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, 2009




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




For the
transition period from ________ to ________




Commission
file number   000-51006




HARBIN
ELECTRIC, INC.


(Exact
name of registrant as specified in its charter)




Nevada
            98-0403396(State
      or other jurisdiction of
              incorporation
      or organization)
            (I.R.S.
      Employer
              Identification
      Number)




No. 9 Ha Ping Xi Lu, Ha Ping Lu Ji
Zhong Qu


Harbin
Kai Fa Qu, Harbin, People’s Republic of China 150060


(Address
of principal executive offices)




Telephone:
86-451-86116757


(Issuer’s
telephone number)




Indicate
by check 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 xNo o




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes oNo o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
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 July 31, 2009: 22,187,305 shares of common stock, par value $0.00001 per
share.













TABLE
OF CONTENTS




PagePart
      I. Financial InformationItem
      1. Financial Statements
            
            1Consolidated
      Balance SheetsAs
      of June 30, 2009 (Unaudited) and December 31, 2008
            
            1Consolidated
      Statements of Income and Other Comprehensive IncomeFor
      the Three Months and Six Months Ended June 30, 2009 and 2008
      (Unaudited)
            
            2Consolidated
      Statements of Shareholders’ Equity (Unaudited)
            
            3Consolidated
      Statements of Cash FlowsFor
      the Six Months Ended June 30, 2009 and 2008 (Unaudited)
            
            4Notes
      to the Consolidated Financial Statements (Unaudited)
            
            5Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            
            38Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            
            48Item
      4. Controls and Procedures
            
            48Part
      II. Other InformationItem
      1. Legal Proceedings
            
            48Item
      1A. Risk Factors
            
            48Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            
            54Item
      3. Defaults upon Senior Securities
            
            54Item
      4. Submission of Matters to a Vote of Securities Holders
            
            54Item
      5. Other Information
            
            54Item
      6. Exhibits
            
            54Signatures
            
            55Index
      to Exhibits
            
            56










PART
I. FINANCIAL INFORMATION




Item
1. Financial Statements




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





CONSOLIDATED
BALANCE SHEETS


AS OF
JUNE 30, 2009 (UNAUDITED) AND DECEMBER 31, 2008


June
      30,
              
              
              December
      31,2009
              
              
              2008(Unaudited)ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
              
              $
              67,801,324
              
              
              $
              48,412,263Restricted
      cash
              
              
              1,022,570
              
              
              
              513,450Notes
      receivable
              
              
              485,547
              
              
              
              1,451,977Accounts
      receivable, net of allowance for doubtful accounts of
    $800,365and
      $153,155 as of June 30, 2009 and December 31, 2008,
      respectively
              
              
              24,781,758
              
              
              
              30,284,080Inventories
              
              
              15,156,464
              
              
              
              21,960,084Other
      receivables & prepaid expenses
              
              
              223,806
              
              
              
              248,552Advances
      on inventory purchases
              
              
              3,789,111
              
              
              
              3,529,607Loan
      receivable - related party
              
              
              4,248,500
              
              
              
              -Total
      current assets
              
              
              117,509,080
              
              
              
              106,400,013PLANT
      AND EQUIPMENT, net
              
              
              98,341,965
              
              
              
              94,931,999OTHER
      ASSETS:Debt
      issuance costs, net
              
              
              1,401,059
              
              
              
              1,672,279Advances
      on equipment purchases
              
              
              10,421,618
              
              
              
              10,416,187Advances
      on intangible assets
              
              
              3,123,380
              
              
              
              1,892,430Goodwill
              
              
              12,273,778
              
              
              
              12,273,778Other
      intangible assets, net of accumulated amortization
              
              
              5,896,922
              
              
              
              6,430,397Other
      assets
              
              
              814,352
              
              
              
              471,220Deposit
      in derivative hedge
              
              
              1,000,000
              
              
              
              1,000,000Total
      other assets
              
              
              34,931,109
              
              
              
              34,156,291Total
      assets
              
              $
              250,782,154
              
              
              $
              235,488,303LIABILITIES AND SHAREHOLDERS'
      EQUITYCURRENT
      LIABILITIES:Notes
      payable - short term
              
              $
              2,045,140
              
              
              $
              1,026,900Accounts
      payable
              
              
              8,022,194
              
              
              
              8,415,919Short
      term loan - bank
              
              
              4,248,500
              
              
              
              4,180,950Other
      payables & accrued Liabilities
              
              
              1,798,334
              
              
              
              2,789,792Customer
      deposits
              
              
              1,200,233
              
              
              
              1,244,622Taxes
      payable
              
              
              2,554,771
              
              
              
              2,096,521Interest
      payable
              
              
              783,882
              
              
              
              800,954Cross
      currency hedge payable
              
              
              411,237
              
              
              
              175,986Current
      portion of notes payable, net of debt discount of $4,703,140
      and$4,420,129
      as of June 30, 2009 and December 31, 2008, respectively
              
              
              5,496,860
              
              
              
              1,979,871Total
      current liabilities
              
              
              26,561,151
              
              
              
              22,711,515LONG
      TERM LIABILITIES:Amounts
      due to original shareholder
              
              
              732,500
              
              
              
              733,500Notes
      payable, net of debt discount of $5,678,346 and $7,969,005 as
      ofJune
      30, 2009 and December 31, 2008, respectively
              
              
              28,121,654
              
              
              
              31,630,995Fair
      value of derivative instrument
              
              
              9,003,322
              
              
              
              5,762,958Warrant
      liability
              
              
              17,857,181
              
              
              
              -Total
      liabilities
              
              
              82,275,808
              
              
              
              60,838,968COMMITMENTS
      AND CONTINGENCIESSHAREHOLDERS'
      EQUITY:Common
      Stock, $0.00001 par value, 100,000,000 shares authorized,22,187,305
      and 22,102,078 shares issued and outstandingas
      of June 30, 2009 and December 31, 2008, respectively
              
              
              221
              
              
              
              220Paid-in-capital
              
              
              83,043,892
              
              
              
              95,029,290Retained
      earnings
              
              
              59,483,164
              
              
              
              52,100,479Statutory
      reserves
              
              
              16,568,559
              
              
              
              14,573,994Accumulated
      other comprehensive income (loss)
              
              
              9,410,510
              
              
              
              12,945,352Total
      shareholders' equity
              
              
              168,506,346
              
              
              
              174,649,335Total
      liabilities and shareholders' equity
              
              $
              250,782,154
              
              
              $
              235,488,303





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




-1-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOME


FOR THE
THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2009 AND 2008


(UNAUDITED)




Three
      Months Ended June 30,
              
              
              Six
      Months Ended June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008REVENUES
              
              $
              38,363,484
              
              
              $
              23,959,073
              
              
              $
              69,088,377
              
              
              $
              46,417,258COST
      OF SALES
              
              
              25,500,208
              
              
              
              12,502,939
              
              
              
              45,301,323
              
              
              
              24,201,647GROSS
      PROFIT
              
              
              12,863,276
              
              
              
              11,456,134
              
              
              
              23,787,054
              
              
              
              22,215,611RESEARCH
      AND DEVELOPMENT EXPENSE
              
              
              408,520
              
              
              
              186,676
              
              
              
              801,802
              
              
              
              284,371SELLING,
      GENERAL AND  ADMINISTRATIVE EXPENSES
              
              
              3,638,936
              
              
              
              3,044,821
              
              
              
              6,143,840
              
              
              
              5,070,780INCOME
      FROM OPERATIONS
              
              
              8,815,820
              
              
              
              8,224,637
              
              
              
              16,841,412
              
              
              
              16,860,460OTHER
      EXPENSE (INCOME), NETOther
      income, net
              
              
              (2,100,885
              )
              
              
              (256,379
              )
              
              
              (2,640,264
              )
              
              
              (247,189
              )Interest
      expense, net
              
              
              842,528
              
              
              
              1,194,731
              
              
              
              2,283,912
              
              
              
              3,477,511Change
      in fair value of warrant
              
              
              14,014,790
              
              
              
              -
              
              
              
              11,441,369
              
              
              
              -Total
      other expense, net
              
              
              12,756,433
              
              
              
              938,352
              
              
              
              11,085,017
              
              
              
              3,230,322INCOME
      BEFORE PROVISION FOR INCOME TAXES
              
              
              (3,940,613
              )
              
              
              7,286,285
              
              
              
              5,756,395
              
              
              
              13,630,138PROVISION
      FOR INCOME TAXES
              
              
              1,478,751
              
              
              
              1,055,342
              
              
              
              2,521,425
              
              
              
              2,045,959NET
      (LOSS) INCOME
              
              
              (5,419,364
              )
              
              
              6,230,943
              
              
              
              3,234,970
              
              
              
              11,584,179OTHER
      COMPREHENSIVE INCOME (LOSS)Foreign
      currency translation adjustment
              
              
              (9,110
              )
              
              
              3,047,862
              
              
              
              (294,478
              )
              
              
              8,355,687Change
      in fair value of derivative instrument
              
              
              (711,288
              )
              
              
              4,244,252
              
              
              
              (3,240,364
              )
              
              
              (249,634
              )COMPREHENSIVE
      INCOME (LOSS)
              
              $
              (6,139,762
              )
              
              $
              13,523,057
              
              
              $
              (299,872
              )
              
              $
              19,690,232EARNINGS
      PER SHARE:Basic
              
              $
              (0.24
              )
              
              $
              0.33
              
              
              $
              0.15
              
              
              $
              0.63Diluted
              
              $
              (0.24
              )
              
              $
              0.31
              
              
              $
              0.14
              
              
              $
              0.58WEIGHTED
      AVERAGE NUMBER OF SHARESBasic
              
              
              22,140,568
              
              
              
              18,639,687
              
              
              
              22,121,746
              
              
              
              18,424,832Diluted
              
              
              22,140,568
              
              
              
              20,023,990
              
              
              
              22,350,126
              
              
              
              19,998,192




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




-2-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF SHAREHOLDERS' EQUITY




AccumulatedCommon
      stock
              
              
              Additional
              
              
              Retained
      earnings
              
              
              otherPar
              
              
              paid-in
              
              
              Unrestricted
              
              
              Statutory
              
              
              comprehensiveShares
              
              
              value
              
              
              capital
              
              
              earnings
              
              
              reserves
              
              
              income
      (loss)
              
              
              TotalBALANCE,
      January 1, 2008
              
              
              18,143,156
              
              
              $
              181
              
              
              $
              44,970,589
              
              
              $
              32,281,312
              
              
              $
              9,014,462
              
              
              $
              (1,649,969
              )
              
              $
              84,616,575Exercise
      of stock warrants at $3.50
              
              
              202,300
              
              
              
              2
              
              
              
              708,048
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              708,050Exercise
      of stock warrants at $3.10
              
              
              25,000
              
              
              
              -
              
              
              
              77,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              77,500Stock
      issuance for cash at $14.13
              
              
              3,500,000
              
              
              
              35
              
              
              
              46,290,708
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              46,290,743Stock
      based compensation
              
              
              
              
              
              
              
              
              
              
              912,465
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              912,465Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              11,584,179
              
              
              
              
              
              
              
              
              
              
              
              11,584,179Adjustment
      to statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,049,758
              )
              
              
              2,049,758
              
              
              
              
              
              
              
              -Foreign
      currency translation gain
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,355,687
              
              
              
              8,355,687Net
      change related to cash flow hedge
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (249,634
              )
              
              
              (249,634
              )BALANCE,
      June 30, 2008 (unaudited)
              
              
              21,870,456
              
              
              
              218
              
              
              
              92,959,310
              
              
              
              41,815,733
              
              
              
              11,064,220
              
              
              
              6,456,084
              
              
              
              152,295,565Exercise
      of stock warrants at $3.50
              
              
              119,998
              
              
              
              1
              
              
              
              419,992
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              419,993Non
      cash exercise of stock options at $3.10
              
              
              11,624
              
              
              
              -
              
              
              
              -
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Exercise
      of stock warrants at $7.80
              
              
              100,000
              
              
              
              1
              
              
              
              779,999
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              780,000Stock
      based compensation
              
              
              
              
              
              
              
              
              
              
              869,989
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              869,989Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              13,794,520
              
              
              
              
              
              
              
              
              
              
              
              13,794,520Adjustment
      to statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (3,509,774
              )
              
              
              3,509,774
              
              
              
              
              
              
              
              -Foreign
      currency translation gain
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,158,220
              
              
              
              1,158,220Net
      change related to cash flow hedge
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,331,048
              
              
              
              5,331,048BALANCE,
      December 31, 2008,

                  as
      previously reported
              
              
              22,102,078
              
              
              
              220
              
              
              
              95,029,290
              
              
              
              52,100,479
              
              
              
              14,573,994
              
              
              
              12,945,352
              
              
              
              174,649,335Cumulative
      effect of reclassification of warrants
              
              
              
              
              
              
              
              
              
              
              (13,613,718
              )
              
              
              6,142,280
              
              
              
              
              
              
              
              
              
              
              
              (7,471,438
              )BALANCE,
      January 1, 2009 as adjusted
              
              
              22,102,078
              
              
              
              220
              
              
              
              81,415,572
              
              
              
              58,242,759
              
              
              
              14,573,994
              
              
              
              12,945,352
              
              
              
              167,177,897Amortization
      of stock compensation
              
              
              
              
              
              
              
              
              
              
              584,290
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              584,290Non
      cash exercise of warrant at $7.80
              
              
              85,227
              
              
              
              1
              
              
              
              1,044,030
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,044,031Net
      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
              
              
              $
              83,043,892
              
              
              $
              59,483,164
              
              
              $
              16,568,559
              
              
              $
              9,410,510
              
              
              $
              168,506,346




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




-3-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR THE
SIX MONTHS ENDED JUNE 30, 2009 AND 2008


(UNAUDITED)


Six
      Months Ended June 30,2009
                    
                    
                    2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                    
                    $
                    3,234,970
                    
                    
                    $
                    11,584,179Adjustments
      to reconcile net income to cashprovided
      by (used in) operating activities:Depreciation
                    
                    
                    1,287,510
                    
                    
                    
                    433,706Amortization
      of intangible assets
                    
                    
                    524,960
                    
                    
                    
                    505,517Amortization
      of debt issuance costs
                    
                    
                    271,220
                    
                    
                    
                    351,948Amortization
      of debt discount
                    
                    
                    2,007,648
                    
                    
                    
                    2,302,871Loss
      (gain) on derivative instrument
                    
                    
                    -
                    
                    
                    
                    (192,731
                    )Share-based
      compensation
                    
                    
                    584,290
                    
                    
                    
                    912,465Bad
      debt expense
                    
                    
                    647,729
                    
                    
                    
                    -Gain
      on cashless conversion of warrants
                    
                    
                    (11,595
                    )
                    
                    
                    -Change
      in fair value of warrants
                    
                    
                    11,441,369
                    
                    
                    
                    -Change
      in operating assets and liabilitiesNotes
      receivable
                    
                    
                    964,911
                    
                    
                    
                    -Accounts
      receivable
                    
                    
                    4,816,100
                    
                    
                    
                    (1,413,683
                    )Inventories
                    
                    
                    6,776,920
                    
                    
                    
                    518,092Other
      receivables & prepaid expenses
                    
                    
                    24,422
                    
                    
                    
                    199,856Advances
      on inventory purchases
                    
                    
                    (264,438
                    )
                    
                    
                    (1,730,440
                    )Other
      assets
                    
                    
                    (343,857
                    )
                    
                    
                    (589
                    )Accounts
      payable
                    
                    
                    (384,241
                    )
                    
                    
                    (112,265
                    )Other
      payables & accrued liabilities
                    
                    
                    (986,764
                    )
                    
                    
                    (1,281,544
                    )Other
      payables - related party
                    
                    
                    -
                    
                    
                    
                    (47,064
                    )Customer
      deposits
                    
                    
                    (42,712
                    )
                    
                    
                    (46,390
                    )Taxes
      payable
                    
                    
                    461,321
                    
                    
                    
                    1,096,594Interest
      payable
                    
                    
                    28,294
                    
                    
                    
                    (80,231
                    )Net
      cash  provided by operating activities
                    
                    
                    31,038,057
                    
                    
                    
                    13,000,291CASH
      FLOWS FROM INVESTING ACTIVITIES:Cash
      deposit on acquisition
                    
                    
                    -
                    
                    
                    
                    (698,850
                    )Payment
      for advances on intangible assets
                    
                    
                    (1,234,119
                    )
                    
                    
                    -Payment
      for advances on equipment purchases
                    
                    
                    -
                    
                    
                    
                    (10,716,226
                    )Purchase
      of intangible assets
                    
                    
                    -
                    
                    
                    
                    (707,875
                    )Additions
      to plant and equipment
                    
                    
                    (268,408
                    )
                    
                    
                    (7,114,655
                    )Additions
      to CIP
                    
                    
                    (4,057,555
                    )
                    
                    
                    -Increase
      in loan receivable - related party
                    
                    
                    (4,250,530
                    )
                    
                    
                    -Net
      cash used in investing activities
                    
                    
                    (9,810,612
                    )
                    
                    
                    (19,237,606
                    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Increase
      in restricted cash
                    
                    
                    (510,064
                    )
                    
                    
                    -Net
      proceeds from stock issuance 3.5 million shares
                    
                    
                    -
                    
                    
                    
                    46,290,743Proceeds
      received from conversion of warrants and options
                    
                    
                    -
                    
                    
                    
                    785,551Payment
      of cross currency hedge
                    
                    
                    (332,027
                    )
                    
                    
                    -Proceeds
      from cross currency hedge
                    
                    
                    -
                    
                    
                    
                    145,945Payment
      on notes payable
                    
                    
                    (2,000,000
                    )
                    
                    
                    (2,000,000
                    )Increase
      of notes payable-short term
                    
                    
                    1,020,127
                    
                    
                    
                    -Proceeds
      from short term loan
                    
                    
                    3,077,970
                    
                    
                    
                    -Payment
      on short term loan
                    
                    
                    (3,004,685
                    )
                    
                    
                    -Net
      cash (used in) provided by financing activities
                    
                    
                    (1,748,679
                    )
                    
                    
                    45,222,239EFFECTS
      OF EXCHANGE RATE CHANGE ON CASH
                    
                    
                    (89,705
                    )
                    
                    
                    3,256,222INCREASE
      IN CASH
                    
                    
                    19,389,061
                    
                    
                    
                    42,241,146Cash
      and cash equivalents, beginning of period
                    
                    
                    48,412,263
                    
                    
                    
                    45,533,893Cash
      and cash equivalents, end of period
                    
                    $
                    67,801,324
                    
                    
                    $
                    87,775,039





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




-4-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES


NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)


Note
1 – Organization and description of business





Harbin
Electric, Inc., (the “Company”), was incorporated in Nevada on July 9, 2003. The
Company through its indirect wholly-owned subsidiaries, 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 other international markets as discussed further in Note
11.





