UNITED
STATES





SECURITIES
AND EXCHANGE COMMISSION





Washington,
D.C. 20549





FORM
10-Q





(Mark
One)


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


For
the quarterly period ended September 30, 2010





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


For
the transition period from _______ to _______





Commission
file number: 001-34587





SHENGKAI
INNOVATIONS, INC.


(Exact
      name of small business issuer as specified in its
  charter)





Florida
                
                11-3737500(State
      or other jurisdiction of incorporation or
                  organization)
                
                (IRS
      Employer identification
No.)





NO.
27, WANG GANG ROAD


JIN
NAN (SHUANG GANG) ECONOMIC AND TECHNOLOGY DEVELOPMENT AREA


TIANJIN, PEOPLE’S REPUBLIC
OF CHINA


(Address
of principal executive offices)





(8622)
5883-8509


(Registrant’s
telephone number, including area code)





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





Indicate
by check mark whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the Registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes x  No   ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). 
  Yes    ̈  No   ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





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





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





APPLICABLE
ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
DURING THE PRECEDING FIVE YEARS:





Check
whether the registrant filed all documents and reports required to be filed by
Section 12, 13 or 15(d) of the Exchange Act after the distribution of securities
under a plan confirmed by a court. Yes  ̈  No  ̈





APPLICABLE
ONLY TO CORPORATE ISSUERS:





State the
number of shares outstanding of each of the issuer's classes of common equity,
as of the latest practicable date: 23,191,165 shares of common stock, $.001 par
value, were outstanding as of November 10, 2010.








TABLE
OF CONTENTS





PagePART
      IItem
      1.
                
                Financial
      Statements
                
                3Item
      2.
                
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operation
                
                38Item
      3.
                
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                47Item
      4.
                
                Controls
      and Procedures
                
                47PART
      IIItem
      1.
                
                Legal
      Proceedings
                
                48Item
      1A.
                
                Risk
      Factors
                
                48Item
      2.
                
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                48Item
      3.
                
                Defaults
      Upon Senior Securities
                
                48tem
      4.
                
                Removed
      and Reserved
                
                48Item
      5.
                
                Other
      Information
                
                48Item
      6.
                
                Exhibits
                
                48SIGNATURES
                
                49


2


PART
I – FINANCIAL INFORMATION





Item
      1.
            Financial
      Statements





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


AS
AT SEPTEMBER 30, 2010 AND JUNE 30, 2010


(Stated
in US Dollars) (Unaudited)





Note
                  
                  
                  September
      30,
                    2010
                  
                  
                  June
      30,
                    2010(Unaudited)
                  
                  
                  (Audited)ASSETSCurrent
      assetsCash
      and cash equivalents
                  
                  
                  
                  
                  $
                  19,621,870
                  
                  
                  $
                  20,995,182Restricted
      cash
                  
                  
                  
                  
                  
                  2,111,426
                  
                  
                  
                  1,849,958Trade
      receivables
                  
                  
                  
                  
                  
                  8,700,424
                  
                  
                  
                  6,490,110Notes
      receivable
                  
                  
                  
                  
                  
                  -
                  
                  
                  
                  73,437Other
      receivables
                  
                  4
                  
                  
                  
                  611,709
                  
                  
                  
                  325,183Advances
      to suppliers
                  
                  
                  
                  
                  
                  399,141
                  
                  
                  
                  408,110Inventories
                  
                  5
                  
                  
                  
                  1,945,395
                  
                  
                  
                  2,556,166Total
      current assets
                  
                  
                  
                  
                  $
                  33,389,965
                  
                  
                  $
                  32,698,146Plant
      and equipment, net
                  
                  6
                  
                  
                  
                  7,588,301
                  
                  
                  
                  6,120,056Construction
      in progress
                  
                  
                  
                  
                  
                  30,177,661
                  
                  
                  
                  25,185,643Land
      use rights, net
                  
                  7
                  
                  
                  
                  2,517,298
                  
                  
                  
                  2,480,929Other
      intangible assets, net
                  
                  8
                  
                  
                  
                  5,872,214
                  
                  
                  
                  6,001,411Advances
      to suppliers for purchase of equipment and construction
                  
                  
                  
                  
                  
                  11,822,103
                  
                  
                  
                  12,119,764TOTAL
      ASSETS
                  
                  
                  
                  
                  $
                  91,367,542
                  
                  
                  $
                  84,605,949LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesNotes
      payable
                  
                  9
                  
                  
                  $
                  2,873,923
                  
                  
                  $
                  2,652,095Accounts
      payable
                  
                  
                  
                  
                  
                  2,572,264
                  
                  
                  
                  2,848,600Advances
      from customers
                  
                  
                  
                  
                  
                  741,163
                  
                  
                  
                  1,256,777Other
      payables
                  
                  10
                  
                  
                  
                  908,377
                  
                  
                  
                  1,244,839Accruals
                  
                  
                  
                  
                  
                  21,319
                  
                  
                  
                  20,359Income
      tax payable
                  
                  
                  
                  
                  
                  1,140,076
                  
                  
                  
                  1,061,783Total
      current liabilities
                  
                  
                  
                  
                  $
                  8,257,122
                  
                  
                  $
                  9,084,453Warrant
      liabilities
                  
                  
                  
                  
                  
                  24,489,328
                  
                  
                  
                  37,424,035Preferred
      (conversion option) liabilities
                  
                  
                  
                  
                  
                  31,608,596
                  
                  
                  
                  40,378,640Total
      non-current liabilities
                  
                  
                  
                  
                  $
                  56,097,924
                  
                  
                  $
                  77,802,675TOTAL
      LIABILITIES
                  
                  
                  
                  
                  $
                  64,355,046
                  
                  
                  $
                  86,887,128Commitments
      and contingencies
                  
                  15
                  
                  
                  $
                  -
                  
                  
                  $
                  -




See
accompanying notes to consolidated financial statements




3





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


AS
AT SEPTEMBER 30, 2010 AND JUNE 30, 2010


(Stated
in US Dollars) (Unaudited)





Note
                  
                  
                  September
      30,
                    2010
                  
                  
                  June
      30,2010(Unaudited)
                  
                  
                  (Audited)STOCKHOLDERS’
      EQUITYPreferred
      Stock – $0.001 par value 15,000,000 share authorized; 6,987,368 and
      6,987,368 issued and outstanding as of September 30, and June 30, 2010
      respectively.
                  
                  11
                  
                  
                  $
                  6,987
                  
                  
                  $
                  6,987Common
      stock - $0.001 par value 100,000,000 shares authorized; 23,191,165 and
      23,191,165 shares issued and outstanding as of September 30, and June 30,
      2010 respectively.
                  
                  
                  
                  
                  
                  23,192
                  
                  
                  
                  23,192Additional
      paid-in capital
                  
                  
                  
                  
                  
                  35,291,868
                  
                  
                  
                  34,259,304Statutory
      reserves
                  
                  
                  
                  
                  
                  7,081,706
                  
                  
                  
                  7,081,706Accumulated
      loss
                  
                  
                  
                  
                  
                  (19,741,186
                  )
                  
                  
                  (46,686,271
                  )Accumulated
      other comprehensive income
                  
                  
                  
                  
                  
                  4,349,929
                  
                  
                  
                  3,033,903TOTAL
      STOCKHOLDER’S
      EQUITY
                  
                  
                  
                  
                  $
                  27,012,496
                  
                  
                  $
                  (2,281,179
                  )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY
                  
                  
                  
                  
                  $
                  91,367,542
                  
                  
                  $
                  84,605,949





See
accompanying notes to consolidated financial statements


4





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars) (Unaudited)





Three
      months ended September 30,Note
                  
                  
                  2010
                  
                  
                  2009Revenues
                  
                  
                  
                  
                  $
                  17,174,516
                  
                  
                  $
                  11,110,169Cost
      of sales
                  
                  
                  
                  
                  
                  (7,220,428
                  )
                  
                  
                  (4,320,091
                  )Gross
      profit
                  
                  
                  
                  
                  $
                  9,954,088
                  
                  
                  $
                  6,790,078Operating
      expenses:Selling
                  
                  
                  
                  
                  
                  (1,602,572
                  )
                  
                  
                  (1,001,612
                  )General
      and administrative
                  
                  
                  
                  
                  
                  (2,061,646
                  )
                  
                  
                  (747,728
                  )Total
      Operating expenses
                  
                  
                  
                  
                  
                  (3,664,218
                  )
                  
                  
                  (1,749,340
                  )Income
      from operations
                  
                  
                  
                  
                  $
                  6,289,870
                  
                  
                  $
                  5,040,738Other
      income, net
                  
                  
                  
                  
                  
                  57,971
                  
                  
                  
                  -Interest
      income, net
                  
                  
                  
                  
                  
                  18,744
                  
                  
                  
                  287,712Changes
      in fair value of instruments - gain/(loss)
                  
                  
                  
                  
                  
                  21,704,751
                  
                  
                  
                  (6,902,923
                  )Income
      (loss) before income taxes
                  
                  
                  
                  
                  $
                  28,071,336
                  
                  
                  $
                  (1,574,473
                  )Income
      taxes
                  
                  13
                  
                  
                  
                  (1,126,251
                  )
                  
                  
                  (1,280,003
                  )Net
      income (loss)
                  
                  
                  
                  
                  $
                  26,945,085
                  
                  
                  $
                  (2,854,476
                  )Foreign
      currency translation adjustment
                  
                  
                  
                  
                  
                  1,316,026
                  
                  
                  
                  60,103Comprehensive
      income (loss)
                  
                  
                  
                  
                  $
                  28,261,111
                  
                  
                  $
                  (2,794,373
                  )Basic
      earnings (loss) per share
                  
                  14
                  
                  
                  $
                  1.16
                  
                  
                  $
                  (0.13
                  )Diluted
      earnings (loss) per share
                  
                  14
                  
                  
                  $
                  0.76
                  
                  
                  $
                  (0.13
                  )Basic
      weighted average shares outstanding
                  
                  14
                  
                  
                  
                  23,191,165
                  
                  
                  
                  22,362,500Diluted
      weighted average shares outstanding
                  
                  14
                  
                  
                  
                  35,277,322
                  
                  
                  
                  22,362,500





See
accompanying notes to consolidated financial statements


5





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars) (Unaudited)





Three
      months ended September 30,2010
                
                
                2009Cash
      flows from operating activitiesNet
      (loss) income
                
                $
                26,945,085
                
                
                $
                (2,854,476
                )Depreciation
                
                
                147,044
                
                
                
                104,109Amortization
                
                
                231,906
                
                
                
                229,088Gain
      on disposal of property, plant and equipment
                
                
                (3,780
                )
                
                
                -Changes
      in fair value of instruments – (gain)/loss
                
                
                (21,704,751
                )
                
                
                6,902,923Stock
      based compensation
                
                
                1,032,564
                
                
                
                -Changes
      in operating assets and liabilities:(Increase)
      decrease in assets:Trade
      receivables
                
                
                (2,077,742
                )
                
                
                (1,683,834
                )Notes
      receivable
                
                
                73,743
                
                
                
                -Other
      receivables
                
                
                (277,752
                )
                
                
                133,922Advances
      to suppliers
                
                
                14,624
                
                
                
                (520,340
                )Inventories
                
                
                645,023
                
                
                
                22,925Increase
      (decrease) in liabilities:Notes
      payable
                
                
                175,916
                
                
                
                (612,092
                )Accounts
      payable
                
                
                (301,712
                )
                
                
                478,539Advances
      from customers
                
                
                (529,844
                )
                
                
                948,159Other
      payables
                
                
                (352,668
                )
                
                
                116,787Accruals
                
                
                616
                
                
                
                (112,802
                )Income
      tax payable
                
                
                60,040
                
                
                
                (192,172
                )Net
      cash provided by operating activities
                
                $
                4,078,312
                
                
                $
                2,960,736Cash
      flows from investing activitiesSales
      proceeds of property, plant and equipment
                
                $
                -
                
                
                $
                -Purchase
      of property, plant and equipment
                
                
                (9,643
                )
                
                
                (168,807
                )Payment
      of construction in progress
                
                
                (4,521,029
                )
                
                
                -Advance
      to suppliers (equipment & construction related)
                
                
                (1,011,827
                )
                
                
                -Payment
      of intangible assets
                
                
                (1,966
                )
                
                
                -Increase
      in restricted cash
                
                
                (228,148
                )
                
                
                (747,158
                )Net
      cash used in investing activities
                
                $
                (5,772,613
                )
                
                $
                (915,965
                )Cash
      flows from financing activitiesNet
      cash provided by financing activities
                
                $
                -
                
                
                $
                -





See
accompanying notes to consolidated financial statements


6





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars) (Unaudited)





Three
      months ended September 30,2010
                
                
                2009Net
      cash and cash equivalents sourced
                
                $
                (1,694,301
                )
                
                $
                2,044,771Effect
      of foreign currency translation on cash and cash
    equivalents
                
                
                320,989
                
                
                
                42,110Cash
      and cash equivalents–beginning of period
                
                
                20,995,182
                
                
                
                38,988,958Cash
      and cash equivalents–end of period
                
                $
                19,621,870
                
                
                $
                41,075,839Supplementary
      cash flow information:Interest
      received
                
                $
                18,739
                
                
                $
                287,712Tax
      paid
                
                $
                1,066,211
                
                
                $
                1,472,175





See
accompanying notes to consolidated financial statements


7


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





1.
            ORGANIZATION AND PRINCIPAL
      ACTIVITIES





Shengkai
Innovations, Inc. (the “Company”) was incorporated in the State of Florida on
December 8, 2004. Prior to June 9, 2008 the company has only nominal operations
and assets. On October 23, 2008, the Company changed its name from Southern
Sauce Company, Inc. to Shengkai Innovations, Inc.





On June
9, 2008, the Company executed a reverse-merger with Shen Kun International
Limited (“Shen Kun”) by an exchange of shares whereby the Company issued
20,550,000 common shares at $0.001 par value in exchange for all Shen Kun
shares. Immediately after the closing of the reverse-merger, we had a total of
22,112,500 shares of common stock outstanding, with the Shen Kun shareholders
(and their assignees) owning approximately 92.9% of our outstanding common stock
on a non-diluted basis. Shen Kun became our wholly-owned
subsidiary.





The
exchange transaction was accounted for as a reverse acquisition in accordance
with Accounting Standards Codification (“ASC”) 805, “Business Combinations”
(formerly included under Statement of Financial Accounting Standards No. 141
(revised 2007), Business Combinations). For financial reporting purposes, this
transaction is classified as a recapitalization of the Company and Shen Kun. The
accompanying consolidated financial statements were retroactively adjusted to
reflect the effects of the recapitalization of the financial statements of the
Company and the historical financial statements of Shen Kun. The 1,562,500
shares of Shengkai Innovations, Inc. outstanding prior to this stock exchange
transaction were accounted for at the net book value at the time of the
transaction, which was a deficit of $62,206. The consolidated statements of
operations include the results of operations of Tianjin Shengkai Industrial
Technology Development Co., Ltd and Shengkai (Tianjin) Limited for the periods
ended September 30, 2010 and 2009.





