it is not marked up subsequently based on changes
in underlying facts and circumstances.  Inventories are composed
of raw material for manufacturing electrical motors, work in process, and
finished goods within the Company’s warehouse premise or consigned at a customer
site.
 
 Plant and
equipment
 
 Plant and
equipment are stated at cost, net of depreciation. 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
      - 40  yearsVehicle
                5 -10  yearsOffice
      equipment
                5 - 6  yearsProduction
      equipment
                10 - 12  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 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.
  10
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 The
Company recognizes an impairment loss when estimated cash flows generated by
those assets are less than the carrying amounts of the asset. Based on
management review, the Company believes that there were no impairments as of
June 30, 2010 and December 31, 2009.
 
 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.  Goodwill is tested for impairment at the reporting unit
level (operating segment or one level below an operating segment) on an annual
basis in the fourth quarter or more frequently if there are indicators of
impairment exist. For purposes of our goodwill impairment test, a two-step test
is used to identify the potential impairment and to measure the amount of
goodwill impairment, if any. The first step is to compare the fair value of the
reporting unit with its carrying amount, including goodwill. If the fair value
of the reporting unit exceeds its carrying amount, goodwill is considered not
impaired. If the carrying amount of a reporting unit exceeds its fair value, the
second step of the goodwill impairment test is performed to measure the amount
of impairment loss, if any. Under step two, the impairment loss is measured by
comparing the implied fair value of the reporting unit goodwill with the
carrying amount of that goodwill. If the carrying amount of the reporting unit
goodwill exceeds the implied fair value of that goodwill, an impairment loss is
recognized in an amount equal to that excess.
 
 Land use
rights - all land in the PRC is government owned.  As a result,
the government grants land use rights (the “Right”).  The Company has
the Right to use the land for 50 years and amortizes the Right 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
acquisition on July 16, 2007. Capitalized patent costs are amortized on a
straight line method over the related patent terms generally from 6 to 10
years.
 
 The
Company evaluates intangible assets for impairment, at least annually and
whenever events or changes in circumstances indicate that the assets might be
impaired.  We perform our annual impairment test in the fourth
quarter.
 
 Our
impairment test consists of a comparison of the fair value of the intangible
asset with its carrying amount. If the carrying amount of an intangible asset
exceeds its fair value, an impairment loss is recognized in an amount equal to
the excess.  As of June 30, 2010, management believes there was
no impairment.
 
 Accounting for long-lived
assets
 
 Long-lived
assets are reviewed for impairment whenever events or changes in circumstances
indicate that the carrying value of an asset may not be recoverable. We assess
the recoverability of the assets based on the undiscounted future cash flow the
assets are expected to generate and recognize an impairment loss when
estimated undiscounted future cash flow expected to result from the use of the
asset plus net proceeds expected from disposition of the asset, if any, are less
than the carrying value of the asset. When we identify an impairment, we reduce
the carrying amount of the asset to its estimated fair value based on a
discounted cash flow approach or, when available and appropriate, to comparable
market values.  As of June 30, 2010, management believes there was no
impairment.
 
 Stock-based compensation
 
 We record
share-based compensation expense based upon the grant date fair value of
share-based awards. The value of the award is principally recognized as expense
ratably over the requisite service periods. We use the Black-Scholes Merton
(“BSM”) option-pricing model, which incorporates various assumptions including
volatility, expected life and interest rates to determine fair value. 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.
  11
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 The
Company is required to measure the cost of the equity instruments issued in
exchange for the receipt of goods or services from other than employees 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.
 
 Stock
compensation expense is recognized based on awards expected to
vest.  GAAP requires forfeitures to be estimated at the time of grant
and revised in subsequent periods, if necessary, when actual forfeitures differ
from those estimates.  There were no estimated forfeitures as the
Company has a short history of issuing options.
 
 Revenue
recognition
 
 The
Company recognizes sales 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 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
industrial rotary motor business, our products are standardized 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. Should returns
increase in the future it would be necessary to adjust the estimates, in which
case recognition of revenues could be delayed.
 
 Shipping
and handling costs are included in selling, general and administrative costs and
totaled $1,212,761 and $485,201 for the three months ended June 30, 2010 and
2009, respectively. For the six months ended June 30, 2010 and 2009, shipping
and handling costs totaled $2,045,176 and $949,564, respectively.
 
 Income
taxes
 
 The
Company utilizes the asset and liability method of accounting for income taxes,
under which deferred taxes are determined based on the temporary differences
between the financial statement and tax basis of assets and liabilities using
tax rates expected to be in effect during the years in which the basis
differences reverse. A valuation allowance is recorded when it is more likely
than not that some of the deferred tax assets will not be
realized.  GAAP also 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. As of January 1, 2007,
income tax positions must meet a more-likely-than-not recognition threshold to
be recognized.  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.
  12
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Under
this method, deferred income taxes are recognized for the tax consequences in
future years of differences between the tax bases of assets and 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, when
necessary, to reduce deferred tax assets to the amount expected to be
realized.  No material deferred tax amounts were recorded at June 30,
2010 and December 31, 2009, respectively. Penalties and interest incurred
related to underpayment of income tax are classified as income tax expense in
the year incurred.  No significant penalties or interest relating to income
taxes have been incurred during the three and six months ended June 30, 2010 and
2009.  GAAP also provides guidance on de-recognition, classification,
interest and penalties, accounting in interim periods, disclosures, and
transition.
 
 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
Company’s operating subsidiaries located in PRC are subject to PRC income tax.
Under the current Enterprise Income Tax (“EIT”) 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 HTFE is subject to a 10% EIT
rate from January 1, 2008 to December 31, 2010. Weihai is currently at the
standard 25% income tax rate.  Our operations under STFE
were income tax exempt in 2009 and is subject to preferential income
tax rate of 11% in 2010 since STFE is located in an economic development
zone.  Simo Motor is located in the Province of Shaanxi which is in
the mid-west region of China, a specially designated region where the government
grants special income tax rates to qualified entities.  Simo Motor
qualifies for the “Go-West” special income tax rate of 15% promulgated by the
government and therefore is subject to a 15% EIT rate from year 2007 to
2010.
 
 The
Company’s subsidiaries were paying the following tax rate for the three and six
months ended June 30:
 
 2010
                    
                    
                    2009Subsidiaries
                    
                    Income
                      Tax
                      Exemption
                    
                    
                    Effective
                      Income
                      Tax Rate
                    
                    
                    Income
                      Tax
                      Exemption
                    
                    
                    Effective
                      Income
                      Tax RateHTFE
                    
                    
                    15
                    %
                    
                    
                    10
                    %
                    
                    
                    15
                    %
                    
                    
                    10
                    %Weihai
                    
                    
                    0
                    %
                    
                    
                    25
                    %
                    
                    
                    0
                    %
                    
                    
                    25
                    %STFE
                    
                    
                    14
                    %
                    
                    
                    11
                    %
                    
                    
                    25
                    %
                    
                    
                    0
                    %Simo
      Motor (a)
                    
                    
                    10
                    %
                    
                    
                    15
                    %
                    
                    
                    n/a
                    
                    
                    
                    n/a
  (a) Simo
Motor was acquired in October 2009 and the tax rate only applied to its results
of operations included in the consolidated financial statements, which are for
the three months and six months ended June 30, 2010.
 
 The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the three months ended June 30:
  2010
                      
                      
                      2009U.S.
      statutory reserve rates
                      
                      
                      34.0
                      %
                      
                      
                      34.0
                      %Foreign
      income not recognized in U.S.
                      
                      
                      -34.0
                      %
                      
                      
                      -34.0
                      %China
      income taxes
                      
                      
                      25.0
                      %
                      
                      
                      25.0
                      %Tax
      exemption
                      
                      
                      -9.4
                      %
                      
                      
                      -13.0
                      %Other
      items (b)
                      
                      
                      -2.7
                      %
                      
                      
                      -50.0
                      %Effective
      income taxes
                      
                      
                      12.9
                      %
                      
                      
                      -38.0
                      %
  13
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 (b)  The
(2.7) % represents the $786,587 of gain incurred by the Company and its US
subsidiaries AEM and AAG that are not subject to PRC income tax for the three
months ended June 30, 2010. The (50)% represents the $15,269,121
of expenses incurred by the Company and its US subsidiaries AEM and
AAG that are not subject to PRC income tax for the three months ended June 30,
2009.
 
 The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the six months ended June 30:
  2010
                    
                    
                    2009U.S.
      statutory reserve rates
                    
                    
                    34.0
                    %
                    
                    
                    34.0
                    %Foreign
      income not recognized in U.S.
                    
                    
                    -34.0
                    %
                    
                    
                    -34.0
                    %China
      income taxes
                    
                    
                    25.0
                    %
                    
                    
                    25.0
                    %Tax
      exemption
                    
                    
                    -11.6
                    %
                    
                    
                    -13.0
                    %Other
      items (c)
                    
                    
                    0.5
                    %
                    
                    
                    32.0
                    %Effective
      income taxes
                    
                    
                    13.9
                    %
                    
                    
                    44.0
                    %
 
 (c)  The
0.5 % represents the $279,410 of expenses incurred by the Company and its US
subsidiaries AEM and AAG that are not subject to PRC income tax for the six
months ended June 30, 2010. The 32% represents the $15,138,049 of
expenses incurred by the Company and its US subsidiaries AEM and AAG that
are not subject to PRC income tax for the six months ended June 30,
2009.
 
 The
estimated tax savings for the six months ended June 30, 2010 and 2009 amounted
to $6,806,723 and $2,865,216, respectively. The net effect on earnings per share
attributable to controlling interest had the income tax been applied would
decrease earnings per share from $1.49 to $1.27 for the six months ended June
30, 2010, and $0.15 to $0.02 for the six months ended June 30,
2009.
 
 Harbin
Electric, AEM, and AAG were organized in the United States and have incurred net
operating losses for income tax purposes for the six months ended June 30,
2010.  The net operating loss carry forwards for United States income
taxes amounted to $30,437,873 which may be available to reduce future years’
taxable income.  These carry forwards will expire, if not utilized,
starting from 2027 through 2030.  Management believes that the
realization of the benefits from these losses appears uncertain due to the
Company’s limited operating 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 for the six months
ended June 30, 2010 was an increase of approximately $394,990. Management will
review this valuation allowance periodically and make adjustments
accordingly.
 
 The
Company has cumulative undistributed earnings of foreign subsidiaries of
approximately $172,575,926 as of June 30, 2010, which is included in
consolidated retained earnings and will continue to be indefinitely reinvested
in international operations.  Accordingly, no provision has been made for
U.S. deferred taxes related to future repatriation of these earnings, nor is it
practicable to estimate the amount of income taxes that would have to be
provided if we concluded that such earnings would be remitted in the
future.
 
 Value added
tax
 
 Sales
revenue represents the invoiced value of goods, net of a value-added tax
(“VAT”). All of the Company’s products that are sold in the PRC are subject to a
Chinese value-added tax at 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 the cost 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.
  14
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 VAT on
sales and VAT on purchases amounted to $20,075,916 and $13,653,918 for the three
months ended June 30, 2010, respectively.  VAT on sales and VAT on
purchases amounted to $6,708,657 and $3,916,888 for the three months ended
June 30, 2009, respectively. VAT on sales and VAT on purchases amounted to
$38,059,087 and $24,967,631 for the six months ended June 30, 2010,
respectively.  VAT on sales and VAT on purchases amounted
to $12,695,403 and $7,586,458 for the six months ended June 30, 2009,
respectively. Sales and purchases are recorded net of VAT collected and
paid as the Company acts as an agent for the government.
 
 Advertising
costs
 
 The
Company expenses the cost of advertising as incurred in selling, general and
administrative costs. The Company incurred $23,662 and $53,489 for the three
months ended June 30, 2010 and 2009, respectively. The Company incurred
$56,111 and $57,105 for the six months ended June 30, 2010 and 2009,
respectively.
 
 Research and development
costs
 
 Research
and development costs are expensed as incurred.  The costs of material
and equipment that are acquired or constructed for research and development
activities and have alternative future uses are classified as plant and
equipment and depreciated over their estimated useful lives.
 
 Noncontrolling
interest
 
 The
Company owns 100% of Simo Motor. The 0.04% of noncontrolling interest was
indirectly from one of Simo Motor’s subsidiary Qishan Simo Moulding Co,
Ltd.
 
 Fair value of financial
instruments
 
 On
January 1, 2008, the Company began recording financial assets and liabilities
subject to recurring fair value measurement at the price that would be received
to sell an asset or paid to transfer a liability in an orderly transaction
between market participants. On January 1, 2009, the Company began recording
non-recurring financial as well as all non-financial assets and liabilities
subject to fair value measurement under the same principles. These fair value
principles prioritize valuation inputs across three broad levels. 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.
 
 As of
June 30, 2010, the outstanding principal on the Company’s 2012 Notes Payable,
evaluated under these accounting standards, amounted to $5,083,486, net of
discount.  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.
  15
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Effective
January 1, 2009, a total of 2,030,158 warrants previously treated as equity
pursuant to the derivative treatment exemption is 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, the Chinese
RMB.  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. 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 $7.4
million to warrant liabilities to recognize the fair value of such warrants. As
of June 30, 2010, the Company has 366,697 warrants outstanding. The fair value
of the outstanding warrants was $3.2 million.  The Company recognized
a total of $1.7 million gain from the change in fair value of the warrants
for the three months ended June 30, 2010 and $1.4 million gain for the six
months ended June 30, 2010.
 
 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-Scholes
Option Pricing Model using the following assumptions:
 
 June30,2010
                    
                    
                    January1,2009(Unaudited)
                    
                    
                    (Unaudited)Annual
      dividend yield
                    
                    
                    -
                    
                    
                    
                    -Expected
      life (years)
                    
                    
                    2.17
                    
                    
                    
                    3.67Risk-free
      interest rate
                    
                    
                    0.70
                    %
                    
                    
                    1.20
                    %Expected
      volatility
                    
                    
                    69
                    %
                    
                    
                    66
                    %
 
 Expected
volatility is based primarily on historical volatility. Historical volatility
was computed using daily price observations for recent periods that correspond
to 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.
 
 Carrying Value
                      as of
                      June
      30,
                      2010
                    
                    
                    Fair Value Measurements at June
      30, 2010 Using
                      Fair Value Hierarchy(Unaudited)
                    
                    
                    Level 1
                    
                    
                    Level 2
                    
                    
                    Level 3Fair
      value of warrant liabilities
                    
                    $
                    3,200,179
                    
                    
                    
                    
                    
                    
                    $
                    3,200,179
 
 Other
than the warranty liabilities, the Company did not identify any assets and
liabilities that are required to be presented on the balance sheet at fair
value.
 