In
December 2006, the Company formed Shanghai Tech Full Electric Co., Ltd.
(“Shanghai Tech Full”), a wholly-owned subsidiary, to develop and manufacture
specialty micro-motors and their components and accessories.




In April
2007, the Company entered into an Agreement with Shelton Technology, LLC
(“Shelton”), whereby the Company and Shelton agreed to work together
through the Company’s newly formed, wholly-owned subsidiary, Advanced
Automation Group, LLC (“AAG”) to design, develop and manufacture custom
industrial automation controllers. The Company is required to invest a total of
$3 million in AAG while Shelton contributes an exclusive worldwide royalty-free
license for motorized automation technology. As of June 30, 2009, the Company
has contributed a total of $2 million to AAG. Based upon a mutual
agreement, the Company will contribute the remaining $1,000,000 to AAG at a
later date according to actual needs.




In July
2008, the Company’s subsidiary Harbin Tech Full Electric Co., Ltd.
(“HTFE”) acquired Weihai Hengda Electric Motor (Group) Co., Ltd. for an
aggregate price of approximately $54.7 million (RMB 375 million) payable in
cash. On March 27, 2008, HTFE deposited approximately $0.7 million
(RMB 5 million) toward the purchase price. The Company paid approximately $54.0
million (RMB 370 million) in 2008 and expects to pay the remaining
investment balance of $0.7 million (RMB 5 million) within two years from the
Agreement (see Note 15).  Hengda manufactures and distributes various
industrial rotary motors such as high/low voltage motors, AC/DC motors and speed
control motors. In June 2009, Weihai Hengda Electric Motor (Group) Co., Ltd.
changed its name to Weihai Tech Full Simo Motors Co., Ltd.
(“Weihai”).




In
October 2008, the Company, through AAG, formed Advanced Automation Group
Shanghai Co., 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 $500,000 in AAG Shanghai through June 30, 2009.





Note
2 – Accounting policies





Use of
estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. For
example, the Company estimates the fair value of its derivative instrument using
the discounted cash flow method. The Company also estimates the fair value of
options using subjective assumptions including estimated length of time
employees will retain their options before exercising them, forfeitures, and
expected volatility of Company’s stock price over the expected term. Changes in
these assumptions materially affect the estimated fair value and the resulting
expense. Actual results could differ from management’s estimates.




-5-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)




Management
has included all adjustments, consisting only of normal recurring adjustments,
considered necessary to give a fair presentation of operating results for the
periods presented. Interim results are not necessarily indicative of results for
a full year. The information included in this Form 10-Q should be read in
conjunction with information included in the 2008 annual report filed on Form
10-K.





Basis of
presentation





The
consolidated financial statements of Harbin Electric Inc. reflect the activities
of the following subsidiaries:




Place
      incorporated
            
            Ownership
              percentageAdvanced
      Electric Motors, Inc. (“AEM”)
            
            Delaware,
      USA
            
            100%Harbin
      Tech Full Electric Co., Ltd.
            
            Harbin,
      China
            
            100%Advanced
      Automation Group, LLC
            
            Delaware,
      USA
            
            100%Advanced
      Automation Group Shanghai Co., Ltd.
            
            Shanghai,
      China
            
            100%Shanghai
      Tech Full Electric Co., Ltd.
            
            Shanghai,
      China
            
            100%Weihai
      Tech Full Simo Motors Co., Ltd.
            
            Weihai,
      China
            
            100%





The
accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of
America.  All material intercompany transactions and balances have
been eliminated in the consolidation.




Since
Weihai was acquired in July 2008, its operating results are reflected in the
consolidated financial statements for the three months and six months ended June
30, 2009 and in the consolidated balance sheets as of December 31, 2008, and its
results of operations are not included in the consolidated financial statements
for the three months and six months ended June 30, 2008.




-6-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)


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 People’s
Republic of China (“PRC”) and the United States. The Company maintains balances
at financial institutions which, from time to time, may exceed Federal Deposit
Insurance Corporation insured limits for the banks located in the Unites States.
Balances at financial institutions or state owned banks within the PRC are not
insured. As of June 30, 2009 and December 31, 2008, the Company had
deposits in excess of federally insured limits totaling $68,446,685 and
$47,783,767, 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.





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. Five major customers accounted for 74% of the net revenue for the
six months ended June 30, 2008, with each customer individually accounted for
23%, 20%, 15%, 9% and 7%, respectively. At June 30, 2008, the total
receivable balance due from these customers was $23,600,431, representing 90% of
total accounts receivable.





One major
vendor provided approximately 25% of the Company’s purchases of raw materials
for the six months ended June 30, 2009, and five major vendors provided 78% of
the Company’s purchase of raw materials for the six months ended June 30, 2008,
with each vendor individually accounting for 28%, 21%, 12%, 10% and 7%,
respectively. There were no accounts payable due to these vendors at June 30,
2009 and 2008, respectively.





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




Restricted
cash





Restricted
cash represent amounts set aside by the Company in accordance with the Company’s
debt agreements with certain financial institutions.  These cash
amounts are designated for the purpose of paying 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.




-7-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
 Accounts
receivable





The
Company’s business operations are conducted in the PRC.  During the
normal course of business, the Company extends unsecured credit to its
customers.  Management reviews the composition of accounts
receivable and analyzes historical bad debts, customer concentrations, customer
credit worthiness, current economic trends and changes in customer payment
patterns to determine if the allowance for doubtful accounts is
adequate.  An estimate for doubtful accounts is made when collection
of the full amount is no longer probable.  Delinquent account balances
are written-off after management has determined that the likelihood of
collection is not probable, known bad debts are written off against allowance
for doubtful accounts when identified.





Inventories





Inventory
is composed of raw material for manufacturing electrical motors, work in process
and finished goods. Inventory is valued at the lower of cost or market value
using the weighted average method. Management compares the cost of inventory
with the market value and an allowance is made for writing down the inventory to
its market value, if lower than cost.





Plant and
equipment





Plant and equipment are stated at cost.
Expenditures for maintenance and repairs are charged to earnings as incurred;
additions, renewals and betterments are capitalized. When assets are retiredor otherwise disposed of,
the related cost and accumulated depreciation are removed from the respective
accounts, and any gain or loss is included in operations. Depreciation of plant
and equipment is provided using the straight-line method for
substantially all assets with estimated lives as
follows:





Estimated
      Useful LifeBuildings
            
            20
      yearsVehicle
            
            5
      yearsOffice
      equipment
            
            5
      yearsProduction
      equipment
            
            10
      years





Construction
in progress represents the costs incurred in connection with the construction of
buildings or new additions to the Company’s plant facilities.  No
depreciation is provided for construction in progress until such time as the
assets are completed and placed into service. Maintenance, repairs and
minor renewals are charged directly to expense as incurred. Major additions and
betterment to buildings and equipment are capitalized. Interest incurred during
construction is capitalized into construction in progress. All other interest is
expensed as incurred.




-8-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  The
Company evaluates the carrying value of long-lived assets in accordance with FAS
144 “Accounting for Impairment or Disposal of Long Lived Assets.” When estimated
cash flows generated by those assets are less than the carrying amounts of the
asset, the Company recognizes an impairment loss. Based on its review, the
Company believes that, as of June 30, 2009 there were no impairments of its
long-lived assets.





Goodwill and other
intangible assets





Goodwill
– the excess of the cost of an acquired entity over the net of the amounts
assigned to assets acquired and liabilities assumed shall be recognized as
goodwill. In accordance with FAS 142, “Goodwill and Other Intangible Assets”,
goodwill is not amortized.





Land use
rights - all land in the People’s Republic of China is government
owned.  However, the government grants “land use
rights”.  The Company has the right to use the land for 50 years and
amortizes 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 carrying value may
not be recoverable from its estimated future cash flows. Recoverability of
intangible assets, other long-lived assets, and goodwill is measured by
comparing their net book value to the related projected undiscounted cash flows
from these assets, considering a number of factors including past operating
results, budgets, economic projections, market trends and product development
cycles. If the net book value of the asset exceeds the related undiscounted cash
flows, the asset is considered impaired, and a second test is performed to
measure the amount of impairment loss. As of June 30, 2009, management believes
there was no impairment.





Stock-based
compensation





The
Company records stock based compensation expense pursuant to FAS 123R, “Share
Based Compensation.” The Company estimates the fair value of the award using the
Black-Scholes Option Pricing Model. Under FAS 123R, the Company’s expected
volatility assumption is based on the historical volatility of Company’s stock.
The expected life assumption is primarily based on the simplified method of the
terms of the options. The risk-free interest rate for the expected term of
the option is based on the U.S. Treasury yield curve in effect at the time of
grant.




-9-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  The
Company accounts for equity instruments issued in exchange for the receipt of
goods or services from other than employees in accordance with SFAS 123R and the
conclusions reached by EITF 96-18, “Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring or in Conjunction with Selling
Goods or Services.” Costs are measured at the estimated fair market value of the
consideration received or the estimated fair value of the equity instruments
issued, whichever is more reliably determinable. The value of equity instruments
issued for consideration other than employee services is determined on the
earlier of a performance commitment or completion of performance by the provider
of goods or services as defined by EITF 96-18.





Stock
compensation expense is recognized based on awards expected to vest, and there
were no estimated forfeitures as the Company has a short history of issuing
options. FAS 123R requires forfeitures to be estimated at the time of grant and
revised in subsequent periods, if necessary, if actual forfeitures differ from
those estimates.





Revenue
recognition





The
Company's revenue recognition policies are in accordance with Staff Accounting
Bulletin (“SAB”) 104. Sales revenue is recognized at the date of shipment to
customers when a formal arrangement exists, the price is fixed or determinable,
the delivery is completed, no other significant obligations of the Company exist
and collectability is reasonably assured. For products that are required to be
examined by customers, sales revenue is recognized after the customer
examination is passed. Payments received before all of the relevant criteria for
revenue recognition are recorded as customer deposits.





In
addition, revenue recognition could be negatively impacted by returns. For our
linear motor and specialty micro-motor businesses, our products are custom
products which are customer specific, and no returns are allowed. We warrant our
product for repair, only in the event of defects for two years from the date of
shipment.  We charge such costs to cost of goods sold. For our newly
acquired rotary motor business, our products 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. 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 $485,201 and $203,461 for the three months ended June 30, 2009 and 2008
and $949,564, and $433,887 for the six months ended June 30, 2009, and
2008.




-10-





HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)


Income
taxes





The
Company reports income taxes pursuant to FAS 109, "Accounting for Income Taxes,"
which requires the recognition of deferred tax assets and liabilities for the
expected future tax consequences of events that have been included in the
financial statements or tax returns. The Company adopted FIN 48, “Accounting for
Uncertainty in Income Taxes”, as of January 1, 2007. A tax position is
recognized as a benefit only if it is “more likely than not” that the tax
position would be sustained in a tax examination, with a tax examination being
presumed to occur. The amount recognized is the largest amount of tax benefit
that is greater than 50% likely of being realized on examination. For tax
positions not meeting the “more likely than not” test, no tax benefit is
recorded.





Under
this method, deferred income taxes are recognized for the tax consequences in
future years of differences between the tax bases of 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.   $161,434 and $0 was recorded as deferred tax amounts at
June 30, 2009, and December 31, 2008, respectively.





The
charge for taxation is based on the results for the reporting period as adjusted
for items, which are non-assessable or disallowed.  It is calculated
using tax rates that have been enacted or substantively enacted by the balance
sheet date.





The new
Chinese Enterprise Income Tax (“EIT”) law was effective on January 1, 2008.
Under the new Income Tax Laws of PRC, a company is generally subject to income
tax at an effective rate of 25% on income reported in the statutory financial
statements after appropriated tax adjustments. HTFE is located in a specially
designated region where HTFE is subject to a 10% EIT rate from January 1, 2008
to December 31, 2010 and 15% beginning January 1, 2011. Weihai is currently
at a 25% income tax rate.





The
Company’s subsidiaries were paying the following tax rate for the three months
and six months ended:





June
      30, 2009
              (Unaudited)
            
            
            June
      30, 2008
              (Unaudited)Subsidiaries
            
            Income
      Tax Exemption
            
            
            Effective
      Income Tax Rate
            
            
            Income
      Tax Exemption
            
            
            Effective
      Income Tax RateHTFE
            
            
            15
            %
            
            
            10
            %
            
            
            15
            %
            
            
            10
            %Weihai
            
            
            -
            %
            
            
            25
            %
            
            
            N/A
            (a)
            
            
            N/A
            (a)




-11-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)




(a)
Weihai was acquired in July 2008 and its results of operations are not included
in the consolidated financial statements for the three months and six months
ended June 30, 2008.





The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the six months ended:




June
      30, 2009
            
            
            June
      30, 2008U.S.
      Statutory rates
            
            
            34
            %
            
            
            34
            %Foreign
      income not recognized in USA
            
            
            -34
            
            
            
            -34China
      income taxes
            
            
            25
            
            
            
            25China
      income tax exemption
            
            
            -13
            
            
            
            -15Other
      item (b)
            
            
            32
            
            
            
            5Effective
      income taxes
            
            
            44
            %
            
            
            15
            %





(b)  The
32 % and 5% represents the $15,138,049 and $6,837,063 of expenses
incurred by the Company, and its subsidiaries AEM and AAG that are not subject
to income tax for the six months ended June 30, 2009 and 2008,
respectively.





The
following table reconciles the U.S. statutory rates to the Company’s effective
tax rate for the three months ended:




June
      30, 2009
            
            
            June
      30, 2008U.S.
      Statutory rates
            
            
            34
            %
            
            
            34
            %Foreign
      income not recognized in USA
            
            
            -34
            
            
            
            -34China
      income taxes
            
            
            25
            
            
            
            25China
      income tax exemption
            
            
            -13
            
            
            
            -15Other
      item (c)
            
            
            -50
            
            
            
            5Effective
      income taxes
            
            
            -38
            %
            
            
            15
            %





(c)  The
(-50) % and 5%  represents the $15,269,121 and $3,299,681 of expenses
incurred by the Company, and its subsidiaries AEM and AAG that are not subject
to income tax for the three months ended June 30, 2009 and 2008,
respectively.





The
estimated tax savings for the three months ended June 30, 2009 and 2008 amounted
to $1,559,705 and $1,588,711, respectively. The net effect on earnings per share
had the income tax been applied would decrease earnings per share from $(0.24)
to $(0.31) in 2009 and $0.33 to $0.23 in 2008. The estimated tax savings for the
six months ended June 30, 2009 and 2008 amounted to $2,865,216
and $3,074,637, respectively. The net effect on earnings per share had the
income tax been applied would decrease earnings per share from $0.15 to $0.02 in
2009 and $0.63 to $0.46 in 2008.




-12-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  Harbin
Electric, Inc., Advanced Electric Motors, Inc. and Advanced Automation Group,
LLC were organized in the United States and have incurred net operating losses
for income tax purposes for the six months ended June 30, 2009.  The
net operating loss carry forwards for United States income taxes amounted to
$24,248,591 which may be available to reduce future years’ taxable
income.  These carry forwards will expire, if not utilized, beginning
2024 through 2029.  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, 2009 was an increase of approximately $287,3410. Management will
review this valuation allowance periodically and make adjustments
accordingly.





The
Company has cumulative undistributed earnings of foreign subsidiaries of
approximately $99,135,093 as of June 30, 2009, 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 will 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.





VAT on
sales and VAT on purchases amounted to $6,708,657 and $3,916,888 for the three
months ended June 30, 2009 and $3,653,736 and $1,919,481 for the same period of
2008, 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 and $6,866,810
and $3,719,861 for the same period of 2008, respectively. Sales and
purchases are recorded net of VAT collected and paid as the Company acts as an
agent for the government.





Taxes
payable consisted of the following:





June
      30, 2009
            
            
            December
      31, 2008VAT
      tax payable
            
            $
            1,169,182
            
            
            $
            1,019,771Individual
      income tax payable
            
            
            9,118
            
            
            
            4,281Corporation
      income tax payable
            
            
            1,245,829
            
            
            
            956,583Others
      misc. tax payable
            
            
            130,642
            
            
            
            115,886Total
            
            $
            2,554,771
            
            
            $
            2,096,521





-13-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)




Advertising
costs





The
Company expenses the cost of advertising as incurred in selling, general and
administrative costs. The Company incurred $53,489 and $0 for the three months
ended June 30, 2009 and 2008, respectively.  The Company incurred
$57,105 and $5,929 for the six months ended June 30, 2009 and 2008,
respectively.