Shen Kun
formed Sheng Kai (Tianjin) Ceramic Valves Co., Ltd., which was renamed to
Shengkai (Tianjin) Limited in April 2010 (“SK” or “WFOE”), which entered into a
series of agreements with Tianjin Shengkai Industrial Technology Development
Co., Ltd (“Shengkai”) including but not limited to consigned management,
technology service, loan, exclusive purchase option, equity pledge, etc. The
agreements were entered on May 30, 2008. As a result of entering the
abovementioned agreements, WFOE deem to control Shengkai as a Variable Interest
Entity as required by Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) 810-10 (formerly FASB Interpretation No. 46
(revised March 2003) Consolidated of Variable Interest Entities, and
Interpretation of ARB No. 51).





Shengkai
(Tianjin) Trading Ltd., which is wholly-owned by SK WFOE, was organized as a
wholly foreign-owned enterprise under the laws of the PRC on June 25, 2010 with
a total registered capital of RMB500,000. Shengkai (Tianjin) Trading Ltd. is
primarily engaged in the international trading of non-valve products to better
serve the Company’s international customers.





In
connection with the reverse merger transaction, on June 11, 2008 the Company
sold 5,915,526 Units for aggregate gross proceeds of $15,000,000, at a price of
$2.5357 per Unit. Each Unit consists of one share of Southern Sauce Series A
Convertible Preferred Stock, par value $0.001 per share (the “Preferred
Shares”), convertible into one share of common stock, par value $0.001 per share
(the “Common Stock”), and one Series A Warrant to purchase Common Stock equal to
120% of the number of shares of Common Stock issuable upon conversion of the
Preferred Shares (“Warrant”). Additionally, on July 18, 2008, the Company sold
1,971,842 Units for aggregate gross proceeds of $5,000,000, at a price of
$2.5357 per Unit. Each Unit consists of one Preferred Share, convertible into
one share of Common Stock, par value $0.001 per share, and one Warrant to
purchase Common Stock equal to 120% of the number of shares of Common Stock
issuable upon conversion of the Preferred Shares.


8


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





1.
            ORGANIZATION AND PRINCIPAL
      ACTIVITIES





The
Company, through its subsidiaries and Shengkai, (hereinafter, collectively
referred to as “the Group”), is now in the business of manufacturing and sale of
industrial ceramic valves and components.





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES





(a)
            Basis
      of presentation and method of
accounting





The
unaudited condensed consolidated financial statements of Shengkai innovations,
Inc. and subsidiaries (the “Company”) have been prepared in accordance with U.S.
generally accepted accounting principles for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all the information and footnotes required by
accounting principles generally accepted in the United States of America for
complete financial statements.  However, the information included in these
interim financial statements reflects all adjustments (consisting solely of
normal recurring adjustments) which are, in the opinion of management, necessary
for the fair presentation of the consolidated financial position and the
consolidated results of operations. Results shown for interim periods are not
necessarily indicative of the results to be obtained for a full year. The
consolidated balance sheet as of  June 30, 2010 has been derived from
the audited consolidated financial statements included in the Company’s Annual
Report on Form 10-K.  These interim financial statements should be read in
conjunction with that report.





The
Company maintains its general ledger and journals with the accrual method
accounting for financial reporting purposes. The financial statements and notes
are representations of management.  Accounting policies adopted by the
Company conform to generally accepted accounting principles in the United States
of America and have been consistently applied in the presentation of financial
statements.





(b)
            Principles of
      Consolidation





The
consolidated financial statements, which include the Company and its
subsidiaries, are complied in accordance with generally accepted accounting
principles in the United States of America. All significant inter-company
accounts and transactions have been eliminated. The consolidated financial
statements include 100% of assets, liabilities, and net income or loss of those
wholly-owned subsidiaries.





The
company owned the four
subsidiaries since its reverse-merger on June 9, 2008. The detailed identities
of the consolidating subsidiaries would have been as follows:





Name of Company
                      
                      Place of
                        incorporation
                      
                      Attributable
                        interestShen
      Kun International Limited
                      
                      BritishVirginIslands
                      
                      
                      100
                      %Shengkai
      (Tianjin) Limited, formerly Sheng Kai (Tianjin) Ceramic Valves Co.,
      Ltd
                      
                      PRC
                      
                      
                      100
                      %*Tianjin
      Shengkai Industrial Technology Development Co., Ltd.
                      
                      PRC
                      
                      
                      100
                      %Shengkai
      (Tianjin) Trading Ltd.
                      
                      PRC
                      
                      
                      100
                      %*Deemed
      variable interest entity member


9


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES





(c)
            Use of
      estimates





The
preparation of the financial statements in conformity with generally accepted
accounting principles in the United States of America 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 periods. Management makes these estimates using the best
information available at the time the estimates are made; however actual results
could differ materially from those estimates.





(d)
            Economic and political
      risks





The
Group’s operations are conducted in the People’s Republic of China (“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 economy.





The
Group’s operations in the PRC are subject to special considerations and
significant risks not typically associated with companies in North America and
Western Europe. These include risks associated with, among others, the
political, economic and legal environment and foreign currency exchange. The
Group’s results may be adversely affected by changes in the political and social
conditions in the PRC, and by changes in governmental policies with respect to
laws and regulations, anti-inflationary measures, currency conversion,
remittances abroad, and rates and methods of taxation, among other
things.





(e)
            Restricted
      Cash





Restricted
cash represents amounts held by a bank as security for bank acceptance notes and
therefore is not available for the Company’s use. The restricted cash is
expected to be released within the next twelve months.





(f)
            Accounts
      receivable





Accounts
receivable are carried at net realizable value.  An allowance for doubtful
accounts will be recorded in the period when loss is probable based on an
assessment of specific evidence indicating troubled collection, historical
experience, accounts aging and other factors. Accounts are written off after
exhaustive efforts at collection.  If accounts receivable are to be
provided for, or written off, they would be recognized in the consolidated
statement of operations within operating expense.  The Company did not
provide allowance for doubtful accounts at September 30, 2010 and 2009,
respectively, as per the management's judgment based on their best
knowledge.


10


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(g)
            Property, plant and
      equipment





Plant and
equipment are carried at cost less accumulated depreciation.  Depreciation
is provided over their estimated useful lives, using the straight-line method.
Estimated useful lives of the plant and equipment are as follows:





Buildings
                20
      – 40 yearsMachinery
      and equipment
                3 –
      20 yearsOffice
      equipment
                3 –
      10 yearsMotor
      vehicles
                10
      years





The cost
and related accumulated depreciation of assets sold or otherwise retired are
eliminated from the accounts and any gain or loss is included in the statement
of income. The cost of maintenance and repairs is charged to income as incurred,
whereas significant renewals and betterments are capitalized.





(h)
            Construction in
      progress





Construction
in progress represents direct costs of construction incurred. Capitalization of
these costs ceases and the construction in progress is transferred to plant and
equipment when substantially all the activities necessary to prepare the assets
for their intended use are completed. No depreciation is provided until it is
completed and ready for intended use.





(i)
            Land use
      rights





According
to PRC laws, the government owns all the land in the PRC. Companies or
individuals are authorized to possess and use the land only through land use
rights granted by the PRC government. Land use rights are being amortized using
the straight-line method over the lease term of 50 years commencing from the
date of acquisition.





(j)
            Other intangible
      assets





Other
intangible assets include patent rights and software costs which are stated at
acquisition cost less accumulated amortization. Amortization expense is
recognized using the straight-line method over the estimated useful life. Patent
rights are carried at cost and amortized on a straight-line basis over the
period of rights of 10 years commencing from the date of acquisition of
equitable interest.  Software costs are carried at cost and amortized on a
straight-line basis over the period of 6 years.


11


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(k)
            Accounting for the impairment of
      long-lived assets





The Group
periodically evaluates the carrying value of long-lived assets to be held and
used, including intangible assets subject to amortization, when events and
circumstances warrant such a review, pursuant to the guidelines established in
Statement of Financial Accounting Standards (“SFAS”) No. 144 (now known as "ASC
360"). The carrying value of a long-lived asset is considered impaired when the
anticipated undiscounted cash flow from such asset is separately identifiable
and is less than its carrying value. In that event, a loss is recognized based
on the amount by which the carrying value exceeds the fair market value of the
long-lived asset. Fair market value is determined primarily using the
anticipated cash flows discounted at a rate commensurate with the risk involved.
Losses on long-lived assets to be disposed of are determined in a similar
manner, except that fair market values are reduced for the cost to
dispose.





During
the reporting periods, there was no impairment loss.





(l)
            Inventories





Inventories
are stated at lower of cost or net realizable value.  Cost is determined by
the weighted average basis and includes all expenditures incurred in bringing
the goods to the point of sale and putting them in a saleable condition. 
In case of manufacturing inventories and work in progress, cost includes an
appropriate share of production overheads based on normal operating capacity.
Net realizable value is the estimated selling price in the ordinary course of
business less any applicable selling expenses.





(m)
            Cash and cash
      equivalents





Cash and
cash equivalents consist of cash on hand and bank deposits with original
maturities of nine months or less, which are unrestricted as to withdrawal and
use. The Company maintains bank accounts in the U.S.A., mainland China and Hong
Kong.





September 30,
                
                
                June 30,2010
                
                
                2010Cash
      on hand
                
                $
                6,050
                
                
                $
                5,348Bank
      deposits:Agricultural
      Bank of China
                
                
                -
                
                
                
                -Bank
      of China
                
                
                904,234
                
                
                
                889,600Industrial
      and Commercial Bank of China
                
                
                111,258
                
                
                
                307,818Industrial
      Bank Co. Ltd.
                
                
                355,117
                
                
                
                1,326,844Shanghai
      Pudong Development Bank
                
                
                17,906,393
                
                
                
                18,043,632The
      Hong Kong and Shanghai Banking Corporation Limited
                
                
                15,483
                
                
                
                15,483JPMorgan
      Chase Bank
                
                
                323,335
                
                
                
                406,457$
                19,621,870
                
                
                $
                20,995,182


12


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(n)
            Fair Value of Financial
      Instruments





FASB ASC
820 (formerly Statement of Financial Accounting Standard (“SFAS”) No. 157 Fair
Value Measurements) establishes a three-tier fair value hierarchy, which
prioritizes the inputs used in measuring fair value. The hierarchy prioritizes
the inputs into three levels based on the extent to which inputs used in
measuring fair value are observable in the market





These
tiers include:





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





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





•
            Level 3—defined as unobservable
      inputs in which little or no market data exists, therefore requiring an
      entity to develop its own
assumptions.





The
carrying amounts of financial assets and liabilities, such as cash and cash
equivalents, accounts receivable, notes receivable, other receivables,
short-term bank loans, accounts payable, notes payable, other payables and
accrued expenses and due to related parties, approximate their fair values
because of the short maturity of these instruments.





Accounting
guidance on fair value measurement and disclosures permits entities to choose to
measure many financial instruments and certain other items at fair value. It was
effective for our year beginning July 1, 2009. Upon its adoption and at this
time, we do not intend to reflect any of our current financial instruments at
fair value (except that we are required to carry our derivative financial
instruments at fair value). However, we will consider the appropriateness of
recognizing financial instruments at fair value on a case by case basis in
future periods.


13


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





The
summary of fair values of financial instruments as of September 30 and June 30,
2010 are as follows:





September 30, 2010Instrument
                
                Fair Value
                
                
                Carrying Value
                
                
                Level
                
                Valuation
                  MethodologyDerivative
      warrant liabilities
                
                $
                24,489,328
                
                
                $
                24,489,328
                
                
                
                3
                
                Black-ScholesEmbedded
      conversion liability
                
                $
                31,608,596
                
                
                $
                31,608,596
                
                
                
                3





June 30, 2010Instrument
                
                Fair Value
                
                
                Carrying Value
                
                
                Level
                
                Valuation
                  MethodologyDerivative
      warrant liabilities
                
                $
                37,424,035
                
                
                $
                37,424,035
                
                
                
                3
                
                Black-ScholesEmbedded
      conversion liability
                
                $
                40,378,640
                
                
                $
                40,378,640
                
                
                
                3








The
following represents a reconciliation of the changes in fair value of financial
instruments measured at fair value on a recurring basis using significant
unobservable inputs (Level 3) for the three months ended September 30, 2010 and
2009:





September 30, 2010
                      
                      
                      September 30, 2009Beginning
      balance: Derivative liabilities
                      
                      $
                      77,802,675
                      
                      
                      $
                      —Total
      gains
                      
                      
                      (21,704,751
                      )
                      
                      
                      —Ending
      balance: Derivative liabilities
                      
                      $
                      56,097,924
                      
                      
                      $
                      —





(o)
            Revenue
      recognition





Revenue
represents the invoiced value of goods sold and is recognized upon the delivery
of goods to customers. Revenue is recognized when all of the following criteria
are met:





-
Persuasive evidence of an arrangement exists;


-
Delivery has occurred or services have been rendered;


- The
seller’s price to the buyer is fixed or determinable, and


-
Collection is reasonably assured.





Revenues
are recognized when customer takes delivery and acceptance of products, the
price is fixed or determinable as stated on sales contract, and the
collectability is reasonably assured. The products are not subject to
returns.





(p)
            Costs of
    sales





Cost of
sales consists primarily of direct material costs, direct labor cost, direct
depreciation and related direct expenses attributable to the production of
products.  Write-down of inventory to lower of cost or market is also
reflected in cost of revenues.


14


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(q)
            Advertising





The
Company expensed all advertising costs as incurred.  Advertising expenses
included in the selling expenses for three months ended September 30, 2010 and
2009 were $0 and $0, respectively.





(r)
            Research and development
      costs





The
Company expensed all research and development costs as incurred.  Research
and development expenses included in the general and administrative expenses for
the three months ended September 30, 2010 and 2009 were $133,346 and $158,148,
respectively.





(s)
            Retirement benefit
      plans





The
employees of the Company are members of a state-managed retirement benefit plan
operated by the government of the PRC.  The Company is required to
contribute a specified percentage of payroll costs to the retirement benefit
scheme to fund the benefits.  The only obligation of the Company with
respect to the retirement benefit plan is to make the specified
contributions.





Retirement
benefits in the form of contributions under defined contribution retirement
plans to the relevant authorities are charged to the statements of income as
incurred. The retirement benefit expenses included in general and administrative
expenses for the three months ended September 30, 2010 and 2009 were $45,714 and
$35,880, respectively.