 Recent Accounting
Pronouncements
 
 In
January 2010, FASB issued ASU No. 2010-01– Accounting for Distributions to
Shareholders with Components of Stock and Cash. The amendments in this Update
clarify that the stock portion of a distribution to shareholders that allows
them to elect to receive cash or stock with a potential limitation on the total
amount of cash that all shareholders can elect to receive in the aggregate is
considered a share issuance that is reflected in EPS prospectively and is not a
stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings
Per Share). The amendments in this update are effective for interim and annual
periods ending on or after December 15, 2009, and should be applied on a
retrospective basis. The adoption of this ASU did not have impact on the
Company’s consolidated financial statements.
  16
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 In
January 2010, FASB issued ASU No. 2010-02 – Accounting and Reporting for
Decreases in Ownership of a Subsidiary – a Scope Clarification. The amendments
in this Update affect accounting and reporting by an entity that experiences a
decrease in ownership in a subsidiary that is a business or nonprofit activity.
The amendments also affect accounting and reporting by an entity that exchanges
a group of assets that constitutes a business or nonprofit activity for an
equity interest in another entity. The amendments in this update are effective
beginning in the period that an entity adopts SFAS No. 160, “Non-controlling
Interests in Consolidated Financial Statements – An Amendment of ARB No. 51.” If
an entity has previously adopted SFAS No. 160 as of the date the amendments in
this update are included in the Accounting Standards Codification, the
amendments in this update are effective beginning in the first interim or annual
reporting period ending on or after December 15, 2009. The amendments in this
update should be applied retrospectively to the first period that an entity
adopted SFAS No. 160. The adoption of this ASU did not have a material impact on
the Company’s consolidated financial statements.
 
 In
January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair
Value Measurements. This update provides amendments to Subtopic 820-10 that
requires new disclosure as follows: 1) Transfers in and out of Levels 1 and 2. A
reporting entity should disclose separately the amounts of significant transfers
in and out of Level 1 and Level 2 fair value measurements and describe the
reasons for the transfers. 2) Activity in Level 3 fair value measurements. In
the reconciliation for fair value measurements using significant unobservable
inputs (Level 3), a reporting entity should present separately information about
purchases, sales, issuances, and settlements (that is, on a gross basis rather
than as one net number). This update provides amendments to Subtopic 820-10 that
clarifies existing disclosures as follows: 1) Level of disaggregation. A
reporting entity should provide fair value measurement disclosures for each
class of assets and liabilities. A class is often a subset of assets or
liabilities within a line item in the statement of financial position. A
reporting entity needs to use judgment in determining the appropriate classes of
assets and liabilities. 2) Disclosures about inputs and valuation techniques. A
reporting entity should provide disclosures about the valuation techniques and
inputs used to measure fair value for both recurring and nonrecurring fair value
measurements. Those disclosures are required for fair value measurements
that fall in either Level 2 or Level 3. The new disclosures and clarifications
of existing disclosures are effective for interim and annual reporting periods
beginning after December 15, 2009, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements. These disclosures are effective for fiscal years
beginning after December 15, 2010, and for interim periods within those fiscal
years. The Company is currently evaluating the impact of this ASU, however, the
Company does not expect the adoption of this ASU to have a material impact on
its consolidated financial statements.
 
 In
February 2010, FASB issued ASU No. 2010-9 –Amendments to Certain
Recognition and Disclosure Requirements. This update addresses certain
implementation issues related to an entity’s requirement to perform and disclose
subsequent-events procedures, removes the requirement that public companies
disclose the date of their financial statements in both issued and revised
financial statements. According to the FASB, the revised statements include
those that have been changed to correct an error or conform to a retrospective
application of U.S. GAAP. The amendment is effective for interim and annual
reporting periods in fiscal year ending after June 15, 2010. The adoption of
this ASU did not have a material impact on the Company’s consolidated financial
statements.
 
 In March
2010, FASB issued ASU No. 2010-10 –Amendments for Certain Investment Funds. This
update defers the effective date of the amendments to the consolidation
requirements made by FASB Statement 167 to a reporting entity’s interest in
certain types of entities. The deferral will mainly impact the evaluation of
reporting enterprises’ interests in mutual funds, private equity funds, hedge
funds, real estate investment entities that measure their investment at fair
value, real estate investment trusts, and venture capital funds. The ASU also
clarifies guidance in Statement 167 that addresses whether fee arrangements
represent a variable interest for all service providers and decision makers. The
ASU is effective for interim and annual reporting periods in fiscal year
beginning after November 15, 2009. The adoption of this ASU did not have a
material impact on the Company’s consolidated financial
statements.
  17
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 In March
2010, FASB issued ASU No. 2010-11 –Scope Exception Related to Embedded Credit
Derivatives. Embedded credit-derivative features related only to the transfer of
credit risk in the form of subordination of one financial instrument to another
are not subject to potential bifurcation and separate accounting as clarified by
recently issued FASB guidance. Other embedded credit-derivative features are
required to be analyzed to determine whether they must be accounted for
separately. This update provides guidance on whether embedded credit-derivative
features in financial instruments issued by structures such as
collateralized debt obligations (CDOs) and synthetic CDOs are subject to
bifurcation and separate accounting. The guidance is effective at the beginning
of a company’s first fiscal quarter beginning after June 15, 2010. The Company
does not expect the adoption of this ASU to have a material impact on the
Company’s consolidated financial statements.
 
 Reclassifications
 
 Certain
prior period amounts have been reclassified to conform to the current period
presentation. These reclassifications have no effect on net income or cash
flows.
 
 Note
3 – Disposal of subdivisions
 
 Effective
April 1, 2010, Simo Motor, a PRC subsidiary of the Company, sold its equity
interests in its three subsidiaries, Tianjin Simo, Science and Technology, and
Imports and Exports, to certain shareholders of these three
subsidiaries.  As a result of the above dispositions, Simo Motor will
no longer own any of the outstanding equity of these three
subsidiaries.  The Company evaluates the impact of the disposal of the
above entities, which results in the Company failing the test in ASC 205-20-45.
The failure of this test therefore does not require the classification of the
disposal of the above entities as a discontinued operation. The aggregate sales
price for the equity interests in Tianjin Simo, Science and Technology, and
Imports and Exports is RMB12.55 million (US$1.84 million). A net loss of
$623,158 was recorded in loss from disposal of subdivisions, net of income taxes
in the Company’s Consolidated Statements of Operations.
 
 Note
4 – Acquisition of the noncontrolling interests
 
 Effective
April 1, 2010, Simo Motor, a PRC subsidiary of the Company, acquired all of the
equity interests in its four subsidiaries, Lamination, A’Da Motor, Moulds, and
Transportation.  As a result of the above acquisitions, Simo Motor
will now own 100% of the outstanding equity of these four
subsidiaries.  The aggregate purchase price for the equity interests
in these four subsidiaries is $27.60 million, of which $26.55 million was
received in June with the remaining $1.1 million received in July
2010.
 
 The
effects of changes in the Company’s ownership interest in its
subsidiaries:
 
 ForthesixmonthsendedJune302010
                      
                      2009(Unaudited)Net
      income attributable to controlling interest
                      
                      $
                      46,228,492
                      
                      
                      $
                      3,234,970Transfer
      (to) from the noncontrolling interestDecrease
      in Paid-in Capital for purchase of
      noncontrolling interests
                      
                      
                      (5,387,208
                      )
                      
                      
                      -Change
      from net income attributable to controlling interest and transfers (to)
      noncontrolling interest
                      
                      $
                      40,841,284
                      
                      
                      $
                      3,234,970
  18
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Note
5 – Supplemental disclosure of cash flows
 
 The
Company prepares its statements of cash flows using the indirect method as
defined under the ASC Topic 230. The following information relates to non-cash
investing and financing activities for the six months ended June 30, 2010 and
2009.
 
 Total
interest paid amounted to $1,513,782 and $1,807,095 for the six months ended
June 30, 2010 and 2009, respectively.
 
 Total
income tax paid amounted to $7,089,794 and $2,312,075 for the six months ended
June 30, 2010 and 2009, respectively.
 
 For the
six months ended June 30, 2010, equipment in the amount of $322,027 was
transferred as payment to accounts payable for $171,279 and as payment to other
payables for the amount of $150,748.
 
 Note
6 – Accounts receivable
 
 Accounts
receivable consisted of the following:
 
 June
      30,
                      
                      
                      December 31,2010
                      
                      
                      2009(Unaudited)Accounts
      receivable
                      
                      $
                      99,438,034
                      
                      
                      $
                      97,302,153Less:
      allowance for bad debts
                      
                      
                      (3,953,599
                      )
                      
                      
                      (3,979,268
                      )Accounts
      receivable, net
                      
                      $
                      95,484,435
                      
                      
                      $
                      93,322,885
 
 The
following table consists of allowance for bad debts:
 
 Allowance
      for bad debts at January 1, 2009
                    
                    $
                    153,155Provision
      for bad debts
                    
                    
                    647,729Accounts
      receivable write off
                    
                    
                    -Effect
      of foreign currency translation
                    
                    
                    (519
                    )Allowance
      for bad debts at June 30, 2009 (Unaudited)
                    
                    
                    800,365Recovery
      of accounts receivable
                    
                    
                    (1,082,929
                    )Increase
      in allowance from acquisition of Simo Motor
                    
                    
                    4,263,411Effect
      of foreign currency translation
                    
                    
                    (1,579
                    )Allowance
      for bad debts at December 31, 2009
                    
                    
                    3,979,268Recovery
      of accounts receivable
                    
                    
                    (29,116
                    )Accounts
      receivable write off
                    
                    
                    -Effect
      of foreign currency translation
                    
                    
                    3,447Allowance
      for bad debts at June 30, 2010 (Unaudited)
                    
                    $
                    3,953,599
 
 Note
7 – Inventories
 
 The
following is a summary of inventories by major category:
 
 June
      30,
                      
                      
                      December 31,2010
                      
                      
                      2009(Unaudited)Raw
      and packing materials
                      
                      $
                      13,680,851
                      
                      
                      $
                      11,826,804Work
      in process
                      
                      
                      26,158,585
                      
                      
                      
                      28,434,522Finished
      goods
                      
                      
                      32,003,242
                      
                      
                      
                      25,471,544Finished
      goods - consignment
                      
                      
                      17,516,405
                      
                      
                      
                      18,077,870Inventory
      valuation allowance
                      
                      
                      (8,493,792
                      )
                      
                      
                      (8,896,863
                      )Total
      inventories, net
                      
                      $
                      80,865,291
                      
                      
                      $
                      74,913,877
  19
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 As of
June 30, 2010 and December 31, 2009, total inventory valuation allowance
amounted to $8,493,792 and $8,896,863.  All inventory valuation
allowance is from the subsidiary Simo Motor acquired on October 2,
2009.
 
 Allowance
      for inventory valuation at January 1, 2009
                    
                    $
                    -Additional
      reserves
                    
                    
                    -Recovery
      of reserves
                    
                    
                    -Effect
      of foreign currency translation
                    
                    
                    -Allowance
      for inventory valuation at June 30, 2009 (Unaudited)
                    
                    
                    -Additional
      reserves
                    
                    
                    710,466Recovery
      of reserves
                    
                    
                    -Increase
      in allowance from acquisition of Simo Motor
                    
                    
                    8,186,252Effect
      of foreign currency translation
                    
                    
                    145Allowance
      for inventory valuation at December 31, 2009
                    
                    
                    8,896,863Additional
      reserves
                    
                    
                    998,749Recovery
      of inventory reserves
                    
                    
                    (1,385,949
                    )Effect
      of foreign currency translation
                    
                    
                    (15,871
                    )Allowance
      for inventory valuation at June 30, 2010 (Unaudited)
                    
                    $
                    8,493,792
 
 Note
8 – Advances on inventory purchases
 
 The
Company makes advances to certain vendors for inventory
purchases.  The advances on inventory purchases were $13,255,272 and
$11,718,544 as of June 30, 2010 and December 31, 2009,
respectively.
 
 Note
9 – Plant and equipment
 
 The
following table presents details of our property and equipment:
 
 June
      30,
                      
                      
                      December 31,2010
                      
                      
                      2009(Unaudited)Buildings
                      
                      $
                      87,607,192
                      
                      
                      $
                      88,081,895Office
      equipment
                      
                      
                      2,481,373
                      
                      
                      
                      1,437,761Production
      equipment
                      
                      
                      29,203,327
                      
                      
                      
                      28,801,414Vehicles
                      
                      
                      2,848,332
                      
                      
                      
                      3,633,367Construction
      in progress
                      
                      
                      69,095,265
                      
                      
                      
                      40,504,272Total
                      
                      
                      191,235,489
                      
                      
                      
                      162,458,709Less:
      accumulated depreciation
                      
                      
                      (9,086,930
                      )
                      
                      
                      (6,094,161
                      )Property
      and equipment, net
                      
                      $
                      182,148,559
                      
                      
                      $
                      156,364,548
 
 Construction
in progress represents labor costs, material, and capitalized interest incurred
in connection with the construction of the new plant facility in Shanghai and
the construction and installation of manufacturing equipment in HTFE, Weihai,
and Simo Motor.  The Company expects to complete the construction of
Shanghai plant on or before the end of year 2010.
  20
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Depreciation
expense for the three months ended June 30, 2010 and 2009 amounted to $1,941,073
and $619,730, respectively. Depreciation expense for the six months ended
June 30, 2010 and 2009 amounted to $3,829,181 and $1,287,510,
respectively.
 
 For the
six months ended June 30, 2010 and 2009, a total of $127,751 and $2,092,580
of interest were capitalized into construction in progress,
respectively.
 
 Note
10 – Advances on non-current assets
 
 Advances
on non-current assets consisted of advance for intangible assets and advanced
payment to certain vendors for equipment and construction project, as
follows:
 
 June 30,
                                
                                
                                December 31,2010
                                
                                
                                2009(Unaudited)Advance
      for intangible assets
                                
                                $
                                3,146,328
                                
                                
                                $
                                3,133,512Advance
      for equipments and constructions
                                
                                
                                21,021,101
                                
                                
                                
                                10,532,902Total
      advances on non-current assets
                                
                                $
                                24,167,429
                                
                                
                                $
                                13,666,414
 
 Advance for intangible
assets
 
 The
advances for intangible assets consisted of land use right prepayment. 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").  The size of
the land used by HTFE was later revised to a total of approximately 53,000
square meters. The term of the land use agreement is 50 years and the
aggregate amount HTFE shall pay to Shanghai Lingang is approximately $6.28
million (RMB 42,840,000) ("Fee"), approximately 96.8% or $6.08 million (RMB
41,452,020) has been paid, as of June 30, 2010. 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 in connection
with applicable tax generation requirements.
 