Fair value of financial
instruments





FAS 107,
“Disclosures About Fair Value of Financial Instruments” defines financial
instruments and requires fair value disclosure of applicable financial
instruments FAS 157, “Fair Value Measurements,” adopted January 1, 2008,
defines fair value, establishes a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosure requirements for
fair value measures. The carrying amounts reported in the balance sheets for
current receivables and payables qualify as financial
instruments.  Management concluded the carrying values are a
reasonable estimate of fair value because of the short period of time between
the origination of such instruments and their expected realization and if
applicable, their stated interest rate approximates current
rates available. The three levels are defined as follows:





·  Level
      1
                  inputs
      to the valuation methodology are quoted prices (unadjusted) for identical
      assets or liabilities in active
markets.




·  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.





The
Company analyzes all financial instruments with features of both liabilities and
equity under FAS 150, “Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity,” FAS 133, “Accounting for
Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company’s Own Stock.” As of June 30, 2009, the outstanding principal on the
Company’s note payable, evaluated under these accounting standards, amounted to
$33,618,514.  Management concluded the carrying value of the note is a
reasonable estimate of fair value because the stated interest rate
approximates current rates available.





Effective
January 1, 2009, the Company adopted the provisions of EITF 07-5,
"Determining Whether an Instrument (or Embedded Feature) is Indexed to an
Entity’s Own Stock”, which is effective for financial statements for fiscal
years beginning after December 15, 2008 and which replaced the previous guidance
on this topic in EITF 01-6.  Paragraph 11(a) of FAS 133 specifies that
a contract that would otherwise meet the definition of a derivative but is both
(a) indexed to the Company’s own stock and (b) classified in stockholders’
equity in the statement of financial position would not be considered a
derivative financial instrument.  EITF 07-5 provides a new two-step
model to be applied in determining whether a financial instrument or an embedded
feature is indexed to an issuer’s own stock and thus able to qualify for the FAS
133 paragraph 11(a) scope exception.




-14-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)


As a
result of adopting EITF 07-5, 2,030,158 warrants previously treated as equity
pursuant to the derivative treatment exemption are no longer afforded equity
treatment because the strike price of the warrants is denominated in US dollar,
a currency other than the Company’s functional currency, the Chinese
Renminbi.  As a result, the warrants are not considered indexed to the
Company’s own stock, and as such, all future changes in the fair value of these
warrants will be recognized currently in earnings until such time as the
warrants are exercised or expired.





As such,
effective January 1, 2009, the Company reclassified the fair value of these
warrants from equity to liability, as if these warrants were treated as a
derivative liability since their issuance in August 2006. On January 1,
2009, the Company reclassified from additional paid-in capital, as a cumulative
effect adjustment, $6.1 million to beginning retained earnings and $7.5
million to warrant liabilities to recognize the fair value of such warrants. In
May 2009, 234,615 warrants were exercised through cashless
conversion.  As of June 30, 2009, the Company has 1,795,543 warrants
outstanding. The fair value of the outstanding warrants was $17.9
million.  The Company recognized a total of $14.0 million loss
from the change in fair value of the warrants for the three months ended June
30, 2009 and $11.4 million loss from change in fair value of the same amount of
warrants for the six months ended June 30, 2009, respectively.





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:





June
      30, 2009
            January
      1, 2009(Unaudited)Annual
      dividend yield
            
            
            -
            
            -Expected
      life (years)
            
            
            3.17
            
            3.32Risk-free
      interest rate
            
            
            1.73%
            
            1.10%Expected
      volatility
            
            
            69%
            
            69%





Expected
volatility is based primarily on historical volatility. Historical volatility
was computed using daily pricing 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.




-15-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  As of
June 30, 2009, the Company carries a derivative instrument valued at $9.0
million. Management obtains the fair value of the derivative instrument from a
financial institution using Level 3 inputs since there is no observable market
price.





Carrying
      Value as of
              June
      30, 2009
            
            Fair
      Value Measurements at June 30, 2009 Using Fair Value
    Hierarchy(Unaudited)
            
            Level
      1
            
            Level
      2
            
            
            Level
      3Derivative
            
            $
            9,003,322
            
            
            
            
            
            
            $
            9,003,322Fair
      value of warrant liabilities
            
            $
            17,857,181
            
            
            
            $
            17,857,181





A
discussion of the valuation techniques used to measure fair value for the
liabilities listed above and activity for these liabilities for the three and
six months ended June 30, 2009 is provided elsewhere in this footnote and in
Note 13.  Other than the derivative instruments, the Company did not
identify any assets and liabilities that are required to be presented on the
balance sheet at fair value in accordance with FAS 157.





Derivative
instrument





Effective
January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, and amendment of FASB No. 133” (“SFAS 161”),
which amends and expands the disclosure requirements of SFAS 133 (“SFAS 133”).
SFAS 161 requires qualitative disclosures about objectives and strategies
for using derivatives and quantitative disclosures about the fair value of and
gains and losses on derivative instruments.





The
Company uses a cross currency interest rate swap, a derivative financial
instrument, to hedge the risk of rising interest rates on their variable
interest rate debt.  This type of derivative financial instrument is
known as a cash flow hedge.  The Company accounts for this interest
rate swap in accordance with FAS 133 which requires the derivative to be carried
on the balance sheet at fair value and to meet certain documentary and
analytical requirements to qualify for hedge accounting treatment. The above
derivative qualifies for hedge accounting under FAS 133 and, accordingly,
changes in the fair value is reported in accumulated other comprehensive income,
net of related income tax effects.  Amounts included in accumulated
other comprehensive income are reclassified into earnings when the hedged
transaction effects earnings.




At the
inception of the transaction, the Company documents the relationship between
hedging instruments and hedged items, as well as its risk management objective
and the strategy for undertaking various hedge transactions. This process
includes linking all derivatives designated to specific firm commitments of
forecast transactions. The Company also documents its assessment, both at
inception and on an ongoing basis, of whether the derivative financial
instruments that are used in 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.




-16-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  Foreign currency
transactions





The
reporting currency of the Company is the US dollar.  The functional
currency of PRC subsidiaries is the Chinese Renminbi. The financial statements
of PRC subsidiaries are translated to United States dollars using quarter-end
exchange rates as to assets and liabilities and average exchange rates
as to revenues, expenses and cash flows.  Capital accounts are
translated at their historical exchange rates when the capital transaction
occurred.  Translation adjustments resulting from this process are
included in accumulated other comprehensive income in the statement of
shareholders’ equity.  Transaction gains and losses that arise from
exchange rate fluctuations on transactions denominated in a currency other than
the functional currency are included in the results of operations as
incurred.





Translation
adjustments resulting from this process amounted to a loss of $294,478 and a
gain of $8,355,687 for the six months ended June 30, 2009 and 2008,
respectively.  The balance sheet amounts with the exception of equity
at June 30, 2009 were translated 6.8448 RMB to $1.00 as compared to 6.8542
RMB at December 31, 2008.  The equity accounts were stated at
their historical exchange rate.  The average translation rates applied
to the income and cash flow statement amounts for the six months ended June 30,
2009 and 2008 were 6.8432 RMB and 7.0726 RMB to $1.00,
respectively.




Transaction
gains and losses that arise from exchange rate fluctuations on transactions
denominated in a currency other than the functional currency are included in the
results of operations as incurred. Transaction gain of $87,619 and $0 were
recognized during three months ended June 30, 2009 and 2008, respectively.
Transaction loss of $204,690 and $0 were recognized during six months ended June
30, 2009 and 2008, respectively. The amount has recorded in the statement of
operations during the period.




Recently issued accounting
pronouncements and adopted accounting





In May
2008, the FASB issued SFAS 162, "The Hierarchy of Generally Accepted Accounting
Principles". SFAS 162 is intended to improve financial reporting by identifying
a consistent framework, or hierarchy, for selecting accounting principles to be
used in preparing financial statements that are presented in conformity with
U.S. GAAP for nongovernmental entities. SFAS 162 is effective 60 days following
the SEC's approval of the Public Company Accounting Oversight Board amendments
to AU Section 411, "The Meaning of Present Fairly in Conformity with Generally
Accepted Accounting Principles." The Company is in the process of evaluating the
impact of adoption of this statement on the results of operations, financial
position or cash flows.




-17-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  In June
2008, FASB issued EITF 08-4, “Transition Guidance for Conforming Changes to
Issue No. 98-5”. The objective of EITF 08-4 is to provide transition
guidance for conforming changes made to EITF 98-5, “Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios”, that result from EITF 00-27 “Application of Issue No. 98-5
to Certain Convertible Instruments”, and SFAS 150, “Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity”. This
Issue is effective for financial statements issued for fiscal years ending after
December 15, 2008. The adoption of EITF 08-4 did not have a material impact on
our financial position or results.





On
October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” which clarifies
the application of SFAS 157 in a market that is not active and provides an
example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not active. FSP
157-3 became effective on October 10, 2008, and its adoption did not have a
material impact on our financial position or results.





In April
2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly” (FSP FAS 157-4). FSP FAS 157-4
amends SFAS 157 and provides additional guidance for estimating fair value in
accordance with SFAS 157 when the volume and level of activity for the asset or
liability have significantly decreased and also includes guidance on identifying
circumstances that indicate a transaction is not orderly for fair value
measurements. This FSP shall be applied prospectively with retrospective
application not permitted. This FSP shall be effective for interim and
annual periods ending after June 15, 2009, with early adoption permitted
for periods ending after March 15, 2009. An entity early adopting this FSP
must also early adopt FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation
of Other-Than-Temporary Impairments” (FSP FAS 115-2 and FAS 124-2).
Additionally, if an entity elects to early adopt either FSP FAS 107-1 and APB
28-1, “Interim Disclosures about Fair Value of Financial Instruments” (FSP FAS
107-1 and APB 28-1) or FSP FAS 115-2 and FAS 124-2, it must also elect to early
adopt this FSP. The adoption of this new FSP does not have a significant impact
on the determination or reporting of our financial results.





In April
2009, the FASB issued FSP FAS 115-2 and FAS 124-2. This FSP amends SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities,” SFAS 124,
“Accounting for Certain Investments Held by Not-for-Profit Organizations,” and
EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held
by a Transferor in Securitized Financial Assets,” to make the
other-than-temporary impairments guidance more operational and to improve the
presentation of other-than-temporary impairments in the financial statements.
This FSP will replace the existing requirement that the entity’s management
assert it has both the intent and ability to hold an impaired debt security
until recovery with a requirement that management assert it does not have the
intent to sell the security, and it is more likely than not it will not have to
sell the security before recovery of its cost basis. This FSP provides increased
disclosure about the credit and noncredit components of impaired debt securities
that are not expected to be sold and also requires increased and more frequent
disclosures regarding expected cash flows, credit losses, and an aging of
securities with unrealized losses. Although this FSP does not result in a change
in the carrying amount of debt securities, it does require that the portion of
an other-than-temporary impairment not related to a credit loss for a
held-to-maturity security be recognized in a new category of other comprehensive
income and be amortized over the remaining life of the debt security as an
increase in the carrying value of the security. This FSP shall be effective for
interim and annual periods ending after June 15, 2009, with early adoption
permitted for periods ending after March 15, 2009. An entity may early
adopt this FSP only if it also elects to early adopt FSP FAS 157-4. Also, if an
entity elects to early adopt either FSP FAS 157-4 or FSP FAS 107-1 and APB 28-1,
the entity also is required to early adopt this FSP. The adoption of this new
FSP does not have a significant impact on the determination or reporting of our
financial results.




-18-




HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
  NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009
 (UNAUDITED)
  In April
2009, the FASB issued FSP FAS 107-1 and APB 28-1. This FSP amends SFAS
No. 107, “Disclosures about Fair Value of Financial Instruments,” to
require disclosures about fair value of financial instruments not measured on
the balance sheet at fair value in interim financial statements as well as in
annual financial statements. Prior to this FSP, fair values for these assets and
liabilities were only disclosed annually. This FSP applies to all financial
instruments within the scope of SFAS 107 and requires all entities to disclose
the method(s) and significant assumptions used to estimate the fair value of
financial instruments. This FSP shall be effective for interim periods ending
after June 15, 2009, with early adoption permitted for periods ending after
March 15, 2009. An entity may early adopt this FSP only if it also elects
to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS 124-2. This FSP does not
require disclosures for earlier periods presented for comparative purposes at
initial adoption. In periods after initial adoption, this FSP requires
comparative disclosures only for periods ending after initial adoption. We are
currently evaluating the disclosure requirements of this new FSP. The adoption
of this new FSP does not have a significant impact on the determination or
reporting of our financial results.






In
May 2009, the FASB issued Statement of Financial Accounting Standards
No. 165, “Subsequent Events,” (SFAS 165). SFAS 165 establishes general
standards of accounting for and disclosure of events that occur after the
balance sheet date but before financial statements are issued or are available
to be issued. It requires disclosure of the date through which an entity has
evaluated subsequent events. The Company adopted SFAS 165 in the second quarter
of 2009 and the adoption of SFAS 165 did not impact the Company’s consolidated
financial statements. We evaluated all events or transactions that occurred
after June 30, 2009 up through August 7, 2009. See Note 21 for the
disclosure.




-19-





HARBIN
ELECTRIC, INC. AND SUBSIDIARIES





NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS


JUNE 30,
2009


(UNAUDITED)




Accounting pronouncements
not yet adopted




In
December 2008, the Financial Accounting Standards Board (FASB) issued
FASB Staff Position (FSP) Financial Accounting Standard (SFAS) 132(R)-1,
“Employers’ Disclosures about Postretirement Benefit Plan Assets,” which is
effective for fiscal years ending after December 15, 2009. The new standard
expands disclosures for assets held by employer pension and other postretirement
benefit plans. FSP SFAS 132(R)-1 will not affect the company’s financial
position or results of operations.




In
June 2009 the FASB issued SFAS 166, “Accounting for Transfers of Financial
Assets — an amendment of FASB Statement No. 140” (SFAS 166). SFAS 166
eliminates the concept of a qualifying special-purpose entity, creates more
stringent conditions for reporting a transfer of a portion of a financial
asset as a sale, clarifies other sale-accounting criteria, and changes the
initial measurement of a transferor’s interest in transferred financial assets.
SFAS 166 is effective for fiscal years beginning after November 15, 2009.
We are currently assessing the potential impacts, if any, on the Company’s
consolidated financial statements.




In June
2009, the FASB issued Statement of Financial Accounting Standards No. 167,
Amendments to FASB Interpretation No. 46(R) (“FAS 167”) [ASC 810-10], which
modifies how a company determines when an entity that is insufficiently
capitalized or is not controlled through voting (or similar rights) should be
consolidated. FAS 167 clarifies that the determination of whether a company is
required to consolidate an entity is based on, among other things, an entity’s
purpose and design and a company’s ability to direct the activities of the
entity that most significantly impact the entity’s economic performance. FAS 167
requires an ongoing reassessment of whether a company is the primary beneficiary
of a variable interest entity. FAS 167 also requires additional disclosures
about a company’s involvement in variable interest entities and any significant
changes in risk exposure due to that involvement. FAS 167 is effective for
fiscal years beginning after November 15, 2009. The Company has not completed
the assessment of the impact FAS 167 will have on the Company’s financial
condition, results of operations or cash flows.




In June
2009, the FASB issued SFAS 168, “The FASB Accounting Standards Codification and
the Hierarchy of Generally Accepted Accounting Principles – a replacement of
FASB Statement No. 162” (SFAS 168). SFAS 168 provides for the FASB
Accounting Standards Codification (the “Codification”) to become the single
official source of authoritative, nongovernmental U.S. generally accepted
accounting principles (GAAP). The Codification did not change GAAP but
reorganizes the literature. SFAS 168 is effective for interim and annual
periods ending after September 15, 2009.





Note
3 - Accounts receivable





Accounts
receivable consisted of the following at June 30, 2009 and December 31,
2008:





June
      30,
              2009
            
            
            December
      31,
              2008Trade
      accounts receivable
            
            $
            25,582,123
            
            
            $
            30,437,235Allowance
      for bad debts
            
            
            (800,365
            )
            
            
            (153,155
            )Trade
      accounts receivable, net
            
            $
            24,781,758
            
            
            $
            30,284,080




-20-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


The
following table consists of allowance for doubtful accounts.




Allowance
      for doubtful accounts at June 30, 2008
            
            $
            123,699Additional
      reservesAccounts
      receivable write off
            
            
            -Increase
      in allowance from acquisition of Weihai
            
            
            29,456Effect
      of foreign currency translationAllowance
      for doubtful accounts at December 31, 2008
            
            
            153,155Changes
      in reserves
            
            
            645,738Accounts
      receivable write off
            
            
            -Effect
      of foreign currency translation
            
            
            1,472Allowance
      for doubtful accounts at June 30, 2009
            
            $
            800,365





Note
4 – Inventories





Inventories
consist of the following:





June
      30,
            
            
            December 31,2009
            
            
            2008Raw
      and packing materials
            
            $
            4,106,288
            
            
            $
            2,702,417Work
      in process
            
            
            4,213,984
            
            
            
            7,978,350Finished
      goods
            
            
            6,836,192
            
            
            
            11,279,317Total
            
            $
            15,156,464
            
            
            $
            21,960,084





Note
5 - Loan receivable – related party





The
Company had a loan receivable from a related party for the amount of $4,248,500
and $0 as of June 30, 2009 and December 31, 2008, respectively.  The
related party is 100% owned by the Company’s CEO Mr. Tianfu Yang. The loan
receivable was non-interest bearing and short term in nature, and due on August
6, 2009. The Company expects to receive the loan in cash on the due
date.





