UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





(Mark One)





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





For the quarterly period ended June 30, 2012





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





For the transition period from __________ to __________





COMMISSION FILE NUMBER: 001-34591





CLEANTECH SOLUTIONS INTERNATIONAL, INC.


(Name of Registrant as specified in its charter)




NEVADA

90-0648920(State or other jurisdiction of incorporation of organization)

(I.R.S. Employer

Identification No.)




No. 9 Yanyu Middle Road


Qianzhou Township, Huishan District, Wuxi City


Jiangsu Province, China 150090


(Address of principal executive office)





(86) 51083397559


(Registrant’s telephone number)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o





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





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





Large accelerated filer
o
Accelerated filer
oNon-accelerated filer

(Do not check if smaller reporting company)
o
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 o No x





Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.  2,667,017shares of common stock are issued and outstanding as of August 14, 2012.









CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES


FORM 10-Q


June 30, 2012





TABLE OF CONTENTS




Page No.PART I. - FINANCIAL INFORMATIONItem 1.
Financial StatementsConsolidated Balance Sheets as of June 30, 2012 (Unaudited) and December 31, 2011 (Audited)


3Consolidated Statements of Income and Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011 (unaudited)


4Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011 (unaudited)


5Notes to Unaudited Consolidated Financial Statements.


6Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
23Item 3
Quantitative and Qualitative Disclosures About Market Risk.


39Item 4
Controls and Procedures.


40PART II - OTHER INFORMATIONItem 2.
Unregistered Sales of Equity Securities and Use Of Proceeds.


41Item 6.
Exhibits.


41





FORWARD LOOKING STATEMENTS





This report contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this report. Additionally, statements concerning future matters are forward-looking statements.




Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed under the headings “Risks Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-Q and information contained in other reports that we file with the SEC. You are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report.




We file reports with the SEC. The SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, including us. You can also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You can obtain additional information about the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.




We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report, except as required by law. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this quarterly report, which are designed to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects.









PART 1 - FINANCIAL INFORMATION





Item 1. Financial Statements.





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSJune 30,


December 31,2012


2011(Unaudited)


(Audited)ASSETSCURRENT ASSETS:Cash and cash equivalents

$
1,307,312


$
1,152,607Restricted cash


284,824



314,233Notes receivable


47,471



53,420Accounts receivable, net of allowance for doubtful accounts


8,011,584



7,087,958Inventories, net of reserve for obsolete inventory


5,911,511



4,276,090Advances to suppliers


1,601,450



219,347Prepaid VAT on purchases


608,960



1,512,213Prepaid expenses and other


199,190



110,670Total Current Assets


17,972,302



14,726,538PROPERTY AND EQUIPMENT - net


64,668,749



64,042,079OTHER ASSETS:Land use rights, net


3,800,970



3,820,536Total Assets

$
86,442,021


$
82,589,153LIABILITIES AND STOCKHOLDERS' EQUITYCURRENT LIABILITIES:Short-term bank loans

$
2,690,001


$
2,356,749Bank acceptance notes payable


284,824



314,233Accounts payable


4,843,331



4,997,109Accrued expenses


948,011



771,597Capital lease obligations- current portion


248,046



244,747Advances from customers


2,394,167



1,166,942VAT and service taxes payable


54,736



-Income taxes payable


484,216



592,202Total Current Liabilities


11,947,332



10,443,579OTHER LIABILITIES:Capital lease obligations - net of current portion


254,800



381,235Total Liabilities


12,202,132



10,824,814STOCKHOLDERS' EQUITY:Preferred stock $0.001 par value (30,000,000 shares authorized, all of whichwere designated as series A convertible preferred, 0 and 10,995,807 sharesissued and outstanding at June 30, 2012 and December 31, 2011, respectively)


-



10,996Common stock ($0.001 par value; 50,000,000 shares authorized;2,667,017 and 2,101,849 shares issued and outstandingat June 30, 2012 and December 31, 2011, respectively)


2,667



2,102Additional paid-in capital


28,089,776



27,489,600Retained earnings


35,892,733



34,618,341Statutory reserve


2,164,324



2,064,551Accumulated other comprehensive gain - foreign currency translation adjustment


8,090,389



7,578,749Total Stockholders' Equity


74,239,889



71,764,339Total Liabilities and Stockholders' Equity

$
86,442,021


$
82,589,153
 
 See notes to unaudited consolidated financial statements
  3


CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME`

For the Three Months Ended


For the Six Months EndedJune 30,


June 30,2012


2011


2012


2011(Unaudited)


(Unaudited)


(Unaudited)


(Unaudited)REVENUES

$
12,832,863


$
12,608,181


$
22,242,092


$
30,174,561COST OF REVENUES


10,138,628



9,557,236



17,665,171



22,571,010GROSS PROFIT


2,694,235



3,050,945



4,576,921



7,603,551OPERATING EXPENSES:Depreciation


373,924



340,208



748,536



420,795Selling, general and administrative


751,544



1,028,695



1,417,667



1,860,496Total Operating Expenses


1,125,468



1,368,903



2,166,203



2,281,291INCOME FROM OPERATIONS


1,568,767



1,682,042



2,410,718



5,322,260OTHER INCOME (EXPENSE):Interest income


346



118



5,850



830Interest expense


(70,363
)


(32,826
)


(160,396
)


(62,528
)Foreign currency gain (loss)


1,115



(1,884
)


5,391



(3,341
)Warrants modification expense


-



-



(235,133
)


-Other income


6,635



68,463



13,280



77,113Total Other Income (Expense)


(62,267
)


33,871



(371,008
)


12,074INCOME BEFORE INCOME TAXES


1,506,500



1,715,913



2,039,710



5,334,334INCOME TAXES


435,130



545,954



665,545



1,499,215NET INCOME

$
1,071,370


$
1,169,959


$
1,374,165


$
3,835,119COMPREHENSIVE INCOME:NET INCOME

$
1,071,370


$
1,169,959


$
1,374,165


$
3,835,119OTHER COMPREHENSIVE INCOME:Unrealized foreign currency translation gain


59,938



1,084,955



511,640



1,490,783COMPREHENSIVE INCOME

$
1,131,308


$
2,254,914


$
1,885,805


$
5,325,902NET INCOME PER COMMON SHARE:Basic

$
0.42


$
0.61


$
0.58


$
2.01Diluted

$
0.40


$
0.47


$
0.53


$
1.51WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:Basic


2,572,753



1,919,660



2,370,138



1,906,203Diluted


2,660,983



2,509,757



2,592,864



2,537,761


See notes to unaudited consolidated financial statements


4


CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFor the Six Months EndedJune 30,2012


2011(Unaudited)


(Unaudited)CASH FLOWS FROM OPERATING ACTIVITIES:Net income

$
1,374,165


$
3,835,119Adjustments to reconcile net income from operations to net cashprovided by operating activities:Depreciation


3,092,511



2,503,759Amortization of land use rights


46,727



45,138(Decrease) increase in allowance for doubtful accounts


(46,631
)


166,640Warrants modification expense


235,133



-Stock-based compensation expense


101,590



214,807Changes in assets and liabilities:Restricted cash


-



(152,714
)Notes receivable


6,324



(139,095
)Accounts receivable


(825,725
)


1,439,402Inventories


(1,603,500
)


(705,682
)Prepaid value-added taxes on purchases


913,184



752,472Prepaid and other current assets


(32,988
)


(91,109
)Advances to suppliers


(1,379,275
)


(1,610,347
)Bank acceptance notes payable


-



152,714Accounts payable


(188,919
)


(2,838,972
)Accrued expenses


171,338



438,205VAT and service taxes payable


54,685



(82,407
)Income taxes payable


(112,101
)


(605,803
)Advances from customers


1,217,798



1,139,208NET CASH PROVIDED BY OPERATING ACTIVITIES


3,024,316



4,461,335CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property and equipment


(3,263,008
)


(4,796,171
)NET CASH USED IN INVESTING ACTIVITIES


(3,263,008
)


(4,796,171
)CASH FLOWS FROM FINANCING ACTIVITIES:Principal payments on capital lease


(127,477
)


-Proceeds from bank loans


2,213,264



1,832,570Repayment of bank loans


(1,897,083
)


(1,374,428
)Decrease in restricted cash


31,618



-Decrease in bank acceptance notes payable


(31,618
)


-Proceeds from sale of common stock


-



125,000Proceeds from exercise of warrants


198,142



400,000NET CASH PROVIDED BY FINANCING ACTIVITIES


386,846



983,142EFFECT OF EXCHANGE RATE ON CASH AND CASH EQUIVALENTS


6,551



29,087NET INCREASE IN CASH AND CASH EQUIVALENTS


154,705



677,393CASH AND CASH EQUIVALENTS - beginning of period


1,152,607



947,177CASH AND CASH EQUIVALENTS - end of period

$
1,307,312


$
1,624,570SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid for:Interest

$
160,396


$
62,528Income taxes

$
777,646


$
2,105,018NON-CASH INVESTING AND FINANCING ACTIVITIES:Series A preferred converted to common shares

$
13,198


$
936Common stock issued for future service

$
54,880


$
113,317
 See notes to unaudited consolidated financial statements.




5




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012




NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Organization





Cleantech Solutions International, Inc. (the “Company”) was incorporated in Delaware on June 24, 1987 under the name of Malex, Inc.  On December 18, 2007, the Company’s corporate name was changed to China Wind Systems, Inc., and on June 13, 2011, the Company’s corporate name was changed to Cleantech Solutions International, Inc.   On August 7, 2012, the Company was converted into a Nevada corporation. (See Note 15)  Through its affiliated companies and subsidiaries, the Company manufactures and sells forged products and fabricated products to a range of clean technology customers including high precision forged rolled rings and related products for the wind power industry and other industries and equipment to the solar industry.  The Company also makes textile dyeing and finishing machines. The Company is the sole owner of Fulland Limited (“Fulland”), a Cayman Island limited liability company, which was organized on May 9, 2007.  Fulland owns 100% of the capital stock of Green Power Environment Technology (Shanghai) Co., Ltd. (“Green Power”) and Wuxi Fulland Wind Energy Equipment Co., Ltd. (“Fulland Wind Energy”), which are wholly foreign-owned enterprises (“WFOE”) organized under the laws of the People’s Republic of China (“PRC” or “China”).  Green Power is a party to a series of contractual arrangements, as fully described below, dated October 12, 2007 with Wuxi Huayang Electrical Power Equipment Co., Ltd. (“Electrical”) and Wuxi Huayang Dyeing Machinery Co., Ltd. (“Dyeing”), both of which are limited liability companies organized under the laws of, and based in, the PRC.   Electrical and Dyeing are sometimes collectively referred to as the “Huayang Companies.”





Fulland was organized by the owners of the Huayang Companies as a special purpose vehicle for purposes of raising capital, in accordance with requirements of the PRC State Administration of Foreign Exchange (“SAFE”). On May 31, 2007, SAFE issued an official notice known as Hui Zong Fa [2007] No. 106 (“Circular 106”), which requires the owners of any Chinese company to obtain SAFE’s approval before establishing any offshore holding company structure for foreign financing as well as subsequent acquisition matters in China. Accordingly, the owners of the Huayang Companies, Mr. Jianhua Wu and Ms. Lihua Tang, submitted their application to SAFE in early September 2007. On October 11, 2007, SAFE approved their application, permitting these Chinese citizens to establish Fulland as a special purpose vehicle for any foreign ownership and capital raising activities by the Huayang Companies.