 Note
11 – Goodwill and other intangible assets
 
 Net
intangible assets consist of the following at:
 
 June30,
                    2010
                  
                  
                  December31,
                    2009(Unaudited)Goodwill
      on 2008 Acquisition of Weihai
                  
                  $
                  12,273,778
                  
                  
                  $
                  12,273,778Goodwill
      on 2009 Acquisition of Simo Motor
                  
                  
                  40,835,817
                  
                  
                  
                  41,799,976Total
      goodwill
                  
                  
                  53,109,595
                  
                  
                  
                  54,073,754Land
      use rights
                  
                  
                  17,795,814
                  
                  
                  
                  17,481,972Patents
                  
                  
                  6,733,782
                  
                  
                  
                  6,702,983Software
                  
                  
                  233,786
                  
                  
                  
                  95,110Total
      goodwill and other intangible assets
                  
                  
                  77,872,977
                  
                  
                  
                  78,353,819Less:
      accumulated amortization
                  
                  
                  (4,199,236
                  )
                  
                  
                  (2,807,594
                  )Intangible
      assets, net
                  
                  $
                  73,673,741
                  
                  
                  $
                  75,546,225
 
 Amortization
expense for the three months ended June 30, 2010 and 2009 amounted to $387,916
and $232,033, respectively. Amortization expense for the six months ended
June 30, 2010 and 2009 amounted to $753,764 and $524,960,
respectively.
  21
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 The
Company uses the purchase method of accounting for business combinations. Annual
testing for impairment of goodwill is performed during the fourth quarter of
each year unless events or circumstances indicate earlier impairment testing is
required. No impairment loss was recognized for the three months and six months
ended June 30, 2010 and 2009. As a result of the disposition of the three
subdivisions, effective April 1, 2010, Simo Motor would no longer own any of the
outstanding equity of Tianjin Simo, Science and Technology, and Imports and
Exports (see Note 3 for more discussion).  Goodwill of these three
subdivisions in the amount of $964,159 was included in the carrying amount
of the reporting unit in determining the gain or loss on disposal.
 
 Goodwill,
      at the date of the acquisition of Simo Motor, (audited)
                              
                              $
                              41,799,976Goodwill,
      disposed subsidiaries
                              
                              
                              (964,159
                              )Goodwill,
      as of June 30, 2010 (unaudited)
                              
                              $
                              40,835,817
 
 Note
12 – Taxes payable
 
 Taxes
payable consisted of the following:
 June30,
                    2010
                  
                  
                  December 31,
                    2009(Unaudited)VAT
      tax payable
                  
                  $
                  3,161,276
                  
                  
                  $
                  3,473,092Individual
      income tax withholding payable
                  
                  
                  79,597
                  
                  
                  
                  71,563Corporation
      income tax payable
                  
                  
                  3,400,750
                  
                  
                  
                  2,825,545Others
      miscellaneous tax payable
                  
                  
                  2,371,184
                  
                  
                  
                  1,863,662Total
                  
                  $
                  9,012,807
                  
                  
                  $
                  8,233,862
 
 Note
13 – 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 into 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 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.
 
 On June
1, 2009, the Company and Citadel entered into a Letter Agreement (the “Citadel
Agreement”). Pursuant to the Citadel Agreement, the Company was granted the
option to repurchase, all (but not part), of the $26.5 million 2012 Notes held
by Citadel before August 31, 2009 (“the Proposed 2012 Notes
Repurchase”).  On August 4, 2009, the Company notified Citadel
that pursuant to the Citadel Agreement (i) the Company was exercising its option
to consummate the Proposed 2012 Notes Repurchase and (ii) the Proposed 2012
Notes Repurchase shall be consummated on August 11, 2009 (the “Citadel
Repurchase Date”) at an aggregate Citadel Repurchase Price of $23,131,997 to be
paid in cash, which Repurchase Price shall be comprised of $22,525,000
representing 85% of the $26,500,000 aggregate principal amount of the 2012 Notes
held by Citadel (the “Citadel Notes”) plus $606,997 representing accrued
and unpaid interest on the Citadel Notes to but excluding the Repurchase Date.
On August 11, 2009, the Company made cash payment in accordance with terms of
the Citadel Agreement and recorded a gain of $3,975,000 from the repurchase
transaction.  After principal payment of $2,400,000 made in September 2009
and $3,800,000 made in March 2010, the 2012 Notes balance as of June 30, 2010
amounted to $5,083,486 (net of debt discount of $216,514), or a total of
$5,300,000 which will be fully paid off in September 2010.
  22
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 On July
14, 2009, the Company entered into a Letter Agreement with Merrill Lynch
International and ABN AMRO Bank N.V., London Branch (the “Merrill Agreement”).
Pursuant to the Merrill Agreement, the Company was granted the option to
repurchase, all (but not part),  of the remaining $6 million 2010
Notes held by Merrill Lynch International ($3 million) and ABN AMRO Bank N.V.,
London Branch  ($3 million) before July 31, 2009.  On July
31, 2009, the Company paid a total of $5,983,844 to repurchase the 2010
Notes, which amount was comprised of $5,820,000 representing 97% of the
$6,000,000 aggregate principal amount of the 2010 Notes held by the Holders plus
$163,844 representing accrued and unpaid interest on the 2010 Notes to but
excluding the Repurchase Date. As of August 5, 2009, the repurchase was
completed and the 2010 Notes were cancelled and the Company recorded a gain of
$180,000 from the repurchase transaction.
 
 The
following table disclosed the combined aggregate amounts of maturities for all
the notes payable discussed above for each of the five years following
June 30, 2010:
 
 Contractual Obligations
                    
                    2012 Notes
                    
                    
                    Total2010
                    
                    $
                    5,300,000
                    
                    
                    $
                    5,300,000Thereafter
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    5,300,000
                    
                    
                    $
                    5,300,000
 
 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 Merrill Lynch. 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 the three months and six months ended June 30,
2010, no warrants were exercised.
 
 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 life
of the loan using the effective interest method. $312,741 and $885,034 were
amortized to interest expense for the three months ended June 30, 2010 and 2009,
respectively.  $1,223,276 and $2,007,648 were amortized to interest expense
for the six months ended June 30, 2010 and 2009, respectively.  As of June
30, 2010 and December 31, 2009, the unamortized discounts totaled $216,514 and
$1,439,790, respectively.
 
 Debt
issuance costs, initially $2,954,625, are carried in other assets and are
amortized over the life of the loan using the effective interest
method.  A total of $140,968 and $135,610 was amortized to interest
expense for the three months ended June 30, 2010 and 2009, respectively. A total
of $281,936 and $271,220 was amortized to interest expense for the six months
ended June 30, 2010 and 2009, respectively. As of June 30, 2010 and December 31,
2009, unamortized debt issuance costs totaled $77,319, and $359,255,
respectively.
 
 Note
14 -Short term loans
 
 The
Company’s short term loans are comprised of the following:
 
 June30, 2010
                    
                    
                    December 31, 2009(Unaudited)Short
      term loan – bank
                    
                    $
                    40,068,546
                    
                    
                    $
                    38,291,634Short
      term loan – noncontrolling shareholders
                    
                    
                    -
                    
                    
                    
                    918,342Short
      term loan – others
                    
                    
                    5,545,525
                    
                    
                    
                    5,229,653Short
      term loan – officers and employees
                    
                    
                    536,172
                    
                    
                    
                    -Total
      short term loans
                    
                    $
                    46,150,243
                    
                    
                    $
                    44,439,629
  23
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Short
term loans – bank
 June30,
                            2010
                          
                          
                          December 31,
                            2009(Unaudited)Loan
      from Citic Bank in city of Wendeng, due June 2010. Monthly interest-only
      payments at 5.310% per annum, secured by assets
                          
                          $
                          -
                          
                          
                          $
                          3,080,700Loan
      from Citic Bank in city of Wendeng, due May 2011. Monthly interest-only
      payments at 5.310% per annum, secured by assets
                          
                          
                          3,093,300
                          
                          
                          
                          -Loan
      from Commercial Bank in city of Wendeng, due from various dates from
      August to September 2010. Monthly interest-only payments at 5.841% per
      annum, guaranteed loan
                          
                          
                          1,178,400
                          
                          
                          
                          -Loan
      from Xi'an City Commercial Bank, due September 2010. Monthly interest-only
      payment at 5.31% per annum, guaranteed loan
                          
                          
                          1,178,400
                          
                          
                          
                          1,173,600Loan
      From Huaxia Bank, due various dates from April to October 2010. Monthly
      interest-only payment at 6.480% per annum, secured by
      assets
                          
                          
                          -
                          
                          
                          
                          8,802,000Loan
      From Industrial Commercial Bank of China, due various dates from July to
      December 2010. Monthly interest-only payment at 6.372% per annum,
      guaranteed loan
                          
                          
                          3,007,866
                          
                          
                          
                          2,995,614Loan
      From Weihai City Commercial Bank, due various dates from August to
      September 2010. Monthly interest-only payment at 5.841% per annum, secured
      by assets
                          
                          
                          -
                          
                          
                          
                          1,173,600Loan
      from Citic Bank, due in January 2010 through January 2011. Average
      interest from 5.310% per annum, secured by assets
                          
                          
                          7,365,000
                          
                          
                          
                          6,161,400Loan
      from China Merchant Bank, due various dates from May to December 2010.
      Monthly interest-only payments from 5.310% to 5.346% per annum, secured by
      assets
                          
                          
                          8,248,800
                          
                          
                          
                          8,215,200Loan
      from China Construction Bank, due in October 2010. Monthly interest-only
      payment at 10% per annum, guaranteed loan
                          
                          
                          1,473,000
                          
                          
                          
                          1,467,000Loan
      from China Zheshang Bank, due in various dates from June to July 2010.
      Monthly interest-only payment at 5.841% per annum, guaranteed
      loan.
                          
                          
                          3,387,900
                          
                          
                          
                          4,401,000Loan
      from Bank of China. Monthly interest-only payment at 4% per
      annum
                          
                          
                          -
                          
                          
                          
                          821,520Loan
      from Bank of Communications, due in June 2011.  Monthly interest-only
      payment at 5.841% per annum, guaranteed loan
                          
                          
                          1,473,000
                          
                          
                          
                          -Loan
      from Bank of China.  Monthly interest-only payment at %4 per
      annum.
                          
                          
                          824,880Loan
      from Huaxia Bank in city of Xi’an, due various dates from February 2011 to
      March 2011.  Interest-only payments at 6.48% per annum, secured
      by assets.
                          
                          
                          8,838,000Short
      term loan - bank
                          
                          $
                          40,068,546
                          
                          
                          $
                          38,291,634
  24
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Short
term loan – noncontrolling shareholders represent borrowing from its minority
shareholders and amounted to $0 and $918,342 as of June 30, 2010 and December
31, 2009, respectively. All amounts are due within one year, uncollaterized and
the amount was repaid in cash.
 
 The
Company’s short term loans from sources other than banks amounted to $5,545,525
and $5,229,653 as of June 30, 2010 and December 31, 2009.
 
 The
Company’s short term loans from officers and employees amounted to $563,172 and
$0 as of June 30, 2010 and December 31, 2009.
 
 The
Company’s long term bank loan as of June 30, 2010 and December 31, 2009 are as
follows:
  June30,
                    2010
                  
                  
                  December 31,
                    2009(Unaudited)Loan
      from Huaxia Bank in city of Xi’an, due various dates from February 2011 to
      March 2011.  Interest-only payments at 6.48% per annum, secured
      by assets.
                  
                  $
                  -
                  
                  
                  $
                  4,401,000$
                  -
                  
                  
                  $
                  4,401,000
 
 The above
loans are secured by the Company's plants, buildings, land use rights and
inventories located within PRC, with carrying net value as follows:
  June30,
                    2010
                  
                  
                  December31,
                    2009(Unaudited)Plant
      in Xi’an, Shaanxi, China
                  
                  $
                  18,260,163
                  
                  
                  $
                  18,424,465Buildings
      in Xi’an and Weihai, China
                  
                  
                  5,935,262
                  
                  
                  
                  6,037,376Land
      use rights in Xi’an and Weihai, China
                  
                  
                  4,768,431
                  
                  
                  
                  4,742,161Inventories
      in Xi’an, Shaanxi, China
                  
                  
                  8,838,000
                  
                  
                  
                  8,802,000Total
      assets pledged as collateral for bank loans
                  
                  $
                  37,801,856
                  
                  
                  $
                  38,006,002
  25
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Net
interest expense for the three months ended June 30, 2010 and 2009 was comprised
of the following (Unaudited):
 
 2010
                  
                  
                  2009Amortization
      of debt discount
                  
                  $
                  312,741
                  
                  
                  $
                  885,034Amortization
      of debt issuance costs
                  
                  
                  140,968
                  
                  
                  
                  135,610Interest
      expense
                  
                  
                  697,207
                  
                  
                  
                  82,286Interest
      earned on cash deposits
                  
                  
                  (208,854
                  )
                  
                  
                  (172,783
                  )Foreign
      currency transaction loss
                  
                  
                  35,796
                  
                  
                  
                  (87,619
                  )Interest
      expense, net
                  
                  $
                  977,858
                  
                  
                  $
                  842,528
 
 Net
interest expense for the six months ended June 30, 2010 and 2009 was comprised
of the following (Unaudited):
 
 2010
                  
                  
                  2009Amortization
      of debt discount
                  
                  $
                  1,223,276
                  
                  
                  $
                  2,007,648Amortization
      of debt issuance costs
                  
                  
                  281,936
                  
                  
                  
                  271,220Interest
      expense
                  
                  
                  1,492,424
                  
                  
                  
                  171,984Interest
      earned on cash deposits
                  
                  
                  (411,333
                  )
                  
                  
                  (371,630
                  )Foreign
      currency transaction loss
                  
                  
                  38,478
                  
                  
                  
                  204,690Interest
      expense, net
                  
                  $
                  2,624,781
                  
                  
                  $
                  2,283,912
 
 Note
15 – Due to original shareholders
 
 Due to
original shareholders represent the amount that was unpaid for the acquisition
of Simo Motor and Wehai, which consisted of the following:
 June30,
                    2010
                  
                  
                  December 31,
                    2009(Unaudited)Amount
      due to Simo Motor original shareholders
                  
                  $
                  -
                  
                  
                  $
                  27,948,476Amount
      due to Weihai original shareholders
                  
                  
                  736,500
                  
                  
                  
                  733,500$
                  736,500
                  
                  
                  $
                  28,681,976
 
 The
amount due to Simo Motor original shareholders was paid in January 2010 in full.
Amount due to Weihai original shareholders is due on demand.
 
 Note
16 – Derivative instrument
 
 The
Company's operations are exposed to a variety of global market risks, including
the effect of changing currency exchange rates and interest rates. The Company
has used a financial derivative to manage these exposures in the past.
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 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.  This swap was
designated and qualified as a cash flow hedge. The fair value of this swap
agreement at April 02, 2007 (inception date) was a payable of $5,387,487, and on
September 16, 2009 (the termination date), was a payable of $9,003,322,
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 six
months ended June 30, 2009, the Company recorded $3,240,364 as loss on the
derivative instrument, respectively, in other comprehensive income
(loss).
 