Note
6 – Plant and equipment





Plant and
equipment consist of the following at June 30, 2009 and December 31,
2008:





June
      30,
            
            
            December
      31,2009
            
            
            2008Buildings
            
            $
            26,404,194
            
            
            $
            26,440,241Office
      equipment
            
            
            959,553
            
            
            
            925,372Production
      equipment
            
            
            8,155,521
            
            
            
            7,908,020Vehicles
            
            
            1,445,541
            
            
            
            1,472,593Construction
      in progress
            
            
            65,570,068
            
            
            
            61,095,712Total
            
            
            102,534,877
            
            
            
            97,841,938Less:
      accumulated depreciation
            
            
            (4,192,912
            )
            
            
            (2,909,939
            )Property
      and equipment, net
            
            $
            98,341,965
            
            
            $
            94,931,999




-21-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Construction
in progress represents labor costs, material, capitalized interest incurred in
connection with the construction of the new plant facility in Shanghai and the
construction and installation of manufacturing equipment in Harbin manufacture
plant.  The Company expects the Shanghai plant to be completed on or
before the end of year 2010.




Depreciation
expense for the three months ended June 30, 2009 and 2008 amounted to $619,730
and $221,996, respectively.  Depreciation expense for the six months
ended June 30, 2009 and 2008 amounted to $1,287,510 and $433,706,
respectively.





As of
June 30, 2009 and December 31, 2008, a total of $5,726,594 and $3,634,014,
of interest was capitalized into construction in progress,
respectively.





Note 7 – Goodwill and other
intangible assets





Net
intangible assets consist of the following at June 30, 2009 and December
31, 2008:





June
      30,
              2009
            
            
            December
      31, 2008Goodwill
            
            $
            12,273,778
            
            
            $
            12,273,778Other
      intangible assets:Land
      use rights
            
            
            1,541,101
            
            
            
            1,531,202Patents
            
            
            6,619,991
            
            
            
            6,629,028Less:
      accumulated amortization
            
            
            (2,264,170
            )
            
            
            (1,729,833
            )Other
      intangible assets, net
            
            
            5,896,922
            
            
            
            6,430,397Total
      Intangible assets, net
            
            $
            18,170,700
            
            
            $
            18,704,175





Amortization
expense for the three months ended June 30, 2009 and 2008 amounted to $232,033
and $263,214, respectively.  Amortization expense for the six months
ended June 30, 2009 and 2008 amounted to $524,960 and $505,517,
respectively.




-22-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Note
8 – Advance for intangible assets





The
advances for intangible assets consisted of land use right prepayment. As of
June 30, 2009 and December 31, 2008, advances for intangible assets amounted to
$3,123,380 and $1,892,430, respectively.





On
September 8, 2006, HTFE entered into an agreement ("Land Use Agreement") with
Shanghai Lingang Investment and Development Company Limited ("Shanghai Lingang")
with respect to HTFE’s use of 40,800 square meters of State-owned land in the
Shanghai Zhuqiao Airport Industrial Zone (the "Site"). The term of the land use
agreement is 50 years. The size of the land used by HTFE was later revised to a
total of approximately 53,000 square meters. The aggregate amount HTFE shall pay
to Shanghai Lingang is approximately $6.28 million (RMB42,840,000) ("Fee"),
approximately 49.8% or $3.12 million (RMB 21,320,000) has been paid with the
balance payable in installments. The Land Use Agreement requires HTFE to invest
approximately $16.5 million in the site through December 2008. This
investment amount includes fees, improvement costs, constructing a factory
building and installing necessary equipment. HTFE shall register a Sino-foreign
joint venture company at the location of Shanghai Lingang, with taxes payable
at the same location. HTFE has agreed to compensate Shanghai Lingang for
certain local taxes due to the local tax authority in connection with applicable
tax generation requirements.




Note
9 – Advances to suppliers





The
Company makes advances to certain vendors for inventory purchases and
construction projects. The advances on inventory purchases were $3,789,111 and
$3,529,607 as of June 30, 2009 and December 31, 2008, respectively.
Additionally, the Company made advances on equipment purchases amounted to
$10,421,618 and $10,416,187 as of June 30, 2009 and December 31, 2008,
respectively.





Note
10 – Other assets





Other
assets consist of the following at June 30, 2009 and December 31,
2008:





June
      30,
              2009
            
            
            December
      31,
              2008Research
      and development prepayment
            
            $
            406,860
            
            
            $
            407,415Deferred
      expenses & other assets
            
            
            407,492
            
            
            
            63,805Total
            
            $
            814,352
            
            
            $
            471,220





On August
21, 2006, HTFE entered into a joint research and development agreement (the
“R&D Agreement”) with the Institute of Electrical Engineering of the Chinese
Academy of Sciences (“IEECAS”) to produce a train system to be tested at the
Beijing Airport railway line in the People’s Republic of China (“PRC”) in 2009.
The Agreement provides that the term of the project shall commence on August
2006 and terminate in the second half of 2009.





The
R&D Agreement provides for a budget of approximately $3.65 million (RMB 25
million), consisting of $2.19 million (RMB 15 million) to be invested by HTFE
and the remainder to be invested by IEECAS.  Of this amount,
approximately $1.46 million (RMB 10 million) has been invested to date by HTFE.
The balance of approximately $0.73 million (RMB 5 million) will be invested in
2009 as testing and evaluation occurs. The Company has started to amortize the
R&D prepayment based on the progress of the project. A total of $1,058,140
has been amortized and netted with R&D prepayment to the amount of
$406,860.




-23-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


The
research and development prepayment is being expensed based on the service
incurred pursuant to FAS 2 and EITF 07-3. A total of $801,802 and $0 have been
expensed as research and development for the six months ended June 30, 2009 and
2008, and a total of $408,520 and $0 have been expensed as research and
development for the three months ended June 30, 2009 and 2008.





Note
11 – 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 and six
months ended June 30, 2009 and 2008 are as follows:





2009
            
            
            2008For
      the three months ended June 30, 2009 and 2008Geographic
      AreaChina
            
            $
            34,781,470
            
            
            $
            20,867,836International
            
            
            3,582,014
            
            
            
            3,091,237Total
      sales
            
            
            38,363,484
            
            
            
            23,959,073Cost
      of sales - China
            
            
            23,444,181
            
            
            
            10,530,775Cost
      of sales - International
            
            
            2,056,027
            
            
            
            1,972,164Total
      cost of sales
            
            
            25,500,208
            
            
            
            12,502,939Gross
      profit
            
            $
            12,863,276
            
            
            $
            11,456,134





2009
            
            
            2008For
      the six months ended June 30, 2009 and 2008Geographic
      AreaChina
            
            $
            62,244,476
            
            
            $
            39,521,395International
            
            
            6,843,901
            
            
            
            6,895,863Total
      sales
            
            
            69,088,377
            
            
            
            46,417,258Cost
      of sales - China
            
            
            41,445,491
            
            
            
            20,336,133Cost
      of sales - International
            
            
            3,855,832
            
            
            
            3,865,514Total
      cost of sales
            
            
            45,301,323
            
            
            
            24,201,647Gross
      profit
            
            $
            23,787,054
            
            
            $
            22,215,611





Note
12 – Financing





On August
29, 2006, the Company, Citadel Equity Fund Ltd. (“Citadel”) and Merrill Lynch
International (“Merrill Lynch” and, together with Citadel, the “Investors”)
entered a purchase agreement (the “Purchase Agreement”) relating to the purchase
and sale of (a) $50 million aggregate principal amount of the Company's
Guaranteed Senior 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.




-24-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


The Notes
are governed by an indenture, dated August 30, 2006, entered into among the
Company, AEM as guarantor, and The Bank of New York, as trustee for the Notes
(the “Indenture”). Of the $50 million aggregate principal amount of the Notes,
Citadel subscribed to $38 million of the principal amount of the Notes, which
mature on September 1, 2012 (the “2012 Notes”), and Merrill Lynch subscribed to
$12 million of the principal amount of the Notes, which mature on September 1,
2010 (the “2010 Notes”). Pursuant to the indenture, AEM has agreed, and all of
the Company’s other existing and future subsidiaries (other than subsidiaries
domiciled in the People's Republic of China) are obligated, to guarantee, on a
senior secured basis, to the Investors and to the trustee the payment and
performance of our obligations under the Notes.





The 2010
Notes bear interest, payable semi-annually in arrears commencing March 1, 2007,
at a rate equal to LIBOR (approximately 1.09% and 1.75% at June 30, 2009 and
December 31, 2008, respectively), plus 4.75%. The 2010 Notes bear an additional
4% interest on any overdue principal and premium, if any, including interest on
overdue interest, to the extent permitted by law.




The 2010
Notes are redeemable at the option of the Company, in whole but not in part, at
any time after September 1, 2007, initially at 106% of the principal amount
thereof and declining to 100% of the principal amount on September 1, 2009. The
2010 Notes are subject to mandatory redemption semi-annually commencing March 1,
2008 in the principal amount of $2,000,000 at a price equal to 100% of such
principal amount.





The 2012
Notes bear interest, payable semi-annually in arrears commencing March 1, 2007,
at a rate equal to LIBOR plus 3.35%. See below for discussion of swap agreement
changing the variable interest to a 7.2% RMB fixed rate. The 2012 Notes bear an
additional 4% interest on any overdue principal and premium, if any, including
interest on overdue interest, to the extent permitted by law. The 2012 Notes are
redeemable at the option of the Company, in whole but not in part, at any time
after September 1, 2007, initially at 106% of the principal amount thereof
and declining to 100% of the principal amount on September 1, 2011. The 2012
Notes are subject to mandatory redemption semi-annually commencing September 1,
2009 in the principal amount $2,400,000 on September 1, 2009, $3,800,000 on
March 1, 2010, $9,900,000 on September 1, 2010 and March 1, 2011, and $4,000,000
on September 1, 2011, March 1, 2012 and September 1, 2012, in each instance at a
price equal to 100% of such principal amount. Holders of the 2012 Notes may
require the Company to repurchase such Notes at 100% of the principal
amount thereof at any time after September 1, 2011.





Upon a
Change of Control (as defined in the indenture), holders of the Notes may
require the Company to repurchase any or all such Notes at a price equal to
102.5% of the principal amount thereof. The Company is required to offer to
purchase Notes at a price equal to 100% of the principal amount thereof with the
proceeds of certain asset sales. As security for the Notes, the Company and The
Bank of New York, as collateral agent, entered into a share pledge agreement,
dated August 30, 2006, to secure the Notes with all of the shares of AEM common
stock held by the Company as collateral.




-25-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


The
following table disclosed the combined aggregate amounts of maturities for all
long-term borrowings disclosed for each of the five years following June 30,
2009.:





Contractual
      Obligations
            
            2012
      Notes
            
            
            2010
      Notes
            
            
            Total2009
            
            $
            2,400,000
            
            
            $
            2,000,000
            
            
            $
            4,400,0002010
            
            
            13,700,000
            
            
            
            4,000,000
            
            
            
            17,700,0002011
            
            
            13,900,000
            
            
            
            -
            
            
            
            13,900,0002012
            
            
            8,000,000
            
            
            
            -
            
            
            
            8,000,000Thereafter
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            38,000,000
            
            
            $
            6,000,000
            
            
            $
            44,000,000





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. 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
six months ended June 30, 2009, the remaining 234,615 shares of 2009 Warrants
outstanding were exercised by cashless transaction and 85,227 shares of common
stock were issued upon this exercise.





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. $885,034 and $958,942 were
amortized to interest expense for the three months ended June 30, 2009 and 2008,
respectively. $2,007,648 and $2,302,871 were amortized to interest expense for
the six months ended June 30, 2009 and 2008, respectively. The carrying value of
the debt is as follows at June 30, 2009 and December 31, 2008:





June
      30,
                    2009
                  
                  
                  December
      31, 2008Current
      portion of notes payable
                  
                  $
                  10,200,000
                  
                  
                  $
                  6,400,000Less
      unamortized discount
                  
                  
                  (4,703,140
                  )
                  
                  
                  (4,420,129
                  )Current
      portion of notes payable, net
                  
                  
                  5,496,860
                  
                  
                  
                  1,979,871Long
      term notes payable
                  
                  
                  33,800,000
                  
                  
                  
                  39,600,000Less
      unamortized discount
                  
                  
                  (5,678,346
                  )
                  
                  
                  (7,969,005
                  )Long
      term notes payable, net
                  
                  
                  28,121,654
                  
                  
                  
                  31,630,995Total
      notes payable principal amount
                  
                  
                  44,000,000
                  
                  
                  
                  46,000,000Less
      unamortized discount
                  
                  
                  (10,381,486
                  )
                  
                  
                  (12,389,134
                  )Total
      notes payable, net of unamortized discount
                  
                  $
                  33,618,514
                  
                  
                  $
                  33,610,866
 
 -26-
 HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


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.
$135,610 and $123,767 were amortized to interest expense for the three months
ended June 30, 2009 and 2008, respectively.  $271,220 and $351,948
were amortized to interest expense for the six months ended June 30, 2009 and
2008, respectively. As of June 30, 2009 and December 31, 2008, unamortized debt
issuance costs totaled $1,401,059 and $1,672,279, respectively.





The
Company’s short term loan as of June 30, 2009 and December 31, 2008 are as
follows:




June
      30,
              2009
            
            
            December 31,
              2008Loan
      from Zhongxin Bank in city of Wendeng, due September 2010. Monthly
      interest-only payments at 5.310% per annum, secured by
    assets
            
            $
            3,076,500
            
            
            $
            -Loan
      from Agriculture Bank in city of Wendeng, due October 2009. Monthly
      interest-only payments at 8.360% per annum, secured by
      buildings
            
            
            -
            
            
            
            3,007,350Loan
      from Commercial Bank in city of Wendeng, due August 2009. Monthly
      interest-only payments at 7.47% per annum, guaranteed loan
            
            
            586,000
            
            
            
            1,173,600Loan
      from Commercial Bank in city of Wendeng, due September 2009. Monthly
      interest-only payments at 7.47% per annum, guaranteed loan
            
            
            586,000Short
      term loan - bank
            
            $
            4,248,500
            
            
            $
            4,180,950




Net
interest expense for the three months and six months ended June 30, 2009
and 2008 was comprised of the following:





For
      the three months ended June 30,
              
              2009
              
              
              2008Amortization
      of debt discount
              
              $
              885,034
              
              
              $
              958,942Amortization
      of debt issuance costs
              
              
              135,610
              
              
              
              123,767Interest
      expense
              
              
              82,286
              
              
              
              331,590Interest
      earned on cash deposits
              
              
              (172,783
              )
              
              
              (195,051
              )Interest
      expense (income) on derivative instrument
              
              
              -
              
              
              
              (24,517
              )Foreign
      currency transaction loss (gain)
              
              
              (87,619)
              
              
              
              -Interest
      expense, net
              
              $
              842,528
              
              
              $
              1,194,731




-27-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


For
      the six months ended June 30,
            
            2009
            
            
            2008Amortization
      of debt discount
            
            $
            2,007,648
            
            
            $
            2,302,871Amortization
      of debt issuance costs
            
            
            271,220
            
            
            
            351,948Interest
      expense
            
            
            171,984
            
            
            
            1,425,219Interest
      earned on cash deposits
            
            
            (371,630
            )
            
            
            (409,796
            )Interest
      expense (income) on derivative instrument
            
            
            -
            
            
            
            (192,731
            )Foreign
      currency transaction loss (gain)
            
            
            204,690
            
            
            
            -Interest
      expense, net
            
            $
            2,283,912
            
            
            $
            3,477,511





Note
13 – 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.
These exposures are managed, in part, with the use of a financial
derivative. The Company uses financial derivatives only to hedge exposures in
the ordinary course of business and dose not invest in derivative instruments
for speculative purposes.





Effective
April 17, 2007, the Company entered into a cross currency interest rate swap
agreement with Merrill Lynch exchanging the LIBOR plus 3.35% variable rate
interest payable on the $38 million principle amount or 2012 Notes for a 7.2%
(3.6% semi-annually) RMB fixed rate interest.  The agreement requires
semi-annual payments on March 1 and September 1 through the maturity of the
agreement on September 1, 2012.  Merrill Lynch required the Company to
deposit $1,000,000 with them to secure the agreement.  The deposit may
be increased to $2,500,000 if the exchange rate for Renminbi to USD falls below
6.5, and to $4,000,000 if the exchange rate falls below 5.5. This swap is
designated and qualified as a cash flow hedge.





The fair
value of this swap agreement at April 02, 2007 (inception date) was a payable of
$5,387,487, and at June 30, 2009 and December 31, 2008, was a payable of
$9,003,322 and $5,762,958, respectively. Changes in the fair values of
derivative instruments accounted for as cash flow hedges, to the extent they
qualify for hedge accounting, are recorded in accumulated other comprehensive
income.  For the six and three months ended June 30, 2009 and 2008,
there were no amounts recorded in the consolidated statements of income in
relation to ineffectiveness of this interest swap. Accordingly, for the three
months ended June 30, 2009 and 2008, loss of $711,288 and gain of $4,244,252 was
recorded on the derivative instrument, respectively, in other comprehensive
income (loss).  For the six months ended June 30, 2009 and 2008,
$3,240,364 and $249,634 was recorded as loss on the derivative instrument,
respectively, in other comprehensive income (loss).





During
the six months ended June 30, 2009, the Company paid $332,027 as hedging payment
and Company recognized $567,278, which was recorded as interest expenses from
derivative transactions and was capitalized as construction in
progress. During the six months ended June 30, 2008, the Company recognized
$192,731, which was recorded as interest income derivative
transactions.