Electrical was formed on May 21, 2004, and Fulland Wind Energy was formed on August 27, 2008.  Beginning in April 2007, Electrical began to produce large-scaled forged rolled rings that are up to three meters in diameter for the wind-power and other industries.  In 2009, the Company began to produce and sell forged products through Fulland Wind Energy. Through Fulland Wind Energy, the Company manufactures and machines all forged products, including wind products such as shafts, rolled rings, gear rims, gearboxes, bearings and other components and finished products and assemblies for the wind power industry, and solar products, including large-scale equipment used in the manufacturing process for the solar industry. The Company refers to this segment of its business as the forged rolled rings and related components division.





Dyeing, which was formed on August 17, 1995, produces and sells a variety of high and low temperature dyeing and finishing machinery for the textile industry. The Company refers to this segment as the dyeing division.





Basis of presentation; management’s responsibility for preparation of financial statements





Management acknowledges its responsibility for the preparation of the accompanying interim consolidated financial statements which reflect all adjustments, consisting of normal recurring adjustments, considered necessary in its opinion for a fair statement of its consolidated financial position and the results of its operations for the interim period presented.





These consolidated financial statements should be read in conjunction with the summary of significant accounting policies and notes to consolidated financial statements included in the Company’s Form 10-K annual report for the year ended December 31, 2011.





6





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Basis of presentation; management’s responsibility for preparation of financial statements (continued)





The accompanying unaudited consolidated financial statements for Cleantech Solutions International, Inc., its subsidiaries and variable interest entities, have been prepared in accordance with accounting principles generally accepted in the United States of America (the “U.S.”) for interim financial information and with the instructions to Form 10-Q and Article 8-03 of Regulation S-X. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole.





The Company’s consolidated financial statements include the financial statements of its wholly-owned subsidiaries, Fulland, Green Power and Fulland Wind Energy, as well as the financial statements of Huayang Companies, Dyeing and Electric.  All significant intercompany accounts and transactions have been eliminated in consolidation.





Pursuant to Accounting Standards Codification (“ASC”) Topic 810, the Huayang Companies are considered variable interest entities (“VIE”), and the Company is the primary beneficiary.  The Company’s relationships with the Huayang Companies and their shareholders are governed by a series of contractual arrangements between Green Power, the Company’s wholly foreign-owned enterprise in the PRC, and each of the Huayang Companies, which are the operating companies of the Company in the PRC. Under PRC laws, each of Green Power, Dyeing and Electrical is an independent legal entity and none of them is exposed to liabilities incurred by the other parties. The contractual arrangements constitute valid and binding obligations of the parties of such agreements. Each of the contractual arrangements and the rights and obligations of the parties thereto are enforceable and valid in accordance with the laws of the PRC. On October 12, 2007, the Company entered into the following contractual arrangements with each of Dyeing and Electrical:





Consulting Services Agreement. Pursuant to the exclusive consulting services agreements between Green Power and the Huayang Companies, Green Power has the exclusive right to provide to the Huayang Companies general business operation services, including advice and strategic planning, as well as consulting services related to the technological research and development of dyeing and finishing machines, electrical equipment and related products (the “Services”). Under this agreement, Green Power owns the intellectual property rights developed or discovered through research and development, in the course of providing the Services, or derived from the provision of the Services. The Huayang Companies shall pay a quarterly consulting service fees in Renminbi (“RMB”) to Fulland that is equal to all of the Huayang Companies’ profits for such quarter.





Operating Agreement. Pursuant to the operating agreement among Green Power, the Huayang Companies and all shareholders of the Huayang Companies, Green Power provides guidance and instructions on the Huayang Companies’ daily operations, financial management and employment issues. The Huayang Companies shareholders must designate the candidates recommended by Green Power as their representatives on the boards of directors of each of the Huayang Companies. Green Power has the right to appoint senior executives of the Huayang Companies. In addition, Green Power agrees to guarantee the Huayang Companies’ performance under any agreements or arrangements relating to the Huayang Companies’ business arrangements with any third party. The Huayang Companies, in return, agree to pledge their accounts receivable and all of their assets to Green Power. Moreover, each of the Huayang Companies agrees that, without the prior consent of Green Power, it will not engage in any transactions that could materially affect its assets, liabilities, rights or operations, including, without limitation, incurrence or assumption of any indebtedness, sale or purchase of any assets or rights, incurrence of any encumbrance on any of their assets or intellectual property rights in favor of a third party or transfer of any agreements relating to their business operation to any third party. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended only upon Green Power’s written confirmation prior to the expiration of the this agreement, with the extended term to be mutually agreed upon by the parties.





7





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Basis of presentation; management’s responsibility for preparation of financial statements (continued)





Equity Pledge Agreement.Under the equity pledge agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders pledged all of their equity interests in the Huayang Companies to Green Power to guarantee the Huayang Companies’ performance of their respective obligations under the consulting services agreement. If the Huayang Companies or the Huayang Companies’ shareholders breach their respective contractual obligations, Green Power, as pledgee, will be entitled to certain rights, including the right to sell the pledged equity interests. The Huayang Companies’ shareholders also agreed that, upon occurrence of any event of default, Green Power shall be granted an exclusive, irrevocable power of attorney to take actions in the place and stead of the Huayang Companies’ shareholders to carry out the security provisions of the equity pledge agreement and take any action and execute any instrument that Green Power may deem necessary or advisable to accomplish the purposes of the equity pledge agreement. The Huayang Companies’ shareholders agreed not to dispose of the pledged equity interests or take any actions that would prejudice Green Power’s interest. The equity pledge agreement will expire two years after the Huayang Companies’ obligations under the consulting services agreements have been fulfilled.





Option Agreement.Under the option agreement between the Huayang Companies’ shareholders and Green Power, the Huayang Companies’ shareholders irrevocably granted Green Power or its designated person an exclusive option to purchase, to the extent permitted under PRC law, all or part of the equity interests in the Huayang Companies for the cost of the initial contributions to the registered capital or the minimum amount of consideration permitted by applicable PRC law. Green Power or its designated person has sole discretion to decide when to exercise the option, whether in part or in full. The term of this agreement, as amended on November 1, 2008, is 20 years from October 12, 2007 and may be extended prior to its expiration by written agreement of the parties.





Pursuant to ASC Topic 810 and related subtopics related to the consolidation of variable interest entities, the accounts of the Huayang Companies are consolidated in the accompanying financial statements.  As VIEs, the Huayang Companies’ sales are included in the Company’s total sales, its income from operations is consolidated with the Company’s, and the Company’s net income includes all of the Huayang Companies net income. The Company does not have any non-controlling interest and, accordingly, did not subtract any net income in calculating the net income of the VIEs that is attributable to the Company. Because of the contractual arrangements, the Company has a pecuniary interest in the Huayang Companies that requires consolidation of the Company’s and the Huayang Companies’ financial statements.





Use of estimates





The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses, and the related disclosures at the date of the financial statements and during the reporting period. Actual results could materially differ from these estimates. Significant estimates in the six months ended June 30, 2012 and 2011 include the allowance for doubtful accounts, the allowance for obsolete inventory, the useful life of property and equipment and intangible assets, assumptions used in assessing impairment of long-term assets and valuation of deferred tax assets, accruals for taxes due, and the value of stock-based compensation.





Cash and cash equivalents





For purposes of the consolidated statements of cash flows, the Company considers all highly liquid instruments purchased with a maturity of three months or less and money market accounts to be cash equivalents. The Company maintains cash and cash equivalents with various financial institutions mainly in the PRC and the U.S.  Balances in banks in the PRC are uninsured.





8





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012




NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Fair value of financial instruments





The Company adopted the guidance of ASC Topic 820 for fair value measurements which clarifies the definition of fair value, prescribes methods for measuring fair value, and establishes a fair value hierarchy to classify the inputs used in measuring fair value as follows:





Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.





Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data.





Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.





The carrying amounts reported in the balance sheets for cash and cash equivalents, restricted cash, notes receivable, accounts receivable, inventories, advances to suppliers, prepaid VAT on purchases, prepaid expenses and other, short-term bank loans, bank acceptance notes payable, accounts payable, accrued expenses, capital lease obligations, advances from customers, VAT and service taxes payable and income taxes payable approximate their fair market value based on the short-term maturity of these instruments. The Company did not identify any assets or liabilities that are required to be presented on the consolidated balance sheets at fair value in accordance with the accounting guidance.





ASC Topic 825-10 “Financial Instruments” allows entities to voluntarily choose to measure certain financial assets and liabilities at fair value (fair value option). The fair value option may be elected on an instrument-by-instrument basis and is irrevocable, unless a new election date occurs. If the fair value option is elected for an instrument, unrealized gains and losses for that instrument should be reported in earnings at each subsequent reporting date. The Company did not elect to apply the fair value option to any outstanding instruments.





Concentrations of credit risk





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





Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and trade accounts receivable. Substantially all of the Company’s cash is maintained with state-owned banks within the PRC, and none of these deposits are covered by insurance. The Company has not experienced any losses in such accounts and believes it is not exposed to any risks on its cash in bank accounts. A significant portion of the Company’s sales are credit sales which are primarily to customers whose ability to pay is dependent upon the industry economics prevailing in these areas; however, concentrations of credit risk with respect to trade accounts receivables is limited due to generally short payment terms.  The Company also performs ongoing credit evaluations of its customers to help further reduce credit risk.





9




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Concentrations of credit risk (continued)





At June 30, 2012 and December 31, 2011, the Company’s cash balances by geographic area were as follows:




June 30, 2012


December 31, 2011Country:United States

$
75,187



5.8
%

$
288,090



25.0
%China


1,232,125



94.2
%


864,517



75.0
%Total cash and cash equivalents

$
1,307,312



100.0
%

$
1,152,607



100.0
%





Restricted cash





Restricted cash consists of cash deposits held by a bank to secure bank acceptance notes payable.





Notes receivable





Notes receivablerepresents trade accounts receivable due from various customers where the customers’ bank has guaranteed the payment of the receivable. This amount is non-interest bearing and is normally paid within six months. Historically, the Company has experienced no losses on notes receivable. The Company’s notes receivable totaled $47,471 and $53,420 at June 30, 2012and December 31, 2011, respectively.





Accounts receivable





Accounts receivable are presented net of an allowance for doubtful accounts. The Company maintains allowances for doubtful accounts for estimated losses. The Company reviews the accounts receivable on a periodic basis and makes general and specific allowances when there is doubt as to the collectability of individual balances. In evaluating the collectability of individual receivable balances, the Company considers many factors, including the age of the balance, a customer’s historical payment history, its current credit-worthiness and current economic trends. Accounts are written off after exhaustive efforts at collection. At June 30, 2012 and December 31, 2011, the Company has established, based on a review of its outstanding balances, an allowance for doubtful accounts inthe amounts of $2,590,581 and $2,618,608, respectively.





Inventories





Inventories, consisting of raw materials, work in process and finished goods related to the Company’s products are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, the Company will record reserves for the difference between the cost and the market value.These reserves are recorded based on estimates. The Company recorded an inventory reserve of $173,785 and $172,557 at June 30, 2012 and December 31, 2011, respectively.





Advances to suppliers





Advances to suppliers represent the cash paid in advancefor the purchase of raw material from suppliers. The advance payments are intended toensure preferential pricing and delivery. The amounts advanced under such arrangements totaled $1,601,450 and $219,347 as of June 30, 2012 and December 31, 2011, respectively.





10





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Property and equipment





Property and equipment are carried at cost and are depreciated on a straight-line basis over the estimated useful lives of the assets. The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized.  When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition. The Company examines the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable.





Included in property and equipment is construction-in-progress which consisted of factory improvements and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation of the assets. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use. Property purchased from a related party is recorded at the cost to the related party and any payment to or on behalf of the related party in excess of the cost is reflected as a distribution to a related party.