 Effective
September 1, 2009, the whole original swap, with outstanding USD notional of
35,600,000 and outstanding CNY notional of 281,240,000 was unwound with a
$9,000,000 premium payment made to Merrill Lynch.  As a result,
$9,000,000 was transferred from the accumulated other comprehensive loss into
earnings as a loss from termination of the swap.  There were no
amounts recorded in the consolidated statements of income in relation to
ineffectiveness of this interest swap prior to unwind.
  26
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 During
the six months ended June 30, 2009, the Company paid $332,027 as hedging
payment and the Company recognized $567,278 of loss from derivative
transactions.
 
 Changes
of cross currency hedge are as follows:
 
 Cross
      currency hedge payable balance at January 1,
    2009
                    
                    $
                    175,986Proceeds
      from cross currency hedge
                    
                    
                    -Loss
      from derivative transactions
                    
                    
                    567,278Payments
      for cross currency hedge
                    
                    
                    (332,027
                    )Cross
      currency hedge payable balance at June 30, 2009
(Unaudited)
                    
                    
                    411,237Proceeds
      from cross currency hedge
                    
                    
                    -Loss
      from derivative transactions
                    
                    
                    556,500Payments
      for cross currency hedge
                    
                    
                    (967,737
                    )Cross
      currency hedge payable balance at December 31,
      2009
                    
                    
                    -Proceeds
      from cross currency hedge
                    
                    
                    -Loss
      from derivative transactions
                    
                    
                    -Payments
      for cross currency hedge
                    
                    
                    -Cross
      currency hedge payable balance at June 30, 2010
(Unaudited)
                    
                    $
                    -
 
 Note
17 – Additional product sales information
 
 The
Company has a single operating segment. The majority of the Company’s revenue
was generated from local sales. Summarized financial information concerning the
Company’s revenues based on geographic areas for the three months ended June 30,
2010 and 2009 are as follows (Unaudited):
 
 2010
                                      
                                      
                                      2009China
                                      
                                      $
                                      99,835,366
                                      
                                      
                                      $
                                      34,781,470International
                                      
                                      
                                      5,600,604
                                      
                                      
                                      
                                      3,582,014Total
      sales
                                      
                                      
                                      105,435,970
                                      
                                      
                                      
                                      38,363,484Cost
      of sales - China
                                      
                                      
                                      66,759,306
                                      
                                      
                                      
                                      23,444,181Cost
      of sales - International
                                      
                                      
                                      3,344,477
                                      
                                      
                                      
                                      2,056,027Total
      cost of sales
                                      
                                      
                                      70,103,783
                                      
                                      
                                      
                                      25,500,208Gross
      profit
                                      
                                      $
                                      35,332,187
                                      
                                      
                                      $
                                      12,863,276
 
 Summarized
financial information concerning the Company’s revenues based on geographic
areas for the six months ended June 30, 2010 and 2009 are as follows
(Unaudited):
 
 2010
                        
                        
                        2009China
                        
                        $
                        198,257,076
                        
                        
                        $
                        62,244,476International
                        
                        
                        12,664,051
                        
                        
                        
                        6,843,901Total
      sales
                        
                        
                        210,921,127
                        
                        
                        
                        69,088,377Cost
      of sales - China
                        
                        
                        132,039,495
                        
                        
                        
                        41,445,491Cost
      of sales - International
                        
                        
                        7,807,375
                        
                        
                        
                        3,855,832Total
      cost of sales
                        
                        
                        139,846,870
                        
                        
                        
                        45,301,323Gross
      profit
                        
                        $
                        71,074,257
                        
                        
                        $
                        23,787,054
  27
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Note
18 – Business combinations
 
 Acquisition of
Xi’an Tech Full Simo Motor
Co. Ltd.
 
 On
October 2, 2009, HTFE entered into an Equity Acquisition Agreement (the
“Agreement”) with Xi’an Simo Electric Co. Ltd. (“Xi’an Simo”) and Shaanxi
Electric Machinery Association (“Shaanxi Electric” and collectively with Xi’an
Simo, the “Selling Shareholders”) whereby HTFE agreed to acquire (i)
100% of the outstanding shares of Simo Motor, which was 99.94% owned by
Xi’an Simo and 0.06% owned by Shaanxi Electric, and (ii) all corresponding
assets of Simo Motor, including but not limited to, all of the manufacturing
equipment, real-estate, land use rights, stocks, raw materials, automobiles,
intellectual property, receivables, other receivables, payables, business
contracts, and external investments owned by Simo Motor for an aggregate price
of approximately $111.6 million (RMB 763.2 million), payable in
cash.  The acquisition also included 15 wholly-owned and 8
majority-owned subsidiaries by Simo Motor. As a result, the Company’s ownership
to Simo Motor and all subsidiaries averaged to 87.2%. The remaining 12.8% was
owned by noncontrolling shareholders. On October 13, 2009, the Company completed
the acquisition of Simo Motor. As of the closing date, HTFE had completed the
registration of the share transfer with the requisite PRC authorities and had
obtained the required business registration and transfer of licenses of
Simo Motor, all as contemplated by the Agreement. On October 13, 2009, Simo
Motor changed its name to Xi’an Tech Full Simo Motor Co. Ltd.
 
 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 Value
                    
                    
                    Fair ValueCurrent
      assets
                    
                    $
                    150,918,962
                    
                    
                    $
                    150,918,962Property,
      plant and equipment, net
                    
                    
                    53,417,013
                    
                    
                    
                    54,331,338Other
      noncurrent assets
                    
                    
                    6,890,327
                    
                    
                    
                    14,116,814Goodwill
                    
                    
                    -
                    
                    
                    
                    41,799,976Total
      assets
                    
                    
                    211,226,302
                    
                    
                    
                    261,167,090Total
      liabilities
                    
                    
                    131,250,800
                    
                    
                    
                    131,250,800Noncontrolling
      interest
                    
                    
                    17,957,814
                    
                    
                    
                    17,957,814Net
      assets
                    
                    $
                    62,017,688
                    
                    
                    $
                    111,958,476
 
 Based on
an evaluation by an independent appraisal and final asset evaluation by the
management, the purchase price exceeded the fair value of Simo Motor’s net
assets by $41.8 million, which was recognized as goodwill.
 
 Effective
April 1, 2010, as a result of the disposition of the three subdivisions, Simo
Motor would no longer own any of the outstanding equity of Tianjin Simo, Science
and Technology, Imports and Exports (see Note 3 for more
discussion).  Goodwill of these three subdivisions in the amount of
$964,159 was included in the carrying amount of the reporting unit in
determining the gain or loss on disposal.
 Goodwill,
      at the date of the acquisition of Simo Motor, (audited)
                      
                      $
                      41,799,976Goodwill,
      disposed subsidiaries
                      
                      
                      (964,159
                      )Goodwill,
      as of June 30, 2010 (unaudited)
                      
                      $
                      40,835,817
 
 For the
above acquisition, the acquirer, HTFE and the acquired subsidiaries of the
Company, engaged a third party independent appraiser to evaluate and determine
the fair value of major assets acquired. The third party independent appraiser
is a certified public accountant under the laws of PRC (the “PRC CPA”). The
assets evaluated by the independent appraiser included fixed assets (equipment
and buildings), construction in progress, and intangible assets (land use
rights).  The PRC CPA conducted an on-site visit, inspected each item,
conducted market research and investigation, and provided an evaluation report
based on certain asset evaluation policies and regulations issued by the Chinese
government. The Company’s management used the PRC CPA’s appraisal reports as a
reference to assess the fair value of these assets and reported in the financial
statements. For current assets, however, the management used the carrying value
on the acquisition date.
  28
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Pro
Forma
 
 The
following unaudited pro forma condensed income statement for the six months
ended June 30, 2010 and 2009 were prepared under generally accepted accounting
principles, as if the acquisition of Simo Motor had occurred the first day of
the respective periods. The pro forma information may not be indicative of the
results that actually would have occurred if the acquisition had been in
effect from and on the date indicated.
 
 For the three
      months ended June 30 (Unaudited),
                    
                    2010
                    
                    
                    2009Sales
                    
                    $
                    105,435,970
                    
                    
                    $
                    76,605,811Cost
      of Goods Sold
                    
                    
                    70,103,783
                    
                    
                    
                    50,926,643Gross
      Profit
                    
                    
                    35,332,187
                    
                    
                    
                    25,679,168Operating
      Expenses
                    
                    
                    7,248,837
                    
                    
                    
                    8,457,091Income
      from Operations
                    
                    $
                    28,083,350
                    
                    
                    $
                    17,222,077Other
      expense (Income), net
                    
                    
                    (1,383,116
                    )
                    
                    
                    13,704,891Income
      Tax
                    
                    
                    3,790,892
                    
                    
                    
                    1,995,789Net
      Income before noncontrolling interest
                    
                    $
                    25,675,574
                    
                    
                    $
                    1,521,397Net
      Income attributable to controlling interest
                    
                    $
                    25,674,804
                    
                    
                    $
                    (118,083
                    )
 
 For the six months ended June
      30 (Unaudited),
                    
                    2010
                    
                    
                    2009Sales
                    
                    $
                    210,921,127
                    
                    
                    $
                    141,094,482Cost
      of Goods Sold
                    
                    
                    139,846,870
                    
                    
                    
                    95,720,751Gross
      Profit
                    
                    
                    71,074,257
                    
                    
                    
                    45,373,731Operating
      Expenses
                    
                    
                    15,259,790
                    
                    
                    
                    14,609,160Income
      from Operations
                    
                    $
                    55,814,467
                    
                    
                    $
                    30,764,571Other
      expense (Income), net
                    
                    
                    (621,401
                    )
                    
                    
                    12,602,084Income
      Tax
                    
                    
                    7,854,253
                    
                    
                    
                    3,837,679Net
      Income before noncontrolling interest
                    
                    $
                    48,581,615
                    
                    
                    $
                    14,324,808Net
      Income attributable to controlling interest
                    
                    $
                    46,228,492
                    
                    
                    $
                    11,452,834
 
 Note
19 – Commitments and contingencies
 
 Commitments
 
 The
Company enters into non-cancelable purchase commitments with some of its
vendors. As of June 30, 2010 and December 31, 2009, the Company was obligated
under the non-cancelable commitments to purchase materials totaling $2,610,324
and $456,174, respectively. These commitments are short-term and expire within
one year. The Company has not experienced losses on these purchase commitments
over the years.
 
 On April
9, 2007, the Company entered into an agreement with Shelton Technology,
LLC.  Under the terms of the agreement, the Company is required to
contribute a total of $3 million in installments to AAG by March 31,
2009.  The Company has invested a total of $2 million to AAG as of
June 30, 2010 and has the remaining $1,000,000 to be invested.  Based
upon a mutual agreement, the Company will contribute the remaining $1,000,000 to
AAG at a later date according to actual needs.
  29
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 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 size of the
land used by HTFE was later revised to a total of approximately 53,000 square
meters. The term of the Land Use Agreement is 50 years and totaled $6.28 million
(RMB 42.84 million) (“Fee”), approximately 96.8% or $6.08 million (RMB
41,452,020) of which has been paid with the balance to be paid in
installments.
 
 On August
10, 2009, AEM increased its investment capital in its 100% owned subsidiary HTFE
from $57 million to $82 million.  Of the $25 million increase in
capital, $18 Million was paid as of June 30, 2010 with the remaining $7
million of contribution payable by AEM to be paid prior to September
2011.
 
 Contingencies
 
 As of
June 30, 2010, the Company guaranteed bank loans for third parties’ bank loans,
including line of credit, amounting to $18,368,310.
 
 Nature of
                        
                        Guaranteeguarantee
                        
                        amount
                        
                        Guaranty periodDomestic
      Letters of Credit
                        
                        $
                        7,365,000
                        
                        Various
      from September 2009 to April 2011Bank
      loans
                        
                        
                        11,003,310
                        
                        Various
      from January 2010 to April 2011Total
                        
                        $
                        18,368,310
 
 The
Company has evaluated the guarantee and concluded that the likelihood of having
to make payments under the guarantee is remote.
 
 Note
20 – Earnings per share
 
 FASB
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 common stockholders 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:
 
 Forthethreemonthsended
                                June302010
                              
                              
                              2009(Unaudited)Net
      income before noncontrolling interest
                              
                              $
                              25,675,574
                              
                              
                              $
                              (5,419,364
                              )Less:
      Net income attributable to noncontrolling interest
                              
                              
                              770
                              
                              
                              
                              -Net
      income attributable to controlling interest
                              
                              $
                              25,674,804
                              
                              
                              $
                              (5,419,364
                              )Weighted
      average shares used in basic computation
                              
                              
                              31,067,471
                              
                              
                              
                              22,140,568Diluted
      effect of stock options and warrants
                              
                              
                              275,835
                              
                              
                              
                              -Weighted
      average shares used in diluted computation
                              
                              
                              31,343,306
                              
                              
                              
                              22,140,568Earnings
      per share - Basic:Net
      income before noncontrolling interest
                              
                              $
                              0.83
                              
                              
                              $
                              (0.24
                              )Less:
      Net income attributable to noncontrolling interest
                              
                              $
                              -
                              
                              
                              $
                              -Net
      income attributable to controlling interest
                              
                              $
                              0.83
                              
                              
                              $
                              (0.24
                              )Earnings
      per share - Diluted:Net
      income before noncontrolling interest
                              
                              $
                              0.82
                              
                              
                              $
                              (0.24
                              )Less:
      Net income attributable to noncontrolling interest
                              
                              $
                              -
                              
                              
                              $
                              -Net
      income attributable to controlling interest
                              
                              $
                              0.82
                              
                              
                              $
                              (0.24
                              )
  30
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Forthesixmonthsended
                                June302010
                              
                              
                              2009(Unaudited)Net
      income before noncontrolling interest
                              
                              $
                              48,581,615
                              
                              
                              $
                              3,234,970Less:
      Net income attributable to noncontrolling interest
                              
                              
                              2,353,123
                              
                              
                              
                              -Net
      income attributable to controlling interest
                              
                              $
                              46,228,492
                              
                              
                              $
                              3,234,970Weighted
      average shares used in basic computation
                              
                              
                              31,067,471
                              
                              
                              
                              22,121,746Diluted
      effect of stock options and warrants
                              
                              
                              281,092
                              
                              
                              
                              228,380Weighted
      average shares used in diluted computation
                              
                              
                              31,348,563
                              
                              
                              
                              22,350,126Earnings
      per share - Basic:Net
      income before noncontrolling interest
                              
                              $
                              1.56
                              
                              
                              $
                              0.15Less:
      Net income attributable to noncontrolling interest
                              
                              $
                              (0.08
                              )
                              
                              $
                              -Net
      income attributable to controlling interest
                              
                              $
                              1.49
                              
                              
                              $
                              0.15Earnings
      per share - Diluted:Net
      income before noncontrolling interest
                              
                              $
                              1.55
                              
                              
                              $
                              0.14Less:
      Net income attributable to noncontrolling interest
                              
                              $
                              (0.08
                              )
                              
                              $
                              -Net
      income attributable to controlling interest
                              
                              $
                              1.47
                              
                              
                              $
                              0.14
 All stock
options and warrants have been included in the diluted earnings per share
calculation for the three and six months ended June 30, 2010 and
2009.
 