(t)
            Share-based
      compensation





Share-based
compensation includes 1) stock options and common stock awards granted to
employees and directors for services, and are accounted for under FASB ASC 718
"Compensation - Stock Compensation", and 2) common stock awards granted to
consultants which are accounted for under FASB ASC 505-50 "Equity - Equity-Based
Payment to Non-employees".





All
grants of common stock awards and stock options to employees and directors are
recognized in the financial statements based on their grant date fair values.
The Company has elected to recognize compensation expense using the
straight-line method for all common stock awards and stock options granted with
service conditions that have a graded vesting schedule, with a corresponding
charge to additional paid-in capital.





The
Company estimates fair value of common stock awards based on the number of
shares granted and the quoted price of the Company's common stock on the date of
Grant.





The fair
value of stock options is estimated using the Black-Scholes model. The Company's
expected volatility assumption is based on the historical volatility of the
Company's stock as well as historical volatility of comparable public companies,
due to its relatively short trading history. The expected life assumption is
presumed to be the mid-point between the vesting date and the end of the
contractual term, as is permitted for "plain vanilla" employee stock 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.


15


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





FASB ASC
718 requires forfeitures to be estimated at the time of grant and revised, if
necessary, in the subsequent period if actual forfeitures differ from initial
estimates. Forfeiture rate is estimated based on historical and future
expectation of employee turnover rate and are adjusted to reflect future change
in circumstances and facts, if any. Share-based compensation expense is recorded
net of estimated forfeitures such that expenses were recorded only for those
stock options and common stock awards that are expected to vest.





(u)
            Income
  tax





Deferred
tax assets and liabilities are recognized for the future tax consequence
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to be
applied to taxable income in the years in which those temporary differences are
expected to reverse.  The effect on deferred tax assets and liabilities of
a change in tax rates is recognized in the statement of income in the period
that includes the enactment date.  A valuation allowance is provided for
deferred tax assets if it is more likely than not these items will either expire
before the Company is able to realize their benefits, or that future
deductibility is uncertain.





The
Company uses FASB ASC 740 (formerly FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes (“FIN 48”)). – AN INTERPRETATION OF FASB STATEMENT NO. 109,
ACCOUNTING FOR INCOME TAXES.  The Interpretation addresses the
determination of whether tax benefits claimed or expected to be claimed on a tax
return should be recorded in the financial statements.  Under FIN 48, we
may recognize the tax benefit from an uncertain tax position only if it is more
likely than not that the tax position will be sustained on examination by the
taxing authorities, based on the technical merits of the position.  The tax
benefits recognized in the financial statements from such a position should be
measured based on the largest benefit that has a greater than fifty percent
likelihood of being realized upon ultimate settlement.  FASB ASC 740 also
provides guidance on recognition, classification, interest and penalties on
income taxes, accounting in interim periods and requires increased
disclosures.  At September 30 and June 30, 2010, the Company did not have a
liability for unrecognized tax benefits.





(v)
            Value-Added Tax
      (“VAT”)





Enterprises
or individuals, who sell commodities, engage in repair and maintenance or import
or export goods in the PRC are subject to a value-added tax in accordance with
the People’s Republic of China (“PRC”) laws.  The standard value-added tax
rate is 17% of the gross sales price and the Company records its revenue net of
VAT.  A credit is available whereby VAT paid on the purchases of
semi-finished products or raw materials used in the production of the Company’s
finished products can be used to offset the VAT due on the sales of the finished
products. Therefore, the amounts included in VAT recoverable on the balance
sheets represent the excess of VAT paid on purchases over the VAT due on sales
at September 30 and June 30, 2010, respectively, which can be used to offset
future VAT that is due on sales.


16


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(w)
            Foreign currency
      translation





The
accompanying consolidated financial statements are presented in United States
dollars (“US$” or “$”), while the functional currency of the Company is Renminbi
(“RMB”), as determined based on the criteria of Financial Accounting Standards
Board (“FASB”) Accounting Standards Codification (“ASC”) ASC 830 “Foreign
Currency Matters”.  The consolidated financial statements are translated
into United States dollars from RMB at year-end exchange rates as to assets and
liabilities and average exchange rates as to revenues and expenses. 
Capital accounts are translated at their historical exchange rates when the
capital transactions occurred.  The resulting transaction adjustments are
recorded as a component of other comprehensive income with in shareholders’
equity.  Gains and losses from foreign currency transactions are included
in net income.





The
exchange rates used to translate amounts in RMB into USD for the purposes of
preparing the consolidated financial statements were as follows:





September
      30, 2010Balance
      sheet
                      
                      RMB
      6.69810 to US$1.00Statement
      of income and comprehensive income
                      
                      RMB
      6.78032 to US$1.00June
      30, 2010Balance
      sheet
                      
                      RMB
      6.80860 to US$1.00Statement
      of income and comprehensive income
                      
                      RMB
      6.83667 to US$1.00September
      30, 2009Balance
      sheet
                      
                      RMB
      6.83760 to US$1.00Statement
      of income
                      
                      RMB
      6.84110 to
US$1.00





The RMB
is not freely convertible into foreign currency and all foreign exchange
transactions must take place through authorized institutions.  No
representation is made that the RMB amounts could have been, or could be,
converted into US$ at the rates used in translation.





(x)
            Cash and concentration of
      risk





Cash
includes cash on hand and demand deposits in bank accounts.  Total cash in
the banks at September 30 and June 30, 2010 amounted to $19,615,819 and
$20,989,834, respectively. The Company has not experienced any losses in such
accounts and believes it is not exposed to significant financial institution
risks on its cash in bank accounts. Also see Note 3 for credit risk
details.





(y)
            Statutory
      reserves





As
stipulated by the PRC’s Company Law and as provided in the SK, and Shengkai’s
Articles of Association, SK, and Shengkai’s net income after taxation can only
be distributed as dividends after appropriation has been made for the
following:


17


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(i)
            Making up cumulative prior years’
      losses, if any;


(ii)
            Allocations to the “Statutory
      surplus reserve” of at least 10% of income after tax, as determined under
      PRC accounting rules and regulations, until the fund amounts to 50% of the
      Company's registered capital, which is restricted for set off against
      losses, expansion of production and operation or increase in registered
      capital;


(iii)
            Allocations of 5-10% of income
      after tax, as determined under PRC accounting rules and regulations, to
      the Company's “Statutory common welfare fund”, which is restricted for
      capital expenditure for the collective benefits of the Company's
      employees; and


(iv)
            Allocations to the discretionary
      surplus reserve, if approved in the shareholders’ general
      meeting.





On
December 31, 2003, Shengkai established a statutory surplus reserve as well as a
statutory common welfare fund and commenced to appropriate 10% and 5%,
respectively of the PRC net income after taxation to these reserves. The amounts
included in the statutory reserves were surplus reserve of $7,081,706 and
$7,081,706 as at September 30 and June 30, 2010, respectively.





(z)
            Comprehensive
      income





Comprehensive
income is defined to include all changes in equity except those resulting from
investments by owners and distributions to owners.  Among other
disclosures, all items that are required to be recognized under current
accounting standards as components of comprehensive income are required to be
reported in a financial statement that is presented with the same prominence as
other financial statements.  The Company’s current component of other
comprehensive income is the foreign currency translation
adjustment.





(ai)
            Recent accounting
      pronouncements





Effective
July 1, 2009, the Company adopted ASC 815-40 (formerly Emerging Issues Task
Force ("EITF") Issue No. 07-05, Determining Whether an Instrument (or Embedded
Feature) Is Indexed to an Entity's Own Stock ("EITF 07-05"). ASC 815-40
addresses the determination of whether an instrument (or an embedded feature) is
indexed to an equity's own stock, which is the first part of the scope exception
in paragraph 11(a) of FASB SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities ("SFAS 133"). If and instrument (or an embedded feature)
that has the characteristics of a derivative instrument under paragraph 6-9 of
SFAS 133 is indexed to an entity's own stock, it is still necessary to evaluate
whether it is classified in stockholders' equity (or would be classified in
stockholders' equity if it were a freestanding instrument). Other applicable
authoritative accounting literature, including Issues EITF 00-19, Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock, and EITF 05-2, The Meaning of "Conventional Debt
Instrument" in Issue No. 00-19, provides guidance for determining whether an
instrument (or an embedded feature) is classified in stockholders' equity (or
would be classified in stockholders' equity if it were a freestanding
instrument). ASC 815-40 does not address that second part of the scope exception
in paragraph 11(a) of SFAS 133. As a result of the adoption of ASC 815-40, the
Company adjusted its accounting effective from the beginning of fiscal year
2010, i.e. July 1, 2009, on which date ASC 815-40 was adopted, by bifurcating
the embedded conversion option of the Preferred Shares which should be recorded
as a liability measured at fair value, with changes in fair value recognized in
earnings for each reporting period, and recording a cumulative-effect adjustment
to the opening balance of retained earnings.


18


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(ai)
            Recent accounting pronouncements
      (Continued)





In August
2009, the FASB issued FASB ASU 2009-05, "Measuring Liabilities at Fair Value".
FASB ASU 2009-05 amends FASB ASC 820, "Fair Value Measurements". Specifically,
FASB ASU 2009-05 provides clarification that in circumstances in which a quoted
price in an active market for the identical liability is not available, a
reporting entity is required to measure fair value using one or more of the
following methods: 1) a valuation technique that uses a) the quoted price of the
identical liability when traded as an asset or b) quoted prices for similar
liabilities or similar liabilities when traded as assets and/or 2) a valuation
technique that is consistent with the principles of FASB ASC 820 of the
Accounting Standards Codification (e.g. an income approach or market approach).
FASB ASU 2009-05 also clarifies that when estimating the fair value of a
liability, a reporting entity is not required to adjust to include inputs
relating to the existence of transfer restrictions on that liability. The
adoption of such standard did not have a material impact on the Company's
consolidated financial statements.





In May
2009, the FASB issued SFAS No. 165, "Subsequent Event", ("FASB ASC 855-10")
which establishes general standards of accounting for and disclosure of events
that occur after the balance sheet date but before financial statements. The
statement is effective for interim and annual periods ended after June 15, 2009.
The standard was subsequently amended by FASB ASU 2010-09 which exempts an
entity that is an SEC filer from the requirement to disclose the date through
which subsequent events have been evaluated.





In
September 2009, the Emerging Issues Task Force reached final consensus on FASB
ASU 2009-13, "Revenue Arrangements with Multiple Deliverables". FASB ASU 2009-13
addresses how to determine whether an arrangement involving multiple
deliverables contains more than one unit of accounting, and how the arrangement
consideration should be allocated among the separate units of accounting. This
ASU will be effective prospectively for revenue arrangements entered into or
materially modified in fiscal years beginning on or after June 15, 2010. Early
adoption is permitted. The adoption of such standard does not have a material
impact on the Company's consolidated financial statements.





In
December 2009, the FASB issued FASB ASU 2009-17, Consolidation of Variable
Interest Entities ("FASB ASC 810"): improvements to Financial Reporting by
Enterprises involved with Variable Interest Entities. This ASU amends the FASB
Accounting Standards Codification for statement No.167. In June 2009, the FASB
issued SFAS No.167, Amendments to FASB Interpretation No. 46(R), which requires
an enterprise to perform an analysis and ongoing reassessments to determine
whether the enterprises variable interest or interests give it a controlling
financial interest in a variable interest entity und amends certain guidance for
determining whether an entity is a variable interest entity. It also requires
enhanced disclosures that will provide users of financial statements with more
transparent information about an enterprises involvement in a variable interest
entity. SFAS No.167 is effective as of the beginning of each reporting entity's
first annual reporting period that begins after November 15, 2009 and for all
interim reporting periods after that, with early application prohibited. The
adoption of such standard did not have a material impact on the Company's
consolidated financial statements.


19


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(ai)
            Recent accounting pronouncements
      (Continued)





In
January 2010, the FASB issued Accounting Standards Update 2010-05 (ASU 2010-05),
"Compensation - Stock Compensation (Topic 718)". This standard codifies EITF
Topic D-110 Escrowed Share Arrangements and the Presumption of Compensation and
is effective immediately. The provisions of ASU 2010-05 did not have a material
effect on the Company's consolidated financial statements and is effective
immediately.





In
January 2010, the FASB issued Update No. 2010-6, “Improving Disclosures About
Fair Value Measurements” (“ASU 2010-6”), which requires reporting entities to
make new disclosures about recurring or nonrecurring fair-value measurements
including significant transfers into and out of Level 1 and Level 2 fair-value
measurements and information on purchases, sales, issuances, and settlements on
a gross basis in the reconciliation of Level 3 fair-value measurements. ASU
2010-6 is effective for annual reporting periods beginning after December 15,
2009, except for Level 3 reconciliation disclosures, which are effective for
annual periods beginning after December 15, 2010. The adoption of this update is
not expected to have a material effect on the Company's consolidated financial
statements.





In
February 2010, the FASB issued Accounting Standards Update 2010-09 (ASU
2010-09), "Subsequent Events (Topic 855)." The amendments remove the
requirements for an SEC filer to disclose a date, in both issued and revised
financial statements, through which subsequent events have been reviewed.
Revised financial statements include financial statements revised as a result of
either correction of an error or retrospective application of U.S. GAAP. ASU
2010-09 is effective for interim or annual financial periods ending after June
15, 2010. The provisions of ASU 2010-09 did not have a material effect on the
Company's consolidated financial statements.





In
February 2010, the FASB issued Accounting Standards Update 2010-10 (ASU
2010-10), "Consolidation (Topic 810)." The amendments to the consolidation
requirements of Topic 810 resulting from the issuance of Statement 167 are
deferred for a reporting entity's interest in an entity (1) that has all the
attributes of an investment company or (2) for which it is industry practice to
apply measurement principles for financial reporting purposes that are
consistent with those followed by investment companies. An entity that qualifies
for the deferral will continue to be assessed under the overall guidance on the
consolidation of variable interest entities in Subtopic 810-10 (before the
Statement 167 amendments) or other applicable consolidation guidance, such as
the guidance for the consolidation of partnerships in Subtopic 810-20. The
deferral is primarily the result of differing consolidation conclusions reached
by the International Accounting Standards Board ("IASB") for certain investment
funds when compared with the conclusions reached under Statement 167. The
deferral is effective as of the beginning of a reporting entity's first annul
period that begins after November 15, 2009, and for interim periods within that
first annual reporting period, which coincides with the effective date of
Statement 167. Early application it not permitted. The provisions of ASU 2010-10
are effective for the Company beginning in 2010. The adoption of ASU 2010-10 did
not have a material impact on the Company's consolidated financial
statements.