Impairment of long-lived assets





In accordance with ASC Topic 360, the Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable, or at least annually. The Company recognizes an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value. The Companydid not record anyimpairment charges for the six months ended June 30, 2012 and 2011.





Advances from customers





Advances from customers at June 30, 2012 and December 31,2011 amounted to $2,394,167 and $1,166,942, respectively, and consist of prepayments from customers for merchandise that hadnot yet been shipped. The Company will recognize the deposits as revenue as customers take delivery of the goods in accordance with its revenue recognition policy.





Revenue recognition





Pursuant to the guidance of ASC Topic 605 and ASC Topic 360, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. The Company accounts for the product sale as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. The Company recognizes revenues from the sale of dyeing and finishing equipment, forged rolled rings and other components upon shipment and transfer of title. The other elements may include installation and, generally, a one-year warranty. Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally within a couple days of the delivery of the equipment. Grant income is recognized when funds have been received and all significant terms of the grant have been fulfilled by the Company. Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period.  For the six months ended June 30, 2012 and 2011, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal. All other product sales with customer specific acceptance provisions, including the forged rolled rings, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.




11




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Income taxes





The Company is governed by the Income Tax Law of the PRC and the U.S. Internal Revenue Code of 1986, as amended.  The Company accounts for income taxes using the liability method prescribed by ASC Topic 740, “Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized. The effect on deferred taxes of a change in tax rates is recognized as income or loss in the period that includes the enactment date.





The Company applied the provisions of ASC 740-10-50, “Accounting for Uncertainty in Income Taxes,” which provides clarification related to the process associated with accounting for uncertain tax positions recognized in our financial statements. Audit periods remain open for review until the statute of limitations has passed. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to the Company’s liability for income taxes. Any such adjustment could be material to the Company’s results of operations for any given quarterly or annual period based, in part, upon the results of operations for the given period. As of June 30, 2012 and December 31, 2011, theCompany had no uncertaintax positions, and will continue to evaluate for uncertain positions in the future.





Stock-based compensation





Stock-based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC Topic 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award (presumptively, the vesting period). The Financial Accounting Standards Board (“FASB”) ASC also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.





Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the vesting period of the award. Until the measurement date is reached, the total amount of compensation expense remains uncertain. The Company records compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated, based on the then current fair value, at each subsequent reporting date.





Shipping costs





Shipping costs are included in sellingexpenses and totaled $492,676 and $670,718 for the six months ended June 30, 2012 and 2011, respectively. Shipping costs totaled $275,829 and $312,096 for the three months ended June 30, 2012 and 2011, respectively.





Employee benefits





The Company’s operations and employees are all located in the PRC.  The Company makes mandatory contributions to the PRC government’s health, retirement benefit and unemployment funds in accordance with the relevant Chinese social security laws, equal to approximately 25% of salaries. The costs of these payments are charged to income in the same period as the related salary costs and are not material.





12





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Advertising





Advertising is expensed as incurred and is included in selling, general and administrative expenses on the accompanying consolidated statements of income and comprehensive income and was not material.





Research and development





Research and development costs are expensed as incurred. For the six months ended June 30, 2012 and 2011, research and development costs were not material.





Foreign currency translation





The reporting currency of the Company is the U.S. dollar. The functional currency of the parent company is the U.S. dollar and the functional currency of the Company’s operating subsidiaries is the Chinese Renminbi (“RMB”). For the subsidiaries and affiliates whose functional currencies are the RMB, results of operations and cash flows are translated at average exchange rates during the period, assets and liabilities are translated at the unified exchange rate at the end of the period, and equity is translated at historical exchange rates. As a result, amounts relating to assets and liabilities reported on the statements of cash flows may not necessarily agree with the changes in the corresponding balances on the balance sheets.  Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income. The cumulative translation adjustment and effect of exchange rate changes on cash for the six months ended June 30, 2012 and2011 was $6,551 and $29,087, respectively. Transactions denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing on the transaction dates. Assets and liabilities denominated in foreign currencies are translated into the functional currency at the exchange rates prevailing at the balance sheet date with any transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.





All of the Company’s revenue transactions are transacted in the functional currency of the operating subsidiaries and affiliates. Other than for the purchase of equipment from non-Chinese suppliers, the Company does not enter into any material transaction in foreign currencies. Transaction gains or losses have not had, and are not expected to have, a material effect on the results of operations of the Company.





Asset and liability accounts at June 30, 2012 and December 31, 2011 weretranslated at 6.3197 RMB to $1.00 and at 6.3647 RMB to $1.00, respectively, which were the exchange rates on the balance sheet dates. Equity accounts were stated at their historical rate. The average translation rates applied to the statements of income for the six months ended June 30, 2012 and 2011 were 6.3255 RMB and 6.54818 RMB to $1.00, respectively.  Cash flows fromthe Company’s operations are calculated based upon the local currencies using the average translation rate. As a result, amounts related to assets and liabilities reported on the statement of cash flows will not necessarily agree with changes in the corresponding balances on the consolidated balance sheets.





Reverse stock split





The Company effected a one-for-ten reverse stock split on March 6, 2012.  All share and per share information has been retroactively adjusted to reflect this reverse stock split.





13





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)





Income per share of common stock





ASC Topic 260 “Earnings per Share,” requires presentation of both basic and diluted earnings per share (“EPS”) with a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes dilution. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.





Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of shares of common stock, common stock equivalents and potentially dilutive securities outstanding during each period. Potentially dilutive common stock consist of common stock issuable upon the conversion of series A convertible preferred stock (using the if-converted method) and common stock purchase warrants (using the treasury stock method).





The following table presents a reconciliation of basic and diluted net income per share:





Three Months Ended June 30,


Six Months Ended June 30,2012


2011


2012


2011Net income available to common stockholders for basic and diluted net income per share of common stock

$
1,071,370


$
1,169,959


$
1,374,165


$
3,835,119Weighted average common stock outstanding - basic


2,572,753



1,919,660



2,370,138



1,906,203Effect of dilutive securities:Series A convertible preferred stock


58,974



532,403



207,431



531,410Warrants


29,256



57,694



15,295



100,148Weighted average common stock outstanding - diluted


2,660,983



2,509,757



2,592,864



2,537,761Net income per common share - basic

$
0.42


$
0.61


$
0.58


$
2.01Net income per common share - diluted

$
0.40


$
0.47


$
0.53


$
1.51





The Company’s aggregate common stock equivalents at June 30, 2012 and December 31, 2011 include the following:





June 30,

2012


December 31,

2011Warrants


-



220,158Series A convertible preferred stock


-



366,527Total


-



586,685


14
 
 CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 1 – ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)


Deemed preferred stock dividend


When we issue shares of convertible preferred stock at a price that is, on an “as if converted” basis, less than the market price of the underlying shares of common stock, the difference between the value of the underlying shares of common stock and the purchase price of the convertible preferred stock is treated as a deemed preferred stock dividend.  In connection with the issuance of shares of preferred stock upon exercise of warrants, as a result of board approval of the issuance of series A preferred stock instead of common stock, the Company does not record a deemed preferred stock dividend since the Company issues the equivalent number of preferred shares which are convertible into the number of common shares that would have been issued upon exercise.





Accumulated other comprehensive income





Comprehensive income is comprised of net income and all changes to the statements of stockholders’ equity, except those due to investments by stockholders, changes in paid-in capital and distributions to stockholders. For the Company, comprehensive income for the six months ended June 30, 2012 and 2011 included net income and unrealized gains from foreign currency translation adjustments.





Related parties





Parties are considered to be related to the Company if the parties, directly or indirectly, through one or more intermediaries, control, are controlled by, or are under common control with the Company. Related parties also include principal owners of the Company, its management, members of the immediate families of principal owners of the Company and its management and other parties with which the Company may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. The Company discloses all related party transactions. All transactions shall be recorded at fair value of the goods or services exchanged. Property purchased from a related party is recorded at the cost to the related party and any payment to or on behalf of the related party in excess of the cost is reflected as a distribution to related party.





Recent accounting pronouncement





Accounting standards that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on the consolidated financial statements upon adoption.





NOTE 2 – ACCOUNTS RECEIVABLE





At June 30 2012 and December 31, 2011, accounts receivable consisted of the following:





June 30,

2012


December 31,

2011Accounts receivable

$
10,602,165


$
9,706,566Less: allowance for doubtful accounts


(2,590,581
)


(2,618,608
)$
8,011,584


$
7,087,958





15





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 3 - INVENTORIES





At June 30, 2012 and December 31, 2011, inventories consisted of the following:





June 30,

2012


December 31,

2011Raw materials

$
1,450,875


$
1,514,928Work in process


2,276,087



1,441,231Finished goods


2,358,334



1,492,4886,085,296



4,448,647Less: reserve for obsolete inventory


(173,785
)


(172,557
)$
5,911,511


$
4,276,090





NOTE 4 - PROPERTY AND EQUIPMENT





At June 30, 2012 and December 31, 2011, property and equipment consisted of the following:




Useful Life


June 30,

2012


December 31,

2011Office equipment and furniture

5 Years


$
217,350


$
215,145Manufacturing equipment

5 – 10 Years



61,354,490



57,347,726Vehicles

5 Years



125,095



124,211Construction in progress


-



-



330,730Building and building improvements

20 Years



20,770,774



20,623,91982,467,709



78,641,731Less: accumulated depreciation






(17,798,960
)


(14,599,652
)$
64,668,749


$
64,042,079




For the six months ended June 30, 2012and 2011, depreciation expense amounted to $3,092,511 and $2,503,759, respectively, of which $2,343,975 and $2,082,964, respectively, is included in inventory and cost of revenues and the remainder is included in general and administrative expenses. For the three months ended June 30, 2012 and 2011, depreciation expense amounted to $1,545,166 and $1,326,757, respectively, of which $1,171,242 and $986,549, respectively, is included in inventory and cost of revenues and the remainder is included in general and administrative expenses. Depreciationis not taken during the period of construction or equipment installation. Upon completion of the installation of manufacturing equipment or any construction in progress, construction in progress balances will be classified to their respective property and equipment category.





NOTE 5 – LAND USE RIGHTS




There is no private ownership of land in China. Land is owned by the government and the government grants land use rights for specified terms. The Company’s land use rights have terms of 45 and 50 years and expire on January 1, 2053 and October 30, 2053. The Company amortizes the land use rightsover the term of the respective land use right. For the six months ended June 30, 2012 and 2011, amortization of land use rights amounted to $46,727 and $45,138, respectively. For the three months ended June 30, 2012 and 2011, amortization of land use rights amounted to $23,344 and $22,710, respectively. At June 30, 2012 and December 31, 2011, land use rights consisted of the following:




Useful Life

June 30,

2012


December 31,

2011Land use rights
45 - 50 years

$
4,272,480


$
4,242,273Less: accumulated amortization



(471,510
)


(421,737
)$
3,800,970


$
3,820,536





16





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 5 – LAND USE RIGHTS (continued)




Amortization of land use rights attributable to future periods is as follows:




Twelve-month periods ending June 30:2013

$
93,5392014


93,5392015


93,5392016


93,5392017


93,539Thereafter


3,333,275$
3,800,970





NOTE 6 – SHORT-TERM BANK LOANS





Short-term bankloan represents an amount due to a bank that is due within one year. This loan can be renewed with the bank upon maturity. At June 30, 2012 and December 31, 2011, short-term bank loans consisted of the following:


June 30,

2012


December 31,

2011Loan from Agricultural and Commercial Bank, due on March 30, 2012 with annual interest at December 31, 2011 of 7.88%, secured by certain assets of the Company and repaid on due date.