-28-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Changes
of cross currency hedge are as follows,





Cross
      currency hedge receivable balance at December 31,
2008
            
            $
            175,986Proceeds
      from cross currency hedge
            
            
            -Payments
      for cross currency hedge
            
            
            (332,027
            )Loss
      from derivative transactions
            
            
            567,278Cross
      currency hedge payable balance at June 30, 2009
            
            $
            411,237





Note
14 - Other expenses and income, net





Other
income and expense for the three months and six months ended June 30, 2009 and
2008 consist of the following:





For
      the three months ended
            
            June
      30,
              2009
            
            
            June
      30,
              2008Interest
      expense
            
            $
            82,286
            
            
            $
            363,751Interest
      income
            
            
            (172,783
            )
            
            
            (222,166
            )Amortization
      of debt discount
            
            
            885,034
            
            
            
            958,942Amortization
      of debt issuance cost
            
            
            135,610
            
            
            
            123,767Other
      non-operating income
            
            
            (2,129,326
            )
            
            
            (347,744
            )Other
      non-operating expense
            
            
            40,036
            
            
            
            61,802Change
      in fair value of warrants
            
            
            14,003,195
            
            
            
            -Foreign
      currency transaction loss
            
            
            (87,619)
            
            
            
            -Total
      other expense, net
            
            $
            12,756,433
            
            
            $
            938,352





For
      the six months ended
            
            June
      30,
              2009
            
            
            June
      30,
              2008Interest
      expense
            
            $
            171,984
            
            
            $
            1,427,817Interest
      income
            
            
            (371,630
            )
            
            
            (605,125
            )Amortization
      of debt discount
            
            
            2,007,648
            
            
            
            2,302,871Amortization
      of debt issuance cost
            
            
            271,220
            
            
            
            351,948Other
      non-operating income
            
            
            (2,709,017
            )
            
            
            (339,788
            )Other
      non-operating expense
            
            
            80,348
            
            
            
            92,599Change
      in fair value of warrants
            
            
            11,429,774
            
            
            
            -Foreign
      currency transaction loss
            
            
            204,690
            
            
            
            -Total
      other expense, net
            
            $
            11,085,017
            
            
            $
            3,230,322





In June
2009, Harbin municipal government awarded a grant of $1,172,560 (RMB 8 million)
to the Company’s subsidiary HTFE to support the Company’s linear motor driven
subway train project that qualified as engaging in China’s advanced
industrialization. This government grant of $1,172,560 is included in the other
income for the three months and six months ended June 30, 2009.





-29-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Note
15 – Business combinations





On July
10, 2008, the Company’s subsidiary HTFE entered into an Equity and Assets
Transfer Agreement (the “Agreement”) with respect to the acquisition by HTFE of
Weihai for an aggregate price of approximately $54.7 million (RMB 375
million), payable in cash. The results of operations of the acquired companies
are included in the consolidated statement of income for the three
months and six months ended June 30, 2009.





Amounts
due to original shareholders represent the unpaid portion for the acquisition of
Weihai (see Note 1 for the acquisition). As of June 30, 2009, HTFE had
payables of $732,500 (RMB 5 million), which will be paid within two years from
the acquisition date.





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
            
            $
            43,572,481
            
            
            $
            43,572,481Property,
      plant and equipment, net
            
            
            22,350,703
            
            
            
            22,350,703Other
      non current assets
            
            
            1,201,828
            
            
            
            1,201,828Goodwill
            
            
            -
            
            
            
            12,273,778Total
      assets
            
            
            67,125,012
            
            
            
            79,398,790Total
      liabilities
            
            
            24,590,248
            
            
            
            24,590,248Net
      assets
            
            $
            42,534,764
            
            
            $
            54,808,542





Based on
an evaluation by an independent appraisal and final asset evaluation by the
management, the purchase price exceeded the fair value of Weihai’s net assets by
$12.3 million, which was recognized as goodwill, pursuant to FAS
141.





Pro
Forma





The
following unaudited pro forma condensed income statement for the three and
six months ended June 30, 2009 and 2008 were prepared under generally
accepted accounting principles, as if the acquisition of Weihai 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,
                  
                  2009
                  
                  
                  2008Sales
                  
                  $
                  38,363,484
                  
                  
                  $
                  37,626,105Cost
      of Goods Sold
                  
                  
                  25,500,208
                  
                  
                  
                  24,386,205Gross
      Profit
                  
                  
                  12,863,276
                  
                  
                  
                  13,239,900Operating
      Expenses
                  
                  
                  4,047,456
                  
                  
                  
                  3,662,733Income
      from Operations
                  
                  $
                  8,815,820
                  
                  
                  $
                  9,577,167Other
      expense (Income), net
                  
                  
                  12,756,433
                  
                  
                  
                  (746,133
                  )Income
      Tax
                  
                  
                  1,478,751
                  
                  
                  
                  1,815,874Net
      (Loss) Income
                  
                  $
                  (5,419,364
                  )
                  
                  $
                  8,507,426
  -30-
 HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)
 For
      the six months ended June 30,
                  
                  2009
                  
                  
                  2008Sales
                  
                  $
                  69,088,377
                  
                  
                  $
                  70,682,686Cost
      of Goods Sold
                  
                  
                  45,301,323
                  
                  
                  
                  45,102,518Gross
      Profit
                  
                  
                  23,787,054
                  
                  
                  
                  25,580,168Operating
      Expenses
                  
                  
                  6,945,642
                  
                  
                  
                  6,153,837Income
      from Operations
                  
                  $
                  16,841,412
                  
                  
                  $
                  19,426,331Other
      expense (Income), net
                  
                  
                  11,085,017
                  
                  
                  
                  1,241,037Income
      Tax
                  
                  
                  2,521,425
                  
                  
                  
                  3,186,749Net
      Income
                  
                  $
                  3,234,970
                  
                  
                  $
                  14,998,545




Note
16 – Commitments and contingencies





The
Company enters into non-cancelable purchase commitments with its vendors. As of
June 30, 2009 and December 31, 2008, the Company was obligated under the non
cancelable commitments to purchase materials totaling to $1,715,300 and
$305,100, respectively.  These commitments are short-term and expire
within one year.  The Company has experienced no losses on these
purchase commitments over the years.





As
discussed in more detail in Note 1, the Company entered into an agreement with
Shelton Technology, LLC on April 9, 2007.  Under the terms of the
agreement, the Company is required to contribute a total of $3 million in
installments to AAG by March 31, 2009.  The Company has invested a
total of $2 million to AAG as of June 30, 2009 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.





As
discussed in Note 12, the Company entered into a swap agreement that required a
$1,000,000 deposit to secure the transaction.  If the exchange rate
for Renminbi to US Dollars drops below certain levels, the Company will be
required to deposit up to $4,000,000.





As
discussed in Note 12, the 2010 Notes are subject to mandatory redemption
semi-annually commencing March 1, 2008 in the principal amount $2,000,000 at
price equal to 100% of such principal amount. The 2012 Notes are subject to
mandatory redemption semi-annually commencing September 1, 2009 in the principal
amount $2,400,000 on September 1, 2009, $3,800,000 on March 1, 2010, $9,900,000
on September 1, 2010 and March 1, 2011, and $4,000,000 on September 1, 2011,
March 1, 2012 and September 1, 2012, in each instance at price equal to 100% of
such principal amount. Holders of the 2012 Notes may require the Company to
repurchase such Notes at 100% of the principal amount thereof at any time after
September 1, 2011.





On
September 8, 2006, HTFE entered into an agreement (“Land Use Agreement”) with
Shanghai Lingang Investment and Development Company Limited (“Shanghai Lingang”)
with respect to HTFE’s lease and use of 40,800 square meters of State-owned land
in the Shanghai Zhuqiao Airport Industrial Zone (the “Site”). The 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 49.8% or $3.12 million (RMB
21.32 million) of which has been paid with the balance payable in installments.
The amount paid is recorded as advances on intangible assets for $3,123,380 and
$1,481,670 as of June 30, 2009 and December 31, 2008.




-31-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Note
17 – Earnings per share





The
Company reports earnings per share in accordance with the provisions of FAS 128,
“Earnings Per Share.”  FAS 128 requires presentation of basic and
diluted earnings per share in conjunction with the disclosure of the methodology
used in computing such earnings per share.  Basic earnings per share
excludes dilution and is computed by dividing income available to 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:





For
      the Three Months ended June 30:
            
            2009
            
            
            2008Net
      loss (income) for basic and diluted earnings per
share
            
            $
            (5,419,364)
            
            
            $
            6,230,943Weighted
      average shares used in basic computation
            
            
            22,140,568
            
            
            
            18,639,687Diluted
      effect of stock options and warrants
            
            
            -
            
            
            
            1,384,303Weighted
      average shares used in diluted computation
            
            
            22,140,568
            
            
            
            20,023,990Earnings
      per share:Basic
            
            $
            (0.24)
            
            
            $
            0.33Diluted
            
            $
            (0.24)
            
            
            $
            0.31





For
      the Six Months ended June 30:
            
            2009
            
            
            2008Net
      income for basic and diluted   earnings per
      share
            
            $
            3,234,970
            
            
            $
            11,584,179Weighted
      average shares used in basic computation
            
            
            22,121,746
            
            
            
            18,424,832Diluted
      effect of stock options and warrants
            
            
            228,380
            
            
            
            1,573,360Weighted
      average shares used in diluted computation
            
            
            22,350,126
            
            
            
            19,998,192Earnings
      per share:Basic
            
            $
            0.15
            
            
            $
            0.63Diluted
            
            $
            0.14
            
            
            $
            0.58





For the three months ended June 30,
2009, a total of 260,000 options were excluded from diluted earnings per
sharedue to the anti-dilutive
effect. All other stock options and warrants have been included in the diluted
earnings per share calculation.For the
six months ended June 30, 2009, a total of626,697warrants andoptions were excluded from diluted
earnings pershare due to
the anti-dilutive effect. All other stock options and warrants have been
included in the diluted earnings per share calculation.




-32-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Note
18 – 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.





For the
six months ended June 30, 2009, the Company transferred $1,994,565 representing
10% of the current quarter’s 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 $23.4 million and $25.4
million as of June 30, 2009 and December 31, 2008, 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, 2008
            
            
            2,454,960Granted
            
            
            -Forfeited
            
            
            -Exercised
            
            
            (202,300
            )Outstanding
      as of June 30, 2008 (unaudited)
            
            
            2,252,660Granted
            
            
            -Forfeited
            
            
            (2,504)Exercised
            
            
            (219,998
            )Outstanding
      as of December 31, 2008
            
            
            2,030,158Granted
            
            
            -Forfeited
            
            
            -Cancelled
            
            
            -Exercised
            
            
            (234,615)Outstanding
      as of June 30, 2009 (unaudited)
            
            
            1,795,543




-33-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Following
is a summary of the status of warrants outstanding at June 30,
2009:




Outstanding
      Warrants
            
            
            Exercisable
      WarrantsExercise
      Price
            
            
            Number
      of Shares
            
            
            Average
      Remaining Contractual Life
            
            
            Average
              Exercise
      Price
            
            
            Number
      of Shares
            
            
            Average
      Remaining Contractual Life$
            10.84
            
            
            
            366,697
            
            
            
            3.17
            
            
            $
            10.84
            
            
            
            366,697
            
            
            
            3.17$
            7.80
            
            
            
            1,428,846
            
            
            
            3.17
            
            
            $
            7.80
            
            
            
            1,428,846
            
            
            
            3.17Total
            
            
            
            1,795,543
            
            
            
            
            
            
            
            
            
            
            
            1,795,543





Options





Following
is a summary of stock option activity:





Options
      Outstanding
            
            
            Weighted
      Average Exercise Price
            
            
            Aggregate
      Intrinsic ValueOutstanding
      as of January 1, 2008
            
            
            761,250
            
            
            $
            9.82
            
            
            $
            12,370,313Granted
            
            
            -
            
            
            
            -
            
            
            
            -Forfeited
            
            
            -
            
            
            
            -
            
            
            
            -Exercised
            
            
            (25,000
            )
            
            
            3.10
            
            
            
            -Outstanding
      as of June 30, 2008 (unaudited)
            
            
            736,250
            
            
            $
            10.05
            
            
            $
            3,062,800Granted
            
            
            -
            
            
            
            
            
            
            
            -Forfeited
            
            
            (26,667
            )
            
            
            8.10
            
            
            
            -Exercised
            
            
            (15,000
            )
            
            
            3.10
            
            
            
            -Outstanding
      as of December 31, 2008
            
            
            694,583
            
            
            $
            10.27
            
            
            $
            -Granted
            
            
            -
            
            
            
            -
            
            
            
            -Forfeited
            
            
            (25,000
            )
            
            
            12.40
            
            
            
            -Exercised
            
            
            -
            
            
            
            -
            
            
            
            -Outstanding
      as of June 30, 2009 (unaudited)
            
            
            669,583
            
            
            $
            10.19
            
            
            $
            3,648,656





Following
is a summary of the status of options outstanding at June 30, 2009:





Outstanding
      Options
            
            
            Exercisable
      OptionsExercise
      Price
            
            
            Number
            
            
            Average
      Remaining Contractual Life
            
            
            Average
      Exercise Price
            
            
            Number
            
            
            Average
      Remaining Contractual Life$
            3.10
            
            
            
            110,000
            
            
            
            0.58
            
            
            $
            3.10
            
            
            
            110,000
            
            
            
            0.58$
            8.10
            
            
            
            299,583
            
            
            
            1.58
            
            
            $
            8.10
            
            
            
            299,583
            
            
            
            1.58$
            15.60
            
            
            
            260,000
            
            
            
            1.47
            
            
            $
            15.60
            
            
            
            156,000
            
            
            
            1.47Total
            
            
            
            669,583
            
            
            
            
            
            
            
            
            
            
            
            565,583




-34-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


For six
months ended June 30, 2009 and 2008, stock compensation expense related to
warrants and options issued amounted to $584,290 and $912,465
respectively.





For three
months ended June 30, 2009 and 2008, stock compensation expense related to
warrants and options issued amounted to $242,928 and $456,233
respectively.





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 proceeding fifteen consecutive trading days before
June 16, 2007, the date when the Company and HTFE entered into the asset
purchase agreement with Harbin Taifu Auto Electric Co., Ltd, the trading price
of the stock on the date of transfer, as a capital contribution totaling
$3,844,904 by the CEO, the value was amortized over the vesting period. 
For the three months ended June 30, 2009 and 2008, respectively, the Company
recorded a total of $99,556 and $99,556 has been expensed and included in the
stock compensation expenses.  For the six months ended June 30, 2009 and
2008, respectively, the Company recorded a total of $199,112 and
$199,112 has been expensed and included in the stock compensation expenses.





Note
19 – Supplemental disclosure of cash flows





The
Company prepares its statements of cash flows using the indirect method as
defined under the FAS 95. The following information relates to non-cash
investing and financing activities for 2009 and 2008.





Total
interest paid amounted to $1,807,095 and $2,120,346 for the six months ended
June 30, 2009 and 2008, respectively.





Total
income tax paid amounted to $2,312,075 and $1,018,431 for the six months ended
June 30, 2009 and 2008, respectively.





Note 20
– 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 Harbin generally
includes two parts: the first part to be paid by the Company is 20% of the
employees’ actual salary in the prior year. If the average salary falls below
$1,165 for each individual, $1,165 will be used as the basis. The other part,
paid by the employees, is 8% of actual salary with the same minimum
requirement. The Company made contributions to employment benefits, including
pension, of $154,066 and $49,278 for the six months ended June 30, 2009 and
2008, respectively. The Company made contributions to employment benefits,
including pension, of $130,290 and $19,019 for the three months ended June 30,
2009 and 2008, respectively.




-35-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)


Note 21
– Subsequent Events





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
$26,500,000 aggregate principal amount of 2012 Notes held by Citadel (“the
Citadel Notes”) before August 31, 2009.  On August 7, 2009, the
Company paid a total of $23,131,997.22 to repurchase the Citadel Notes,
which amount was comprised of $22,525,000 representing 85% of the $26,500,000
aggregate principal amount of the 2012 Notes held by Citadel plus $606,997.22
representing accrued and unpaid interest on the Citadel Notes to but excluding
the Repurchase Date.  The Company anticipates the repurchase of
Citadel Notes to be completed and the Citadel Notes to be cancelled on August
10, 2009.





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 $5,983,843.76 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
$163,843.76 representing accrued and unpaid interest on the 2010 Notes to but
excluding the Repurchase Date. As of August 5, 2009, the repurchase had been
completed and the 2010 Notes were cancelled.





On August
4, 2009, the Company completed the sale of 6,250,000 shares of its common stock
in an underwritten public offering at a public offering price of $16.00 per
share. The Company received net proceeds of approximately $93.4 million from the
offering, after deducting underwriting commissions and fees and expenses
associated with the offering.





The
following table sets forth our consolidated capitalization as of June 30, 2009
on an actual basis and on a pro forma as adjusted basis to give effect to
(i) the sale by us of 6,250,000 shares of our common stock in this
offering after deducting underwriting discounts and commissions and estimated
offering expenses payable by us and assuming no exercise of the underwriter’s
over-allotment option, (ii) the initial application of the proceeds of this
offering, and (iii) the repurchase for cash on or prior to July 31, 2009 of
the $6.0 million aggregate principal amount of our outstanding Guaranteed Senior
Secured Floating Rate Notes due 2010 for a repurchase price equal to 97% of such
principal amount plus accrued and unpaid interest to the date prior to the
repurchase date.