20


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





2.
            SUMMARY OF SIGNIFICANT ACCOUNTING
      POLICIES (Continued)





(ai)
            Recent accounting pronouncements
      (Continued)





In March
2010, the FASB issued Accounting Standards Update 2010-11 (ASU 2010-11),
"Derivative and Hedging (Topic 815)." All entities that enter into contracts
containing an embedded credit derivative feature related to the transfer of
credit risk that is not only in the form of subordination of one financial
instrument to another will be affected by the amendments in this Update because
the amendments clarify that the embedded credit derivative scope exception in
paragraph 815-15-15-8 through 15-9 does not apply to such contracts. ASU 2010-11
is effective at the beginning of the reporting entity's first fiscal quarter
beginning after June 15, 2010. The adoption of such standard does not have a
material impact on the Company's consolidated financial statements.





In April
2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13),
"Compensation - Stock Compensation (Topic 718)." This Update provides amendments
to Topic 718 to clarity that an employee share-based payment award with an
exercise price denominated in the currency of a market in which a substantial
portion of the entity's equity securities trades should not be considered to
contain a condition that is not a market, performance, or service condition.
Therefore, an entity would not classify such an award as a liability if it
otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for
fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2010. The provisions of ASU 2010-13 are not expected to have
a material effect on the Company's consolidated financial
statements.





In July
2010, the FASB issued an accounting update to provide guidance to enhance
disclosures related to the credit quality of a company's financing receivables
portfolio and the associated allowance for credit losses. Pursuant to this
accounting update, a company is required to provide a greater level of
disaggregated information about its allowance for credit loss with the objective
of facilitating users' evaluation of the nature of credit risk inherent in the
company's portfolio of financing receivables, how that risk is analyzed and
assessed in arriving at the allowance for credit losses, and the changes and
reasons for those changes in the allowance for credit losses. The revised
disclosures as of the end of the reporting period are effective for the Company
beginning in the second quarter of fiscal 2011, and the revised discourses
related to activities during the reporting period are effective for the Company
beginning in the third quarter of fiscal 2011. The Company is currently
evaluating the impact of this accounting update on its financial
disclosures.


21


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





3.
            CONCENTRATIONS OF CREDIT RISK AND
      MAJOR CUSTOMERS





Financial
instruments which potentially expose the Group to concentrations of credit risk,
consists of cash and accounts receivable as of September 30 and June 30, 2010.
The Group performs ongoing evaluations of its cash position and credit
evaluations to ensure sound collections and minimize credit losses
exposure.





As of
September 30 and June 30, 2010, almost all the Group’s bank deposits were
conducted with banks in the PRC where there is currently no rule or regulation
mandated on obligatory insurance of bank accounts. Relatively small bank
deposits were maintained with the banks in the U.S.A and Hong Kong.





For the
three months ended September 30, 2010 and 2009, more than 90% of the Group’s
sales were generated from the PRC. In addition, nearly all accounts receivable
as of September 30 and June 30, 2010, also arose in the PRC.





The
maximum amount of loss exposure due to credit risk that the Group would bear if
the counter parties of the financial instruments fail to perform represents the
carrying amount of each financial asset in the balance sheet.





Normally
the Group does not require collateral from customers or debtors.





For the
three months ended September 30, 2010 and 2009, there was no single customer who
accounts for 10% or more of the Group’s revenue.





As at
September 30 and June 30, 2010, there was no customer who accounts for 10% or
more of the Group’s accounts receivable.


22


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





4.
            OTHER
      RECEIVABLES





Other
receivables consist of the followings:





September
      30, 2010
                
                
                June
      30, 2010Advance
      to employees
                
                $
                19,055
                
                
                $
                24,935Tender
      deposits
                
                
                62,841
                
                
                
                37,304Sundry
                
                
                40,412
                
                
                
                32,656VAT
      recoverable
                
                
                489,401
                
                
                
                230,288$
                611,709
                
                
                $
                325,183





5.
            INVENTORIES





Inventories
consist of the followings:





September
      30, 2010
                
                
                June
      30, 2010Finished
      goods
                
                $
                849,763
                
                
                $
                592,034Work
      in process
                
                
                2,627
                
                
                
                -Raw
      materials
                
                
                1,093,005
                
                
                
                1,964,132$
                1,945,395
                
                
                $
                2,556,166





6.
            PROPERTY, PLANT AND EQUIPMENT,
      NET





Property,
plant and equipment consist of the followings:





September
      30, 2010
                          
                          
                          June
      30, 2010At
      costBuildings
                          
                          $
                          2,154,414
                          
                          
                          $
                          2,119,449Machinery
      and equipment
                          
                          
                          6,205,511
                          
                          
                          
                          4,598,723Office
      equipment
                          
                          
                          177,699
                          
                          
                          
                          175,507Motor
      vehicles
                          
                          
                          470,569
                          
                          
                          
                          507,3469,008,193
                          
                          
                          
                          7,401,025Less:
      accumulated depreciationBuildings
                          
                          
                          (358,636
                          )
                          
                          (338,732
                          )Machinery
      and equipment
                          
                          
                          (794,960
                          )
                          
                          
                          (666,345
                          )Office
      equipment
                          
                          
                          (137,393
                          )
                          
                          
                          (132,066
                          )Motor
      vehicles
                          
                          
                          (128,903
                          )
                          
                          
                          (143,826
                          )(1,419,892
                          )
                          
                          
                          (1,280,969
                          )Property,
      plant and equipment, net
                          
                          $
                          7,588,301
                          
                          
                          $
                          6,120,056


23





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





6.
            PROPERTY, PLANT AND EQUIPMENT,
      NET (Continued)





Depreciation
expenses included in the cost of sales for the three months ended September 30,
2010 and 2009 were $93,136 and $87,588 respectively; and in the general and
administrative expenses for the three months ended September 30, 2010 and 2009
were $53,908 and $16,521 respectively.





7.
            LAND USE
      RIGHTS





30-Sep-10
                  
                  
                  30-Jun-10Cost
      of land use rights
                  
                  $
                  2,849,439
                  
                  
                  $
                  2,803,194Less:
      Accumulated amortization
                  
                  
                  (332,141
                  )
                  
                  
                  (322,265
                  )Land
      use rights, net
                  
                  $
                  2,517,298
                  
                  
                  $
                  2,480,929





Amortization
expenses for the three months ended September 30, 2010 and 2009 were $4,504 and
$4,464 respectively.





8.
            OTHER INTANGIBLE
      ASSETS





30-Sep-10
                  
                  
                  30-Jun-10At
      cost:Patent
      rights
                  
                  $
                  7,614,100
                  
                  
                  $
                  7,490,527Software
                  
                  
                  1,564,386
                  
                  
                  
                  1,537,9219,178,486
                  
                  
                  
                  9,028,448Less:
      Accumulated amortizationPatent
      rights
                  
                  $
                  (3,082,964
                  )
                  
                  $
                  (2,858,219
                  )Software
                  
                  
                  (223,308
                  )
                  
                  
                  (168,818
                  )-3,306,272
                  )
                  
                  
                  (3,027,037
                  )Other
      intangible assets, net
                  
                  $
                  5,872,214
                  
                  
                  $
                  6,001,411





Amortization
expenses for the three months ended September 30, 2010 and 2009 were $227,402
and $224,624 respectively.


24


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





9.
            NOTES
    PAYABLE





Notes
payable consists of the following:





September
                  30,
      2010
                
                
                June
      30,
                  2010Due
      January 28, 2011
                
                $
                110,180
                
                
                $
                -Due
      January 29, 2011
                
                
                17,914
                
                
                
                -Due
      February 18, 2011
                
                
                111,930
                
                
                
                -Due
      February 18, 2011
                
                
                11,560
                
                
                
                -Due
      February 18, 2011
                
                
                20,245
                
                
                
                -Due
      February 25, 2011
                
                
                41,056
                
                
                
                -Due
      February 28, 2011
                
                
                39,746
                
                
                
                -Due
      March 26, 2011
                
                
                23,887
                
                
                
                -Due
      March 26, 2011
                
                
                1,493
                
                
                
                -Due
      March 26, 2011
                
                
                1,493
                
                
                
                -Due
      March 26, 2011
                
                
                223,944
                
                
                
                -Due
      March 26, 2011
                
                
                29,859
                
                
                
                -Due
      March 26, 2011
                
                
                29,859
                
                
                
                -Due
      March 26, 2011
                
                
                29,859
                
                
                
                -Due
      March 26, 2011
                
                
                29,859
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                14,930
                
                
                
                -Due
      March 26, 2011
                
                
                7,465
                
                
                
                -Due
      March 26, 2011
                
                
                7,465
                
                
                
                -Due
      March 26, 2011
                
                
                7,465
                
                
                
                -Due
      March 26, 2011
                
                
                7,465
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                17,916
                
                
                
                -Due
      March 26, 2011
                
                
                29,262
                
                
                
                -


25


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





9.
            NOTES PAYABLE
      (Continued)





September
                        30, 2010
                      
                      
                      June 30,
                        2010Due
      December 30,2010
                      
                      
                      132,575
                      
                      
                      
                      130,423Due
      December 30,2010
                      
                      
                      54,829
                      
                      
                      
                      53,939Due
      December 30,2010
                      
                      
                      146,432
                      
                      
                      
                      144,055Due
      December 28,2010
                      
                      
                      558,248
                      
                      
                      
                      549,188Due
      December 3,2010
                      
                      
                      25,529
                      
                      
                      
                      25,115Due
      December 3,2010
                      
                      
                      57,778
                      
                      
                      
                      56,840Due
      December 3,2010
                      
                      
                      251,713
                      
                      
                      
                      247,628Due
      November 28,2010
                      
                      
                      29,860
                      
                      
                      
                      29,375Due
      November 28,2010
                      
                      
                      14,929
                      
                      
                      
                      14,687Due
      November 28,2010
                      
                      
                      8,957
                      
                      
                      
                      8,812Due
      November 28,2010
                      
                      
                      20,901
                      
                      
                      
                      20,562Due
      November 28,2010
                      
                      
                      8,957
                      
                      
                      
                      8,812Due
      November 28,2010
                      
                      
                      29,860
                      
                      
                      
                      29,375Due
      November 28,2010
                      
                      
                      28,665
                      
                      
                      
                      28,200Due
      October 15,2010 (subsequently repaid on due dates)
                      
                      
                      125,857
                      
                      
                      
                      123,814Due
      October 14,2010 (subsequently repaid on due dates)
                      
                      
                      208,268
                      
                      
                      
                      204,888Due
      October 6,2010 (subsequently repaid on due dates)
                      
                      
                      20,245
                      
                      
                      
                      19,916Due
      October 2,2010 (subsequently repaid on due dates)
                      
                      
                      18,961
                      
                      
                      
                      18,653Due
      September 15,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      69,265Due
      September 9,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      2,910Due
      September 9,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      14,687Due
      September 9,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      10,046Due
      September 9,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      1,702Due
      September 9,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      1,692Due
      September 3,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      569,103Due
      August 3,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      1,908Due
      August 3,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      2,127Due
      August 3,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      1,654Due
      July 20,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      204,888Due
      July 4,2010, subsequently repaid on due dates
                      
                      
                      -
                      
                      
                      
                      57,831Total
                      
                      $
                      2,873,932
                      
                      
                      $
                      2,652,095





All the
notes payable are subject to bank charges of 0.05% of the principal amount as
commission on each loan transaction.  Bank charges for notes payable were
$558 and $113 for the three months ended September 30, 2010 and 2009,
respectively.





The
interest-free notes payable are secured by $ 2,111,426  and $1,849,958
restricted cash as of September 30 and June 30, 2010.


26


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





10.
            OTHER
    PAYABLES





30-Sep-10
                  
                  
                  30-Jun-10Commissions
      payables
                  
                  $
                  384,516
                  
                  
                  $
                  441,860Accrued
      expenses
                  
                  
                  55,163
                  
                  
                  
                  127,975Deposit
      for project
                  
                  
                  717
                  
                  
                  
                  266,134Sundry
      PRC taxes payables
                  
                  
                  438,988
                  
                  
                  
                  379,588Sundry
                  
                  
                  28,993
                  
                  
                  
                  29,282$
                  908,377
                  
                  
                  $
                  1,244,839





11.
            PREFERRED STOCK AND
      WARRANTS





On June
11, 2008, the Company sold 5,915,526 Preferred Shares and various stock purchase
warrants for cash consideration totaling $15 million dollars (the “June 2008
Financing”). The exercise price, expiration date and number of share eligible to
be purchased with the warrants are summarized in the following
table:





Series
      of warrant
                    
                    Number
      of shares
                    
                    
                    Exercise
      price
                    
                    Contractual
      termSeries
      A
                    
                    
                    7,098,632
                    
                    
                    $
                    3.52
                    
                    5.0
      years





The
Preferred Shares have liquidation rights senior to common stock and to any other
class or series of stock issued by the Company not designated as ranking senior
to or pari passu with the Preferred Shares.  In the event of a liquidation
of the Company, holders of Preferred Shares are entitled to receive a
distribution equal to $2.5357 per share of Preferred Shares prior to any
distribution to the holders of common stock or any other stock that ranks junior
to the Preferred Shares. The Preferred Shareholders are not entitled to
dividends unless paid to Common Shareholders. Any dividend paid will have the
same record and payment date and terms as the dividend payable to the Common
Stock. The Preferred Shares will participate based on their respective as-if
conversion rates if the Company declares any dividends. Holders of Preferred
Shares also have voting rights required by applicable law and the relevant
number of votes shall be equal to the number of shares of Common Stock issuable
upon conversion of  Preferred Shares. At any time, each Preferred
Share is convertible into 1 share of Common Stock adjusted from time to time to
the Conversion Rate. The Conversion Rate is computed as the Liquidation
Preference Amount ($2.5357 per share) divided by the Conversion Price. The
Conversion Price is initially $2.5357 per share but can adjust for
anti-dilution.The
holder can also void the conversion or exercise its Buy-in Rights. The
Buy-in-Rights entitle the holder to be protected in the case that the Company is
unable to deliver the shares upon conversion while the holder has transacted to
sell such underlying shares to a third party. The Preferred Shares have
registration rights that the Company is required to have a registration
statement filed with the SEC within 45 days after the earlier of the date of the
Second Closing or June 30, 2008, and declared effective by the SEC not later
than November 27, 2008. We filed the initial registration statement on August 7,
2008, and it was declared effective by the SEC on August 21,
2008.


27





SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





11.
            PREFERRED STOCK AND WARRANTS
      (Continued)





The
Warrants were issued at an exercise price of $3.52 per share. The exercise price
can adjust for dilutive events. The Warrants are immediately exercisable.
However, if after exercise the holder would become a holder of greater than 9.9%
of common stock they cannot exercise without filing a waiver with the
company.  The waiver is required to be filed 61 days prior to exercise and
by filing the waiver the restriction is removed. (Since the company is required
to accept the waiver this restriction is not considered significant in valuing
the warrant.) The Warrants expire 5 years from the date of issuance. The
Warrants are freely transferable upon registration. The Warrants are subject to
the same Registration Rights Agreement as that of the Preferred Shares. If a
registration statement providing for the resale of the Common Stock issued upon
exercise of the Warrant is not declared effective after 180 days after the
issuance date, the Warrants can be cashless exercised. Also, the Warrants have
Buy-in Rights similar to those of the Preferred Shares.