$
-


$
628,466Loan from China Merchants Bank, due on May 20, 2012 with annual interest rate of 6.73% at March 31, 2012 and December 31, 2011, respectively, and repaid on due date.


-



471,350Loan from China Merchants Bank, due on November 17, 2012 with annual interest rate being adjusted quarterly based on 130% of People’s Bank of China’s base rate.


474,706



-Loan from Agricultural and Commercial Bank, due on October 10, 2012 with annual interest rate of 5.75% at June 30, 2012 and December 31, 2011, respectively, secured by certain assets of the Company.


474,706



471,350Loan from Bank of Communications, due on May 14, 2012 with annual interest rate being adjusted quarterly based on 120% of People’s Bank of China’s base rate, and repaid on due date.


-



471,350Loan from Bank of Communications, due on November 14, 2012 with annual interest rate of 7.32% at June 30, 2012.


474,706



-Loan from Bank of Communications, due on May 23, 2012 with annual interest rate being adjusted quarterly based on 120% of People’s Bank of China’s base rate, and repaid on due date.


-



314,233Loan from Bank of Communications, due on November 21, 2012 with annual interest rate of 7.32% at June 30, 2012.


316,471



-Loan from Bank of China, due on January 16, 2013 with annual interest rate of 7.35% at June 30, 2012 and secured by certain assets of the Company.


949,412



-Total short-term bank loans

$
2,690,001


$
2,356,749





17





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 7 – BANK ACCEPTANCE NOTES PAYABLE





Bank acceptance notes payable represents amounts due to a bank which are collateralized and typically renewed. All bank acceptance notes payable are secured by the Company’s restricted cash which is on deposit with the lender. At June 30, 2012 and December 31, 2011, the Company’s bank acceptance notes payables consisted of the following:


June 30,

2012


December 31,

2011Agricultural and Commercial Bank, non-interest bearing, due and paid on January 15, 2012, collateralized by 100% of restricted cash deposited.

$
-


$
314,233Bank of China, non-interest bearing, due and paid on July 13, 2012, collateralized by 100% of restricted cash deposited.


158,235



-Bank of China, non-interest bearing, due on August 23, 2012, collateralized by 100% of restricted cash deposited.


126,589



-Total

$
284,824


$
314,233





NOTE 8 -CAPITAL LEASE OBLIGATIONS





The Company has entered into a non-cancelable capital lease agreement with expiration date of June 3, 2014. The asset and liability under the capital lease are recorded at the lower of the present value of the minimum lease payments or the fair value of the asset. The asset and future obligations related to the capital lease included in the accompanying consolidated balance sheets in property and equipment and capital lease obligations, respectively.  Minimum future lease payments under the capital lease are as follows:




Twelve-month periods ending June 30,

Amount2013

$
394,6982014


350,491Total minimum lease payments


745,189Less: amount representing interest


(114,926
)Less: security deposit due


(127,417
)Present value of net minimum lease payment


502,846Less: current portion


(248,046
)Long-term portion

$
254,800





NOTE 9 – INCOME TAXES





The Company accounts for income taxes pursuant to the accounting standards that require the recognition of deferred tax assets and liabilities for both the expected impact of differences between the financial statements and the tax basis of assets and liabilities, and for the expected future tax benefit to be derived from tax losses and tax credit carry forwards.  Additionally, the accounting standards require the establishment of a valuation allowance to reflect the likelihood of realization of deferred tax assets. Realization of deferred tax assets, including those related to the U.S. net operating loss carry forwards, are dependent upon future earnings, if any, of which the timing and amount are uncertain.





18




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 9 – INCOME TAXES (continued)





Accordingly, the net deferred tax asset related to the U.S. net operating loss carry forward has been fully offset by a valuation allowance. The Company is governed by the Income Tax Law of the PRC and the U.S. Internal Revenue Code of 1986, as amended.  In 2012 and 2011, under the Income Tax Laws of PRC, Chinese companies are generally subject to an income tax at an effective rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments. The Company’s VIEs (Dyeing and Electric) and the Company’s subsidiary, Fulland Wind Energy, are subject to these statutory rates. The Company’s wholly-owned subsidiary, Fulland Limited was incorporated in the Cayman Islands. Under the current laws of the Cayman Islands, this entity is not subject to income taxes.





NOTE 10– STOCKHOLDERS’ EQUITY





(a) Preferred stock issued for warrants modification





On February 7, 2012, in an effort to induce its warrant holder to exercise their warrants, the Company signed an agreement with Barron Partners LP (“Barron”), pursuant to which Barron, as the holder of warrants to purchase 55,158 shares of common stock at $12.00 per share and 165,000 shares of common stock at $16.98 per share, agreed to exchange or convert such warrants into (i) 2,201,582 shares of the Company’s series A preferred stock which are convertible into 73,386 shares of common stock, and (ii) warrants to purchase 73,386 shares of this Company’s common stock at $2.70 per common share, with the proceeds from the exercise of the warrants being used to pay expenses incurred by the Company in connection with its public company expenses.In connection with the warrant modification, the Company valued the 2,201,582 series A preferred shares issued at fair market value on the date of grant of $197,408 based on the 73,386 common shares issuable upon conversion of the series A preferred stock multiplied by the quoted trading price of the common stock on the grant date of $2.70 per share.  In connection with the transaction,on February 7, 2012, the Company revalued the fair market value of the original warrants by using the Black-Scholes option-pricing model.    The total fair market value of the original warrants was estimated to be $52,896 on February 7, 2012. The fair market value of the newly issued exchanged warrants was estimated to be $90,621 using the Black-Scholes option-pricing model.  In connection with the Black-Scholes option pricing calculation, the following weighted-average assumptions were used:  stock price of $2.70; expected dividend yield 0%; risk-free interest rate of 0.15%; volatility of 139.58% and an expected term of 0.77 year. We recorded the difference between the fair market value of original warrants of $52,896 and the fair market value of exchanged warrants of $90,621 which amounted to $37,725 as a warrants modification expense with a corresponding credit of additional paid-in capital.  Accordingly, for the six months ended June 30, 2012, the Company recorded an aggregate warrant modification expense of $235,133 on the accompanying consolidated statement of income. For the three months ended June 30, 2012, the Company did not record any warrant modification expense.





(b)Common stock issued for services





During the six months ended June 30, 2012, the Company issued a total of 51,450 shares of common stock pursuant to its 2010 long-term incentive plan, of which 250 shares were issued to a director, 10,000 shares were issued to the chief executive officers and 41,200 shares were issued to other employees and consultants.  The shares were valued at the fair market value on the date of grant.  During the six months ended June 30, 2012, the Company record stock-based compensation of $101,590 and prepaid expense of $54,880, which is being amortized over the balance of 2012.





(c)Common stock issued for preferred share conversions





During the six months ended June 30, 2012, the Company issued 439,912 shares of common stock upon the conversion of 13,197,389 shares of series A preferred stock. As of June 30, 2012, the Company had no series A preferred stock outstanding.





(d)Common stock issued on exercise of warrants





During the six months ended June 30, 2012, the Company issued 73,386 shares of its common stock upon the exercise of warrants, for which the Company received cash proceeds of $198,142.  At June 30, 2012, there were no warrants outstanding.





19





CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012





NOTE 10– STOCKHOLDERS’ EQUITY (continued)





Warrant activity for the six months ended June 30, 2012 was summarized as follows:





Six Months Ended June 30, 2012Number of Warrants


Weighted Average Exercise PriceBalance at December 31, 2011


220,158


$
15.73Granted


73,386



2.70Exercised


(73,386
)


(2.70
)Cancelled


(220,158
)


(15.73
)Balance at June 30, 2012


-


$
-Warrants exercisable at June 30, 2012


-


$
-




NOTE 11 – STATUTORY RESERVES





The Company is required to make appropriations to reserve funds, comprising the statutory surplus reserve, statutory public welfare fund and discretionary surplus reserve, based on after-tax net income determined in accordance with generally accepted accounting principles of the PRC (the “PRC GAAP”). Appropriation to the statutory surplus reserve should be at least 10% of the after tax net income determined in accordance with the PRC GAAP until the reserve is equal to 50% of the entities’ registered capital or members’ equity. Appropriations to the statutory public welfare fund are at a minimum of 5% of the after tax net income determined in accordance with PRC GAAP. Commencing on January 1, 2006, the new PRC regulations waived the requirement for appropriating retained earnings to a welfare fund. Prior to December 31, 2009, the Company appropriated the required maximum 50% of its registered capital to statutory reserves for Dyeing and Electric.





For the six months ended June 30, 2012, statutory reserve activity is as follows:





Dyeing


Electric


Wuxi Fulland


TotalBalance – December 31, 2011

$
72,407


$
1,168,796


$
823,348


$
2,064,551Addition to statutory reserves


-



-



99,773



99,773Balance – June 30, 2012

$
72,407


$
1,168,796


$
923,121


$
2,164,324





NOTE 12 - SEGMENT INFORMATION





For the three and six months ended June 30, 2012 and 2011, the Company operated in two reportable business segments - (1) the manufacture of forged rolled rings and related components for the wind power and other industries segment, which also includes the manufacture of the Company’s solar industry products, and (2) the manufacture of dyeing and finishing equipment segment. The Company’s reportable segments are strategic business units that offer different products. They are managed separately based on the fundamental differences in their operations.  All of the Company’s operations are conducted in the PRC.




20




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 12 - SEGMENT INFORMATION (continued)





Information with respect to these reportable business segments for the three and six months ended June 30, 2012 and 2011 is as follows:




Three Months Ended

June 30,


Six Months Ended

June 30,2012


2011


2012


2011Revenues:Forged rolled rings and related components

$
8,208,210


$
8,706,888


$
13,793,665


$
22,124,245Dyeing and finishing equipment


4,624,653



3,901,293



8,448,427



8,050,31612,832,863



12,608,181



22,242,092



30,174,561Depreciation:Forged rolled rings and related components


1,215,536



1,092,426



2,432,705



2,106,172Dyeing and finishing equipment


329,630



234,331



659,806



397,5871,545,166



1,326,757



3,092,511



2,503,759Interest expense:Forged rolled rings and related components


52,563



32,826



130,196



62,528Dyeing and finishing equipment


17,800



-



30,200



-70,363



32,826



160,396



62,528Net income (loss):Forged rolled rings and related components


750,036



1,048,738



1,076,705



3,490,411Dyeing and finishing equipment


506,797



406,206



916,140



829,648Other (a)


(185,463
)


(284,985
)


(618,680
)


(484,940
)$
1,071,370


$
1,169,959


$
1,374,165


$
3,835,119
  Identifiable long-lived tangible assets at June 30, 2012 and December 31, 2011 by segment:June 30,

2012


December 31,

2011Forged rolled rings and related components

$
51,621,902


$
51,930,395Dyeing and finishing equipment


13,046,847



12,111,684$
64,668,749


$
64,042,079  Identifiable long-lived tangible assets at June 30, 2012 and December 31, 2011 by geographical location:June 30,

2012


December 31,

2011China

$
64,668,749


$
64,042,079United States


-



-$
64,668,749


$
64,042,079





(a)The Company does not allocate any general and administrative expenses of its U.S. activities to its reportable segments, because these activities are managed at a corporate level.





21




CLEANTECH SOLUTIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012


NOTE 13 – CONCENTRATIONS





Customers





No customer accounted for 10% or more of the Company’s revenues during the six months ended June 30, 2012 and 2011.





Suppliers





The following table sets forth information as to each supplier that accounted for 10% or more of the Company’s purchases for the six months ended June 30, 2012 and 2011.




Six Months Ended June 30,Supplier

2012

2011A

22%

*B

20%

*C

*

17%D

18%

14%E

*

12%F

*

11%


*           Less than 10%.