 Note
21 – Shareholders’ equity
 
 Statutory
reserves
 
 The laws
and regulations of the People’s Republic of China require that before a
Sino-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. The Company will transfer at year end 10% of
the year’s net income determined in accordance with PRC accounting rules and
regulations.
  31
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 For the
six months ended June 30, 2010 and 2009, the Company transferred $5,044,288 and
$1,994,565, representing 10% of the net income generated by the Company’s
subsidiaries located within PRC determined in accordance with PRC accounting
rules and regulations, to this reserve. The remaining reserve to fulfill
the 50% registered capital requirement amounted to approximately $42.5 million
and $49.7 million as of June 30, 2010 and December 31, 2009,
respectively.
 
 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, 2009
                    
                    
                    2,030,158Granted
                    
                    
                    -Forfeited
                    
                    
                    -Exercised
                    
                    
                    (234,615)Outstanding
      as of June 30, 2009 (Unaudited)
                    
                    
                    1,795,543Granted
                    
                    
                    -Forfeited
                    
                    
                    -Exercised
                    
                    
                    (1,428,846
                    )Outstanding
      as of December 31, 2009
                    
                    
                    366,697Granted
                    
                    
                    -Forfeited
                    
                    
                    -Exercised
                    
                    
                    -Outstanding
      as of June 30, 2010 (Unaudited)
                    
                    
                    366,697
 
 Following
is a summary of the status of warrants outstanding at June 30,
2010:
  Outstanding Warrants
                  
                  
                  Exercisable WarrantsExercisePrice
                  
                  
                  Number of
                    Shares
                  
                  
                  Average
                    Remaining
                    Contractual
                    Life
                  
                  
                  Average
                    Exercise Price
                  
                  
                  Number of
                    Shares
                  
                  
                  Average
                    Remaining
                    Contractual
                    Life$
                  10.84
                  
                  
                  
                  366,697
                  
                  
                  
                  2.17
                  
                  
                  $
                  10.84
                  
                  
                  
                  366,697
                  
                  
                  
                  2.17Total
                  
                  
                  
                  366,697
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  366,697
 
 Options
 
 On
November 30, 2009, the Company granted options to an independent director to
purchase an aggregate of 30,000 shares of the Company's common stock, at an
exercise price of $20.02 per share, the closing price of the Company’ s common
stock on November 30, 2009. The fair values of stock options granted to
employees and the independent directors were estimated at the date of grant
using the Black-Scholes option-pricing model with the following
assumptions:
  Expected
                      
                      Expected
                      
                      
                      Dividend
                      
                      
                      Risk Free
                      
                      
                      Grant DateLife
                      
                      Volatility
                      
                      
                      Yield
                      
                      
                      InterestRate
                      
                      
                      FairValueEmployees
      - 2006
                      
                      5.0
      yrs
                      
                      
                      66
                      %
                      
                      
                      0
                      %
                      
                      
                      4.13
                      %
                      
                      $
                      8.10Directors
      - 2006
                      
                      5.0
      yrs
                      
                      
                      66
                      %
                      
                      
                      0
                      %
                      
                      
                      4.13
                      %
                      
                      $
                      8.10Executives
      - 2007
                      
                      3.0
      yrs
                      
                      
                      77
                      %
                      
                      
                      0
                      %
                      
                      
                      4.50
                      %
                      
                      $
                      15.60Directors
      - 2009
                      
                      3.0
      yrs
                      
                      
                      70
                      %
                      
                      
                      0
                      %
                      
                      
                      1.15
                      %
                      
                      $
                      9.39
  32
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Following
is a summary of stock option activity:
 Options Outstanding
                      
                      
                      Weighted
                        Average
                        Exercise Price
                      
                      
                      Aggregate Intrinsic
                        ValueOutstanding
      as of December 31, 2008
                      
                      
                      694,583
                      
                      
                      $
                      10.27
                      
                      
                      $
                      -Granted
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Forfeited
                      
                      
                      (25,000
                      )
                      
                      
                      12.40
                      
                      
                      
                      -Exercised
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Outstanding
      as of June 30, 2009 (Unaudited)
                      
                      
                      669,583
                      
                      
                      $
                      10.19
                      
                      
                      $
                      3,648,656Granted
                      
                      
                      30,000
                      
                      
                      
                      20.02
                      
                      
                      
                      -Forfeited
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Exercised
                      
                      
                      (344,583
                      )
                      
                      
                      7.15
                      
                      
                      
                      -Outstanding
      as of December 31, 2009
                      
                      
                      355,000
                      
                      
                      $
                      13.97
                      
                      
                      $
                      2,333,600Granted
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Forfeited
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Exercised
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Outstanding
      as of June 30, 2010 (Unaudited)
                      
                      
                      355,000
                      
                      
                      $
                      13.97
                      
                      
                      $
                      951,400
 
 Following
is a summary of the status of options outstanding at June 30, 2010:
 
 Outstanding Options
                  
                  
                  Exercisable OptionsExercisePrice
                  
                  
                  Number
                  
                  
                  Average Remaining
                    Contractual
                    Life
                  
                  
                  Average
                    Exercise Price
                  
                  
                  Number
                  
                  
                  Average Remaining
                    Contractual
                    Life$
                  8.10
                  
                  
                  
                  95,000
                  
                  
                  
                  0.60
                  
                  
                  $
                  8.10
                  
                  
                  
                  95,000
                  
                  
                  
                  0.60$
                  15.60
                  
                  
                  
                  230,000
                  
                  
                  
                  0.45
                  
                  
                  $
                  15.60
                  
                  
                  
                  195,333
                  
                  
                  
                  0.45$
                  20.02
                  
                  
                  
                  30,000
                  
                  
                  
                  4.42
                  
                  
                  $
                  20.02
                  
                  
                  
                  17,500
                  
                  
                  
                  4.42Total
                  
                  
                  
                  355,000
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  307,833
 
 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 the shares at $13.73 per share, based on the average
price for the immediately preceding 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 value of the stock
on the date of transfer, as a capital contribution totaling $3,844,904 by the
CEO, was amortized over the vesting period.
 
 For the
three months ended June 30, 2010 and 2009, stock compensation expense related to
options issued amounted to $254,669 and $242,928, respectively. For the six
months ended June 30, 2010 and 2009, stock compensation expense related to
options issued amounted to $509,338, and $584,290,
respectively.
  33
  HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
  (UNAUDITED)
 
 Note 22 –
Employee pension
 
 Regulations
in the People’s Republic of China require 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 service in accordance with a
government managed pension plan. The PRC government is responsible for the
pension liability to the retired staff. The employee pension in the Company
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 contributions to employment benefits,
including pension, of $350,786, and $130,290 for the three months ended June 30,
2010 and 2009, respectively. The Company made contributions to employment
benefits, including pension, of $564,549, and $154,066 for the six months ended
June 30, 2010 and 2009, respectively.
 
 Note 23 –
Subsequent events
 
 On July
28, 2010, the Company entered into a Loan Agreement, dated July 28, 2010 (the
“Agreement”) with Abax Emerald Ltd., a Cayman Islands limited company (“Abax”),
pursuant to which Abax agreed to provide the Company with up to $15,000,000 in
loans (the “Loan”). The Loan shall be made pursuant to one or more borrowings
(each, an “Advance”) from time to time from the Closing Date (July 28, 2010) to
the date falling on the expiration of five (5) months after the Closing Date
upon delivering a notice from us to Abax. In lieu of payment of interest in cash
on each Advance, the outstanding principal amount thereof shall accrete in value
for the period commencing on the Borrowing Date (the date on which any Advance
is made from us to Abax) for such Advance and ending on the day on which such
Advance is repaid, at a rate equal to 10% per annum, computed as described in
the Agreement. The Company may voluntarily prepay any Advance (or portion
thereof in an integral multiple of $100,000) at its accreted value at any time
upon written notice to Abax. On the Maturity Date (six months after the date of
the Agreement), the Company is obligated to repay the remaining outstanding loan
not theretofore paid, together with all fees and other amounts payable under the
Loan.
 
 On July
29, 2010, the Company received the $15 million Loan borrowed against the Loan
Agreement.
 
 The
Company has performed an evaluation of subsequent events through the date these
consolidated financial statements were issued to determine whether the
circumstances warranted recognition and disclosure of those events or
transactions in the consolidated financial statements as of June 30,
2010.
  34




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, 2009
included in our Annual Report on Form 10-K and the 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 energy industry, factory automation, food processing, packaging
industry, power generation systems, mass transportation and freight
transportation systems, chemical, petrochemical, metallurgical, mining, textile,
agricultural, and machinery industries. We primarily supply domestic
markets in China and also certain international markets.




We
currently operate the following four manufacturing facilities in China with an
employee base of approximately 5,060 engineers, production technicians, and
other employees:





·
            Harbin
      Tech Full Electric Co., Ltd. (“Harbin Tech Full”) is located in the
      government-designated Development Zone in the city of Harbin with
      approximately 50,000 square meters of land and manufactures linear motors
      and linear motor integrated
systems.





·
            Shanghai
      Tech Full Electric Co., Ltd. (“Shanghai Tech Full”) is located in the
      Shanghai Zhuqiao Airport Industrial Zone with 40,800 square meters of land
      and manufactures specialty
micro-motors.





·
            Weihai
      Tech Full Simo Motor Co., Ltd. (“Weihai Tech Full Simo”) is located in
      Weihai with approximately 150,000 square meters of land and primarily
      manufactures small to medium sized industrial rotary
    motors.





·
            Xi’an
      Tech Full Simo Motor Co., Ltd. (“Xi’an Tech Full Simo”) was acquired in
      October 2009 and manufactures primarily medium to large sized industrial
      rotary motors. Xi’an Tech Full Simo is located in Xi’an city’s Economy and
      Technology Development Zone and occupies approximately 200,000 square
      meters of land.





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, require
significant 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) describes the method used to apply the accounting
principle.





Accounts
Receivable





The
Company maintains 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. The estimated loss rate is based on our
historical loss experience and also considerations of current market conditions.
Delinquent account balances are written-off after management has determined that
the likelihood of collection is not probable, and known bad debts are written
off against allowance for doubtful accounts when identified.




35


Inventories





Inventories
are valued at the lower of cost or market value, as determined on a first-in,
first-out basis, using the weighted average method. Management compares the cost
of inventories with the market value and an allowance is made for writing down
the inventory to its market value, if lower than cost. 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 net realizable value based upon forecasts for
future demand and market conditions. When inventories are written-down
to the lower of cost or market, it is not marked up subsequently based on
changes in underlying facts and circumstances.  Inventory is composed
of raw material for manufacturing electrical motors, work in process and
finished goods within the Company’s warehouse premise or consigned at a customer
site.





Inventory
levels are maintained based on projections of future demand and market
conditions. Any sudden decline in demand and/or rapid product improvements and
technological changes can result in excess and/or obsolete inventories. To the
extent we increase our reserves for future periods, operating income will be
reduced. Because most of our products are customized and unique to 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,
sometimes we require a binding purchase order or a signed agreement by our
customers agreeing to pay for and take possession of finished
goods inventory parts for the duration of the agreement.





Revenue
Recognition




The
Company recognizes sales 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 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
industrial rotary motor business, our products are standardized 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. Should returns
increase in the future it would be necessary to adjust the estimates, in which
case recognition of revenues could be delayed.





Stock-Based
Compensation




We are
required to estimate the fair value of share-based awards on the date of grant.
The value of the award is principally recognized as expense ratably over the
requisite service periods. The fair value of our restricted stock units is based
on the closing market price of our common stock on the date of grant. We have
estimated the fair value of stock options and stock purchase rights as of the
date of grant or assumption using the Black-Scholes option pricing model, which
was developed for use in estimating the value of traded options that have no
vesting restrictions and that are freely transferable. The Black-Scholes model
considers, among other factors, the expected life of the award and
the expected volatility of our stock price. We evaluate the assumptions
used to value stock options and stock purchase rights on a quarterly basis. The
fair values generated by the Black-Scholes model may not be indicative of the
actual fair values of our equity awards, as it does not consider other factors
important to those awards to employees, such as continued employment, periodic
vesting requirements and limited transferability.





The
Company is required to measure the cost of the equity instruments issued in
exchange for the receipt of goods or services from other than employees 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.





Stock
compensation expense is recognized based on awards expected to vest. GAAP
requires forfeitures to be estimated at the time of grant and revised in
subsequent periods, if necessary, when actual forfeitures differ from those
estimates.  There were no estimated forfeitures as the Company has a
short history of issuing options.





Derivative
Instrument





The
Company has used a cross currency interest rate swap, a derivative financial
instrument, to hedge the risk of rising interest rates on its variable
interest rate debt.  This type of derivative financial instrument is
known as a cash flow hedge.  Cash flow hedges are defined by GAAP as
derivative instruments designated as and used to hedge the exposure to
variability in expected future cash flows that is attributable to a particular
risk. For derivative instruments that are designated and qualify as a cash flow
hedge, the effective portion of the gain or loss on the derivative is reported
as a component of other comprehensive income, net of income taxes and
reclassified into earnings in the same period or periods during which the hedged
transaction affects earnings. Gains and losses on the derivatives representing
either hedge ineffectiveness or hedge components excluded from the assessment of
effectiveness are recognized in current earnings.




36


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 hedging transactions are highly effective in
offsetting changes in fair values or cash flows of hedged items. Any portion
deemed ineffective is recorded in earnings with the effective portion reflected
in accumulated other comprehensive income.





Fair
Value of Financial Instruments





On
January 1, 2008, the Company adopted FASB’s accounting standard related to fair
value measurements and began recording financial assets and liabilities subject
to recurring fair value measurement at the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants. On January 1, 2009 the Company began recording
non-recurring financial as well as all non-financial assets and liabilities
subject to fair value measurement under the same principles. These fair value
principles prioritize valuation inputs across three broad levels.