-36-


HARBIN
ELECTRIC, INC. AND SUBSIDIARIES
 
 NOTES TO
THE CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30,
2009
 (UNAUDITED)
 As
      of June 30, 2009Actual
                (unaudited)
              
              
              Pro
      Forma
                As AdjustedCURRENT
      ASSETSCash
      and Cash Equivalents
              
              $
              67,801,324
              
              
              $
              132,209,608CURRENT
      LIABILITIESNotes
      payable, net of debt discount of $4,703,140 as of June 30, 2009and
      $1,077,202 as adjusted to give effect to the debt
      repurchase
              
              
              5,496,860
              
              
              
              799,115LONG
      TERM LIABILITIESAmounts
      due to original shareholder
              
              
              732,500
              
              
              
              732,500Notes
      payable, net of debt discount of $4,703,140 as of June 30, 2009 and
      $1,906,768 as adjusted to give effect to the debt
    repurchase
              
              
              28,121,654
              
              
              
              7,716,916Fair
      value of derivative instrument
              
              
              9,003,322
              
              
              
              9,003,322Total
      long term debt
              
              
              43,354,336
              
              
              
              18,251,853STOCKHOLDERS’
      EQUITYCommon
      stock, ($0.00001 par value); 100,000,000 shares authorized, 22,187,305
      shares issued 28,437,305, shares issued as adjusted to give effect to the
      offering
              
              
              221
              
              
              
              284Paid-in
      capital
              
              
              83,043,892
              
              
              
              176,643,830Retained
      earnings
              
              
              59,483,164
              
              
              
              55,980,255Statutory
      reserves
              
              
              16,568,559
              
              
              
              16,568,559Accumulated
      other comprehensive income
              
              
              9,410,510
              
              
              
              9,410,510Total
      stockholders’ equity
              
              $
              168,506,346
              
              
              $
              258,603,438





-37-




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





INFORMATION
REGARDING FORWARD LOOKING STATEMENTS





The
following is management’s discussion and analysis of certain significant factors
that have affected aspects of our financial position and results of operations
during the periods included in the accompanying unaudited financial statements.
You should read this in conjunction with the discussion under “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” and
the audited financial statements for the year ended December 31, 2008
included in our Annual Report on Form 10-K 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 oil services, factory automation, food processing, packaging
industries, logistic systems, mass transportation systems, petrochemical,
metallurgical, mining, textile, and agricultural industries. We supply domestic
China and other international markets. We operate three major manufacturing
facilities in China, covering approximately 240,000 meters of land, and have an
employee base of approximately 1800 engineers, production technicians and other
employees.





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) describe the method used to apply the accounting
principle.





Accounts
Receivable





We use
estimates in determining our allowance for bad debts that are based on our
historical collection experience, current trends, credit policy and a percentage
of our accounts receivable by aging category. In determining these percentages,
we review historical write-offs in our receivables. In determining the
appropriate reserve percentages, we also review current trends in the credit
quality of our customers, as well as changes in our internal credit
policies.





We
maintain reserves for potential credit losses on accounts receivable. Management
reviews the composition of accounts receivable and analyzes historical bad
debts, customer concentrations, customer credit worthiness, current economic
trends and changes in customer payment patterns to evaluate the adequacy of
these reserves. Reserves are recorded primarily on a specific identification
basis. Additional allowances for doubtful accounts may be required if there is
deterioration in past due balances, if economic conditions are less favorable
than anticipated, or for customer-specific circumstances, such as financial
difficulty. Delinquent account balances are written-off after management has
determined that the likelihood of collection is not probable, known bad
debts are written off against allowance for doubtful accounts when
identified.





Inventories




Inventory
levels are based on projections of future demand and market conditions.
Inventories are stated at cost, not in excess of market using the weighted
average cost method. Any sudden decline in demand and/or rapid product
improvements and technological changes can result in excess and/or obsolete
inventories. Because most of our products are customized and 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, we
require a binding purchase order or a signed agreement by our customer agreeing
to pay for and take possession of finished goods inventory parts for the
duration of the agreement.




-38-




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. To the extent we increase our reserves
for future periods, operating income will be reduced.





Revenue
Recognition




Our
revenue recognition policies comply with Staff Accounting Bulletin (SAB) 104 and
SFAS 48. SAB 104 requires that revenue can only be recognized when it is
realized or realizable and earned. Revenue generally is realized or realizable
and earned when all four of the following criteria have been met: (1)
persuasive evidence of an arrangement exists; (2) delivery has occurred or
services rendered; (3) the price is fixed and determinable; and (4)
collectability is reasonably assured. For products that are required to be
examined by customers upon receiving shipments, sales revenue is recognized
after the customer examination is passed.





In
addition, our revenue recognition could be negatively impacted by returns. For
our linear motor and specialty micro-motor businesses, our products are custom
products which are customer specific, and no returns are allowed. We warrant our
product for repair, only in the event of defects for two years from the date of
shipment. We charge such costs to cost of goods sold. For our newly acquired
rotary motor business, our products 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.





Stock-Based
Compensation




The
Company accounts for stock-based compensation in accordance with the fair value
recognition provisions of SFAS 123R. The Company uses the Black-Scholes-Merton
option-pricing model which requires the input of highly subjective assumptions.
These assumptions include estimating the length of time employees will retain
their stock options before exercising them (“expected term”), the estimated
volatility of the Company’s common stock price over the expected term and the
number of options that will ultimately not complete their vesting requirements
(“forfeitures”). Changes in the subjective assumptions can materially affect the
estimate of fair value of stock-based compensation and consequently, the related
amount recognized on the consolidated statements of earnings.





The
Company accounts for equity instruments issued in exchange for the receipt of
goods or services from other than employees in accordance with SFAS 123R and the
conclusions reached by EITF 96-18, “Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring or in Conjunction with Selling
Goods or Services.” Costs are measured at the estimated fair market value of the
consideration received or the estimated fair value of the equity instruments
issued, whichever is more reliably determinable. The value of equity instruments
issued for consideration other than employee services is determined on the
earlier of a performance commitment or completion of performance by the provider
of goods or services as defined by EITF 96-18.





Stock
compensation expense is recognized based on awards expected to vest, and there
were no estimated forfeitures as the Company has a short history of issuing
options. FAS 123R requires forfeitures to be estimated at the time of grant and
revised in subsequent periods, if necessary, if actual forfeitures differ from
those estimates.





Derivative
Financial Instruments





The
Company uses a cross-currency interest rate swap to hedge its exposure under the
2012 Notes. The derivative is initially recognized in the balance sheet at cost
and subsequently re-measured at fair value each reporting period. Changes in the
fair values of derivatives accounted for as cash flow hedges, to the extent they
qualify for hedge accounting, are recorded in accumulated other comprehensive
income, net of deferred taxes; changes in fair values of derivative financial
instruments not qualifying as hedges are reported in income.





At the
inception of a hedge transaction, the Company documents the relationship between
hedging instruments and hedged items, as well as its risk management objective
and the strategy for undertaking the hedge. This process includes linking all
derivatives designated to specific firm commitments of forecast transactions.
The Company also documents its assessment, both at inception and on an ongoing
basis, of whether the derivative financial instruments that are used to hedge
are highly effective in offsetting changes in fair values or cash flows of
hedged items.





Fair
Value of Financial Instruments





FAS 107,
“Disclosures About Fair Value of Financial Instruments” defines financial
instruments and requires fair value disclosure of applicable financial
instruments FAS 157, “Fair Value Measurements,” adopted January 1, 2008, defines
fair value, establishes a three-level valuation hierarchy for disclosures of
fair value measurement and enhances disclosure requirements for fair value
measures. The carrying amounts reported in the balance sheets for current
receivables and payables qualify as
financial instruments.  Management concluded the carrying values
are a reasonable estimate of fair value because of the short period of time
between the origination of such instruments and their expected realization and
if applicable, their stated interest rate approximates current rates available.
The three levels are defined as follows:





·
            Level
      1
            inputs
      to the valuation methodology are quoted prices (unadjusted) for identical
      assets or liabilities in active
markets.




-39-




·
            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.





New
accounting pronouncements adopted





Effective
January 1, 2009, the Company adopted SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities, and amendment of FASB No. 133” (“SFAS 161”),
which amends and expands the disclosure requirements of SFAS 133 (“SFAS 133”).
SFAS 161 requires qualitative disclosures about objectives and strategies
for using derivatives and quantitative disclosures about the fair value of and
gains and losses on derivative instruments.




Effective
January 1, 2009, the Company adopted the provisions of EITF 07-5,
"Determining Whether an Instrument (or Embedded Feature) is Indexed to an
Entity’s Own Stock”, which is effective for financial statements for fiscal
years beginning after December 15, 2008 and which replaced the previous guidance
on this topic in EITF 01-6.  Paragraph 11(a) of FAS 133 specifies that
a contract that would otherwise meet the definition of a derivative but is both
(a) indexed to the Company’s own stock and (b) classified in stockholders’
equity in the statement of financial position would not be considered a
derivative financial instrument.  EITF 07-5 provides a new two-step
model to be applied in determining whether a financial instrument or an
embedded feature is indexed to an issuer’s own stock and thus able to qualify
for the FAS 133 paragraph 11(a) scope exception.





As a
result of adopting EITF 07-5, 2,030,158 warrants previously treated as equity
pursuant to the derivative treatment exemption are no longer afforded equity
treatment because the strike price of the warrants is denominated in US dollar,
a currency other than the Company’s functional currency, the Chinese
Renminbi.  As a result, the warrants are not considered indexed to the
Company’s own stock, and as such, all future changes in the fair value of these
warrants will be recognized currently in earnings until such time as the
warrants are exercised or expired.





As such,
effective January 1, 2009, the Company reclassified the fair value of these
warrants from equity to liability, as if these warrants were treated as a
derivative liability since their issuance in August 2006. On January 1,
2009, the Company reclassified from additional paid-in capital, as a
cumulative effect adjustment, $6.1 million to beginning retained earnings
and $7.5 million to warrant liabilities to recognize the fair value of such
warrants. As of June 30, 2009, the Company has 1,795,543 warrants outstanding.
The fair value of the outstanding warrants was $17.9 million on June 30,
2009.  Therefore, the Company recognized a total of $11.4 million
and $14.0 million loss from the change in fair value of these warrants for the
six months and three months ended June 30, 2009,
respectively.  These common stock purchase warrants do not trade in an
active securities market, and as such, the Company uses the Black-Scholes Option
Pricing Model to value its options and warrants, and considering certain key
input, including the trading price on reporting date, volatility of its
stock, conversion price, remaining term of the warrants , dividend rate , and
the risk-free interest rate for the warrant life.





In April
2009, the FASB issued FSP FAS 157-4, “Determining Fair Value When the Volume and
Level of Activity for the Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly” (FSP FAS 157-4). FSP FAS 157-4
amends SFAS 157 and provides additional guidance for estimating fair value in
accordance with SFAS 157 when the volume and level of activity for the asset or
liability have significantly decreased and also includes guidance on identifying
circumstances that indicate a transaction is not orderly for fair value
measurements. This FSP shall be applied prospectively with retrospective
application not permitted. This FSP shall be effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for
periods ending after March 15, 2009. An entity early adopting this FSP must
also early adopt FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of
Other-Than-Temporary Impairments” (FSP FAS 115-2 and FAS 124-2). Additionally,
if an entity elects to early adopt either FSP FAS 107-1 and APB 28-1, “Interim
Disclosures about Fair Value of Financial Instruments” (FSP FAS 107-1 and APB
28-1) or FSP FAS 115-2 and FAS 124-2, it must also elect to early adopt this
FSP. The adoption of this new FSP does not have a significant impact on the
determination or reporting of our financial results.





In April
2009, the FASB issued FSP FAS 115-2 and FAS 124-2. This FSP amends SFAS 115,
“Accounting for Certain Investments in Debt and Equity Securities,” SFAS 124,
“Accounting for Certain Investments Held by Not-for-Profit Organizations,” and
EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on
Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held
by a Transferor in Securitized Financial Assets,” to make the
other-than-temporary impairments guidance more operational and to improve the
presentation of other-than-temporary impairments in the financial statements.
This FSP will replace the existing requirement that the entity’s management
assert it has both the intent and ability to hold an impaired debt security
until recovery with a requirement that management assert it does not have the
intent to sell the security, and it is more likely than not it will not have to
sell the security before recovery of its cost basis. This FSP provides increased
disclosure about the credit and noncredit components of impaired debt securities
that are not expected to be sold and also requires increased and more frequent
disclosures regarding expected cash flows, credit losses, and an aging of
securities with unrealized losses. Although this FSP does not result in a change
in the carrying amount of debt securities, it does require that the portion of
an other-than-temporary impairment not related to a credit loss for a
held-to-maturity security be recognized in a new category of other comprehensive
income and be amortized over the remaining life of the debt security as an
increase in the carrying value of the security. This FSP shall be effective for
interim and annual periods ending after June 15, 2009, with early adoption
permitted for periods ending after March 15, 2009. An entity may early
adopt this FSP only if it also elects to early adopt FSP FAS 157-4. Also, if an
entity elects to early adopt either FSP FAS 157-4 or FSP FAS 107-1 and APB 28-1,
the entity also is required to early adopt this FSP. The adoption of this
new FSP does not have a significant impact on the determination or reporting of
our financial results.




-40-




In April
2009, the FASB issued FSP FAS 107-1 and APB 28-1. This FSP amends SFAS
No. 107, “Disclosures about Fair Value of Financial Instruments,” to
require disclosures about fair value of financial instruments not measured on
the balance sheet at fair value in interim financial statements as well as in
annual financial statements. Prior to this FSP, fair values for these assets and
liabilities were only disclosed annually. This FSP applies to all financial
instruments within the scope of SFAS 107 and requires all entities to disclose
the method(s) and significant assumptions used to estimate the fair value of
financial instruments. This FSP shall be effective for interim periods ending
after June 15, 2009, with early adoption permitted for periods ending after
March 15, 2009. An entity may early adopt this FSP only if it also elects
to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS 124-2. This FSP does
not require disclosures for earlier periods presented for comparative purposes
at initial adoption. In periods after initial adoption, this FSP requires
comparative disclosures only for periods ending after initial adoption. The
adoption of this new FSP does not have a significant impact on the determination
or reporting of our financial results.





In May
2009, the FASB issued Statement of Financial Accounting Standards No. 165,
“Subsequent Events,” (SFAS 165). SFAS 165 establishes general standards of
accounting for and disclosure of events that occur after the balance sheet date
but before financial statements are issued or are available to be issued. It
requires disclosure of the date through which an entity has evaluated subsequent
events. The Company adopted SFAS 165 in the second quarter of 2009 and the
adoption of SFAS 165 did not impact the Company’s consolidated financial
statements. We evaluated all events or transactions that occurred after June 30,
2009 up through August 7, 2009.





Recent
Accounting Pronouncements





In June
2009 the FASB issued SFAS 166, “Accounting for Transfers of Financial Assets —
an amendment of FASB Statement No. 140” (SFAS 166). SFAS 166 eliminates the
concept of a qualifying special-purpose entity, creates more stringent
conditions for reporting a transfer of a portion of a financial asset as a sale,
clarifies other sale-accounting criteria, and changes the initial measurement of
a transferor’s interest in transferred financial assets. SFAS 166 is effective
for fiscal years beginning after November 15, 2009. We are currently assessing
the potential impacts, if any, on the Company’s consolidated financial
statements.





In June
2009, the FASB issued Statement of Financial Accounting Standards No. 167,
Amendments to FASB Interpretation No. 46(R) (“FAS 167”) [ASC 810-10], which
modifies how a company determines when an entity that is insufficiently
capitalized or is not controlled through voting (or similar rights) should be
consolidated. FAS 167 clarifies that the determination of whether a company is
required to consolidate an entity is based on, among other things, an entity’s
purpose and design and a company’s ability to direct the activities of the
entity that most significantly impact the entity’s economic performance. FAS 167
requires an ongoing reassessment of whether a company is the primary beneficiary
of a variable interest entity. FAS 167 also requires additional disclosures
about a company’s involvement in variable interest entities and any significant
changes in risk exposure due to that involvement. FAS 167 is effective for
fiscal years beginning after November 15, 2009. The Company has not completed
the assessment of the impact FAS 167 will have on the Company’s financial
condition, results of operations or cash flows.





In June
2009, the FASB issued SFAS 168, “The FASB Accounting Standards Codification and
the Hierarchy of Generally Accepted Accounting Principles – a replacement of
FASB Statement No. 162” (SFAS 168). SFAS 168 provides for the FASB Accounting
Standards Codification (the “Codification”) to become the single official source
of authoritative, nongovernmental U.S. generally accepted accounting principles
(GAAP). The Codification did not change GAAP but reorganizes the literature.
SFAS 168 is effective for interim and annual periods ending after September 15,
2009.




RESULTS
OF OPERATIONS





THREE
MONTHS ENDED JUNE 30, 2009




Revenues





For the
second quarter of 2009, total revenues were $38.36 million, compared with $23.96
million in the second quarter of 2008 and $30.72 million in the first quarter of
2009, reflecting a 60% growth year-over-year and 25% growth
sequentially.  International sales totaled $3.58 million, or 9.3% of
total sales, for the quarter, an increase of 15.9% and 9.8% compared with $3.09
million in the second quarter of 2008 and $3.26 million in the first quarter of
2009, respectively.





Compared
with the second quarter of 2008, the sales growth was primarily attributable to
the $17.00 million sales from the industrial rotary motor business acquired in
July 2008. Excluding the acquisition, organic revenues for the quarter were
$21.36 million, down by 11%, reflecting lower sales in other product lines
partially offset by higher sales in oil pumps (delivered 105 units in 2Q09
compared to 80 units in 2Q08 and 60 units in 1Q09).




-41-





Compared
with the first quarter of 2009, the sales growth reflected a robust demand in
the industrial rotary motor business which benefited from the Chinese
government’s stimulus program launched in late 2008.  Revenues from
the industrial rotary motor business increased to $17.0 million, from $10.8
million in the first quarter.