The gross
proceeds of the transaction were $15 million. The proceeds from the transaction
were allocated to the Preferred Shares, Warrants and beneficial conversion
feature based on the relative fair value of the securities. The Company
evaluated whether a relative fair value approach or residual fair value approach
was more appropriate given the terms and accounting treatment related to the
financial instruments involved. Given that the Warrants were not classified as a
liability, the relative fair value method was used. The Warrants were first
valued using the Black-Scholes valuation model. The Company valued the Warrants
at issuance at $1.84 per warrant with the following assumptions: common stock
fair market value of $2.55, expected life of 5 year, volatility of 100% and an
interest rate of 4.5%.





The
Company originally
recognized a beneficial conversion feature discount on the Preferred Shares at
their intrinsic value, which was the fair value of the common stock at the
commitment date for the Preferred Shares investment, less the effective
conversion price but limited to the $15 million of proceeds received from the
sale. The Company recognized the $7.8 million beneficial conversion feature in
the equity as a transfer from retained earnings to additional paid in capital as
dividends in the accompanying consolidated financial statements on the date of
issuance of the Preferred Shares since the Preferred Shares were convertible at
the issuance date.The
accounting treatment for such preferred stock and warrants were re-evaluated and
adjustments were made during the year ended June 30, 2010.





On July
18, 2008 the Company sold 1,971,842 shares of Preferred Shares and various stock
purchase warrants for cash consideration totaling $5 million dollars (the “July
2008 Financing”). The exercise price, expiration date and number of share
eligible to be purchased with the Warrants are summarized in the following
table:





Series
      of warrant
                  
                  Number
      of shares
                  
                  
                  Exercise
      price
                  
                  Contractual
      termSeries
      A
                  
                  
                  2,366,211
                  
                  
                  $
                  3.52
                  
                  5.0
      years


28


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





11.
            PREFERRED STOCK AND WARRANTS
      (Continued)





The
Preferred Shares have liquidation rights senior to common stock and to any other
class or series of stock issued by the Company not designated as ranking senior
to or pari passu with the Preferred Shares.  In the event of a liquidation
of the Company, holders of Preferred Shares are entitled to receive a
distribution equal to $2.5357 per share of Preferred Shares prior to any
distribution to the holders of common stock or any other stock that ranks junior
to the Preferred Shares. The Preferred Shareholders are not entitled to
dividends unless paid to Common Shareholders. Any dividend paid will have the
same record and payment date and terms as the dividend payable to the Common
Stock. The Preferred Shares will participate based on their respective as-if
conversion rates if the Company declares any dividends.  Holders of
Preferred Shares also have voting rights required by applicable law and the
relevant number of votes shall be equal to the number of shares of Common Stock
issuable upon conversion of Preferred Shares. At any time, each Preferred Share
is convertible into 1 share of Common Stock adjusted from time to time to the
Conversion Rate. The Conversion Rate is computed as the Liquidation Preference
Amount ($2.5357 per share) divided by the Conversion Price. The Conversion Price
is initially $2.5357 per share but can adjust for anti-dilution.The holder can also void
the conversion or exercise its Buy-in Rights. The Buy-in-Rights entitle the
holder to be protected in the case that the Company is unable to deliver the
shares upon conversion while the holder has transacted to sell such underlying
shares to a third party. The Preferred Shares have registration rights that the
Company is required to have a registration statement filed with the SEC within
45 days after the date of the Closing Date, or September 1, 2008, and declared
effective by the SEC not later than December 15, 2008. We filed the initial
registration statement on August 7, 2008, and it was declared effective by the
SEC on August 21, 2008.





The
Warrants were issued at an exercise price of $3.52 per share. The exercise price
can adjust for dilutive events.  The Warrants are immediately exercisable.
However, if after exercise the holder would become a holder of greater than 9.9%
of common stock they cannot exercise without filing a waiver with the
company.  The waiver is required to be filed 61 days prior to exercise and
by filing the waiver the restriction is removed. (Since the company is required
to accept the waiver this restriction is not considered significant in valuing
the warrant.) The Warrants expire 5 years from the date of issuance. The
Warrants are freely transferable upon registration. The Warrants are subject to
the same Registration Rights Agreement as that of the Preferred Shares. If a
registration statement providing for the resale of the Common Stock issued upon
exercise of the Warrant is not declared effective after 180 days after the
issuance date, the Warrants can be cashless exercised. Also, the Warrants have
Buy-in Rights similar to those of the Preferred Shares.





The gross
proceeds of the transaction were $5 million. The proceeds from the transaction
were allocated to the Preferred Shares, Warrants and beneficial conversion
feature based on the relative fair value of the securities. The Company
evaluated whether a relative fair value approach or residual fair value approach
was more appropriate given the terms and accounting treatment related to the
financial instruments involved. Given that the Warrants was not classified as a
liability, the relative fair value method was used. The Warrants were first
valued using the Black-Scholes valuation model. The Company valued the Warrants
at issuance at $1.84 per warrant with the following
assumptions:  common stock fair market value of $2.55, expected life
of 5 year, volatility of 100% and an interest rate of 4.5%.


29


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





11.
            PREFERRED STOCK AND WARRANTS
      (Continued)





The
Company recognized a beneficial conversion feature discount on the Preferred
Shares at its intrinsic value, which was the fair value of the common stock at
the commitment date for the Preferred Shares investment, less the effective
conversion price but limited to the $5 million of proceeds received from the
sale. The Company recognized the $2.6 million beneficial conversion feature in
the equity as a transfer from retained earnings to additional paid in capital as
dividends in the accompanying consolidated financial statements on the date of
issuance of the Series A preferred shares since the Preferred Shares were
convertible at the issuance date.The
accounting treatment for such preferred stock and warrants were re-evaluated and
adjustments were made during the year ended June 30, 2010.





In
connection with the June 2008 Financing and the July 2008 Financing, in the
event of the Company’s failure to timely convert, additional damages would
become due.  In the event the Company does not have sufficient shares or is
prohibited by law or regulation, then the holder can require cash redemption.
The redemption price would equal 130% of the Liquidation Preference Amount plus
additional amounts based on the difference between the bid prices on the
conversion date and the date the Company has sufficient shares. The holder can
also void the conversion or exercise its Buy-in Rights. The Buy-in-Rights
entitle the holder to be protected in the case that the Company is unable to
deliver the shares upon conversion while the holder has transacted to sell such
underlying shares to a third party. In addition, in the event of a merger,
consolidation or similar capital reorganization (prior to conversion) the
holders can request to be redeemed at 110% of liquidation value.





On April
30, 2010, the Company entered into a Warrant Amendment agreement with each of
the holders of the Warrants in the June 2008 Financing and July 2008 Financing,
namely Vision Opportunity China, LP and Blue Ridge Investments, LLC, to amend
their respective warrants.  In particular, the parties have agreed to
delete Sections 4(d), (e) and (f) of their Warrants and replace Section 4(d)
with a provision to allow the Company to issue additional shares of common stock
or common stock equivalents at a price less than the conversion price of the
warrants with the consent of the majority holders of the warrants.





During
the course of internal evaluation, the Company re-evaluated its accounting
treatment as of July 1, 2009 for the warrants issued in the Private Placements
in June and July, 2008, the denominated currency of the strike price of which is
different from the entity’s functional currency.  According to ASC
815-40-15-7I, if the denominated currency of an equity-linked financial
instrument’s strike price is different from the entity’s functional currency, an
equity-linked financial instrument is not indexed to the entity’s own stock. ASC
815-40-55-36 illustrates the implementation of the above standard. The Company’s
primary operations are conducted in the PRC through its subsidiary, Tianjin
Shengkai Industrial Technology Development Company Limited, and the operating
incomes and expenses are transacted in Renminbi (RMB), which is different from
the strike price of the warrants, which are denominated in US dollars.
Therefore, the Company determined that  warrants shall not be
considered indexed to the entity’s own stock and hence adjusted the
classification of the Warrants effective from the beginning of fiscal year 2010,
i.e. July 1, 2009, on which date ASC 815 should have been adopted, by recording
the warrants as a liability measured at fair value with changes in fair value
recognized in earnings for each reporting period and recording a
cumulative-effect adjustment to the opening balance of retained
earnings.


30


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





11.
            PREFERRED STOCK AND WARRANTS
      (Continued)





During
the course of internal evaluation, the Company re-evaluated its accounting
treatment as of July 1, 2009 for the Preferred Shares issued in the June and
July 2008 Private Placements.  The Certificate of Designations of the
Preferred Shares includes a down-round provision pursuant to which, if the
Company issues any additional shares of common stock at a per share price of
less than $2.5357, the conversion ratio will be adjusted downward to reflect
such lesser issued price for the first two years from the initial issuance date
of the Preferred Shares. The Company performed a complete assessment of the
preferred stock and concluded that the Preferred Shares issued in the June and
July 2008 Private Placements is within the scope of ASC 815-40-55-33 due to the
down-round provisions included in the terms of the agreements.  Pursuant to
ASC 815-40-55-33, the down-round provision precludes the embedded conversion
option of the Preferred Shares from being considered indexed to the entity’s own
stock. Accordingly, the Company adjusted its accounting effective from the
beginning of fiscal year 2010, i.e. July 1, 2009, on which date ASC 815 should
have been adopted, by bifurcating the embedded conversion option of the
Preferred Shares which should be recorded as a liability measured at fair value
with changes in fair value recognized in earnings for each reporting period and
recording a cumulative-effect adjustment to the opening balance of retained
earnings.





On
October 11, 2010 the Company issued to an advisor warrants to purchase 50,000
shares of Common Stock of the Company according to the advisor service agreement
dated April 13, 2010. The exercise price, expiration date and number of share
eligible to be purchased with the warrants are summarized in the following
table:





Number
      of shares
                  
                  Exercise
      price
                  
                  Contractual
      term50,000
                  
                  $
                  6.31
                  
                  5.0
      years





12.
            SHARE-BASED
      COMPENSATION





The
Company’s 2010 Incentive Stock Plan (the “Plan”) was adopted by our Board of
Directors and approved by our shareholders, permits the grant of incentive stock
options, non-statutory stock options; stock awards, restricted stock purchase
offer, to our officers, employees and non-employee directors. The 2010 Incentive
Stock Plan provides for the issuance of up to 2,211,250 shares of common stock
(subject to adjustment for stock split and similar events). Option awards are
generally vest in three to four equal installments and have 5 year contractual
terms. The Company’s general policy is to issue new shares of common stock to
satisfy stock option exercises or grants of unvested shares.





On March
31, 2010, the Company issued 1,651,125 shares of non-statutory stock options to
key employees and 310,000 shares to independent directors as compensation, these
options have a 5 year contractual term. The options issued to key employees vest
in three equal annual installments of 33.3%, with exercise price of $7.97 per
share.  Options issued to independent directors vest in three equal annual
installments of 33.3% or in four equal annual installments of 25%, with exercise
price of $3 per share. On June 22, 2010, the Company issued 150,000 shares of
non-statutory stock options to Mr. Wang Chen, CEO, and 100,125 shares of options
to Ms. Guo Wei, VP International Sales of Shengkai. These options have a 5 year
contractual term, vest in three equal annual installments of 33.3%, with
exercise price of $8.13 per share.


31


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





12.
            SHARE-BASED
      COMPENSATION (CONTINUED)





The
Company accounts for share-based payments in accordance with ASC 718.
Accordingly, the Company expenses the fair value of awards made under its
share-based plan. That cost is recognized in the consolidated financial
statements over the requisite service period of the grants. Total compensation
expense related to the stock options for the three months ended September 30,
2010 was $1,032,564 and was recorded as general and administrative
expense.  As of September 30, 2010, there was $8,350,822 of unrecognized
compensation costs related to nonvested share-based compensation arrangements
granted under the Plan.  That cost is expected to be recognized over a
weighted average period of 2.1 years.  There were 476,667 options have been
vested up to September 30, 2010, and no option was vested during the three
months then ended.





The fair
value of the stock option grant for the three months ended September 30, 2010
was estimated at the date of grant using the Black-Scholes option pricing model
with the following assumptions: volatility of 100%, the risk-free interest rate
of 1.6%, expected dividend yield of 0% and expected life of 3.5 to 4
years.





Expected
volatilities utilized in the model are based on the historic volatility of the
Company’s stock price as well as volatility of comparable companies.  The
risk free interest rate is derived from the U.S. Treasury yield with a remaining
term equal to the expected life of the option in effect at the time of the
grant.  Since the Company has limited option exercise history, it has
elected to estimate the expected life of an award based upon the SEC-approved
“simplified method” noted under the provisions of Staff Accounting Bulletin No.
107 with the continued use of this method extended under the provisions of Staff
Accounting Bulletin No. 110. With the vesting period forms the lower bound of
the estimate of expected term and the life of the option forming the upper
bound.





The above
assumptions were used to determine the weighted average grant date fair value of
stock options of $5.63 per share for the options granted on March 31, 2010 and
June 22, 2010.





A summary
of the Company’s stock option activity as of September 30, 2010, and changes
during the three months then ended is presented in the following
table:





Options
                      
                      
                      Weighted-Average
      Exercise
                        PriceOutstanding
      at July 1, 2010
                      
                      
                      2,211,250
                      
                      
                      $
                      7.29Granted
                      
                      
                      -
                      
                      
                      
                      -Exercised
                      
                      
                      -
                      
                      
                      
                      -Forfeited
      or Expired
                      
                      
                      -
                      
                      
                      
                      -Outstanding
      at September 30, 2010
                      
                      
                      2,211,250
                      
                      
                      $
                      7.29Vested
      at September 30, 2010
                      
                      
                      476,667
                      
                      
                      $
                      7.97


32


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





12.
            SHARE-BASED
      COMPENSATION (CONTINUED)





The
following table summarizes information about stock options outstanding at
September 30, 2010:





Options
      Outstanding
                                              
                                              
                                              Options
      ExercisableExercise
      Price
                                              
                                              
                                              NumberOutstanding
                                              
                                              
                                              Weighted
      Average
                                                Remaining
      Contractual Life
                                                (years)
                                              
                                              
                                              Weighted
      Average
                                                Exercise
      Price
                                              
                                              
                                              Number
                                                Exercisable
                                              
                                              
                                              Weighted
                                                Average
                                                Exercise
                                                Price$
                                              8.13
                                              
                                              
                                              
                                              250,125
                                              
                                              
                                              
                                              4.73
                                              
                                              
                                              $
                                              8.13
                                              
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -$
                                              3
                                              
                                              
                                              
                                              310,000
                                              
                                              
                                              
                                              4.5
                                              
                                              
                                              $
                                              3
                                              
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -$
                                              7.97
                                              
                                              
                                              
                                              1,651,125
                                              
                                              
                                              
                                              4.5
                                              
                                              
                                              $
                                              7.97
                                              
                                              
                                              
                                              476,667
                                              
                                              
                                              $
                                              7.972,211,250
                                              
                                              
                                              
                                              4.53
                                              
                                              
                                              $
                                              7.29
                                              
                                              
                                              
                                              476,667
                                              
                                              
                                              $
                                              7.97





A summary
of the status of the Company’s nonvested shares as of September 30, 2010, and
changes during the three months then ended, is presented below:





Nonvested
      Shares
                              
                              Shares
                              
                              
                              Weighted
      Average
                                Grant
      Date Fair
                                ValueNonvested
      at July 1, 2010
                              
                              
                              1,734,583
                              
                              
                              $
                              5.7Granted
                              
                              
                              -
                              
                              
                              
                              -Vested
                              
                              
                              -
                              
                              
                              
                              -Forfeited
                              
                              
                              -
                              
                              
                              
                              -Nonvested
      at September 30, 2010
                              
                              
                              1,734,583
                              
                              
                              $
                              5.7





13.
            INCOME
      TAXES





The
Company is registered in the State of Florida whereas its subsidiary, Shen Kun
being incorporated in the British Virgin Islands is not subject to any income
tax and conducts all of its business through its PRC subsidiary, SK, Shengkai
and Shengkai (Tianjin) Trading Ltd. (see note 1).