Recent
Accounting Pronouncement





In
January 2010, FASB issued ASU No. 2010-01 – Accounting for Distributions to
Shareholders with Components of Stock and Cash. The amendments in this Update
clarify that the stock portion of a distribution to shareholders that allows
them to elect to receive cash or stock with a potential limitation on the total
amount of cash that all shareholders can elect to receive in the aggregate is
considered a share issuance that is reflected in EPS prospectively and is not a
stock dividend for purposes of applying Topics 505 and 260 (Equity and Earnings
Per Share). The amendments in this update are effective for interim and
annual periods ending on or after December 15, 2009, and should be applied on a
retrospective basis. The Company does not expect the adoption of this ASU to
have a material impact on its consolidated financial
statements.





In
January 2010, FASB issued ASU No. 2010-02 – Accounting and Reporting for
Decreases in Ownership of a Subsidiary – a Scope Clarification. The amendments
in this Update affect accounting and reporting by an entity that experiences a
decrease in ownership in a subsidiary that is a business or nonprofit activity.
The amendments also affect accounting and reporting by an entity that exchanges
a group of assets that constitutes a business or nonprofit activity for an
equity interest in another entity.  The amendments in this update are
effective beginning in the period that an entity adopts SFAS No. 160,
“Non-controlling Interests in Consolidated Financial Statements – An Amendment
of ARB No. 51.” If an entity has previously adopted SFAS No. 160 as of the date
the amendments in this update are included in the Accounting Standards
Codification, the amendments in this update are effective beginning in the first
interim or annual reporting period ending on or after December 15, 2009.
The amendments in this update should be applied retrospectively to the first
period that an entity adopted SFAS No. 160. The Company does not expect the
adoption of this ASU to have a material impact on the Company’s consolidated
financial statements.





In
January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair
Value Measurements. This update provides amendments to Subtopic 820-10 that
requires new disclosure as follows: 1) Transfers in and out of Levels 1 and
2.  A reporting entity should disclose separately the amounts of
significant transfers in and out of Level 1 and Level 2 fair value measurements
and describe the reasons for the transfers.  2)  Activity in
Level 3 fair value measurements.  In the reconciliation for fair value
measurements using significant unobservable inputs (Level 3), a reporting entity
should present separately information about purchases, sales, issuances, and
settlements (that is, on a gross basis rather than as one net number). This
update provides amendments to Subtopic 820-10 that clarify existing disclosures
as follows: 1) Level of disaggregation. A reporting entity should provide
fair value measurement disclosures for each class of assets and liabilities. A
class is often a subset of assets or liabilities within a line item in the
statement of financial position. A reporting entity needs to use judgment in
determining the appropriate classes of assets and liabilities.
2) Disclosures about inputs and valuation techniques. A reporting
entity should provide disclosures about the valuation techniques and inputs
used to measure fair value for both recurring and nonrecurring fair value
measurements. Those disclosures are required for fair value measurements that
fall in either Level 2 or Level 3. The new disclosures and clarifications
of existing disclosures are effective for interim and annual reporting periods
beginning after December 15, 2009, except for the disclosures about purchases,
sales, issuances, and settlements in the roll forward of activity in Level 3
fair value measurements. These disclosures are effective for fiscal years
beginning after December 15, 2010, and for interim periods within those fiscal
years. The Company is currently evaluating the impact of this ASU, however, the
Company does not expect the adoption of this ASU to have a material impact on
its consolidated financial statements.





In
February 2010, FASB issued ASU No. 2010-9 –Amendments to Certain Recognition and
Disclosure Requirements. This update addresses certain implementation issues
related to an entity’s requirement to perform and disclose subsequent-events
procedures, removes the requirement that public companies disclose the date of
their financial statements in both issued and revised financial statements.
According to the FASB, the revised statements include those that have been
changed to correct an error or conform to a retrospective application of U.S.
GAAP. The amendment is effective for interim and annual reporting periods in
fiscal year ending after June 15, 2010. The Company does not expect the adoption
of this ASU to have a material impact on the Company’s consolidated financial
statements.




In March
2010, FASB issued ASU No. 2010-10 – Amendments for Certain Investment
Funds. This update defers the effective date of the amendments to the
consolidation requirements made by FASB Statement 167 to a reporting entity’s
interest in certain types of entities. The deferral will mainly impact the
evaluation of reporting enterprises’ interests in mutual funds, private equity
funds, hedge funds, real estate investment entities that measure their
investment at fair value, real estate investment trusts, and venture capital
funds. The ASU also clarifies guidance in Statement 167 that addresses whether
fee arrangements represent a variable interest for all service providers and
decision makers. The ASU is effective for interim and annual reporting periods
in fiscal year beginning after November 15, 2009. The adoption of this ASU did
not have a material impact on the Company’s consolidated financial
statements.





37


In March
2010, FASB issued ASU No. 2010-11 – Scope Exception Related to Embedded
Credit Derivatives. Embedded credit-derivative features related only to the
transfer of credit risk in the form of subordination of one financial instrument
to another are not subject to potential bifurcation and separate accounting as
clarified by recently issued FASB guidance. Other embedded credit-derivative
features are required to be analyzed to determine whether they must be accounted
for separately. This update provides guidance on whether embedded
credit-derivative features in financial instruments issued by structures such as
collateralized debt obligations (CDOs) and synthetic CDOs are subject to
bifurcation and separate accounting. The guidance is effective at the beginning
of a company’s first fiscal quarter beginning after June 15, 2010. The Company
does not expect the adoption of this ASU to have a material impact on the
Company’s consolidated financial statements.




RESULTS
OF OPERATIONS





THREE
MONTHS ENDED JUNE 30, 2010 AND 2009





Revenues





For the
second quarter of 2010, total revenues were $105.44 million, up 175% compared
with $38.36 million in the second quarter of 2009, which was negatively impacted
by the global financial crisis. The significant sales growth was mainly the
result of higher sales across all product lines and a contribution of
$44.57 million from Xi’an Tech Full Simo which was acquired in October
2009. Excluding the acquisition, organic growth was 59% year over
year.





By
product line, linear motor sales were up 76% driven by higher oil pump sales
(150 units in the second quarter of 2010 compared to 105 units in the
second quarter of 2009) and revenues from coal transportation project ($5.31
million), which started to contribute in the fourth quarter of 2009. Sales of
specialty micro motors were up 77% from the second quarter of 2009. Sales of
industrial rotary motors increased from $17.00 million to $68.12 million
including $44.57 million from Xi’an Tech Full Simo. Sales of rotary motors at
Weihai Tech Full Simo totaled $23.56 million for the quarter, up 39% compared
with $17 million in the second quarter of 2009.





International
sales totaled $5.60 million, or 5.3% of total sales, for the quarter, an
increase of 56% compared with $3.58 million in the second quarter of 2009,
when the global economic downturn hit our international business severely. The
international sales growth was driven primarily by increased sales in our
specialty micro motor and rotary motor products.





The
following table presents the revenue contribution by percentage for each major
product line in the second quarter of 2010 in comparison with
the second quarter of 2009.





PercentofTotalRevenues(%)ProductLine
                          
                          2Q10
                          
                          
                          2Q09Linear
      Motors and Related Systems
                          
                          
                          19.1
                          %
                          
                          
                          30.0
                          %Specialty
      Micro-Motors
                          
                          
                          14.4
                          %
                          
                          
                          22.3
                          %Rotary
      Motors
                          
                          
                          64.6
                          %
                          
                          
                          44.3
                          %Weihai
                          
                          
                          22.3
                          %
                          
                          
                          44.3
                          %Xi’an
                          
                          
                          42.3
                          %
                          
                          
                          N/AOthers
                          
                          
                          1.9
                          %
                          
                          
                          3.4
                          %Total
                          
                          
                          100
                          %
                          
                          
                          100
                          %International
      Sales
                          
                          
                          5.3
                          %
                          
                          
                          9.3
                          %




Net
Income





The
Company recorded a net income attributable to controlling interest of $25.67
million ($0.82 per diluted share), compared with a net loss of $5.42
million (a loss of $0.24 per diluted share) in the second quarter of 2009, which
included a non-cash charge of $14.01 million due to change in fair value of the
warrants issued with our 2010 Notes and our 2012 Notes.





During
the second quarter, Xi’an Tech Full Simo acquired all of the equity interests in
four of its non-wholly-owned subsidiaries. These acquisitions contributed
$2.03 million ($0.06 per diluted share) to the total net income attributable to
controlling interest for the quarter.




The
management of Harbin Electric uses non-GAAP adjusted net earnings to measure the
performance of the Company’s business internally by excluding non-recurring
items as well as special non-cash charges.  The Company’s management
believes that these non-GAAP adjusted financial measures allow management to
focus on managing business operating performance because these measures
reflect the essential operating activities of Harbin Electric and provide a
consistent method of comparison to historical periods. The Company believes that
providing the non-GAAP measures that management uses internally to its
investors is useful to investors for a number of reasons. The non-GAAP measures
provide a consistent basis for investors to understand Harbin Electric's
financial performance in comparison to historical periods without variation of
non-recurring items and non-operating related charges. In addition, it allows
investors to evaluate the Company's performance using the same methodology and
information as that used by management. Non-GAAP measures are subject to
inherent limitations because they do not include all of the expenses included
under GAAP and because they involve the exercise of judgment of which charges
are excluded from the GAAP financial measure. However, the management of Harbin
Electric compensates for these limitations by providing the relevant disclosure
of the items excluded.




38


Excluding
the $1.66 million non-cash gain due to change in fair value of warrants, the
adjusted net income for the quarter was $24.02 million ($0.77 per diluted
share). This compares to the adjusted net income of $7.42 million ($0.33 per
diluted share) for the quarter ended June 30, 2009, which excluded a $14.01
million non-cash charge due to change in fair value of warrants and a $1.17
million (RMB 8 million) government grant. This is a 224% increase
year-over-over. The higher adjusted net income of the current period was
primarily driven by higher sales across all product lines, contributions from
Xi’an Tech Full Simo, and higher other income.





The
adjusted net profit margin increased to 22.8% in the current quarter from 19.4%
in the second quarter of 2009, reflecting a significant improvement in operating
efficiency as a result of business integration and consolidation.





The
following table provides the non-GAAP financial measure and a reconciliation of
the non-GAAP measure to the GAAP net income.




ThreeMonthsEndedJune302010
                  
                  
                  2009Net
      Income Attributable to Controlling Interest (Loss)
                  
                  $
                  25,674,804
                  
                  
                  $
                  (5,419,364
                  )Add
      Back (Deduct):Other
      Income - Government Grant
                  
                  $
                  0
                  
                  
                  $
                  (1,172,560
                  )Change
      in fair value of warrant
                  
                  $
                  (1,657,457
                  )
                  
                  $
                  14,014,790Adjusted
      Net Income Attributable to Controlling Interest
                  
                  $
                  24,017,347
                  
                  
                  $
                  7,422,866Diluted
      EPS Attributable to Controlling Interest
                  
                  $
                  0.82
                  
                  
                  $
                  (0.24
                  )Add
      Back (Deduct):Other
      Income - Government Grant
                  
                  $
                  0
                  
                  
                  $
                  (0.05
                  )Change
      in fair value of warrant
                  
                  $
                  (0.05
                  )
                  
                  $
                  0.62Adjusted
      EPS Attributable to Controlling Interest
                  
                  $
                  0.77
                  
                  
                  $
                  0.33




Gross
Profit Margin





The
following table presents the average gross profit margin by product line for the
second quarter of 2010, in comparison to the second quarter of
2009.





GrossProfitMargin(%)ProductLine
                  
                  2Q10
                  
                  
                  2Q09Linear
      Motors and Related Systems
                  
                  
                  60.9
                  %
                  
                  
                  56.9
                  %Specialty
      Micro-Motors
                  
                  
                  37.1
                  %
                  
                  
                  40.4
                  %Rotary
      MotorsWeihai
                  
                  
                  12.2
                  %
                  
                  
                  13.2
                  %Xi’an
                  
                  
                  30.9
                  %
                  
                  
                  N/AOthers
                  
                  
                  38.5
                  %
                  
                  
                  48.0
                  %Corporate
      Average
                  
                  
                  33.5
                  %
                  
                  
                  33.5
                  %International
      Business
                  
                  
                  40.3
                  %
                  
                  
                  42.6
                  %





The
overall gross margin remained stable. By product line, higher gross margin for
linear motors is attributable to increased sales of oil pumps and sales of
linear motor systems for coal transportation, which have higher gross margins
relative to other types of linear motors. The gross margin for specialty
micro-motors declined slightly primarily as a result of moving the
production from Harbin to Shanghai, where manufacturing costs such as labor and
fixed costs are relatively higher, particularly at the start-up stage. The
slight decline in gross margin for the rotary motor business was related to a
combination of factors such as higher raw material costs and changes
in product mix.




Operating
Income





Operating
income in the second quarter of 2010 totaled $28.08 million, compared with $8.82
million in the second quarter of 2009, representing a 219% year-over-year
growth. Higher operating income was mainly due to increased sales, the
acquisition of Xi’an Tech Full Simo, and improved operating efficiency. Total
operating costs including selling, general and administrative (“SG&A”)
expenses and research & development (R&D) expenses totaled $7.25
million, compared with $4.05 million a year ago. The higher operating costs were
mainly due to the addition of Xi’an Tech Full Simo, higher expenses related to
higher sales such as shipping and handling costs, higher depreciation expense,
and higher costs associated with the production start-up at our Shanghai
facility. As a percentage of total sales, total operating costs decreased from
10.6% to 6.9%. Operating margin improved to 26.6% in the current quarter from
23.0% in the second quarter of 2009, reflecting a significant improvement in
operating efficiency as a result of  business integration and
consolidation.





39





Other
Income, Net





Other
income (net) was $1.33 million in the current quarter, compared with $2.10
million in the first quarter of 2009, which included a $1.17 million government
grant. The other income mainly consists of income from recycling scrap materials
and selling production waste, a government subsidy representing a 2.5% tax rate
reduction granted to Harbin Tech Full to encourage its high-technology related
businesses, and sometimes government grant or awards.





Loss
from Disposal of Subdivision





Effective
April 1, 2010, Xi’an Tech Full Simo sold its equity interests in three of its
non-wholly-owned subsidiaries. As a result of the dispositions, a net loss of
$623,158 was recorded in loss from disposal of subdivisions, net of income
taxes, in the Company’s Consolidated Statements of Operations.





Interest
Expense





Net
interest expense was $0.98 million for the current quarter. This included
$0.45 million in amortization of debt discount and debt issuance cost in
connection with the Company’s 2012 Notes issued in 2006, $0.70 million interest
expense and $0.21 million in interest income. This compares to net interest
expense of $0.84 million for the second quarter of 2014. In all periods, net
interest expense included non-cash amortization expense of debt discount
and debt issuance cost. Please see Note 14 for a breakdown of interest
expense.