The
following table presents the revenue contribution by percentage by each major
product line for the second quarter 2009 in comparison with the first quarter of
2009 and the second quarter of 2008.





Percent
      of Total Revenues (%)Product
      Line
              
              
              2Q09
              
              
              
              2Q08
              
              
              
              1Q09Linear
      Motors and Related Systems
              
              
              30.1
              %
              
              
              51.3
              %
              
              
              40.3
              %Specialty
      Micro-Motors
              
              
              22.3
              %
              
              
              37.7
              %
              
              
              19.9
              %Rotary
      Motors
              
              
              44.1
              %
              
              NA
              
              
              
              35.3
              %Others
              
              
              3.5
              %
              
              
              11.0
              %
              
              
              4.5
              %Total
              
              
              100
              %
              
              
              100
              %
              
              
              100
              %International
      Sales
              
              
              9.3
              %
              
              
              12.9
              %
              
              
              10.6
              %





Net
Income





The
Company recorded a net loss of $5.42 million, or a loss of $0.24 per diluted
share, in the quarter, 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. This compared with  net income of $6.23 million, or $0.31 per
diluted share, in the second quarter of 2008 and a net income of $8.65 million,
or $0.39 per diluted share, in the first quarter of 2009, which included a
non-cash gain of $2.57 million due to change in fair value of
warrants.





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 non-cash charges related to the warrants issued in connection
with the Company’s 2010 Notes and 2012 Notes issued in 2006.  The
Company’s management believes that these non-GAAP adjusted financial measures
allow the 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 the 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 non-GAAP financial measure. However, the
management of Harbin Electric compensates for these limitations by providing the
relevant disclosure of the items excluded.




-42-





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




Three
      Months EndedJune
      30
              
              
              March
      312009
              
              
              2008
              
              
              2009Net
      Income (Loss)
              
              $
              (5,419,364
              )
              
              $
              6,230,943
              
              
              $
              8,654,334Deduct:Other
      Income - Government Grant
              
              $
              (1,172,560
              )
              
              $
              0
              
              
              $
              0Add
      back (Deduct):Change
      in fair value of warrant
              
              $
              14,014,790
              
              
              $
              0
              
              
              $
              (2,573,421
              )Adjusted
      Net Income
              
              $
              7,422,866
              
              
              $
              6,230,943
              
              
              $
              6,080,913Diluted
      EPS
              
              $
              (0.24
              )
              
              $
              0.31
              
              
              $
              0.39Deduct:Other
      Income - Government Grant
              
              $
              (0.05
              )
              
              $
              0.00
              
              
              $
              0.00Add
      back (Deduct):Change
      in fair value of warrant
              
              $
              0.62
              
              
              $
              0.00
              
              
              $
              (0.12
              )Adjusted
      EPS
              
              $
              0.33
              
              
              $
              0.31
              
              
              $
              0.27


The
adjusted net income of $7.42 million, or the adjusted EPS of $0.33 per diluted
share, for the second quarter of 2009 in the table above 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, which was awarded in June 2009 to the
Company’s subsidiary HTFE by the Harbin municipal government to support the
Company’s subway train project that qualifies as engaging in China’s
advanced industrialization. This adjusted net income compared, on the same
basis, with the net income of $6.23 million, or $0.31 per diluted share, in the
second quarter of 2008 and the adjusted net income of $6.08 million, or $0.27
per diluted share, in the first quarter of 2009.





Compared
to the second quarter of 2008 and the first quarter of 2009, the higher adjusted
net income for the current quarter was primarily driven by contributions from
the industrial rotary motor business and lower interest expense.





Gross
Profit Margin





The
following table presents the average gross profit margin by product line for the
second quarter of 2009, in comparison to the second quarter of 2008 and the
first quarter of 2009. The decline in overall gross profit margin was primarily
due to changes in product mix and the lower gross margin in the rotary motor
business.





Gross
      Profit Margin (%)Product
      Line
              
              
              2Q09
              
              
              
              2Q08
              
              
              
              1Q09Linear
      Motors and Related Systems
              
              
              56.9
              %
              
              
              55.7
              %
              
              
              54.1
              %Specialty
      Micro-Motors
              
              
              40.4
              %
              
              
              38.0
              %
              
              
              40.1
              %Rotary
      Motors
              
              
              13.2
              %
              
              NA
              
              
              
              10.1
              %Others
              
              
              48.0
              %
              
              
              43.7
              %
              
              
              49.3
              %Corporate
      Average
              
              
              33.5
              %
              
              
              47.8
              %
              
              
              35.6
              %International
      Business
              
              
              42.6
              %
              
              
              36.2
              %
              
              
              44.8
              %





Operating
Profit





Operating
profits of $8.82 million in the second quarter of 2009 increased from $8.22
million in the second quarter of 2008 and $8.03 million in the first quarter of
2009.





Compared
with the second quarter of 2008, earnings in the current quarter benefited from
the contribution of the industrial rotary motor business, partially offset by
higher R&D expenses and higher selling, general and administrative
(“SG&A”) expenses.  Operating margin declined to 23.0% from 34.3%
in the same quarter of 2008, mainly due to lower gross margin in the industrial
rotary motor business and higher research and development expenses as well as
higher SG&A expenses.




-43-





SG&A
were $3.64 million for the current quarter, compared to $3.04 million for the
same quarter in 2008. The increase in SG&A was primarily due to higher
depreciation expenses, higher shipping and handling costs, and an additional
write-off of $0.65 million bad debt expense associated with the acquired
company, partially offset by lower stock-based compensation expense and other
administrative expenses. As a percentage of total sales, the Company’s total
SG&A expenses declined to 9.5% in this quarter from 12.7% in the same
quarter last year.





Compared
with the first quarter of 2009, earnings primarily benefited from higher sales
and higher gross profit margin in the industrial rotary motor business,
partially offset by higher SG&A expenses due mainly to the $0.65 million
write-off of bad debt expense. Operating margin declined to 23.0% from 26.1% in
the first quarter of 2009, primarily driven by changes in product mix with
higher percentage of lower margin industrial rotary business, as well as higher
SG&A expenses.





Interest
expense





Net
interest expense was $0.84 million for the current quarter. This compared to the
net interest expense of $1.19 million for the second quarter of 2008 and $1.44
million for the first quarter of 2009.  In all periods, net interest
expense included non-cash amortization expense of debt discount and debt
issuance cost.  The lower interest expense in the current quarter was
mainly due to combined factors including lower debt amount and higher
capitalization of interest expense.





Income
Taxes





The
income tax provision was $1.48 million for the current quarter, compared with
$1.06 million and $1.04 million for the second quarter of 2008 and the first
quarter of 2009, respectively.




SIX
MONTHS ENDED JUNE 30, 2009




Revenues





For the
six months ended June 30, 2009, total revenues were $69.09 million, compared
with $46.42 million for the six months ended June 30, 2008, reflecting a 49%
growth year-over-year.  International sales totaled $6.84 million, or
9.9% of total sales, for the current period, compared with $6.90 million in the
corresponding period of prior yeas.





Compared
with the six months ended June 30, 2008, the sales growth was primarily
attributable to the $27.85 million sales from the industrial rotary motor
business acquired in July 2008. Excluding the acquisition, organic revenues for
the six months ended June 30, 2009 were $41.24 million, down by 11%, reflecting
lower sales in other product lines partially offset by higher sales in oil pumps
(delivered 165 units in the six months ended June 30, 2008 compared to 119 units
in the six months ended June 30, 2008).




Net
Income





The
Company recorded a net income of $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. This compared with  net income of
$11.58 million, or $0.58 per diluted share, in the six months ended June 30,
2008.




-44-





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





Six
      Months Ended June 302009
              
              
              2008Net
      Income (Loss)
              
              $
              3,234,970
              
              
              $
              11,584,179Deduct:Other
      Income - Government Grant
              
              $
              (1,172,560
              )
              
              $
              0Add
      back (Deduct):Change
      in fair value of warrant
              
              $
              11,441,369
              
              
              $
              0Adjusted
      Net Income
              
              $
              13,503,779
              
              
              $
              11,584,179Diluted
      EPS
              
              $
              0.14
              
              
              $
              0.58Deduct:Other
      Income - Government Grant
              
              $
              (0.05
              )
              
              $
              0.00Add
      back (Deduct):Change
      in fair value of warrant
              
              $
              0.51
              
              
              $
              0.00Adjusted
      EPS
              
              $
              0.60
              
              
              $
              0.58


The
adjusted net income of $13.50 million, or the adjusted EPS of $0.60 per diluted
share, for the six months ended June 30, 2009 in the table above 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, which was awarded in June 2009
to the Company’s subsidiary HTFE by the Harbin municipal government to support
the Company’s linear motor driven subway train project that qualifies as
engaging in China’s advanced industrialization. This adjusted net income
compared, on the same basis, with the net income of $11.58 million, or $0.58 per
diluted share, in the six months ended June 30, 2008. The higher adjusted net
income for the current period primarily benefited from contributions of
industrial rotary motor business and lower interest expenses.





Operating
Profit





Operating
profits were $16.84 million and $16.86 million in the six months ended June 30,
2009 and 2008, respectively, essentially flat year over year.  This
gave an operating margin of 24.4% in the current period versus 36.3% in the
corresponding period of last year. Major factors that contributed to the decline
in operating margin were lower gross margin in the industrial rotary motor
business, lower sales in higher margin existing product lines, higher R&D
expenses, and higher SG&A expenses.





SG&A
were $6.14 million for the current period, compared to $5.07 million for the
corresponding period of in 2008. The increase in SG&A was primarily due to
higher depreciation expenses, higher shipping and handling costs, and an
additional write-off of $0.65 million bad debt expense associated with the
acquired company, partially offset by lower stock-based compensation expense and
other administrative expenses. As a percentage of total sales, the Company’s
total SG&A expenses declined to 8.9% in the current period from 10.9% in the
same period last year.





Interest
expense





Net
interest expense was $2.28 million for the six months ended June 30, 2009. This
compared to the net interest expense of $3.48 million for the six months ended
June 30, 2008.  In all periods, net interest expense included non-cash
amortization expense of debt discount and debt issuance cost.  The
lower interest expense in the current quarter was mainly due to combined factors
including lower debt amount and higher capitalization of interest
expense.





Income
Taxes





The
income tax provision was $2.52 million for the six months ended June 30, 2009,
compared with $2.05 million for the six months ended June 30, 2008.




Liquidity
and Capital Resources





A major
factor of the Company’s liquidity and capital resource planning is its
generation of operating cash flow, which is strongly dependent on the demand for
our products.  This is supplemented by our financing activities in the
capital markets including potentially debt and equity, which supports major
acquisitions and capital investments for business growth.





Our
liquidity position remains strong, supported by approximately $67.80 million in
cash and cash equivalents as of June 30, 2009, compared to $48.41 million as of
December 31, 2008. The increase in cash and cash equivalents was mainly driven
by cash generated from operations.  Cash provided by operating
activities totaled $31.04 million for the six months ended June 30, 2009,
primarily attributable to our solid cash earnings, a significant improvement in
accounts receivables, and a reduction of inventories. This compares very
favorably with the same period in 2008 when operating activities generated
$13.00 million cash.




-45-





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
mature on September 1, 2012 (the “2012 Notes”), and Merrill Lynch subscribed to
$12.0 million of the principal amount of the Notes, which mature on September 1,
2010 (the “2010 Notes”). Pursuant to the indenture, AEM has agreed, and all of
our other existing and future subsidiaries (other than subsidiaries domiciled in
the People’s Republic of China) are obligated, to guarantee, on a senior secured
basis, to the Investors and to the trustee the payment and performance of our
obligations.





As
security for the Notes, we and The Bank of New York, as collateral agent,
entered into a share pledge agreement, dated August 30, 2006, to secure the
Notes by pledging all the shares of AEM common stock held by us.





The 2010
Notes bear interest, payable semi-annually in arrears, commencing March 1, 2007,
at a rate equal to LIBOR plus 4.75%. The six month LIBOR rate was 1.80375% as of
March 2, 2009 compared to 3.1125% as of September 1, 2008. The 2010 Notes are
subject to mandatory redemption semi-annually commencing March 1, 2008 in the
principal amount $2,000,000 at a price equal to 100% of such principal
amount.  We made $4 million in principal payments in 2008 and
another $2 million in principal payments in March 2009 for the 2010
Notes.





On July
14, 2009, the Company entered into a Letter Agreement with Merrill Lynch and ABN
AMRO Bank N.V., London Branch, pursuant to which Merrill Lynch and ABN/AMRO each
agreed to waive each and every applicable provision of the Indenture but only to
the fullest extent necessary solely to permit the Company to repurchase, all
(but not part), of the remaining $6 million 2010 Notes held by Merrill Lynch ($3
million) and ABN AMRO Bank N.V., London Branch ($3 million) on or prior to July
31, 2009 for a repurchase price equal to 97% of the aggregate principal amount
of the 2010 Notes plus accrued and unpaid interest to but excluding the
repurchase date.  On July 31, 2009, the Company paid a total of
$5,983,843.76 to repurchase the 2010 Notes, which was comprised of $5,820,000
representing 97% of the $6,000,000 aggregate principal amount of the 2010 Notes
held by the Merrill Lynch and ABN AMRO Bank N.V., London Branch plus $163,843.76
representing accrued and unpaid interest on the 2010 Notes to but excluding the
repurchase date of the 2010 Notes.   As of August 5, 2009, the
2010 Notes had been cancelled.





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.





On June
1, 2009, the Company and Citadel Equity Fund Ltd (“Citadel”) entered into a
Letter Agreement (the “Citadel Agreement”), pursuant to which Citadel agreed to
waive each and every applicable provision of the Indenture but only to the
fullest extent necessary solely to permit the Company to repurchase, at its
option, all (but not part), of the $26.5 million 2012 Notes held by Citadel
(“Citadel Notes”) on or prior to August 31, 2009 for  repurchase price
equal to 85% of the aggregate principal amount of the Citadel Notes plus accrued
and unpaid interest to but excluding the repurchase date.  On August
7, 2009, the Company paid a total of  $23,131,997.22 to repurchase the
Citadel Notes, which amount was comprised of $22,525,000 representing 85% of the
$26,500,000 aggregate principal amount of the 2012 Notes held by Citadel plus
$606,997.22 representing accrued and unpaid interest on the Citadel Notes to but
excluding the repurchase date. The Company anticipates the repurchase to be
completed and the Citadel Notes to be cancelled on August 10, 2009.





The
Warrants are governed by a warrant agreement, dated August 30, 2006, between us
and The Bank of New York, as warrant agent. The Warrants consist of (i) six-year
warrants to purchase an aggregate of 2,192,308 shares of our common stock, at an
exercise price of $7.80 per share (the “First Tranche 2012 Warrants”), (ii)
six-year warrants to purchase an aggregate of 525,830 shares of our common stock
at an exercise price of $10.84 per share (the “Second Tranche 2012 Warrants”)
and (iii) three-year warrants to purchase an aggregate of 769,230 shares of our
common stock at an exercise price of $7.80 per share (the “2009 Warrants”). The
First Tranche 2012 Warrants and the Second Tranche 2012 Warrants were issued to
Citadel, and the 2009 Warrants were issued to Merrill. Each Warrant is
exercisable at the option of the Warrant holder at any time through the maturity
date of such Warrant.  As of June 30, 2009, there were 1,428,486
shares of First Tranche 2012 Warrants outstanding and 366,697 shares of Second
Tranche 2012 Warrants outstanding.




-46-





In
August 2006 the Company’s subsidiary Harbin Tech Full signed an R&D
Agreement with the Institute of Electrical Engineering of the Chinese Academy of
Sciences (“IEECAS”). Under the R&D Agreement with IEECAS, Harbin Tech Full
is obligated to invest approximately $2.19 million (RMB 15 million). Of this
amount, approximately $1.46 million (RMB 10 million) has been invested to date
with the balance to be invested in 2009.





In
September 2006 the Company’s subsidiary Harbin Tech Full signed a Land Use
Agreement for a plot of land in Shanghai. Harbin Tech Full is obligated to
invest approximately $2.74 million. Of this amount, 92% or $2.70 million has
been paid with the balance payable upon completion of certain regulatory
applications and receipt of a regulatory permit.




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 $500,000
in AAG Shanghai through June 30, 2009.





Pursuant
to the original agreement (“Original Agreement”) signed in April 2007 between
the Company and Shelton Technology, LLC (“Shelton”), whereby the Company and
Shelton agreed to work together through AAG to design, develop and manufacture
custom industrial automation controllers, the Company is required to invest a
total of $3 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. The Company has
contributed a total of $2.0 million to AAG as of June 30, 2009. 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 process of developing a new agreement to extend the
arrangement between them with respect to this work.





On August
4, 2009, the Company completed the sale of 6,250,000 shares of its common stock
in an underwritten public offering at a public offering price of $16.00 per
share.  The Company received net proceeds (after deducting
underwriting commissions and fees and expenses associated with the offering of
$93,400,000.




Cross-currency
interest rate hedge





The
Company's operations are exposed to a variety of global market risks, including
changes in foreign currency exchange rates and interest rates. These exposures
are managed, in part, with the use of a financial derivative. The Company uses
financial derivatives only to hedge exposures in the ordinary course of business
and does not invest in derivative instruments for speculative
purposes.





Effective
April 17, 2007, the Company entered a cross-currency interest rate swap
agreement with Merrill Lynch, effectively exchanging the LIBOR plus 3.35%
variable rate interest payable on the $38 million principal amount of 2012 Notes
for a 7.2% RMB fixed interest rate. The agreement requires semi-annual payments
on March 1 and September 1 through the maturity of the agreement on September 1,
2012. Merrill Lynch required the Company to deposit $1,000,000 to secure the
agreement. The deposit may be increased to $2,500,000, if the exchange rate for
Renminbi to USD falls below 6.5, and to $4,000,000, if the exchange rate falls
below 5.5. This swap is designated and qualified as a cash flow
hedge.