NOTE 14 – RESTRICTED NET ASSETS





Regulations in the PRC permit payments of dividends by the Company’s PRC VIEs only out of their retained earnings, if any, as determined in accordance with PRC accounting standards and regulations. Subject to certain cumulative limit, a statutory reserve fund requires annual appropriations of at least 10% of after-tax profit, if any, of the relevant PRC VIE’s and subsidiary. The statutory reserve funds are not distributable as cash dividends. As a result of these PRC laws and regulations, the Company’s PRC VIE’s and its subsidiary are restricted in their abilities to transfer a portion of their net assets to the Company. Foreign exchange and other regulations in PRC may further restrict the Company’s PRC VIEs and its subsidiary from transferring funds to the Company in the form of loans and/or advances.





As of June 30, 2012 andDecember 31, 2011, substantially all of the Company’s net assets are attributable to the PRC VIE’s and its subsidiary located in the PRC. Accordingly, the Company’s restricted net assets at June 30, 2012 and December 31, 2011 were approximately $85,895,601 and $71,294,000, respectively.




NOTE 15 – SUBSEQUENT EVENTS





On August 7, 2012, following the approval by the Company’s stockholders on July 20, 2012, the Company was converted from a Delaware corporation to a Nevada corporation.  In connection with the conversion, the shares of preferred stock that had been designated as series A convertible preferred stock ceased to be a separate series of preferred stock and because shares of preferred stock without designation as to series.  At the time of the conversion, there were no share of series A preferred stock outstanding and the Company had no obligation to issue any such shares.




22




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




Overview





We are engaged in two business segments – the forged rolled rings and related components segment, in which we manufacture and sell high precision forged rolled rings, shafts, flanges, and other forged components for the wind power and other industries as well as equipment for the solar power industry, and the dyeing and finishing equipment segment, in which we manufacture and sell textile dyeing and finishing machines.





The following table sets forth information as to revenue of our forged rolled rings and related components and dyeing and finishing equipment segments in dollars and as a percent of revenue (dollars in thousands):





Six Months Ended June 30,2012


2011Dollars


%


Dollars


%Forged rolled rings and related components:Wind power industry

$
7,178



32.3
%

$
16,428



54.4
%Other industries


6,616



29.7
%


5,696



18.9
%Total forged rolled rings and related components


13,794



62.0
%


22,124



73.3
%Dyeing and finishing equipment


8,448



38.0
%


8,051



26.7
%Total

$
22,242



100.0
%

$
30,175



100.0
%




Three Months Ended June 30,2012


2011Dollars


%


Dollars


%Forged rolled rings and related components:Wind power industry

$
4,641



36.2
%

$
6,246



49.5
%Other industries


3,568



27.8
%


2,461



19.5
%Total forged rolled rings and related components


8,209



64.0
%


8,707



69.0
%Dyeing and finishing equipment


4,624



36.0
%


3,901



31.0
%Total

$
12,833



100.0
%

$
12,608



100.0
%





Through our forged rolled rings and other related products division, we supply the following:





●
We produce precision forged rolled rings and other forged components to the wind and other industries. Forged rolled rings and other forged components for the wind industry are used in wind turbines, which are used to generate wind power.





●
Commencing in 2011, we manufactured and delivered test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market. For the six months ended June 30, 2012, we generated revenue from the sale of solar industry related products of $264,565.  We had no revenue for these products in the first half of 2011.




Our forged rolled rings and other related products are sold for use by manufacturers of industrial equipment.  The demand for products used in manufacturing in general including wind power industries, is uncertain.  Although we believe that over the long term, the forged rolled rings and related components segment will expand, and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term other factors, such as economic factors and the fluctuations in the price of oil and coal, may affect the requirements by our customers and potential customers for our products.  To the extent that the demand for our forged rolled rings and related components declines, our revenue and net income will be affected.




23




Our revenue declined significantly for the six months ended June 30, 2012 as compared to the six months ended June 30, 2011, largely because of a decline in revenue during the first quarter of 2012 compared with the first quarter of 2011.  For the six months ended June 30, 2012, our revenue declined by 26.3% from the six months ended June 30, 2011, and for the three months ended June 30, 2012, our revenue increased 1.8% from the comparable period of 2011.  Our gross margin decreased from 25.2% to 20.6% for the six months ended June 30, 2012 from the comparable period of 2011, and from 24.2% to 21.0% for the three months ended June 30, 2012 from the three months ended June 30, 2011.  Our net income decreased 64.2% from the six months ended June 30, 2011 to the six months ended June 30, 2012, and 8.4% from the three months ended June 30, 2011 to the three months ended June 30, 2012.





The decline in our revenue for the six months ended June 30, 2012 was attributable to the decrease in revenue for forged rolled rings and related products for the wind power industry, which declined $9.3 million, or 56.3%, during the six months ended June 30, 2012 as compared to the six months ended June 30, 2011. The six-month decline primarily reflected a decline is the first quarter of 2012, since the decrease in revenue for the three month period was approximately $0.5 million, or 5.6%.




We believe that the decline in our revenue of forged rolled rings and related products for the wind power industry reflects:




●
An apparent decline in the growth rate for the wind industry, following six years of growth during which the total installed capacity doubled each year.  ●
Increased competition.




●
The effects of a 2011 decision by the China central bank to tighten the monetary supply, which reduced the availability of bank financing both for owners of wind farms who require bank loans to purchase equipment and for potential purchasers of heavy equipment.  ●
Decisions by turbine manufactures to establish vertically integrated operations, thus eliminating the need to purchase components from companies such as us.





Revenue from our dyeing segment increased in both the six and three months ended June 30, 2012 from the comparable period of 2011.  For the six month period, the increase was $0.4 million, or 4.9%, and for the three month period, the increase was $0.7 million, or 18.5%.  We believe that the increase reflects our marketing effort for our new air flow dyeing units, which use air instead of water which is used in the traditional dyeing process.  We believes that our air-flow technology, which is designed to enable users to meet the stricter environmental standards, results in reduced input costs, fewer wrinkles, less damage to the textile, and reduced emissions.  Although our revenue increased, our gross margins decreased from 21.1% for the six months ended June 30, 2011 to 20.1% for the six months ended June 30, 2012 and from 21.2% for the second quarter of 2011 to 20.4% for the second quarter of 2012.





The factors that affected our revenue, gross margin and net income during the first half of 2012 may affect our operations during the rest of 2012.  Our ability to expand our operations and increase our revenue is largely affected by the PRC government’s policy on such matters as the availability of credit, which affects all of our operations, and its policies relating to alternative energy such as wind and solar power, which affect our products for these industries.  Our business is also affected by general economic conditions. Because of the nature of our products, our customers’ projection of future economic conditions are an integral part of their decisions as to whether to purchase capital equipment at this time or defer such purchases until a future date.





During the six months ended June 30, 2012, our inventory increased by approximately $1.6 million and our advance from customers was approximately $2.4 million at June 30, 2012.  This increase in inventory was attributable to an increase in steel inventory to secure steel pricing for anticipated forging orders, and an increase in inventory related to our solar products.  A significant portion of the inventory increase relates to products for our solar customer, for which we received advance payments.  At the request of the customer we have kept the products in our warehouse.  This sale will be recognized when the last step of the sale, which is passing Chinese customs, is completed.  Upon the completion of the sale, the advances from this customer will be recognized as revenues and our inventory will be reduced by the products sold. We expect to recognize he sale in the third quarter of 2012.





24





Raw materials





A major element of our cost of revenues is raw materials, principally steel as well as other metals. These metals are subject to price fluctuations, and recently these fluctuations have been significant.  In times of increasing prices, we need to try to fix the price at which we purchase raw materials in order to avoid increases in costs which we cannot recoup through increases in sales prices.  Similarly, in times of decreasing prices, we may have purchased metals at prices which arehigh in terms of the price at which we can sell our products, which also can impair our margins. Three major suppliers provided approximately 60% of our purchases of raw materials for the six months ended June 30, 2012.





Critical accounting policies and estimates





Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to bad debts, inventories, recovery of long-lived assets, income taxes, and the valuation of equity transactions. We base our estimates on historical experience and on various other assumptions that we believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Any future changes to these estimates and assumptions could cause a material change to our reported amounts of revenues, expenses, assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the financial statements.





Exchange of Warrants





On May 4, 2012, our board of directors approved a previously negotiated agreement with Barron Partners LP, dated February 7, 2012,  pursuant to which Barron, as the holder of warrants to purchase 55,160 shares of common stock at $12.00 per share and 165,000 shares of common stock at $16.98 per share, agreed to exchange or convert such warrants into (i) 2,201,582 shares of series A preferred stock which are convertible into 73,386 shares of common stock, and (ii) warrants to purchase 73,386 shares of this Corporation’s common stock at $2.70 per share, which was the market price of the common stock on February 7, 2012, the date the terms of the exchange were negotiated.





The 2,201,582 shares of series A preferred stock were valued at the closing price of the underlying common stock on February 7, 2012 of $2.70 per share, and we recorded it as warrants modification expense of $197,408.





As a result of the transaction, we revalued the fair market value of the original warrants by using the Black-Scholes option-pricing model.    The total fair market value of the original warrants was estimated to be $52,896 on February 7, 2012. The fair market value of the newly issued exchanged warrants was estimated to be $90,621 using the Black-Scholes option-pricing model.  In connection with the Black-Scholes option pricing calculation, the following weighted-average assumptions were used:  stock price of $2.70; expected dividend yield 0%; risk-free interest rate of 0.15%; volatility of 139.58% and an expected term of 0.77 year. We recorded the difference between the fair market value of original warrants of $52,896 and the fair market value of exchanged warrants of $90,621 amounting to $37,725 as warrants modification expense with a corresponding credit of additional paid-in capital.





Variable interest entities





Pursuant to ASC Topic 810 and related subtopics related to the consolidation of variable interest entities, we are required to include in our consolidated financial statements the financial statements of variable interest entities (“VIEs”).  The accounting standards require a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss for the VIE or is entitled to receive a majority of the VIE’s residual returns. VIEs are those entities in which we, through contractual arrangements, bear the risk of, and enjoy the rewards normally associated with ownership of the entity, and therefore we are the primary beneficiary of the entity.




25




The Huayang Companies are considered VIEs, and we are the primary beneficiary. On November 13, 2007, we entered into agreements with the Huayang Companies pursuant to which we shall receive 100% of the Huayang Companies’ net income. In accordance with these agreements, the Huayang Companies shall pay consulting fees equal to 100% of its net income to our wholly-owned subsidiary, Green Power, and Green Power shall supply the technology and administrative services needed to service the Huayang Companies.





The accounts of the Huayang Companies are consolidated in the accompanying financial statements. As VIEs, the Huayang Companies sales are included in our total sales, their income from operations is consolidated with ours, and our net income includes all of the Huayang Companies’ net income, and their assets and liabilities are included in our consolidated balance sheets. The VIEs do not have any non-controlling interest and, accordingly, we did not subtract any net income in calculating the net income attributable to us. Because of the contractual arrangements, we have pecuniary interest in the Huayang Companies that require consolidation of the Huayang Companies financial statements with our financial statements.





Accounts receivable





We have a policy of reserving for uncollectible accounts based on our best estimate of the amount of probable credit losses in our existing accounts receivable.  We periodically review our accounts receivable to determine whether an allowance is necessary based on an analysis of past due accounts and other factors that may indicate that the realization of an account may be in doubt.  Account balances deemed to be uncollectible are charged to the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.