Income
Taxes





The
income tax provision was $3.79 million for the current quarter, compared with
$1.48 million for the second quarter of 2009. The year-over-year increase in
income tax was mainly attributable to the taxable income contributed by Xi’an
Tech Full Simo that was acquired in October 2009, higher income due to the
start-up of Shanghai Tech Full in the fourth quarter of 2009, and higher income
at our Harbin and Weihai facilities.




SIX
MONTHS ENDED JUNE 30, 2010 AND 2009





Revenues





For the
six months ended June 30, 2010, total revenues were $210.92 million, more than
tripled compared with revenues of $69.09 million for the six months ended June
30, 2009.  International sales totaled $12.66 million, or 6.0% of
total sales, in the current period, compared with $6.84 million, or 9.9% of
total sales, in the corresponding period of the prior year.





Compared
with the six months ended June 30, 2009, which was negatively impacted by the
global financial crisis, the significant sales growth was mainly the result of
higher sales across all product lines and a contribution of $89.59 million from
Xi’an Tech Full Simo which was acquired in October 2009. Excluding the
acquisition, sales were up 76% year-over-year.





Net
Income





The
Company recorded a net income attributable to controlling interest of $46.23
million, or $1.47 per diluted share, in the six months ended June 30, 2010,
compared with $3.23 million, or $0.14 per diluted share, in the six months ended
June 30, 2009, which included a non-cash charge of $11.44 million due to change
in fair value of the warrants issued with our 2010 Notes and our 2012
Notes.




Excluding the
$1.42 million non-cash gain due to change in fair value of warrants, the
adjusted net income for the six months ended June 30, 2010 was $44.81 million
($1.43 per diluted share). This compares to the adjusted net income of $13.50
million ($0.60 per diluted share) for the six months ended June 30, 2009, which
excluded a $11.44 million non-cash charge due to change in fair value of
warrants and a $1.17 million (RMB 8 million) government grant to the Company’s
subsidiary HTFE to support the Company’s subway train project that qualified as
engaging in China’s advanced industrialization. This is a 232% of growth
year-over-year. The higher adjusted net income of the current period was
primarily driven by higher sales across all product lines and contributions from
Xi’an Tech Full Simo.





The
adjusted net profit margin increased to 21.2% in the current period from 19.6%
in the same period of 2009, reflecting a significant improvement in operating
efficiency as a result of business integration and
consolidation.


40


The
following table provides the non-GAAP financial measure and a reconciliation of
the non-GAAP measure to the GAAP net income.





SixMonthsEndedJune302010
                
                
                2009Net
      Income Attributable to Controlling Interest (Loss)
                
                $
                46,228,492
                
                
                $
                3,234,970Add
      Back (Deduct):Other
      Income - Government Grant
                
                $
                0
                
                
                $
                (1,172,560)Change
      in fair value of warrant
                
                $
                (1,423,379)
                
                
                $
                11,441,369Adjusted
      Net Income Attributable to Controlling Interest
                
                $
                44,805,113
                
                
                $
                13,503,779Diluted
      EPS Attributable to Controlling Interest
                
                $
                1.47
                
                
                $
                0.14Add
      Back (Deduct):Other
      Income - Government Grant
                
                $
                0
                
                
                $
                (0.05)Change
      in fair value of warrant
                
                $
                (0.04)
                
                
                $
                0.51Adjusted
      EPS Attributable to Controlling Interest
                
                $
                1.43
                
                
                $
                0.60





Operating
Income





Operating
income of $55.81 million in the six months ended June 30, 2010 increased by 231%
from $16.84 million in the six months ended June 30, 2009. Total operating
costs including selling, general and administrative (“SG&A”) expenses and
research & development (R&D) expenses were $15.26 million and $6.95
million in the six months ended June 30, 2010 and 2009, respectively. The higher
operating costs were mainly due to the addition of Xi’an Tech Full Simo, higher
expenses related to higher sales such as shipping and handling costs, higher
depreciation expense, and higher costs associated with the production start-up
at our Shanghai facility. As a percentage of total sales, total operating costs
decreased from 10.1% to 7.2%. Operating margin increased from 24.4% to 26.5%,
reflecting a significant improvement in operating efficiency as a result
of business integration and consolidation.





Other
Income, Net





Other
income (net) was $2.45 million in the six months ended June 30, 2010, compared
with $2.64 million in the six months ended June 30, 2009. The other income
mainly consists of income from recycling scrap materials and selling production
waste, a government subsidy representing a 2.5% tax rate reduction granted to
Harbin Tech Full to encourage its high-technology related businesses, and
sometimes government grant or awards.





Loss
from Disposal of Subdivision





Effective
April 1, 2010, Xi’an Tech Full Simo sold its equity interests in three of its
non-wholly-owned subsidiaries. As a result of the dispositions, a net loss of
$623,158 was recorded in loss from disposal of subdivisions, net of income
taxes, in the Company’s Consolidated Statements of Operations,





Interest
Expense





Net
interest expense was $2.62 million for the six months ended June 30, 2010. This
compares to the net interest expense of $2.28 million for the six months ended
June 30, 2009.  In all periods, net interest expense included non-cash
amortization expense of debt discount and debt issuance cost. Please see Note 14
for a breakdown of interest expense.





Income
Taxes





The
income tax provision was $7.85 million for the six months ended June 30, 2010,
compared with $2.52 million for the six months ended June 30, 2009.





LIQUIDITY
AND CAPITAL RESOURCES





A major
factor in 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 in the
capital markets including potentially debt and equity, which support major
acquisitions and capital investments for business growth.





As of
June 30, 2010, cash and cash equivalents were $40.28 million, compared to $92.90
million as of December 31, 2009. Cash provided by operating activities totaled
$49.14 million for the six months ended June 30, 2010, compared to $31.04
million for the same period in 2009. Net cash used in investing activities
totaled approximately $94.98 million, compared to $9.81 million for the six
months ended June 30, 2009.  Total cash used in financing activities
amounted to $6.94 million and $1.75 million for the six months ended June 30,
2010 and 2009, respectively.





Cash
Provided by Operating Activities





Cash
provided by operating activities totaled $49.14 million for the six months ended
June 30, 2010. The major components of cash provided by operating activities are
consolidated net income (net income attributable to both controlling and
non-controlling interest) adjusted for non-cash income and expense items
and changes in operating assets and liabilities.


41





Financing
Activities





For the
six months ended June 30, 2010, cash used in financing activities totaled $6.94
million, including $12.18 million payment to short term bank loan and notes,
$3.8 million principle payment to the 2012 Notes, and $10.58 million
proceeds from short term bank loan and notes.





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 trustee for the Notes (the
“Indenture”). 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 were scheduled to mature on September 1, 2012 (the “2012
Notes”), and Merrill Lynch subscribed to $12.0 million of the principal amount
of the Notes, which were schedule to 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.





The 2010
Notes bore interest, payable semi-annually in arrears, commencing March 1, 2007,
at a rate equal to LIBOR plus 4.75%. The 2010 Notes were 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.





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.





In 2009,
the Company repurchased the entire 2010 Notes and repurchased part of the 2012
Notes. During the first quarter of 2010, the Company paid $3.8 million principle
amount of the 2012 Notes according to the mandatory redemption
schedule.  As of June 30, 2010, only a total of $5.3 million principle
amount of the 2012 Notes remains outstanding and is due on September 1, 2010
according to the mandatory redemption schedule.





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 Lynch. Each Warrant is exercisable at the option of the Warrant holder
at any time through the maturity date of such Warrant.





As of
June 30, 2010, a total of 366,697 Second Tranche 2012 Warrants remained
outstanding.





On July
28, 2010, the Company entered into a Loan Agreement, dated July 28, 2010 (the
“Loan Agreement”) with Abax
Emerald Ltd., a Cayman Islands limited company (“Abax”), pursuant to
which Abax agreed to provide the Company with up to $15,000,000 in loans (the
“Loan”). The
Loan shall be made pursuant to one or more borrowings (each, an “Advance”) from time
to time from the Closing Date (July 28, 2010) to the date falling on the
expiration of five (5) months after the Closing Date upon delivering a notice
from us to Abax. In lieu of payment of interest in cash on each Advance, the
outstanding principal amount thereof shall accrete in value for the period
commencing on the Borrowing Date (the date on which any Advance is made from us
to Abax) for such Advance and ending on the day on which such Advance is repaid,
at a rate equal to 10% per annum, computed as described in the Agreement. We may
voluntarily prepay any Advance (or portion thereof in an integral multiple of
$100,000) at its accreted value at any time upon written notice to Abax. On the
Maturity Date (six months after the date of the Agreement), the Company is
obligated to  repay the remaining outstanding loan not theretofore
paid, together with all fees and other amounts payable under the
Loan.





On July
29, 2010, the Company received the $15 million loan from Abax.





Investment
Activities





Net cash
used in investing activities totaled approximately $94.98 million for the six
months ended June 30, 2010, including the remaining payment totaled
approximately $27.95 million for the acquisition of Xi’an Tech Full Simo, a
payment of $26.55 million for acquiring remaining interests of non-wholly owned
subsidiaries under Xi’an Tech Full Simo, and capital expenditures totaled $40.58
million.


42





On
October 2, 2009, Harbin Tech Full, a wholly-owned subsidiary of the Company,
entered  into an Equity Acquisition Agreement (the “Agreement”) with
Xi’an Simo Electric Co. Ltd. (“Xi’an Simo”) and Shaanxi Electric Machinery
Association (“Shaanxi Electric” and collectively with Xi’an Simo, the “Selling
Shareholders”) whereby Harbin Tech Full agreed to acquire (i) 100% of the
outstanding shares of Xi’an Simo Motor Incorporation (Group) (“Simo Motor”),
which was 99.94% owned by Xi’an Simo and 0.06% owned by Shaanxi Electric, and
(ii) all corresponding assets of Simo Motor, including but not limited to, all
of the manufacturing equipment, real-estate, land use rights, stocks, raw
materials, automobiles, intellectual property, receivables, other receivables,
payables, business contracts, and external investments owned by Simo Motor for a
purchase price of equal to no less than six (6) times and no more than eight (8)
times the 2008 audited net profits of Simo Motor. Pursuant to the Agreement,
Harbin Tech Full was required to make a payment to the Selling Shareholders
equivalent to six (6) times the 2008 audited net profit of Simo Motor within ten
(10) business days after the effectiveness of the Agreement. Upon verification
of the assets and capital of Simo Motor within seven months of the closing date
of the acquisition, Harbin Tech Full may be required to make an additional
payment to the Selling Shareholders in an amount not to exceed two (2) times the
2008 audited net profit of Simo Motor.





On
October 13, 2009, the Company completed the acquisition of Simo Motor. On
October 22, 2009, the Company paid approximately $84.0 million (RMB
572.7 million) to the Selling Share holders. As of the closing date, Harbin
Tech Full had completed the registration of the share transfer with the
requisite PRC authorities and had obtained the required business registration
and transfer of licenses of Simo Motor, all as contemplated by the Agreement. On
October 13, 2009, Simo Motor changed its name to Xi’an Tech Full Simo Motor Co.
Ltd.





During
the first quarter of 2010, the Company made an additional cash payment in an
amount of $27.95 million (RMB 190.5 million) to the Selling Shareholders
representing the unpaid portion for the acquisition of Xi’an Tech Full Simo. The
acquisition of Xi’an Tech Full Simo has been fully paid for after this
payment pursuant to the Agreement.





On June
3, 2010, Xi’an Tech Full Simo entered into four Sh are Purchase Agreements,
each dated as of June 3, 2010 with certain shareholders of four
subsidiaries of Xi’an Tech Full Simo pursuant to which Xi’an Tech Full Simo
agreed to acquire all of the equity interests of these subsidiaries that are not
currently held by Xi’an Tech Full Simo. Pursuant to these Share Purchase
Agreements, effective April 1, 2010, Xi’an Tech Full Simo would own 100% of the
outstanding equity of the four subsidiaries. These transactions were closed in
the months of June and July 2010. The aggregate purchase price paid by Xi’an
Tech Full Simo for these equity interests is $27.60 million (RMB188.2 million),
of which $26.50 million was paid in May and June 2010 with remaining $1.1
million paid in July 2010.





In
addition, on June 3, 2010, Xi’an Tech Full Simo entered into three Share
Purchase Agreements, each dated as of June 3, 2010 with certain shareholders of
three subsidiaries of Xi’an Tech Full Simo pursuant to which Xi’an Tech Full
Simo agreed to sell its equity interests in such subsidiaries to these
shareholders. Pursuant to these three Share Purchase Agreements, effective
April 1, 2010, Xi’an Tech Full would no longer own any of the outstanding equity
of the three subsidiaries. These transactions were closed in the months of June
and July 2010. The aggregate sales price received by Xi’an Tech Full Simo for
these equity interests is $1.84 million (RMB12.55 million). We received $0.72
million in June 2010 with the remaining $1.12 million received in July
2010.





Contractual
Obligations





As of
June 30, 2010, a total of $5.3 million principal amount of the 2012 Notes
remains outstanding. The Company expects to follow the mandatory redemption
schedule with respect to the 2012 Notes and pay off the 2012 Notes on
September 1, 2010.





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. In June 2009, the Land Use Agreement was
revised with the land size increased to a total of approximately 53,000
square meters. The aggregate amount HTFE shall pay to Shanghai Lingang is now
approximately $6.28 million (RMB42.84 million) ("Fee"), approximately 97% or
$6.08 million (RMB 41.45 million) has been paid as of June 30, 2010 with the
balance payable in installments.




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. AAG has invested $800,000
in AAG Shanghai through June 30, 2010.





The
Company entered into an agreement (“Original Agreement”) with Shelton
Technology, LLC on April 9, 2007 whereby the Company and Shelton agreed to work
together through the Company’s wholly-owned subsidiary, Advanced Automation
Group, LLC (“AAG”), to design, develop, and manufacture custom industrial
automation controllers.  Pursuant to the Original Agreement, 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. Shelton is entitled to receive 49% of any profits earned by AAG
through the initial term of the Agreement which ended August 31, 2008. The
Company and Shelton entered into a first amendment to the Original Agreement on
December 11, 2008 to extend the term of the Original Agreement from August 31,
2008 to December 31, 2008. On April 21, 2009, the Company and Shelton entered
into a second amendment to the Original Agreement to further extend the term to
June 30, 2009. On December 7, 2009, the Company and Shelton entered into
the third amendment to the Original Agreement to further extend the term to
December 31, 2009. The Company has contributed a total of $2.0 million to
AAG as of June 30, 2010. The remaining $1.0 million contribution to AAG is
to be made at a mutually agreed later date.   The Company
and Shelton are continuing their joint work and are currently in the process of
developing a new agreement to extend the arrangement between them with respect
to this work.





The
Company enters into non-cancelable purchase commitments with its vendors. As of
June 30, 2010, and December 31, 2009, the Company was obligated under the
non-cancelable commitments to purchase materials totaling to $2,610,324 and
$456,174, respectively. These commitments are short-term and expire within one
year. The Company has experienced no losses on these purchase commitments over
the years.