SK,
Shengkai and Shengkai (Tianjin) Trading Ltd., being registered in the PRC, are
subject to PRC’s Enterprise Income Tax. Pursuant to the PRC Income Tax Laws,
Enterprise Income Taxes (“EIT”) is generally imposed at 25% since January 1,
2008.





In April
2010, Shengkai was awarded the status of “high technology” enterprise for the
calendar years 2009 through 2011, of which Shengkai enjoys a preferential
enterprise income tax rate of 15%.  However, for the year ended June 30,
2009, we already used income tax rate of 25% to provide and pay for income
taxes.  For the period from July 1, 2009 to December 31, 2009, we used
income tax rate of 25% to provide and pay for income taxed. After January 1,
2010, we used the preferential income tax rate of 15% to provide and pay for
income tax expenses.  We did not record any tax refund receivable as of
September 30, 2010 as we are not sure whether the refund of the overpaid income
tax expenses during the calendar year 2009 would be approved by the local tax
bureau.


33


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





13.
            INCOME
      TAXES (CONTINUED)





On March
16, 2007, the National People’s Congress of China approved the new Corporate
Income Tax Law of the People’s Republic of China (the “New CIT Law”), which is
effective from January 1, 2008.  Prior to January 1, 2008, the CIT rate
applicable to our subsidiaries in the PRC is 33%.  After January 1, 2008,
under the New CIT Law, the corporate income tax rate applicable to our Chinese
subsidiaries is 25%.





In
accordance with the New CIT Law, enterprises established under the laws of
foreign countries or regions and whose “place of effective management” is
located within the PRC territory are considered PRC resident enterprises and
subject to the PRC income tax at the rate of 25% on worldwide income.  The
definition of “place of effective management" refers to an establishment that
exercises, in substance, overall management and control over the production and
business process, personnel, accounting and properties of an enterprise. 
As of September 30, 2010, no detailed interpretation or guidance has been issued
to define “place of effective management”.  Furthermore, as of September
30, 2010, the administrative practice associated with interpreting and applying
the concept of “place of effective management” is unclear.  If the
Company’s non-PRC incorporated entities are deemed PRC tax residents, such
entities would be subject to PRC tax under the New CIT Law.  The Company
has analyzed the applicability of this law, as of September 30, 2010, and the
Company has not accrued for PRC tax on such basis.  The Company will
continue to monitor changes in the interpretation or guidance of this law. 
Income taxes payable was $1,140,076 and $1,061,783 at September 30 and June 30,
2010, respectively.





The New
CIT Law also imposes a 10% withholding income tax, subject to reduction based on
tax treaty where applicable, for dividends distributed by a foreign invested
enterprise to its immediate holding company outside China.  Such dividends
were exempted from PRC tax under the previous income tax law and
regulations.  The foreign invested enterprise is subject to the withholding
tax starting from January 1, 2008.  There were no such dividends
distributed in the three months ended September 30, 2010 or 2009.





Income
tax expenses consist of the following:





Three
      Months Ended September 30,2010
                              
                              
                              2009Current
                              
                              $
                              1,126,251
                              
                              
                              $
                              1,280,003Deferred
                              
                              
                              -
                              
                              
                              
                              -Total
                              
                              $
                              1,126,251
                              
                              
                              $
                              1,280,003


34


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





13.
            INCOME
      TAXES (CONTINUED)





Reconciliation
from the expected income tax expenses calculated with reference to the statutory
tax rate in the PRC of 25% for three months ended September 30, 2010 and 2009 is
as follows:





Three Months Ended September
      30,2010
                            
                            
                            2009Income
      (loss) before income taxes
                            
                            $
                            28,071,336
                            
                            
                            $
                            (1,574,473
                            )Loss
      before income tax from non-Chinese headquarter and
      subsidiaries
                            
                            
                            1,141,736
                            
                            
                            
                            (70,608
                            )Income
      (loss) before income taxes from Chinese subsidiaries
                            
                            
                            29,213,072
                            
                            
                            
                            (1,503,865
                            )Income
      tax expenses (benefits) for Chinese subsidiaries computed at the PRC
      statutory rate of 25%
                            
                            
                            7,303,268
                            
                            
                            
                            (375,966
                            )Preferential
      tax rate effect of 10% on Shengkai for the period quarter ended September
      30, 2010 (Based on income before tax of $7,508,321)
                            
                            
                            (750,829
                            )
                            
                            
                            -Permanent
      difference - (gain) loss on change in fair value of the financial
      instruments
                            
                            
                            (5,426,188
                            )
                            
                            
                            1,725,731Permanent
      difference - others
                            
                            
                            -
                            
                            
                            
                            (69,762
                            )$
                            1,126,251
                            
                            
                            $
                            1,280,003


35


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





14.
            EARNINGS
      (LOSS) PER SHARE





The
calculation of the basic and diluted earnings (loss) per share attributable to
the common stockholders is based on the following data:





For
      the three months ended
                  September
      30,2010
                
                
                2009Earnings:Net
      income (loss) for the quarter
                
                $
                26,945,085
                
                
                $
                (2,854,476
                )Non-Cash
      Dividends on convertible preferred stock
                
                
                -
                
                
                
                -Earnings
      (loss) for the purpose of basic earnings (loss) per share
                
                $
                26,945,085
                
                
                $
                (2,854,476
                )Effect
      of dilutive potential common stock
                
                
                -
                
                
                
                -Earnings
      (loss) for the purpose of dilutive earnings (loss) per
    share
                
                $
                26,945,085
                
                
                $
                (2,854,476
                )Number
      of shares:Weighted
      average number of common stock for the purpose of basic earnings (loss)
      per share
                
                
                23,191,165
                
                
                
                22,362,500Effect
      of dilutive potential common stock-Conversion
      of Series A convertible preferred stock
                
                
                6,987,368
                
                
                
                --Exercise
      of A Warrants
                
                
                4,915,774
                
                
                
                --Exercise
      of options
                
                
                183,015
                
                
                
                -Weighted
      average number of common stock for the purpose of dilutive earnings (loss)
      per share
                
                
                35,277,322
                
                
                
                22,362,500Earnings
      (loss) per share:Basic
      earnings (loss) per share
                
                $
                1.162
                
                
                $
                (0.128
                )Dilutive
      earnings (loss) per share
                
                $
                0.764
                
                
                $
                (0.128
                )


36


SHENGKAI
INNOVATIONS, INC.


(F/K/A
SOUTHERN SAUCE COMPANY, INC.) AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)(Unaudited)





15.
            COMMITMENTS
      AND CONTINGENCY





The newly
completed manufacturing facility and a headquarters’ building are on a plot of
land in Tianjin, China which was obtained in October, 2008. Certain construction
contracts including the main superstructure were executed. The total amount of
executed contracts was $33,686,160 (RMB225,697,271), of which $28,899,563
(RMB193,627,075)  had been paid as of September 30, 2010. The balance
of $4,786,596 (RMB32,070,197) will be settled by the end of calendar year
2010.





Certain
equipment and machinery contracts were executed. The total amount of executed
contracts was $15,732,478 (RMB 105,407,600), of which $13,412,854 (RMB
89,866,120) had been paid as of September 30, 2010. The balance of $2,319,624
(RMB 15,541,480) will be settled by the end of calendar year 2010.





Certain
utility installation and related auxiliary engineering projects will cost a
total of $3,980,009 (RMB 26,666,062), of which $2,587,502 (RMB17,336,262) had
been paid as of September 30, 2010. The balance of $1,392,508 (RMB9,329,801)
will be settled by the end of calendar year 2010.





16.
            SEGMENT
      INFORMATION





The Group
is principally engaged in one segment of the manufacturing and selling of
ceramic valves in the PRC. Substantially all revenues are generated in the PRC
and nearly all identifiable assets of the Group are located in the PRC.
Accordingly, no segmental analysis is presented.





A
breakdown of the Company's revenues for the three months ended September 30,
2010 in terms of customers' industry classification is as follows:





For
      the Three
                        Months
      Ended September 30,Customer
      industry
                      
                      2010
                      
                      
                      2009Electric
      power
                      
                      $
                      11,220,835
                      
                      
                      $
                      7,787,628Petrochemical
      and chemical
                      
                      
                      5,273,444
                      
                      
                      
                      2,714,933Aluminum,
      metallurgy and others
                      
                      
                      680,237
                      
                      
                      
                      607,608Total
      Sales
                      
                      $
                      17,174,516
                      
                      
                      $
                      11,110,169





17.
            SUBSEQUENT
      EVENTS





On
September 30, 2010, the Board of the Company approved an amendment to the
Company’s Articles of Incorporation to increase the total number of authorized
shares of Common Stock of the Company from 50,000,000 to 100,000,000 shares (the
“Amendment”). The Amendment was ratified on September 30, 2010 by the holder of
a majority of the Company’s outstanding shares of Common Stock. The Amendment is
effective on November 2, 2010, the date on which it was filed with the State of
Florida.


37


Item
      2.
            Management’s
      Discussion and Analysis or Plan of
Operation





Cautionary
Notice Regarding Forward-Looking Statements





In this
quarterly report, references to “Shengkai Innovations,” “VALV,” “the Company,”
“we,” “us,” and “our” refer to Shengkai Innovations, Inc.





We make
certain forward-looking statements in this report. Statements concerning our
future operations, prospects, strategies, financial condition, future economic
performance (including growth and earnings), demand for our services, and other
statements of our plans, beliefs, or expectations, including the statements
contained under the captions “Management’s Discussion and Analysis of Financial
Condition and Results of Operations,” “Business,” as well as captions elsewhere
in this document, are forward-looking statements. In some cases these statements
are identifiable through the use of words such as “anticipate,” “believe,”
“estimate,” “expect,” “intend,” “plan,” “project,” “target,” “can”, “could,”
“may,” “should,” “will,” “would,” and similar expressions. We intend such
forward-looking statements to be covered by the safe harbor provisions contained
in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”)
and in Section 21E of the Securities Exchange Act of 1934, as amended (the
“Exchange Act”). The forward-looking statements we make are not guarantees of
future performance and are subject to various assumptions, risks, and other
factors that could cause actual results to differ materially from those
suggested by these forward-looking statements. Because such statements are
subject to risks and uncertainties, actual results may differ materially from
those expressed or implied by the forward-looking statements. Indeed, it is
likely that some of our assumptions will prove to be incorrect. Our actual
results and financial position will vary from those projected or implied in the
forward-looking statements and the variances may be material. You are cautioned
not to place undue reliance on such forward-looking statements. These risks and
uncertainties, together with the other risks described from time to time in
reports and documents that we file with the SEC should be considered in
evaluating forward-looking statements.





The
nature of our business makes predicting the future trends of our revenue,
expenses, and net income difficult. Thus, our ability to predict results or the
actual effect of our future plans or strategies is inherently uncertain. The
risks and uncertainties involved in our business could affect the matters
referred to in any forward-looking statements and it is possible that our actual
results may differ materially from the anticipated results indicated in these
forward-looking statements. Important factors that could cause actual results to
differ from those in the forward-looking statements include, without limitation,
the following:





·
            the
      effect of political, economic, and market conditions and geopolitical
      events;


·
            legislative
      and regulatory changes that affect our
business;


·
            the
      availability of funds and working
capital;


·
            the
      actions and initiatives of current and potential
    competitors;


·
            investor
      sentiment; and


·
            our
      reputation.





We do not
undertake any responsibility to publicly release any revisions to these
forward-looking statements to take into account events or circumstances that
occur after the date of this report. Additionally, we do not undertake any
responsibility to update you on the occurrence of any unanticipated events which
may cause actual results to differ from those expressed or implied by any
forward-looking statements.





The
following discussion and analysis should be read in conjunction with our
consolidated financial statements and the related notes thereto as filed with
the SEC and other financial information contained elsewhere in this
Report.


38


Overview





We were
incorporated in Florida on December 8, 2004 and have since undergone a change in
business. In October 2008, our shareholders approved our name change from
“Southern Sauce Company, Inc.” to “Shengkai Innovations, Inc.”





As
a result of the reverse merger, financing and related transactions described in
our current report on Form 8-K/A filed with the SEC on June 23, 2008, the
Company ceased to be a shell company and became a holding company for entities
that, through equity and contractual relationships, controls the business of
Shengkai (Tianjin) Limited (“SK”) and Tianjin Shengkai Industrial Technology
Development Co., Ltd. (“Shengkai”), both companies organized under the laws of
the PRC that design, manufacture and sell ceramic valves.





On June
25, 2010, Shengkai (Tianjin) Trading Ltd., was organized as a wholly
foreign-owned enterprise under the laws of the PRC by SK, with a total
registered capital of RMB500,000. Shengkai (Tianjin) Trading Ltd. is primarily
engaged in the international trading of non-valve products to better serve the
Company’s international customers.





Because
SK and Shengkai’s operations are the only significant operations of the Company
and its affiliates, this discussion and analysis focuses on the business results
of SK and Shengkai, comparing its results in the three months ended September
30, 2010 to the three months ended September 30, 2009.





Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





The
following discussion of the financial condition and results of operation of the
Company for the three months ended September 30, 2010 and 2009 should be read in
conjunction with the financial statements and the notes to those statements that
are included elsewhere in this Form 10-Q. Our discussion includes
forward-looking statements based upon current expectations that involve risks
and uncertainties, such as our plans, objectives, expectations and intentions.
Actual results and the timing of events could differ materially from those
anticipated in these forward-looking statements as a result of a number of
factors, including those set forth under the Risk Factors, Cautionary Notice
Regarding Forward-Looking Statements and Business sections in this registration
statement. We use terms such as “anticipate,” “estimate,” “plan,” “project,”
“continuing,” “ongoing,” “expect,” “believe,” “intend,” “may,” “will,” “should,”
“could,” and similar expressions to identify forward-looking
statements.