The fair
value of this swap agreement was a payable of $9.00 million on June 30, 2009 and
$5.76 million on December 31, 2008. From the December 31, 2008 to June 30, 2009,
changes in fair value of the swap resulted in other comprehensive loss of $3.24
million and an increase in liabilities.





The
Company accounts for this swap in accordance with FAS 133, “Accounting for
Derivatives Instruments and Hedging Activity,” which requires all derivatives to
be carried on the balance sheet at fair value and to meet certain documentary
and analytical requirements to qualify for hedge accounting treatment.
Accordingly, changes in the fair value are reported in accumulated other
comprehensive income, net of related income tax effects.





Contractual
Obligations





The
Company enters into non-cancelable purchase commitments with its investors. As
of June 30, 2009, and December 31, 2008, the Company was obligated under the
non-cancelable commitments to purchase materials totaling to $1,715,300 and
$305,100, respectively. These commitments are short-term and expire within one
year. The Company has experienced no losses on these purchase commitments over
the years.




As
discussed in more detail in Note 1, the Company entered into an agreement with
Shelton Technology, LLC on April 9, 2007.  Under the terms of the
agreement, the Company is required to contribute a total of $3 million in
installments in AAG by March 31, 2009.  The Company has invested
a total of $2.0 million to AAG as of June 30, 2009 and has the remaining $1.0
million to be invested.  Based upon a mutual agreement, the Company
will contribute the remaining $1.0 million to AAG at a later date to be
addressed in a new agreement that the Company and Shelton are currently
developing.




-47-





As
discussed in Note 13, the Company entered into a swap agreement that required a
$1,000,000 deposit to secure the transaction.  If the exchange rate
for Renminbi to US Dollars drops below certain levels, the Company will be
required to deposit up to $4,000,000.





As
discussed in Note 12, the 2010 Notes are subject to mandatory redemption
semi-annually commencing March 1, 2008 in the principal amount of $2,000,000 at
a price equal to 100% of such principal amount.  As of August 5, 2009,
the 2010 Notes have been repurchased by the Company and are no longer
outstanding. The 2012 Notes are subject to mandatory redemption semi-annually
commencing September 1, 2009 in the principal amount $2,400,000 on September 1,
2009, $3,800,000 on March 1, 2010, $9,900,000 on September 1, 2010 and March 1,
2011, and $4,000,000 on September 1, 2011, March 1, 2012 and September 1, 2012,
in each instance at a price equal to 100% of such principal amount. Holders of
the 2012 Notes may require the Company to repurchase such Notes at 100% of the
principal amount thereof at any time after September 1, 2011.





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 (RMB42,840,000) ("Fee"), approximately 49.8% or $3.12 million (RMB
21,320,000) has been paid with the balance payable in installments. The amount
paid is recorded as advances on intangible assets for $3,123,380 and $1,892,430
as of June 30, 2009 and December 31, 2008, respectively.




Off-balance
sheet arrangement





None.





Item
3. Quantitative and Qualitative Disclosures about Market Risk





Information
relating to quantitative and qualitative disclosures about market risk is
provided in the Company’s 2008 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, 2008.





Item
4. Controls and Procedures





(a)
Evaluation of Disclosure Controls and Procedures





We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our reports filed pursuant to the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules, regulations and related forms, and that
such information is accumulated and communicated to our principal executive
officer and principal financial officer, as appropriate, to allow timely
decisions regarding required disclosure.





Under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer, the Company
conducted an evaluation of the effectiveness of the design and operation of our
disclosure controls and procedures as of the end of the period covered by
this report, as such term is defined in Exchange Act Rules 13a-15(e) and
15d-15(e). Based on this evaluation, our principal executive officer and
principal financial officer have concluded that during the period covered by
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, 2009 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. Legal
Proceedings




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.




-48-




GENERAL
RISKS RELATING TO OUR BUSINESS





We
depend on a few key customers, the loss of any of which could cause a
significant decline in our revenues.




Two major
customers accounted for approximately 27% of net revenue for the six months
ended June 30, 2009. Five major customers accounted for 74% of net revenue for
the six months ended June 30, 2008. The loss of any of our major customers, or a
significant reduction in sales to any such customers, would adversely affect our
revenues and profitability.





Economic
and industry conditions have had and may continue to have an adverse effect on
our business.





The
worldwide economy is currently in significant turmoil. To the extent the
downturn continues or worsens, we could experience a reduction in our sales
growth, an increase in our bad debt expense and other adverse affects. Further,
because we continue to build our infrastructure, if our sales were to
decline or even fail to grow at the rate we anticipate, our profitability would
be impacted, and the impact could be material if we are unable to dramatically
reduce our costs.





Further,
we operate in industries that have been particularly impacted by the global
economic downturn. For example, approximately 28% of our 2008 revenues was
derived from the automotive industry. Although the China automotive industry
remains strong, automotive manufacturers in the U.S., European and some other
countries have experienced significant production cuts and capacity reductions,
and in some cases bankruptcies. Continuing adverse conditions in industries we
serve could affect our results of operations.





Our
rapid growth may strain our resources.




Our
revenues increased by 85% for the year ended December 31, 2008 versus the year
ended December 31, 2007, and 62% in 2007 over 2006, however, it is unlikely that
we will maintain such growth in the long term and cannot assure any growth of
our business for any period. Our rapid expansion will place significant
strain on our management and our operational, accounting, and information
systems. We expect that we will need to continue to improve our financial
controls, operating procedures, and management information systems. We will also
need to effectively train, motivate, and manage our employees. Our failure to
manage our growth could disrupt our operations and ultimately prevent us from
generating the profits we expect. Additionally, the current financial
crisis has made it more difficult for businesses to obtain financing from debt
and capital markets. This would limit our ability to maintain a rapid growth of
our business due to insufficient cash flow for operation or for
acquisitions.





Our
debt may constrict our operations, and cash flows and capital resources may be
insufficient to make required payments on our substantial indebtedness and
future indebtedness.





We have a
substantial amount of debt. As of June 30, 2009, we had approximately $44
million outstanding under our Guaranteed Senior Secured Floating Rate Notes (the
“Notes”) issued in August 2006, due in 2010 and 2012 (respectively, the “2010
Notes” and the “2012 Notes”). On July 31, 2009, we repurchased the $6 million
outstanding 2010 Notes for an aggregate purchase price
of  $5,983,843.76 which was comprised of $5,820,000 representing 97%
of the $6,000,000 aggregate principal amount of the 2010 Notes plus $163,843.76
representing accrued and unpaid interest on the 2010 Notes to but excluding the
repurchase date of the 2010 Notes. As of August 5, 2009, the repurchase has been
completed and the 2010 Notes have been cancelled. On August 4, 2009, we notified
Citadel that pursuant to the Citadel Agreement that (i) we were exercising our
option to repurchase the Citadel Notes, and (ii) such repurchase would be
consummated on August 11, 2009 at an aggregate repurchase price of
$23,131,997.22 to be paid in cash, which repurchase price is comprised of
$22,525,000 representing 85% of the $26,500,000 aggregate principal amount of
the 2012 Notes held by Citadel  plus $606,997.22 representing accrued
and unpaid interest on the Citadel Notes to but excluding the repurchase
date.  On August 7, 2009, we paid the $23,131,997.22 to Citadel to
repurchase the Citadel Notes.  We expect the Citadel Notes to be
cancelled on August 11, 2009. Upon consummation of the repurchase of the Citadel
Notes, $11.5 million aggregate principal amount of our 2012 Notes will remain
outstanding. This debt could have important consequences to you. For example, it
could:




·
            reduce
      the availability of our cash flow to fund future working capital, capital
      expenditures, acquisitions and other general corporate
      purposes;




·
            limit
      our ability to obtain additional financing for working capital, capital
      expenditures, and other general corporate
  requirements;




·
            expose
      us to interest rate fluctuations because the interest rate for a portion
      of our debt is variable; and





·
            restrict
      us from making strategic acquisitions or pursuing business
      opportunities.





-49-




Furthermore,
our obligations under the 2012 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 the loss of our
business, if we default on the 2012 Notes.





To
mitigate our exposure to volatility in interest rates and foreign currency
exchange rates fluctuation associated with the $38 million principal amount of
2012 Notes, in April 2007, the Company entered a cross-currency interest rate
swap transaction with Merrill Lynch International. The swap, in effect, converts
the LIBOR plus 3.35% variable interest rate on the 2012 Notes to a 7.2% RMB
fixed interest rate. The Company uses this derivative instrument only to hedge
exposures in the ordinary business course and does not invest in derivative
instruments for speculative purposes. We regularly evaluate the merits and risks
of continuing the swap.





Covenants
in the Indenture governing our Notes and the Purchase Agreement pursuant to
which the Notes were initially sold, restrict our ability to engage in or enter
into a variety of transactions.





Our 2012
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. 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.





The
Purchase Agreement dated August 29, 2006, pursuant to which the Notes were
initially sold, provides that the initial purchasers of the Notes and their
assignees have a right of first offer for so long as such persons continue
to hold any Notes with respect to any issuances of new equity securities by us
other than shares of stock issued to employees, officers and directors pursuant
to bona fide employee benefit plans. The rights of first offer contained in the
Purchase Agreement could adversely impact our ability to do future equity
offerings.





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.




One major
vendor provided approximately 25% of the Company’s purchases of raw materials
for the six months ended June 30, 2009. Five major vendors provided
approximately 78% of the Company’s purchases of raw materials for the six months
ended June 30, 2008. Any material change in the spot and forward rates for raw
materials could have a material adverse effect on our cost of sales and
profitability. 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 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.





We
operate our facilities in compliance with applicable rules and regulations
and take measures to minimize the risks of disruption at our facilities.
A material disruption at one of 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;




-50-




·
            prolonged
      power failures;




·
            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 12 patents in China relating to linear
motor and automobile specialty micro-motor applications. No assurance can be
given that such patents will not be challenged, invalidated, infringed or
circumvented, or that such intellectual property rights will provide a
competitive advantage 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.





We
do not anticipate paying cash dividends on our common stock.




We do not
anticipate paying cash dividends in the foreseeable future. Presently, we intend
to retain all of our earnings, if any, to finance development and expansion of
our business. Debt covenants and PRC capital and currency regulations may also
limit our ability to pay dividends.




Our
directors and officers control a majority of our common stock and, as a result,
they may exercise voting control and be able to take actions that may be adverse
to your interests.





Our
directors and executive officers, directly or through entities that they
control,  beneficially owned, as a group, approximately 50.3% of our
issued and outstanding common stock as of June 30, 2009. As of August 5, 2009,
giving effect to the consummation of the public offering  of 6,250,000
shares, our directors and executive officers, directly or through entities that
they control beneficially owned, as a group, approximately 39.2% of our issued
and outstanding common stock. 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.




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.




-51-




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.





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 and results of operations would be materially and adversely
affected.




Our
results of operation may be adversely affected by changes to or expiration of
preferential tax concessions that one of our Chinese subsidiaries, Harbin Tech
Full currently enjoys. The statutory tax rate generally applicable to domestic
Chinese companies was 33% before January 1, 2008. On January 1, 2008, the new
Chinese Enterprise Income Tax (“EIT”) law replaced the existing laws for
Domestic Enterprises (“DES”), such as Weihai and Foreign Invested Enterprises
(“FIEs”), such as Harbin Tech Full, 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 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 were subject to
a 10% preferential tax rate until December 31, 2010. As a result, the estimated
tax savings for the six months ended June 30, 2009 and 2008 amounted to
approximately $2,865,216 and $3,074,634, 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.




-52-





Fluctuations
in the value of the RMB could materially affect our financial condition and
results of operations.




The value
of RMB against the U.S. dollar and other currencies may fluctuate and is
affected by, among other things, changes in political and economic conditions.
Our revenues and costs are mostly denominated in RMB. Any significant
fluctuation in value of RMB may materially and adversely affect our cash flows,
revenues, earnings and financial position, and the value of our stock in U.S.
dollars. For example, an appreciation of RMB against the U.S. dollar would make
any new RMB denominated investments or expenditures more costly to us, to the
extent that we need to convert U.S. dollars into RMB for such purposes. In
addition, the depreciation of significant U.S. dollar denominated assets could
result in a charge to our income statement and a reduction in the value of these
assets.





We
must comply with the Foreign Corrupt Practices Act.




We are
required to comply with the United States Foreign Corrupt Practices Act, which
prohibits U.S. companies from engaging in bribery or other prohibited payments
to foreign officials for the purpose of obtaining or retaining business. Foreign
companies, including some of our competitors, are not subject 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 we inform
our personnel that such practices are illegal, we can not assure you that
our employees or other agents will not engage in such conduct for which we might
be held responsible. If our employees or other agents are found to have engaged
in such practices, we could suffer severe penalties.





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





We are
dependent on our relationship with the local government in the province in which
we operate our business.  Chinese government has exercised and
continues to exercise substantial control over virtually every sector of the
Chinese economy through regulation and state ownership.  Our ability
to operate in China may be harmed by changes in its laws and regulations,
including those relating to taxation, environmental regulations, land use
rights, property and other matters.  We believe that our operations in
China are in material compliance with all applicable legal and regulatory
requirements. However, the central or local governments of these jurisdictions
may impose new, stricter regulations or interpretations of existing regulations
that would require additional expenditures and efforts on our part to ensure our
compliance with such regulations or interpretations.  Accordingly,
government actions in 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.





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 and enforce liabilities
against our officers, directors and assets based in the PRC.





Because
most of our executive officers and several of our directors, including our
chairman of the Board of Directors, are Chinese citizens, it may be difficult,
if not impossible, to acquire jurisdiction over these persons in the event a
lawsuit is initiated against us and/or our officers and directors by a
stockholder or group of stockholders in the United States. Also, because the
majority of our assets are located in the PRC, it would also be extremely
difficult to access those assets to satisfy an award entered against us in the
U.S. court.




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The
legal system in China has inherent uncertainties that may limit the legal
protections available in the event of any claims or disputes with third
parties.





The legal
system in China is based on written statutes. Prior court decisions may be cited
for reference but have limited precedential value. Since 1979, the central
government has promulgated laws and regulations dealing with economic matters
such as foreign investment, corporate organization and governance, commerce,
taxation and trade. As China’s foreign investment laws and regulations are
relatively new and the legal system is still evolving, the interpretation of
many laws, regulations and rules is not always uniform and enforcement of these
laws, regulations and rules involve uncertainties, which may limit the remedies
available in the event of any claims or disputes with third parties. In
addition, any litigation in China may be protracted and result in substantial
costs and diversion of resources and management attention.





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





None.





Item 3. Defaults upon Senior
Securities




None.




Item 4. Submission of Matters to a Vote of Securities
Holders




None.




Item
5. Other
Information





On August
4, 2009, the Company closed a public offering of 6,250,000 shares of its common
stock at a price of $16.00 per share. The Company received net proceeds of
approximately $93.4 million from the offering, after deducting underwriting
discounts and estimated offering expenses. The offering was underwritten by Roth
Capital Partners, LLC (“Roth”), pursuant to that certain Underwriting Agreement
by and between the Company and Roth dated as of July 30, 2009, as previously
reported in our Current Report on Form 8-K filed with the Securities and
Exchange Commission on July 30, 2009. The Company has granted Roth the option to
purchase up to an additional 937,500 shares of common stock on or prior to
August 29, 2009 to cover over-allotments, if any.





On August
7, 2009, we utilized $23.1 million of the net proceeds from the offering to
repurchase $26.5 million aggregate principal amount of our 2012 Notes from
Citadel for a purchase price equal to 85% of the aggregate principal amount of
such 2012 Notes plus accrued and unpaid interest to the date preceding the
repurchase date. We intend to use the remainder of the net proceeds from the
securities sold by us in the offering to fund product development and/or for
working capital and general corporate purposes, including for potential
acquisitions.





Item 6. Exhibits.




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




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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 10, 2009
            By:
            /s/ Tianfu
      YangTianfu
      YangChief
      Executive Officer, Director and
              Chairman
      of the Board
              (Principal
      Executive Officer)




Date:
      August 10, 2009
            By:
            /s/ Zedong
      XuZedong
      XuChief
      Financial Officer
              (Principal
      Accounting Officer)




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EXHIBIT
INDEX





Exhibits:




Exhibit Number
            
            Description
            
            Method of Filing1.1
            
            Underwriting
      Agreement by and between the Company and Roth Capital Partners, LLC, dated
      as of July 30, 2009.
            
            Filed
      as Exhibit 1.1 to the current report on Form 8-K filed with the Commission
      on July 30, 2009 and incorporated herein by reference.10.1
            
            Letter
      Agreement by and between the Company and Citadel Equity Fund Ltd., dated
      as of June 1, 2009.
            
            Filed
      as Exhibit 10.1 to the current report on Form 8-K filed with the
      Commission on June 5, 2009 and incorporated herein by
      reference.10.2
            
            Letter
      Agreement by and between the Company, Merrill Lynch International and ABN
      AMRO Bank N.V., London Branch, dated as of July 14, 2009.
            
            Filed
      as Exhibit 10.1 to the current report on Form 8-K filed with the
      Commission on July 20, 2009 and incorporated herein by
      reference.10.3
            
            Letter
      Agreement by and between the Company, Abax Jade Ltd. and Abax Nai Xin A
      Ltd., dated as of July 14, 2009.
            
            Filed
      as Exhibit 10.2 to the current report on Form 8-K filed with the
      Commission on July 20, 2009 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.





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