43





Off-balance
Sheet Arrangements





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 2009 Annual 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, 2009.





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 June 30, 2010, 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 this report, 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
in Internal Control over Financial Reporting





There
have been no changes in our internal control over financial reporting that
occurred during the six months ended June 30, 2010 that have materially
affected, or are reasonably likely to materially affect, the Company’s internal
control over financial reporting.





PART II. OTHER
INFORMATION




Item 1. LegalProceedings





We are
not currently a party to any material legal proceedings. From time to time,
however, we may become involved in various lawsuits and 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 of the
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 175% from the second quarter of 2009 and 85% in the year
ended December 31, 2009 versus the year ended December 31, 2008. However,
it is unlikely that we will maintain such growth in the long term and we cannot
assure any growth of our business for any period. Our rapid expansion will place
significant strain on our management and our operational, accounting, and
information systems as well as our financial resources. 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 hire,
train, motivate, and manage our employees. In addition, we may require
additional financial resources to fund our growing working capital needs. Our
failure to manage our growth could disrupt our operations and ultimately prevent
us from generating the profits we expect.




Our
debt may constrict our future operations and cash flows.





As of
June 30, 2010, we had $5.30 million debt principal outstanding under our
Guaranteed Senior Secured Floating Rate Notes due 2012 (the “Notes”) issued in
August 2006. Additionally, our PRC subsidiaries had a total of approximately
$46.15 million loans outstanding as of June 30, 2010. These loans were obtained
from local PRC banks and unrelated individual companies. They are used to
support our working capital. On July 29, 2010, we borrowed an additional $15
million pursuant to the Loan Agreement we entered into on July 28, 2010 with
Abax. These obligations could have important consequences to you. For example,
they could:


44





·
            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;





·
            in
      the case of the Notes, expose us to interest rate fluctuations because the
      interest rate for the Notes is variable;
and





·
            place
      us at a competitive disadvantage compared to competitors that may 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 own our PRC operating subsidiaries. These security
interests could result in our loss of the business, if we default on the
Notes.





Covenants
in the Indenture governing our Notes and the Loan Agreement with Abax
restrict our ability to engage in or enter into a variety of
transactions.





Our Notes
were issued pursuant to an Indenture, dated as of August 30, 2006, between us
and The Bank of New York, as Trustee. The Indenture 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, create liens on our assets to
secure debt, make capital expenditures, incur additional indebtedness,
and pay dividends. The Indenture also requires us to maintain certain
financial ratios. The Loan Agreement with Abax also contains certain
covenants that may limit our discretion in operating our business. In
particular, we are limited in our ability to merge, consolidate, alter our
corporate structure, transfer substantially all of our assets, incur liens, and
engage in transactions with affiliates. The Loan Agreement also requires us
to maintain certain financial ratios. 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.





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 the continued 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 any of 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 the supply of raw materials and key component parts, and any adverse
changes in such supply or the costs of raw materials may adversely affect our
operations.




No vendor
accounted for more than 10% of the raw material purchases for the three months
and six months ended June 30, 2010. One major vendor provided approximately 13%
and 25% of the Company’s purchases of raw materials for the three months and six
months ended June 30, 2009, respectively. 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.





We
may experience material disruptions to our manufacturing operation.





While we
seek to 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 our manufacturing 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;




45





·
              an
      equipment failure;





·
                disruptions
      in the transportation infrastructure including roads, bridges, railroad
      tracks;





·
              fires,
      floods, earthquakes, or other catastrophes;
and





·
              other
      operational problems.





We
may not be able to adequately protect and maintain our intellectual property,
which could weaken our competitive position.





Our
success will depend on our ability to continue to develop and market electric
motor products. We have been granted 20 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 to us. The implementation and enforcement of PRC
intellectual property laws historically have not been vigorous or consistent,
primarily because of ambiguities in the PRC laws and a relative lack of
developed enforcement mechanisms. Accordingly, intellectual property rights
and confidentiality protections in the PRC are not as effective as in the United
States and other countries. Policing the unauthorized use of proprietary
technology is difficult and expensive, and we might need to resort to litigation
to enforce or defend patents issued to us or to determine the enforceability,
scope and validity of our proprietary rights or those of others. Such litigation
will require significant expenditures of cash and management efforts and could
harm our business, financial condition and results of operations. An adverse
determination in any such litigation will impair our intellectual property
rights and may harm our business, competitive position, business prospects and
reputation. In addition, since we have chosen to secure patents only in China,
we may not be in a position to protect our inventions and technology in other
countries in which we sell our product, which could result in increased
competition and lower pricing for our products.





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 geographically and 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 negative effect 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 exercises significant
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.





PRC
laws and regulations governing our current business operations are sometimes
vague and uncertain and any changes in such laws and regulations may harm our
business.





There are
substantial uncertainties regarding the interpretation and application of PRC
laws and regulations including, but not limited to, the laws and regulations
governing our business, and the enforcement and performance of our arrangements
with customers in the event of the imposition of statutory liens, death,
bankruptcy and criminal proceedings. We are considered foreign persons or
foreign funded enterprises under PRC laws and, as a result, we are required
to comply with PRC laws and regulations. These laws and regulations are
sometimes vague and may be subject to future changes, and their official
interpretation and enforcement may involve substantial uncertainty. The
effectiveness of newly enacted laws, regulations or amendments may be delayed,
resulting in detrimental reliance. New laws and regulations that affect existing
and proposed future businesses may also be applied retroactively. We cannot
predict what effect the interpretation of existing or new PRC laws or
regulations may have on our business.





Inflation
in the PRC could negatively affect our profitability and growth.





The PRC
economy has experienced rapid growth. Rapid economic growth could lead to growth
in the money supply and rising inflation. If prices for our products rise at a
rate that is insufficient to compensate for the rise in the cost of supplies, it
may harm our profitability. In order to control inflation in the past, the PRC
government has imposed controls on bank credit, limits on loans for fixed assets
and restrictions on state bank lending. Such policies can lead to a slowing of
economic growth. In October 2004, the People’s Bank of China, the PRC’s central
bank, raised interest rates for the first time in nearly a decade and
indicated in a statement that the measure was prompted by inflationary concerns
in the Chinese economy. Repeated rises in interest rates by the central bank
would likely slow economic activity in China which could, in turn, materially
increase our costs and also reduce demand for our
products.


46





PRC
regulations relating to mergers, offshore companies, and Chinese stockholders,
if applied to us, may limit our ability to operate our business as we see
fit.





Regulations
govern the process by which we may participate in an acquisition of assets or
equity interests. Depending on the structure of the transaction, the new
regulation will require Chinese parties to make a series of applications and
supplemental applications to various government agencies. In some instances, the
application process may require the presentation of economic data concerning a
transaction, including appraisals of the target business and evaluations of the
acquirer, which are designed to allow the government to assess the
transaction. Government approvals will have expiration dates by which a
transaction must be completed and reported to the government agencies.
Compliance with the new regulations is likely to be more time consuming and
expensive than in the past and the government can now exert more control
over the combination of two businesses. Accordingly, due to the PRC regulations,
our ability to engage in business combination transactions in China through our
Chinese subsidiaries has become significantly more complicated, time consuming
and expensive, and we may not be able to negotiate transactions that are
acceptable to us or sufficiently protective of our interests in a
transaction.





If
preferential tax concessions granted by the PRC government change or expire, our
financial results could be materially and adversely affected.





Our
financial results may be adversely affected by changes to or expiration of
preferential tax concessions that our Chinese subsidiaries currently enjoy. 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”),
such as Weihai Tech Full Simo Motor Co. Ltd. and Xi’an Tech Full Simo Motor Co.,
Ltd., and Foreign Invested Enterprises (“FIEs”), such as Harbin Tech Full
Electric Co., Ltd., Shanghai Tech Full Electric Co., Ltd., and Advanced
Automation Group Shanghai, Ltd. The new standard EIT rate of 25% is now
applicable to both DES and FIEs. The PRC government provides reduced tax
rates for productive foreign investment enterprises in the Economic and
Technological Development Zones and for enterprises engaged in production or
business operations in the Special Economic Zones.  These preferential
tax rates are generally graduated, starting at 0% and increasing to the standard
EIT rate of 25% over time.  Our operations under Harbin Tech Full
Electric Co., Ltd. were subject to a 10% preferential tax rate until December
31, 2010. Our operations under Shanghai Tech Full Electric Co., Ltd. were
subject to 0% preferential tax rate in 2009 and is subject to 11% in 2010. Our
operations under Xi’an Tech Full Simo Motor Co., Ltd. were subject to a 15%
preferential tax rate. As a result, the estimated tax savings for the six months
ended June 30, 2010, and 2009 amounted to $6,806,723 and $2,865,216,
respectively. Tax laws in China are subject to interpretations by relevant
tax authorities. Preferential tax rates 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
of China.





Fluctuation
in the value of the RMB may have a material adverse effect on your
investment.





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 to these
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 the
Company educates our employees not to engage in these illegal practices, we
cannot 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.





The
Chinese government exerts substantial influence over the manner in which we must
conduct our business activities.





Our
ability to operate in China may be harmed by changes in its laws and
regulations, including those related 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 and interpretations. Government actions in
the future, 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.


47





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
such additional 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, as well 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 over 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 a
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.





RISKS
ASSOCIATED WITH OUR COMMON STOCK




Our
common stock may be affected by limited trading volume and may fluctuate
significantly.




Our
common stock is traded on the Nasdaq Global Select Market. Although an active
trading market has developed for our common stock, there can be no assurance
that an active trading market for our common stock will be sustained. Failure to
maintain an active trading market for our common stock may adversely affect our
stockholders’ ability to sell our common stock in short time periods, or
at all. In addition, sales of substantial amounts of our common stock in
the public market could harm the market price of our common stock. Our common
stock has experienced, and may experience in the future, significant price and
volume fluctuations, which could adversely affect the market price of our common
stock.





We
do not anticipate paying cash dividends on our common stock in the foreseeable
future.




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. The Indenture pursuant to which the Notes were issued prohibits us
from paying any dividends on our capital stock while the Notes remain
outstanding. PRC capital and currency regulations may also limit our ability to
pay dividends. Consequently, the only opportunity for investors to achieve a
positive return on your investment in us will be if the market price of our
common stock appreciates.





Our
directors and officers control approximately one third of our common stock and,
as a result, they may exercise some 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, beneficially owned, as a group, approximately 35.20% of our issued
and outstanding common stock as of June 30, 2010. This concentration of share
ownership may adversely affect the trading price of our common stock
because 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
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 effect of 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.


48





Your
percentage ownership in us may be diluted by future issuances of capital stock,
which could reduce your influence over matters on which stockholders
vote.




Subject
to any applicable stockholder approval requirements imposed by the Nasdaq Stock
Market, our board of directors has the authority to issue all or any part of our
authorized but unissued shares of common stock. Issuances of common stock would
reduce your influence over matters on which our stockholders vote.





Item 2. Unregistered Sales of Equity
Securities and Use of Proceeds





None.





Item 3. Defaults upon Senior Securities




None.




Item 4. Removed and
Reserved





Item 5. Other
Information





At its
Annual Meeting of shareholders held on July 26, 2010, the Company submitted the
following matters to a vote of its shareholders:




1.
Election of Directors:


Votes For
                Votes Withheld
                Broker Non-VoteTianfu
      Yang
                21,169,415
                212,323
                4,414,484Lanxiang
      Gao
                21,172,745
                208,993
                4,414,484Ching
      Chuen Chan
                20,985,494
                396,244
                4,414,484Boyd
      Plowman
                21,167,435
                214,303
                4,414,484David
      Gatton
                21,169,040
                212,698
                4,414,484Yunye
      Ye
                21,336,644
                45,094
                4,414,484




2. Ratify
Frazer Frost LLP as the independent registered public accounting firm of the
Company.





Votes For
                
                Votes Against
                
                Abstain
                Broker Non-Vote26,663,953
                
                77,669
                
                54,600
                —





Item 6. Exhibits.




The
exhibits listed on the Exhibit Index are being furnished with this
report.





49




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.




Harbin
      Electric, Inc.Date:
      August 9, 2010
              By:
              /s/ Tianfu
  YangTianfu
      YangChief
      Executive Officer, Director and Chairman of the Board
                (Principal
      Executive Officer)




Date:
      August 9, 2010
              By:
              /s/ Zedong XuZedong
      XuChief
      Financial Officer
                (Principal
      Accounting Officer)





50




EXHIBIT
INDEX





Exhibits:




Exhibit Number
            
            Description
            
            Method of Filing10.1
            
            Share
      Purchase Agreement by and between Xi’an Tech Full Simo Motor Co., Ltd. and
      Zhejiang Ximen Punching Co., Ltd. dated June 3, 2010.
            
            Filed
      as Exhibit 10.1 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.2
            
            Share
      Purchase Agreement by and among Xi’an Tech Full Simo Motor Co., Ltd. and
      Xi’an Simo Imports and Exports Co., Ltd., and Fu Nong, dated June 3,
      2010.
            
            Filed
      as Exhibit 10.2 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.3
            
            Share
      Purchase Agreement by and among Xi’an Tech Full Simo Motor Co., Ltd. and
      Certain PRC Individuals, dated June 3, 2010.
            
            Filed
      as Exhibit 10.3 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.4
            
            Share
      Purchase Agreement by and among Xi’an Tech Full Simo Motor Co., Ltd. and
      Certain PRC Individuals, dated June 3, 2010.
            
            Filed
      as Exhibit 10.4 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.5
            
            Share
      Purchase Agreement by and between Xi’an Tech Full Simo Motor Co., Ltd. and
      Pingan Duan, dated June 3, 2010.
            
            Filed
      as Exhibit 10.5 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.6
            
            Share
      Purchase Agreement by and among Xi’an Tech Full Simo Motor Co., Ltd. and
      Certain PRC Individuals, dated June 3, 2010.
            
            Filed
      as Exhibit 10.6 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.7
            
            Share
      Purchase Agreement by and between Xi’an Tech Full Simo Motor Co., Ltd. and
      Guoping Cui, dated June 3, 2010.
            
            Filed
      as Exhibit 10.7 to the current report on Form 8-K filed with the
      Commission on June 9, 2010 and incorporated herein by
      reference.10.8
            
            Loan
      Agreement by and between the Company and Abax Emerald Ltd., dated July 28,
      2010.
            
            Filed
      as Exhibit 10.1 to the current report on Form 8-K filed with the
      Commission on July 30, 2010 and incorporated herein by
      reference.31.1
            
            Certification
      by the Chief 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 August 9, 2010 - announcing the Company’s results of operations
      for the second quarter of 2010.
            
            Filed
      herewith as Exhibit 99.1.





51