General





Shengkai,
the entity through which we run our operations, is a prominent ceramic valve
manufacturer. We have more than 16 years of experience and possess a unique
method for creating ceramic valves.





We
believe that Shengkai is one of the few ceramic valve manufacturers in the world
with research and development, engineering, and production capacity for
structural ceramics and is the only valve manufacturer in China that is able to
produce large-sized ceramic valves with calibers of 150mm or more. Shengkai’s
product categories include a broad range of valves in nearly all industries that
are sold throughout China, to Europe, North America, Middle East and other
countries in the Asia-Pacific region. Totaling over 400 customers, Shengkai
became a supplier of China Petroleum & Chemical Corporation (“CPCC” or
“Sinopec”) in 2005 and a member of the PetroChina Co. Ltd. (“PetroChina”) supply
network in 2006. Shengkai is currently the only domestic ceramic valve
manufacturer entering the CPCC and PetroChina supply system, after a six-year
application process.


39


Results
of Operations





Comparison of the
Three Months Ended September 30, 2010 and 2009





Revenue





Revenue
for the three months ended September 30, 2010 was $17,174,516, an increase of
$6,064,347 or 54.6% from $11,110,169 for the comparable period in fiscal 2010.
The product output has increased due to increased equipment and shifts of
operation at the old facility, commencement of the new facility in mid-September
2010, as well as improved ceramic production technology to shorten the
production cycle of some kinds of ceramic components, despite disruptions caused
by the relocation of our production facility during this quarter. The
construction of our new manufacturing plant was completed in June 2010 and
commercial production at this new plant began in mid-September 2010.  All
existing equipment and facilities were moved from the old plant into the new
plant as of mid-September 2010. Our headquarters building was also completed in
September 2010. The new facility is expected to increase total production
capacity to 24,000 sets of ceramic valves per year based on operations of one
shift.





Approximately
96.0% of our source of revenue came from customers in the electric power,
petrochemical and chemical industries for the past three months. The electric
power industry was still the significant market to our revenue, contributing
approximately 65.3% of total revenue for the three months ended September 30,
2010. Revenue from the electric power industry was approximately $11.2 million
for the three months ended September 30, 2010, an increase of approximately $3.4
million or 44.1% from approximately $7.8 million for the comparable period in
fiscal 2010. The increase was primarily attributable to the broadening of our
customer base and increased orders from existing customers. Approximately 27% of
revenue from the electric power industry for the three-month period was
generated from new customer accounts. Revenue from the petrochemical and
chemical industry, our biggest potential market, was approximately $5.3 million
for the three months ended September 30, 2010, an increase of approximately $2.6
million or 94.2% from approximately $2.7 million for the comparable period in
fiscal 2010. The increase was primarily due to our heightened efforts to develop
the market of the petrochemical and chemical industry. Approximately 35% of
revenue from the petrochemical and chemical industry for the three-month period
was generated from new customer accounts. Revenue from other industries,
including the aluminum and metallurgy industries, was approximately $0.7 million
for the three months ended September 30, 2010, an increase of approximately $0.1
million or 15.2% from approximately $0.6 million for the comparable period in
fiscal 2010.





Gross
Profit





Gross
profit for the three months ended September 30, 2010 was $9,954,088, an increase
of $3,164,010 or 46.6% compared to $6,790,078 for the comparable period in
fiscal 2010. The increase was primarily attributable to the revenue increase.
The gross margin for the three months ended September 30, 2010 was 58.0%,
compared to 61.1% for the comparable period in fiscal 2010. Included in total
sales for the first quarter of fiscal 2011 were approximately $1 million in
sales of ceramic valve components, which have a gross margin closer to the
industry norm in China and much lower than our high value-added valve products,
dragging down the average gross margin in the quarter. This arge quantity order
for valve  components was made together with an order for ceramic
valves  as a package deal from one particular export customer. 
Such a large quantity of valve component salesis not expected to recur on a
regular basis in future. The average gross margin for our valve products has
been maintained at a stable level.





Selling
Expenses





Selling
expenses for the three months ended September 30, 2010 was $1,602,572, an
increase of $600,960 or 60.0%, from $1,001,612 for the comparable period in
fiscal 2010. The major component of selling expenses was commission paid to
agents for introducing new sales, which was approximately $1.4 million for the
three months ended September 30, 2010, an increase of approximately $0.5 million
or 54.6% from approximately $0.9 million for the three months ended September
30, 2009. Selling expenses as a percentage of total sales revenue slightly
increased to 9.3% for the three months ended September 30, 2010 from 9.0% for
the comparable period in fiscal 2010.


40


General and Administrative
Expenses





General
and administrative expenses for the three months ended September 30, 2010 were
$2,061,646, an increase of 1,313,918 or 175.7% compared to $747,728 for the
comparable period in fiscal 2010. The increase was primarily attributable to the
recognition of $1,032,564 share-based compensation cost on the options to
independent directors and management issued on March 31, 2010 and June 22, 2010,
under the Company’s 2010 Incentive Stock Plan. The increase in G&A over the
comparable periods of fiscal 2010 and 2011was also attributable to the increase
in cash compensation to independent directors and management staff due to new
appointments and hirings; as well to expenses for U.S. capital market-related
activities, such as Nasdaq listing fees and costs for participation in
investment conferences. The amortization of intangible assets for the three
months ended September 30, 2010 was $231,906, an increase of $2,818 or 1.2%
compared to $229,088 for the comparable period in fiscal 2010.





Changes in fair value of
instruments





For the
three months ended September 30, 2010, the Company incurred non-cash gain for
aggregate amount of approximately $21.7 million related to its issuance of
Series A warrants and Series A convertible preferred stock in the Private
Placements in June and July, 2008 pursuant to provision of FASB ASC Topic
815,”Derivative and Hedging”(“ASC 815”). The accounting treatment of the
warrants resulted from the difference between the Company's functional currency
in Renminbi and the denominated currency of the strike price of the warrants in
U.S. Dollars; The accounting treatment of the preferred stock resulted from a
down-round provision providing anti-dilution protection to the preferred
stockholders. Both Series A warrants and the embedded conversion option of
Series A convertible preferred stock are recorded as liabilities measured at
fair value with changes in their fair value recognized in earnings for the three
months ended September 30, 2010. Fair value of the instruments was primarily a
function of the price of our Common Stock. A decrease in our stock price over
the three months resulted in a decrease in fair value of the instruments, which
are liabilities; hence a gain was recognized for the reporting
period.





Provision for Income
Taxes





Provision
for income taxes for the three months ended September 30, 2010 was $1,126,251, a
decrease of $153,752 or 12.0% from $1,280,003 for the comparable period in
fiscal 2010. Excluding the $1.03 million share-based compensation cost and the
$21.7 million gain from changes in fair value of instruments, adjusted income
before taxes was approximately $7.4 million for the three months ended September
30, 2010 compared with approximately $5.3 million for the comparable period in
fiscal 2010. The decrease in provision for income taxes was attributable to the
new preferential income tax rate in calendar 2010. In April 2010, Shengkai, the
Company’s operating entity in Tianjin, China, was newly awarded the status of
“high technology” enterprise for the calendar years 2009 through 2011. Hence
Shengkai enjoys a preferential enterprise income tax rate of 15% starting from
January 1, 2010 through December 31, 2011, and will receive a 10% refund for the
income taxes paid at the standard 25% tax rate for calendar year 2009. The
applicable income tax rate was 25% for the comparable quarter ended September
30, 2009.





Liquidity
and Capital Resources





Cash and Cash
Equivalents





Our cash
and cash equivalents as at the beginning of the three months ended September 30,
2010 was $20,995,182 and decreased to $19,621,870 by the end of the period, a
decrease of $1,373,312 or 6.5%.  The decrease was primarily attributable to
the progressive payments made for the recently completed new manufacturing
facility.





Net cash provided by
operating activities





Net cash
provided by operating activities was $4,078,312 for the three months ended
September 30, 2010, an increase of $1,117,576 or 37.7% from $2,960,736 for the
comparable period in fiscal 2010. The adjusted net income, after deducting the
non-cash gain from changes in fair value of instruments and adding back the
non-cash share-based compensation cost, was $6,272,898  for the three
months ended September 30, 2010, an increase of $2,224,451  or 54.9%
from $4,048,447 for the comparable period in fiscal 2010. The increase in net
cash inflow from operations was primarily attributable to the higher net income
and reduced inventories, in spite of larger working capital used between the two
comparable periods in fiscal 2011 and fiscal 2010, as reflected by increased
cash used in trade receivables and other receivables, accounts payable and other
payables, and advances from customers over the three months ended September 30,
2009 and 2010, respectively.


41


Net cash used in investing
activities





Net cash
used in investing activities was $5,772,613 for the three months ended September
30, 2010, compared to $915,965 for the three months ended September 30, 2009, an
increase of $4,856,648 or 530.2%.The change was primarily attributable to the
approximately $1.5 million payments for equipment purchase and approximately
$4.5 million of progressive payments for construction of the new manufacturing
facility during the three months ended September 30, 2010.





Net cash provided by/used in
financing activities





There was
no net cash provided by or used in financing activities for the three months
ended September 30, 2010 and 2009.





Capital
Expenditures





In
October 2008, we successfully won a bid on a land use right over a plot of land
approximately 43,566.3 square meters in size. The land is located in Tianjin,
China and the bid price was approximately $1.8 million (RMB12.6 million). The
formal contract was signed with the government on January 23, 2009, with the
Company due to pay the bid price in full by March 25, 2009. The land was
purchased with plans to construct corporate headquarters and to build a new
manufacturing facility to expand our production capacity. Expenditures committed
under related construction contracts totaled $33,686,160 (RMB225,697,271), of
which $28,899,563 (RMB193,627,075)  had been paid as of September 30,
2010. The balance of $4,786,596 (RMB32,070,197) will be settled by the end of
calendar year 2010. Certain equipment and machinery contracts have also been
executed, total amount of which was approximately $15,732,478 (RMB105,407,600),
of which $13,412,854 (RMB 89,866,120) had been paid as of September 30, 2010.
The balance of $2,319,624 (RMB15,541,480) will be settled by the end of calendar
year 2010. Expenditures committed under certain utility installation and related
auxiliary engineering projects totaled $3,980,009 (RMB 26,666,062), of which
$2,587,502 (RMB17,336,262) had been paid as of September 30, 2010. The balance
of $1,392,508 (RMB9,329,801) will be settled by the end of calendar year
2010.





Trends





We are
not aware of any trends, events or uncertainties that have or are reasonably
likely to have a material impact on our short-term or long-term
liquidity.





Inflation





We
believe that inflation has not had a material or significant impact on our
revenue or our results of operations.





Contractual
Obligations





We have
certain fixed contractual obligations and commitments that include future
estimated payments. Changes in our business needs, cancellation provisions,
changing interest rates, and other factors may result in actual payments
differing from the estimates. We cannot provide certainty regarding the timing
and amounts of payments. We have presented below a summary of the most
significant assumptions used in our determination of amounts presented in the
tables, in order to assist in the review of this information within the context
of our financial position, results of operations, and cash
flows.


42





The
following table summarizes our contractual obligations as of September 30, 2010,
and the effect these obligations are expected to have on our liquidity and cash
flows in future periods.





Totals
                                      
                                      
                                      Less Than
                                        1 Year
                                      
                                      
                                      1 to 3
                                        Years
                                      
                                      ThereafterCapital
      expenditures (1)
                                      
                                      $
                                      8,498,728
                                      
                                      
                                      $
                                      8,498,728
                                      
                                      
                                      $
                                      -





(1)
Capital expenditures are commitments for the construction of a new manufacturing
facility and for the purchase of new equipment and machinery. See Note 15 -
Commitments and Contingency in the notes to the financial statements, included
elsewhere in this report. The Company entered into certain construction
contracts for building a new manufacturing facility and a headquarters’
building. The total amount of executed contracts was $33,686,160
(RMB225,697,271), of which $28,899,563 (RMB193,627,075)  had been paid
as of September 30, 2010. The construction of both the manufacturing facility
and the headquarters’ building were substantially completed in September 2010.
The Company has also executed certain equipment and machinery contracts totaling
$15,732,478, of which $13,412,854 had been paid as of September 30, 2010.
Certain utility installation and related auxiliary engineering projects will
cost a total of $3,980,009 (RMB 26,666,062), of which $2,587,502 (RMB17,336,262)
had been paid as of September 30, 2010.





Credit
Facility





On
December 10, 2009, Shengkai and Industrial Bank Co., Ltd., Tianjin Branch
(“Industrial Bank”) entered into a line of credit loan agreement (“LOC
Agreement”) with a valid period of December 10, 2009 to October 22, 2010. The
maximum amount Shengkai may draw down on the line of credit is RMB 1,500,000 in
the form of a short-term cash flow loan at an interest rate of no lower than
110% of the base interest rate or in the form of a bank acceptance draft.
Industrial Bank may unilaterally change the maximum amount available under the
line of credit and the term of the line of credit.





The line
of credit loan is secured by properties owned by Shengkai and the personal
properties and income of Wang Chen and Guo Wei through a mortgage agreement and
two personal guarantees, described in more detail below.





In
conjunction with the LOC Agreement, Shengkai entered into a mortgage agreement
for a maximum of RMB 8,682,000 with the Industrial Bank to secure repayment of
the LOC Agreement on December 10, 2009. The collateral covered by the agreement
is certain real property owned by Shengkai, valued at RMB17,540,000 and located
at Wanggang Road, Shuanggang Economic Development Zone, Jinnan District,
Tianjin, PRC.  The mortgage agreement is valid from December 10, 2009 until
all the principal, interest, and other expenses under the LOC Agreement are paid
in full.





In
connection with the LOC Agreement, Wang Chen, our CEO and director, and Guo Wei,
our director, (each, a “Guarantor”) each made an irrevocable personal guarantee
of the LOC Agreement on November 5, 2009 and on November 9, 2009, respectively,
valid for two years from the date the loan becomes payable. Each Guarantor is
jointly and severally liable for the payment of the loan principal, interest,
damages and the expenses incurred relating to the collection of the payment and
guarantees the repayment of the loan by all his/her personal property and
income.





Off
Balance Sheet Arrangements





None.


43


Critical
accounting policies and estimates





The
financial statements are prepared in accordance with accounting principles
generally accepted in the United States, which require us 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 periods. Management makes these estimates using the best information
available at the time the estimates are made. However, actual results could
differ materially from those estimates (See Note 2 in the Notes to Financial
Statements).