As a basis for estimating the likelihood of collection has been established, we consider a number of factors when determining reserves for uncollectable accounts.   We believe that we use a reasonably reliable methodology to estimate the collectability of our accounts receivable. We review our allowances for doubtful accounts on at least a quarterly basis. We also consider whether the historical economic conditions are comparable to current economic conditions. If the financial condition of our customers or other parties that we have business relations with were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.





Inventories





Inventories, consisting of raw materials, work-in-process and finished goods, are stated at the lower of cost or market utilizing the weighted average method. An allowance is established when management determines that certain inventories may not be saleable. If inventory costs exceed expected market value due to obsolescence or quantities in excess of expected demand, we will record additional reserves for the difference between the cost and the market value. These reserves are recorded based on estimates.  We review inventory quantities on hand and on order and record, on a quarterly basis, a provision for excess and obsolete inventory, if necessary. If the results of the review determine that a write-down is necessary, we recognize a loss in the period in which the loss is identified, whether or not the inventory is retained. Our inventory reserves establish a new cost basis for inventory and are not reversed until we sell or dispose of the related inventory. Such provisions are established based on historical usage, adjusted for known changes in demands for such products, or the estimated forecast of product demand and production requirements.





Advances to suppliers





Advances to suppliers represent the cash paid in advance for the purchase of raw material from suppliers. The advance payments are intended to ensure preferential pricing and delivery.




26


Property and equipment





Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using straight-line method over the estimated useful lives of the assets. The estimated useful lives of the assets are as follows:




Useful LifeBuilding and building improvements

20

YearsManufacturing equipment

5 – 10

YearsOffice equipment and furniture

5

YearsVehicle

5

Years





The cost of repairs and maintenance is expensed as incurred; major replacements and improvements are capitalized. When assets are retired or disposed of, the cost and accumulated depreciation are removed from the accounts, and any resulting gains or losses are included in income in the year of disposition.





Included in property and equipment is construction-in-progress which consists of factories and office buildings under construction and machinery pending installation and includes the costs of construction, machinery and equipment, and any interest charges arising from borrowings used to finance these assets during the period of construction or installation. No provision for depreciation is made on construction-in-progress until such time as the relevant assets are completed and ready for their intended use.





We examine the possibility of decreases in the value of fixed assets when events or changes in circumstances reflect the fact that their recorded value may not be recoverable. We recognize an impairment loss when the sum of expected undiscounted future cash flows is less than the carrying amount of the asset. The amount of impairment is measured as the difference between the asset’s estimated fair value and its book value.





Land use rights





There is no private ownership of land in the PRC. All land in the PRC is owned by the government and cannot be sold to any individual or company. The government grants a land use right that permits the holder of the land use right to use the land for a specified period. Our land use rights were granted with a term of 45 or 50 years.  Any transfer of the land use right requires government approval.  We have recorded as an intangible asset the costs paid to acquire a land use right. The land use rights are amortized on the straight-line method over the land use right terms.





Revenue recognition





We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the purchase price is fixed or determinable and collectability is reasonably assured. We account for the product sales as a multiple element arrangement. Revenue from multiple element arrangements is allocated among the separate accounting units based on the residual method. Under the residual method, the revenue is allocated to undelivered elements based on fair value of such undelivered elements and the residual amounts of revenue allocated to delivered elements. We recognize revenue from the sale of dyeing and finishing equipment upon shipment and transfer of title. The other elements may include installation and generally a one-year warranty.





Equipment installation revenue is valued based on estimated service person hours to complete installation and is recognized when the labor has been completed and the equipment has been accepted by the customer, which is generally close to the date of delivery of the equipment.





Warranty revenue is valued based on estimated service person hours to complete a service and generally is recognized over the contract period. For the six months ended June 30, 2012 and 2011, amounts allocated to warranty revenues were not material. Based on historical experience, warranty service calls and any related labor costs have been minimal.





27




All other product sales, including the forged rolled rings, with customer specific acceptance provisions, are recognized upon customer acceptance and the delivery of the parts or service. Revenues related to spare part sales are recognized upon shipment or delivery based on the trade terms.




Income taxes





We are governed by the income tax laws of the PRC and the United States. Income taxes are accounted for pursuant to accounting standards, which is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. The charge for taxes is based on the results for the year as adjusted for items, which are non-assessable or disallowed. It is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date.





Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized.





Deferred tax is calculated using tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it is related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity. Deferred tax assets and liabilities are offset when they related to income taxes levied by the same taxation authority and we intend to settle its current tax assets and liabilities on a net basis.





Stock-based compensation





Stock based compensation is accounted for based on the requirements of the Share-Based Payment topic of ASC 718 which requires recognition in the financial statements of the cost of employee and director services received in exchange for an award of equity instruments over the period the employee or director is required to perform the services in exchange for the award.  The Accounting Standards Codification also requires measurement of the cost of employee and director services received in exchange for an award based on the grant-date fair value of the award.





Pursuant to ASC Topic 505-50, for share-based payments to consultants and other third-parties, compensation expense is determined at the “measurement date.” The expense is recognized over the period of services or the vesting period, whichever is applicable. Until the measurement date is reached, the total amount of compensation expense remains uncertain. We record compensation expense based on the fair value of the award at the reporting date. The awards to consultants and other third-parties are then revalued, or the total compensation is recalculated based on the then current fair value, at each subsequent reporting date.





Recent accounting pronouncements





Accounting standards that have been issued or proposed by FASB that do not require adoption until a future date are not expected to have a material impact on our consolidated financial statements upon adoption.





Currency exchange rates





Our functional currency is the U.S. dollar, and the functional currency of our operating subsidiaries and VIEs is the RMB.  All of our sales are denominated in RMB. As a result, changes in the relative values of U.S. dollars and RMB affect our reported levels of revenues and profitability as the results of our operations are translated into U.S. dollars for reporting purposes. In particular, fluctuations in currency exchange rates could have a significant impact on our financial stability due to a mismatch among various foreign currency-denominated sales and costs. Fluctuations in exchange rates between the U.S. dollar and RMB affect our gross and net profit margins and could result in foreign exchange and operating losses.




28




Our exposure to foreign exchange risk primarily relates to currency gains or losses resulting from timing differences between signing of sales contracts and settling of these contracts. Furthermore, we translate monetary assets and liabilities denominated in other currencies into RMB, the functional currency of our operating subsidiaries. Our results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at the unified exchange rate at the end of the period. Translation adjustments resulting from this process are included in accumulated other comprehensive income in our statement of shareholders’ equity. We have not used any forward contracts, currency options or borrowings to hedge our exposure to foreign currency exchange risk. We cannot predict the impact of future exchange rate fluctuations on our results of operations and may incur net foreign currency losses in the future.





Our financial statements are expressed in U.S. dollars, which is the functional currency of our parent company. The functional currency of our operating subsidiaries and affiliates is RMB.  To the extent we hold assets denominated in U.S. dollars, any appreciation of the RMB against the U.S. dollar could result in a charge in our statement of operations and a reduction in the value of our U.S. dollar denominated assets. On the other hand, a decline in the value of RMB against the U.S. dollar could reduce the U.S. dollar equivalent amounts of our financial results.





RESULTS OF OPERATIONS





Results of Operations for the Three and Six Months ended June 30, 2012 and 2011





The following table sets forth the results of our operations for the six months ended June 30, 2012 and 2011 indicated as a percentage of net revenues (dollars in thousands):





Six Months Ended June 30,2012


2011Dollars


Percentage


Dollars


PercentageRevenues

$
22,242



100.0
%

$
30,175



100.0
%Cost of revenues


17,665



79.4
%


22,571



74.8
%Gross profit


4,577



20.6
%


7,604



25.2
%Operating expenses


2,166



9.7
%


2,282



7.6
%Income from operations


2,411



10.9
%


5,322



17.6
%Other income (expenses)


(371
)


(1.7
)%


12



0.0
%Income before provision for income taxes


2,040



9.2
%


5,334



17.7
%Provision for income taxes


666



3.0
%


1,499



5.0
%Net income


1,374



6.2
%


3,835



12.7
%Other comprehensive income:Foreign currency translation adjustment


512



2.3
%


1,491



4.9
%Comprehensive income

$
1,886



8.5
%

$
5,326



17.7
%




29




The following table sets forth the results of our operations for the three months ended June 30, 2012 and 2011 indicated as a percentage of net revenues (dollars in thousands):





Three Months Ended June 30,2012


2011Dollars


Percentage


Dollars


PercentageRevenues

$
12,833



100.0
%

$
12,608



100.0
%Cost of revenues


10,139



79.0
%


9,557



75.8
%Gross profit


2,694



21.0
%


3,051



24.2
%Operating expenses


1,126



8.8
%


1,369



10.9
%Income from operations


1,568



12.2
%


1,682



13.3
%Other income (expenses)


(62
)


(0.5
)%


34



0.3
%Income before provision for income taxes


1,506



11.7
%


1,716



13.6
%Provision for income taxes


435



3.4
%


546



4.3
%Net income


1,071



8.3
%


1,170



9.3
%Other comprehensive income:Foreign currency translation adjustment


60



0.5
%


1,085



8.6
%Comprehensive income

$
1,131



8.8
%

$
2,255



17.9
%





The following table sets forth information as to the gross margin for our two business segments for the six months ended June 30, 2012 and 2011 (dollars in thousands).





Forged rolled rings and related products


Dyeing and finishing equipment


Total


Forged rolled rings and related products


Dyeing and finishing equipment


TotalSix Months Ended June 30, 2012


Six Months Ended June 30, 2011Revenues

$
13,794


$
8,448


$
22,242


$
22,124


$
8,051


$
30,175Cost of revenues

$
10,911


$
6,754


$
17,665


$
16,222


$
6,349


$
22,571Gross profit

$
2,883


$
1,694


$
4,577


$
5,902


$
1,702


$
7,604Gross margin %


20.9
%


20.1
%


20.6
%


26.7
%


21.1
%


25.2
%





The following table sets forth information as to the gross margin for our two business segments for the three months ended June 30, 2012 and 2011 (dollars in thousands).





Forged rolled rings and related products


Dyeing and finishing equipment


Total


Forged rolled rings and related products


Dyeing and finishing equipment


TotalThree Months Ended June 30, 2012


Three Months Ended June 30, 2011Revenues

$
8,209


$
4,624


$
12,833


$
8,707


$
3,901


$
12,608Cost of revenues

$
6,460


$
3,679


$
10,139


$
6,483


$
3,074


$
9,557Gross profit

$
1,749


$
945


$
2,694


$
2,224


$
827


$
3,051Gross margin %


21.3
%


20.4
%


21.0
%


25.5
%


21.2
%


24.2
%





30




Revenues





For the six months endedJune 30, 2012, we had revenues of $22,242,000, as compared to revenues of $30,175,000 for the six months ended June 30, 2011, a decrease of approximately 26.3%. The decrease in revenue was attributable to the decrease in revenue from our forged rolled rings and related products for wind power industry, offset by the increase in revenue from our forged rolled rings and related products for other industries and the increase in revenue from dyeing segment, and was summarized as follows (dollars in thousands):





For the Six Months Ended June 30,

2012


For the Six Months Ended June 30,

2011


(Decrease)

Increase


Percentage ChangeForged rolled rings and related products:Wind power industry

$
7,178


$
16,428


$
(9,250
)


(56.3
)%Other industries


6,616



5,696



920



16.1
%Total forged rolled rings and related products


13,794



22,124



(8,330
)


37.7
%Dyeing and finishing equipment


8,448



8,051



397



4.9
%Total revenues

$
22,242


$
30,175


$
(7,933
)


(26.3
)%





For the three months endedJune 30, 2012, we had revenues of $12,833,000, as compared to revenues of $12,608,000 for the three months ended June 30, 2011, an increase of approximately 1.8%. The increase in revenue was attributable to the increase in revenue fromour forged rolled rings and related products for other industries and the increase in revenue from dyeing and finishing equipment segment, offset by the decrease in revenue from our forged rolled rings and related products for wind power industry, and was summarized as follows (dollars in thousands):




For the Three Months Ended June 30,

2012


For the Three Months Ended June 30,

2011


(Decrease)

Increase


Percentage ChangeForged rolled rings and related products:Wind power industry

$
4,641


$
6,246


$
(1,605
)


(25.7
)%Other industries


3,568



2,461



1,107



44.9
%Total forged rolled rings and related products


8,209



8,707



(498
)


(5.7
)%Dyeing and finishing equipment


4,624



3,901



723



18.5
%Total revenues

$
12,833


$
12,608


$
225



1.8
%





Forged rolled rings and related products segment





Revenue fromforging of rolled rings and related products totaled $13,794,000 for the six months ended June 30, 2012, with revenues of $7,178,000 from the wind power industry and revenues of $6,616,000 from other forging operations. Revenue from forging of rolled rings and related products totaled $8,209,000 for the three months ended June 30, 2012, with revenues of $4,641,000 from the wind power industry and revenues of $3,568,000 from other forging operations. Revenues from forging of rolled rings and related products totaled $22,124,000 for the six months ended June 30, 2011, with revenues from the wind power industry amounting to $16,428,000 and revenues from other forging operations amounting to $5,696,000. Revenues from forging of rolled rings and related products totaled $8,707,000 for the three months ended June 30, 2011, with revenues from the wind power industry amounting to $6,246,000 and revenues from other forging operations amounting to $2,461,000.