Revenue
recognition





Revenue
represents the invoiced value of goods sold and is recognized upon the delivery
of goods to customers, net of value added tax (“VAT”). Revenue is recognized
when the following four criteria are met: persuasive evidence of an arrangement
exists, delivery has occurred, the selling price is fixed or determinable, and
collectability is reasonably assured.





Intangible
assets





Intangible
assets represent land use rights, patent rights and other assets (such as use of
software) in the PRC. Land use rights are carried at cost and amortized on a
straight-line basis over the period of rights of 50 years commencing from the
date of acquisition of equitable interest. Patent rights are carried at cost and
amortized on a straight-line basis over the period of rights of 10 years
commencing from the date of acquisition of equitable interest. Others are
software costs which are carried at cost and amortized on a straight-line basis
over the period of 6 years.





Foreign
currency translation





The
accompanying consolidated financial statements are presented in United States
dollars (“US$” or “$”), while the functional currency of the Company is Renminbi
(“RMB”), as determined based on the criteria of Financial Accounting Standards
Board (“FASB”) Accounting Standards Codification (“ASC”) ASC 830 “Foreign
Currency Matters”.  The consolidated financial statements are translated
into United States dollars from RMB at year-end exchange rates as to assets and
liabilities and average exchange rates as to revenues and expenses. 
Capital accounts are translated at their historical exchange rates when the
capital transactions occurred.  The resulting transaction adjustments are
recorded as a component of other comprehensive income with in shareholders’
equity.  Gains and losses from foreign currency transactions are included
in net income.





New
Financial Accounting Pronouncements





Effective
July 1, 2009, the Company adopted ASC 815-40 (formerly Emerging Issues Task
Force ("EITF") Issue No. 07-05, Determining Whether an Instrument (or Embedded
Feature) Is Indexed to an Entity's Own Stock ("EITF 07-05"). ASC 815-40
addresses the determination of whether an instrument (or an embedded feature) is
indexed to an equity's own stock, which is the first part of the scope exception
in paragraph 11(a) of FASB SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities ("SFAS 133"). If and instrument (or an embedded feature)
that has the characteristics of a derivative instrument under paragraph 6-9 of
SFAS 133 is indexed to an entity's own stock, it is still necessary to evaluate
whether it is classified in stockholders' equity (or would be classified in
stockholders' equity if it were a freestanding instrument). Other applicable
authoritative accounting literature, including Issues EITF 00-19, Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock, and EITF 05-2, The Meaning of "Conventional Debt
Instrument" in Issue No. 00-19, provides guidance for determining whether an
instrument (or an embedded feature) is classified in stockholders' equity (or
would be classified in stockholders' equity if it were a freestanding
instrument). ASC 815-40 does not address that second part of the scope exception
in paragraph 11(a) of SFAS 133. As a result of the adoption of ASC 815-40, the
Company adjusted its accounting effective from the beginning of fiscal year
2010, i.e. July 1, 2009, on which date ASC 815-40 was adopted, by bifurcating
the embedded conversion option of the Preferred Shares which should be recorded
as a liability measured at fair value, with changes in fair value recognized in
earnings for each reporting period, and recording a cumulative-effect adjustment
to the opening balance of retained earnings.


44


In August
2009, the FASB issued FASB ASU 2009-05, "Measuring Liabilities at Fair Value".
FASB ASU 2009-05 amends FASB ASC 820, "Fair Value Measurements". Specifically,
FASB ASU 2009-05 provides clarification that in circumstances in which a quoted
price in an active market for the identical liability is not available, a
reporting entity is required to measure fair value using one or more of the
following methods: 1) a valuation technique that uses a) the quoted price of the
identical liability when traded as an asset or b) quoted prices for similar
liabilities or similar liabilities when traded as assets and/or 2) a valuation
technique that is consistent with the principles of FASB ASC 820 of the
Accounting Standards Codification (e.g. an income approach or market approach).
FASB ASU 2009-05 also clarifies that when estimating the fair value of a
liability, a reporting entity is not required to adjust to include inputs
relating to the existence of transfer restrictions on that liability. The
adoption of such standard did not have a material impact on the Company's
consolidated financial statements.





In May
2009, the FASB issued SFAS No. 165, "Subsequent Event", ("FASB ASC 855-10")
which establishes general standards of accounting for and disclosure of events
that occur after the balance sheet date but before financial statements. The
statement is effective for interim and annual periods ended after June 15, 2009.
The standard was subsequently amended by FASB ASU 2010-09 which exempts an
entity that is an SEC filer from the requirement to disclose the date through
which subsequent events have been evaluated.





In
September 2009, the Emerging Issues Task Force reached final consensus on FASB
ASU 2009-13, "Revenue Arrangements with Multiple Deliverables". FASB ASU 2009-13
addresses how to determine whether an arrangement involving multiple
deliverables contains more than one unit of accounting, and how the arrangement
consideration should be allocated among the separate units of accounting. This
ASU will be effective prospectively for revenue arrangements entered into or
materially modified in fiscal years beginning on or after June 15, 2010. Early
adoption is permitted. The adoption of such standard does not have a material
impact on the Company's consolidated financial statements.





In
December 2009, the FASB issued FASB ASU 2009-17, Consolidation of Variable
Interest Entities ("FASB ASC 810"): improvements to Financial Reporting by
Enterprises involved with Variable Interest Entities. This ASU amends the FASB
Accounting Standards Codification for statement No.167. In June 2009, the FASB
issued SFAS No.167, Amendments to FASB Interpretation No. 46(R), which requires
an enterprise to perform an analysis and ongoing reassessments to determine
whether the enterprises variable interest or interests give it a controlling
financial interest in a variable interest entity und amends certain guidance for
determining whether an entity is a variable interest entity. It also requires
enhanced disclosures that will provide users of financial statements with more
transparent information about an enterprises involvement in a variable interest
entity. SFAS No.167 is effective as of the beginning of each reporting entity's
first annual reporting period that begins after November 15, 2009 and for all
interim reporting periods after that, with early application prohibited. The
adoption of such standard did not have a material impact on the Company's
consolidated financial statements.





In
January 2010, the FASB issued Accounting Standards Update 2010-05 (ASU 2010-05),
"Compensation - Stock Compensation (Topic 718)". This standard codifies EITF
Topic D-110 Escrowed Share Arrangements and the Presumption of Compensation and
is effective immediately. The provisions of ASU 2010-05 did not have a material
effect on the Company's consolidated financial statements and is effective
immediately.





In
January 2010, the FASB issued Update No. 2010-6, “Improving Disclosures About
Fair Value Measurements” (“ASU 2010-6”), which requires reporting entities to
make new disclosures about recurring or nonrecurring fair-value measurements
including significant transfers into and out of Level 1 and Level 2 fair-value
measurements and information on purchases, sales, issuances, and settlements on
a gross basis in the reconciliation of Level 3 fair-value measurements. ASU
2010-6 is effective for annual reporting periods beginning after December 15,
2009, except for Level 3 reconciliation disclosures, which are effective for
annual periods beginning after December 15, 2010. The adoption of this update is
not expected to have a material effect on the Company's consolidated financial
statements.


45


In
February 2010, the FASB issued Accounting Standards Update 2010-09 (ASU
2010-09), "Subsequent Events (Topic 855)." The amendments remove the
requirements for an SEC filer to disclose a date, in both issued and revised
financial statements, through which subsequent events have been reviewed.
Revised financial statements include financial statements revised as a result of
either correction of an error or retrospective application of U.S. GAAP. ASU
2010-09 is effective for interim or annual financial periods ending after June
15, 2010. The provisions of ASU 2010-09 did not have a material effect on the
Company's consolidated financial statements.





In
February 2010, the FASB issued Accounting Standards Update 2010-10 (ASU
2010-10), "Consolidation (Topic 810)." The amendments to the consolidation
requirements of Topic 810 resulting from the issuance of Statement 167 are
deferred for a reporting entity's interest in an entity (1) that has all the
attributes of an investment company or (2) for which it is industry practice to
apply measurement principles for financial reporting purposes that are
consistent with those followed by investment companies. An entity that qualifies
for the deferral will continue to be assessed under the overall guidance on the
consolidation of variable interest entities in Subtopic 810-10 (before the
Statement 167 amendments) or other applicable consolidation guidance, such as
the guidance for the consolidation of partnerships in Subtopic 810-20. The
deferral is primarily the result of differing consolidation conclusions reached
by the International Accounting Standards Board ("IASB") for certain investment
funds when compared with the conclusions reached under Statement 167. The
deferral is effective as of the beginning of a reporting entity's first annul
period that begins after November 15, 2009, and for interim periods within that
first annual reporting period, which coincides with the effective date of
Statement 167. Early application it not permitted. The provisions of ASU 2010-10
are effective for the Company beginning in 2010. The adoption of ASU 2010-10 did
not have a material impact on the Company's consolidated financial
statements.





In March
2010, the FASB issued Accounting Standards Update 2010-11 (ASU 2010-11),
"Derivative and Hedging (Topic 815)." All entities that enter into contracts
containing an embedded credit derivative feature related to the transfer of
credit risk that is not only in the form of subordination of one financial
instrument to another will be affected by the amendments in this Update because
the amendments clarify that the embedded credit derivative scope exception in
paragraph 815-15-15-8 through 15-9 does not apply to such contracts. ASU 2010-11
is effective at the beginning of the reporting entity's first fiscal quarter
beginning after June 15, 2010. The adoption of such standard does not have a
material impact on the Company's consolidated financial statements.





In April
2010, the FASB issued Accounting Standards Update 2010-13 (ASU 2010-13),
"Compensation - Stock Compensation (Topic 718)." This Update provides amendments
to Topic 718 to clarity that an employee share-based payment award with an
exercise price denominated in the currency of a market in which a substantial
portion of the entity's equity securities trades should not be considered to
contain a condition that is not a market, performance, or service condition.
Therefore, an entity would not classify such an award as a liability if it
otherwise qualifies as equity. The amendments in ASU 2010-13 are effective for
fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2010. The provisions of ASU 2010-13 are not expected to have
a material effect on the Company's consolidated financial
statements.





In July
2010, the FASB issued an accounting update to provide guidance to enhance
disclosures related to the credit quality of a company's financing receivables
portfolio and the associated allowance for credit losses. Pursuant to this
accounting update, a company is required to provide a greater level of
disaggregated information about its allowance for credit loss with the objective
of facilitating users' evaluation of the nature of credit risk inherent in the
company's portfolio of financing receivables, how that risk is analyzed and
assessed in arriving at the allowance for credit losses, and the changes and
reasons for those changes in the allowance for credit losses. The revised
disclosures as of the end of the reporting period are effective for the Company
beginning in the second quarter of fiscal 2011, and the revised discourses
related to activities during the reporting period are effective for the Company
beginning in the third quarter of fiscal 2011. The Company is currently
evaluating the impact of this accounting update on its financial
disclosures.


46


Item
3.   Quantitative and Qualitative Disclosures about Market
Risk.





N/A.





Item
4.   Controls and Procedures.





Our
management is responsible for establishing and maintaining a system of
disclosure controls and procedures (as defined in Rule 13a-15(e)) under the
Exchange Act) that is designed to ensure that information required to be
disclosed by the Company in the reports that we file or submit under the
Exchange Act is recorded, processed, summarized and reported, within the time
specified in the Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by an issuer in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the issuer's management, including its principal executive officer or
officers and principal financial officer or officers, or persons performing
similar functions, as appropriate to allow timely decisions regarding required
disclosure.





Pursuant
to Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation
with the participation of the Company’s management, including Wang Chen, the
Company’s Chief Executive Officer (“CEO”), and David Ming He, the Company’s
Chief Financial Officer (“CFO”), of the effectiveness of the Company’s
disclosure controls and procedures (as defined under Rule 13a-15(e) under the
Exchange Act) as of the three months ended September 30, 2010. Based upon that
evaluation, the Company’s CEO and CFO concluded that, as of the date of
evaluation, there was a material weakness and therefore the Company’s internal
control over financial reporting was not effective. The material weakness was
related to a lack of technical accounting expertise due to the lack of a
sufficient number of personnel with an appropriate level of knowledge of and
experience in generally accepted accounting principles in the United States of
America (U.S. GAAP) that are appropriate to the Company's financial reporting
requirements. As a result of such evaluation, the Company's CEO concluded that,
as of the date of evaluation, the Company’s disclosure controls and procedures
were not effective to ensure that information required to be disclosed by the
Company in the reports that the Company files or submits under the Exchange Act,
is recorded, processed, summarized and reported, within the time periods
specified in the SEC’s rules and forms, or that such information is accumulated
and communicated to the Company’s management, including the Company’s CEO and
CFO, as appropriate, to allow timely decisions regarding required
disclosure.





During
the course of internal evaluation, the Company determined that accounting errors
were made in connection with:





·
            Failure
      to recognize stock compensation expense for the three months ended
      December 31, 2009 and March 31, 2010, as a result of the return of
      escrowed shares from escrow accounts to the Company’s principal
      shareholder in December 2009 and March 2010, respectively, in accordance
      with Accounting Standards
Update-2010-05,





Based on
the impact of the aforementioned accounting errors, the Company restated its
consolidated financial statements as of December 31, 2009 and March 31,
2010.





Changes
in internal controls





Other
than as disclosed above, there were no changes in our internal controls over
financial reporting during the quarter ended September 30, 2010 that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting. Since the identification of the aforementioned
errors, the Company has set up an internal control department with qualified
accounting staff, including a qualified chief financial officer, which directly
reports to the Company’s independent Audit Committee. Management believes this
will help strengthen the general internal control process.


47


PART
II – OTHER INFORMATION





Item
1.  Legal Proceedings.





To our
knowledge, there is no material litigation pending or threatened against
us.





Item
1A.  Risk Factors.





N/A.





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





None.





Item
3.  Defaults Upon Senior Securities.





To our
knowledge, there are no material defaults upon senior securities.





Item
4.  (Removed and Reserved).





Item
5.  Other Information.





None.





Item 6.Exhibits.





(a)
Exhibits





3.1
            Articles
      of Amendment to Articles of Incorporation, dated November 2,
      2010.





31.1
            Certification
      Required Under Section 302 of Sarbanes-Oxley Act of
  2002.





31.2
            Certification
      Required Under Section 302 of Sarbanes-Oxley Act of
  2002.





32.1
            Certification
      Required Under Section 906 of Sarbanes-Oxley Act of
  2002.





32.2
            Certification
      Required Under Section 906 of Sarbanes-Oxley Act of
  2002.


48


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.





SHENGKAI
      INNOVATIONS, INC.Date:
      November 15, 2010
              By:
              /s/ Wang ChenName:
      Wang ChenTitle:
      Chief Executive Officer(principal
      executive officer)Date:
      November 15, 2010
              By:
              /s/ David Ming HeName:
      David Ming HeTitle:
      Chief Financial Officer(principal
      financial and accounting
officer)


49