The decrease in revenue from forging of rolled rings and related products for wind power industry was primarily attributable to:




31




●
An apparent decline in the market for capital equipment, including products for the wind power industry. Although, we have been experiencing a decrease in the sale of forged products, we believe that, on a long-term basis, the demand for forged products in the wind industry in China will continue.  According to the Global Wind Energy Council’s “Global Wind Energy Outlook 2010 Report” as published on the council’s website, 2009 marked China’s sixth consecutive year of doubling its total installed capacity and surpassed 25.8 gigawatts (“GW”) in total capacity installed at the end of 2009. Pursuant to Global Wind Energy Council’s press release dated April 6, 2011, in 2010, China added 18.9 GW of new wind power capacity, thereby reaching a total installed capacity of 44.7 GW The Chinese government’s twelfth Five-Year Plan, which was passed by the Chinese Parliament in March 2011, reflects the Chinese government’s continued commitment to wind power development, with a target of building an additional 90 GW of wind energy by 2015.




During the six months ended June 30, 2012, we sold approximately 4,199 metric tons of forged rolled rings and related products for wind power industry, as compared to 10,572 metric tons for the six months ended June 30, 2011, a decrease of 60.3%.  During the six months ended June 30, 2012, we increased our selling price for forged rolled rings and related products for wind power industry by approximately 10.0% as compared to the six months ended June 30, 2011.




●
Notwithstanding the Chinese government’s commitment to wind power development, the ability and willingness of manufacturing companies and wind power companies to purchase equipment was affected by a 2011 decision by the China central bank to tighten the monetary supply, which reduced the availability of bank financing both for owners of wind farms who require bank loans to purchase equipment and for potential purchasers of heavy equipment.




●
Decisions by turbine manufactures to establish vertically integrated operations, thus eliminating the reducing the potential market for our wind power products.




●
The government of China cancelled a number of preferential policies for forged rolled rings and related products for wind power industry, such as government’s subsidies and tax rebates in 2012.




The demand for products such as ours which are used for wind power specifically is uncertain.  Although we believe that over the long term, our forged rolled rings and related components for wind power industry will expand and the government of the PRC has announced its desire to increase the use of wind power as an energy source, in the short term other factors have affected the requirements of our customers and potential customers for our products which has had an effect of lessening the demand for products such as ours.  To the extent that the demand for our forged rolled rings and related components for wind power industry continues to decline, our revenue and net income will continue to be affected.




The increase in revenue from forging of rolled rings and related products for other industries was primarily attributable to our increased sales efforts. During the six months ended June 30, 2012, we sold approximately 4,111 metric tons of forged rolled rings and related products for other industries, as compared to 3,392 metric tons for the six months ended June 30, 2011, an increase of 21.2%.  During the six months ended June 30, 2012, we decreased our selling price for our forged rolled rings and related products for other industries by approximately 7.8% as compared to the six months ended June 30, 2011.




In 2011, we began to manufacture and delivery test subassemblies for solar cell manufacturing equipment, which marked our entry into the solar products market.  This equipment is being marketed and manufactured in our forged rolled rings segment. We are seeking to use our technical knowledge to manufacture and market solar components used in production of multi crystalline and mono crystalline silicon wafers.   Solar industry capabilities include the manufacture of complex pressure vessels and chamber, high temperature vessels, and thick-walled vessels. For the six months ended June 30, 2012, we generated revenue from the sale of solar industry related products of $264,565.  We generated no revenues from these products in the six months ended June 30, 2011.





32





Dyeing and finishing equipment segment





The increase in revenue from the sale of dyeing and finishing equipment was primarily attributable to the effects of the preferential policies of the PRC local government to encourage the purchase of low-emission airflow dyeing machine which is a kind of environmental protection machine. During the second quarter of 2012, we have seen a steady increase in orders and we expect demand to remain steady.





Cost of revenues





For the six months ended June 30, 2012, cost of revenues was $17,665,000 as compared to $22,571,000 for the six months ended June 30, 2011, a decrease of $4,906,000, or 21.7%. Cost of revenues related to the manufacture of forged rolled rings and related products was $10,911,000 for the six months ended June 30, 2012 as compared to $16,222,000 for the six months ended June 30, 2011. Cost of revenues for the dyeing and finishing equipment segment was $6,754,000 for the six months ended June 30, 2012, as compared to $6,349,000 for the six months ended June 30, 2011.





For the three months ended June 30, 2012, cost of revenues was $10,139,000 as compared to $9,557,000 for the three months ended June 30, 2011, a decrease of $582,000, or 6.1%. Cost of revenues related to the manufacture of forged rolled rings and related products was $6,460,000 for the three months ended June 30, 2012 as compared to $6,483,000 for the three months ended June 30, 2011. Cost of revenues for the dyeing and finishing equipment segment was $3,679,000 for the three months ended June 30, 2012, as compared to $3,074,000 for the three months ended June 30, 2011.





Gross profit and gross margin





Our gross profit was $4,577,000 for the six months ended June 30, 2012 as compared to $7,604,000 for the six months ended June 30, 2011, representing gross margins of 20.6% and 25.2%, respectively. Our gross profit was $2,694,000 for the three months ended June 30, 2012 as compared to $3,051,000 for the three months ended June 30, 2011, representing gross margins of 21.0% and 24.2%, respectively.





Gross profit from forged rolled rings and related products segment was $2,883,000 for the six months ended June 30, 2012 as compared to $5,902,000 for the six months ended June 30, 2011, representing gross margins of approximately 20.9% and 26.7%, respectively.Gross profit from forged rolled rings and related products segment was $1,749,000 for the three months ended June 30, 2012 as compared to $2,224,000 for the three months ended June 30, 2011, representing gross margins of approximately 21.3% and 25.5%, respectively.The decrease in our gross margin for the forged rolled rings and related products segment was mainly attributed to a decline in operational and cost efficiencies, including the allocation of fixed costs primarily consisting of depreciation, to cost of revenues as we operated at lower production levels as well as price reductions which were made to secure additional business. We do not expect that we will be able to improve our gross margin from forged rolled rings and related products segment until we become more efficient and are able to produce larger quantities for inventory and revenues.  However, as long as we need to offer reduced prices in the face of competitive conditions, it will become increasing important to effect operating efficiencies even to maintain existing margins.





Gross profit for the dyeing and finishing equipment segment was $1,694,000 for the six months ended June 30, 2012 as compared to $1,702,000 for the six months ended June 30, 2011, representing gross margins of approximately 20.1% and 21.1%, respectively. Gross profit for the dyeing and finishing equipment segment was $945,000 for the three months ended June 30, 2012 as compared to $827,000 for the three months ended June 30, 2011, representing gross margins of approximately 20.4% and 21.2%, respectively. The decrease in our gross margin for the dyeing and finishing equipment segment was mainly attributable to the increase in labor cost.





33


Depreciation. Depreciation was $3,093,000 and $2,504,000 for the six months ended June 30, 2012 and 2011, respectively. Depreciation was $1,545,000 and $1,327,000 for the three months ended June 30, 2012 and 2011, respectively. Depreciation for the three and six months ended June 30, 2012 and 2011 is included in the following categories (dollars in thousands):




Six Months Ended June 30,


Three Months Ended June 30,2012


2011


2012


2011Inventories and cost of revenues

$
2,344


$
2,083


$
1,171


$
987Operating expenses


749



421



374



340Total

$
3,093


$
2,504


$
1,545


$
1,327





The increase in depreciation for inventories and cost of revenues is attributable to the increase in our depreciable production equipment.





During the six months ended June 30, 2012, we recorded depreciation expense related to ESR production equipment in operating expenses since we did not perform any production for ESR products in this period and, therefore, we did not use the equipment. During the first quarter of 2011, we recorded depreciation expense related to ESR production equipment in inventories and cost of revenues since we generated production activities for ESR products in that period. Since the second quarter of 2011, we recorded depreciation expense related to ESR production equipment in operating expenses because we did not perform any production for ESR products in these periods. Accordingly, for the six months ended June 30, 2012, depreciation included in operating expenses increased by approximately $328,000 as compared to the comparable period in 2011.





Selling, general and administrative expenses. Selling, general and administrative expenses totaled $1,418,000 for the six months ended June 30, 2012, as compared to $1,860,000 for the six months ended June 30, 2011, a decrease of $442,000 or approximately 23.8%. Selling, general and administrative expenses totaled $752,000 for the three months ended June 30, 2012, as compared to $1,029,000 for the three months ended June 30, 2011, a decrease of $277,000 or approximately 26.9%.





Selling, general and administrative expenses for the three and six months ended June 30, 2012 and 2011 consisted of the following (dollars in thousands):





Six Months Ended June 30,


Three Months Ended June 30,2012


2011


2012


2011Professional fees

$
156


$
186


$
85


$
125Bad debt (recovery) expense


(47
)


167



-



174Payroll and related benefits


373



381



205



195Travel and entertainment


91



127



41



54Shipping


493



670



276



311Other


352



329



145



170Total

$
1,418


$
1,860


$
752


$
1,029





●
Professional fees for the six months ended June 30, 2012 decreased by $30,000, or 16.1%, as compared to the six months ended June 30, 2011. The decrease was primarily attributable to a decrease in accounting fees of approximately $19,000 and a decrease in fees paid for investor relations of approximately $16,000, offset by an increase in other miscellaneous service fees of approximately $5,000. Professional fees for the three months ended June 30, 2012 decreased by $40,000, or 32.0%, as compared to the three months ended June 30, 2011. The decrease was primarily attributable to a decrease in accounting fees of approximately $11,000 and a decrease in fees paid for investor relations of approximately $31,000, offset by an increase in other miscellaneous service fees of approximately $2,000.




34




●
For the six months ended June 30, 2012, we had bad debt recovery of approximately $47,000, while, for the six months ended June 30, 2011, we had bad debt expense of approximately $167,000. For the three months ended June 30, 2012, we did not had any bad debt expense, while, for the three months ended June 30, 2011, we had bad debt expense of $174,000. Based on our periodic review of accounts receivable balances, we adjusted the allowance for doubtful accounts after considering management’s evaluation of the collectability of individual receivable balances, including the analysis of subsequent collections, the customers’ collection history, and recent economic events.




●
Payroll and related benefits decreased for the six months ended June 30, 2012 by $8,000, or 2.1%, as compared to the six months ended June 30, 2011. The decrease was mainly attributable to a decrease in stock-based compensation of approximately $75,000 which reflected a drop in our average stock price used to value shares issued as compensation during the six months ended June 30, 2012 as compared to the comparable period in 2011, offset by an increase in compensation and related benefits of approximately $67,000 in our forged rolled rings and related products segment and dyeing and finishing equipment segment resulting from increased salaries paid to management. Payroll and related benefits decreased for the three months ended June 30, 2012 by $10,000, or 5.1%, as compared to the three months ended June 30, 2011. The decrease was mainly attributable to a decrease in stock-based compensation of approximately $14,000 which reflected a drop in our average stock price used to value shares issued as compensation during the second quarter of 2012 as compared to the corresponding period in 2011, offset by an increase in compensation and related benefits of approximately $4,000 in our forged rolled rings and related products segment and dyeing and finishing equipment segment resulting from increased salaries paid to management.




●
Travel and entertainment expense for the six months ended June 30, 2012 decreased by $36,000, or 28.3%, as compared to the six months ended June 30, 2011. Travel and entertainment expense for the three months ended June 30, 2012 decreased by $13,000, or 24.1%, as compared to the three months ended June 30, 2011. The decrease for the periods shown is primarily related to the decrease in travel for investor road shows and conferences.




●
Shipping expense for the six months ended June 30, 2012 decreased by $177,000, or 26.4%, as compared to the six months ended June 30, 2011. The decrease was primarily attributable to the decrease in our revenues during the first half of 2012 as compared to the first half of 2011. Shipping expense for the three months ended June 30, 2012 decreased by $35,000, or 11.3%, as compared to the three months ended June 30, 2011. We did not pay any shipping fee for solar industry related products in the second quarter of 2012, therefore, the shipping expense for the second quarter of 2012 decreased as compared to the corresponding period of 2011.




●
Other selling, general and administrative expenses for the six months ended June 30, 2012 increased by $23,000, or 7.0% as compared to the six months ended June 30, 2011. The increase was primarily attributable to the payment of Delaware franchise taxes in March 2012 of approximately $67,000 for fiscal year of 2011 and fiscal year of 2010, offset by a decrease in other miscellaneous items of approximately $44,000. Other selling, general and administrative expenses for the three months ended June 30, 2012 decreased by $25,000, or 14.7% as compared to the three months ended June 30, 2011, which reflected stricter control on corporation spending.





Income from operations.For the six months ended June 30, 2012, income from operations amounted to $2,411,000, as compared to $5,322,000 for the six months ended June 30, 2011, a decrease of $2,911,000 or 54.7%, as a result of the factors described above. For the three months ended June 30, 2012, income from operations amounted to $1,568,000, as compared to $1,682,000 for the three months ended June 30, 2011, a decrease of $114,000 or 6.7% as a result of the factors described above.




35




Other income (expense). Other income (expense) includes interest expense, nominal foreign currency transaction gain or losses, warrants modification expense, nominal interest income and other income. For the six months ended June 30, 2012, total other expense amounted to $371,000 as compared to total other income of $12,000 for the six months ended June 30, 2011, an increase of $383,000. The increase was primarily attributable to the warrant modification expense of approximately $235,000, as well as an increase in interest expense of approximately $98,000 attributable to an increase in debt and capital lease obligations and a decrease in other income of approximately $64,000.  For the three months ended June 30, 2012, total other expense amounted to $62,000 as compared to total other income of $34,000 for the three months ended June 30, 2011, an increase of $96,000. The increase was primarily attributable to an increase in interest expense of approximately $38,000 attributable to an increase in debt and capital lease obligations and a decrease in other income of approximately $62,000.




Income tax expense. Income tax expense was $666,000 for the six months ended June 30, 2012, as compared to $1,499,000 for the six months ended June 30, 2011, a decrease of $833,000, or 55.6%, The decrease in income tax expense was attributable to the decrease in taxable income generated by our operating entities. Income tax expense was $435,000 for the three months ended June 30, 2012, as compared to $546,000 for the three months ended June 30, 2011, a decrease of $111,000, or 20.3%, The decrease in income tax expense was attributable to the decrease in taxable income generated by our operating entities.





Net income.As a result of the foregoing, our net income was $1,374,000, or $0.58 per share (basic) and $0.53 per share (diluted), for the six months ended June 30, 2012, as compared with $3,835,000, or $2.01 per share (basic) and $1.51 per share (diluted) for the six months ended June 30, 2011, a decrease of $2,461,000 or 64.2%. As a result of the foregoing, our net income was $1,071,000, or $0.42 per share (basic) and $0.40 per share (diluted), for the three months ended June 30, 2012, as compared with $1,170,000, or $0.61 per share (basic) and $0.47 per share (diluted) for the three months ended June 30, 2011, a decrease of $99,000 or 8.4%.





Foreign currency translation gain.The functional currency of our subsidiaries and variable interest entities operating in the PRC is the Chinese Yuan or Renminbi (“RMB”). The financial statements of our subsidiaries are translated to U.S. dollars using period end rates of exchange for assets and liabilities, and average rates of exchange (for the period) for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations. As a result of these translations, which are a non-cash adjustment, we reported a foreign currency translation gain of $512,000 for the six months ended June 30, 2012, as compared to $1,491,000 for the six months ended June 30, 2011. We reported a foreign currency translation gain of $60,000 for the three months ended June 30, 2012, as compared to $1,085,000 for the three months ended June 30, 2011. This non-cash gain had the effect of increasing our reported comprehensive income.





Comprehensive income.As a result of our foreign currency translation gains, we had comprehensive income for the six months ended June 30, 2012 of $1,886,000, compared to $5,326,000 for the six months ended June 30, 2011. We had comprehensive income for the three months ended June 30, 2012 of $1,131,000, compared to $2,255,000 for the three months ended June 30, 2011.





Liquidity and Capital Resources





Liquidity is the ability of a company to generate funds to support its current and future operations, satisfy its obligations and otherwise operate on an ongoing basis.  At June 30, 2012 and December 31, 2011, we had cash balances of $1,307,312 and $1,152,607, respectively. These funds are located in financial institutions located as follows (dollars in thousands):




Country:

June 30, 2012


December 31, 2011United States

$
75



5.8
%

$
288



25.0
%China


1,232



94.2
%


865



75.0
%Total cash and cash equivalents

$
1,307



100.0
%

$
1,153



100.0
%


36




The following table sets forth information as to the principal changes in the components of our working capital from December 31, 2011 to June 30, 2012 (dollars in thousands):




December 31, 2011 to

June 30, 20122012


2011


Change


Percentage ChangeCurrent assets:Cash and cash equivalents

$
1,307


$
1,153


$
154



13.4
%Restricted cash


285



314



(29
)


(9.4
)%Notes receivable


47



54



(7
)


(11.1
)%Accounts receivable, net


8,012



7,088



924



13.0
%Inventories, net of reserve for obsolete inventory


5,912



4,276



1,636



38.2
%Advances to suppliers


1,601



219



1,382



630.1
%Prepaid value-added taxes on purchase


609



1,512



(903
)


(59.7
)%Prepaid expenses and other current assets


199



111



88



80.0
%Current liabilities:Short-term bank loans


2,690



2,357



333



14.1
%Bank acceptance notes payable


285



314



(29
)


(9.4
)%Accounts payable


4,843



4,997



(154
)


(3.1
)%Accrued expenses


948



772



176



22.9
%Capital lease obligations – current portion


248



245



3



1.3
%Advances from customers


2,394



1,167



1,227



105.2
%VAT and service taxes payable


55



-



55



100.0
%Income taxes payable


484



592



(108
)


(18.2
)%Working capital:Total current assets

$
17,972


$
14,727


$
3,245



22.0
%Total current liabilities


11,947



10,444



1,503



14.4
%Working capital:

$
6,025


$
4,283


$
1,742



40.7
%




Our working capital increased $1,742,000 to $6,025,000 at June 30, 2012 from working capital of $4,283,000 at December 31, 2011. This increase in working capital is primarily attributable to an increase in cash and cash equivalents of approximately 154,000, an increase in accounts receivable, net of allowance for doubtful accounts, of approximately $924,000, an increase in inventories, net of reserve for obsolete inventory, of approximately $1,636,000, an increase in advances to suppliers of approximately $1,382,000, a decrease in accounts payable of approximately $154,000, a decrease in income taxes payable of approximately $108,000, offset by a decrease in prepaid VAT on purchases of approximately $903,000, an increase in short-term bank loans of approximately $333,000, an increase in accrued expenses of approximately $176,000, an increase in advances from customers of approximately $1,227,000.





Net cash flow provided by operating activities was $3,024,000 for the six months ended June 30, 2012 as compared to $4,461,000 for the six months ended June 30, 2011, a decrease of $1,437,000, of which $2,461,000 reflected the decline in net income for the six months ended June 30, 2012 as compared to the comparable 2011 period. Because the exchange rate conversion is different for the balance sheet and the statements of cash flows, the changes in assets and liabilities reflected on the statements of cash flows is not necessarily identical with the comparable changes reflected on the balance sheet.





37




●
Net cash flow provided by operating activities for the six months ended June 30, 2012 primarily reflected net income of $1,374,000 adjusted for non-cash items primarily consisting of depreciation of $3,093,000, warrant modification expense of $235,000, and changes in operating assets and liabilities primarily consisting of a decrease in  prepaid value-added taxes on purchases of approximately $913,000, an increase in advances from customers of approximately $1,218,000 related to new orders, offset primarily by an increase in accounts receivable of $826,000, an increase in inventories of approximately $1,604,000 and an increase in advances to suppliers of approximately $1,379,000 to secure favorable raw material pricing.





●
Net cash flow provided by operating activities for the six months ended June 30, 2011 primarily reflected net income of $3,835,000, also reflected the add-back of non-cash items, such as depreciation of $2,504,000 and stock-based compensation expense of $215,000, a decrease in accounts receivable of $1,439,000 due to both the collection old balances and the a decrease in sales, a decrease in prepaid value-added taxes on purchases of $752,000, an increase in accrued expenses of $438,000, and an increase in advances from customers of $1,139,000 related to new orders, offset by an increase in inventories of $706,000, an increase in advances to suppliers of $1,610,000 to secure favorable raw material pricing, a decrease in accounts payable of $2,839,000 and a decrease in income taxes payable of $606,000.





Net cash flow used in investing activities reflects the purchase of property and equipment of $3,263,000 for the six months ended June 30, 2012 as compared to $4,796,000 for the six months ended June 30, 2011.





Net cash flow provided by financing activities was $387,000 for the six months ended June 30, 2012 as compared to net cash flow provided by financing activities $983,000 for the six months ended June 30, 2011. During the six months ended June 30, 2012, we received proceeds from bank loans of $2,213,000, proceeds from decrease in restricted cash of $32,000, and proceeds from exercise of warrants of $198,000, offset by the repayment of bank loans of $1,897,000, repayments of principal on capital lease obligations of $127,000 and decrease in bank acceptance notes payable of $32,000. During the six months ended June 30, 2011, we received proceeds from bank loans of $1,833,000, proceeds from the sale of common stock of $125,000, and proceeds from the exercise of common stock warrants of $400,000 offset by the repayment of bank loans of $1,374,000.





Our capital requirements for the next twelve months relate to purchasing machinery for the manufacture of products for the solar industry as well as additional investment in our forged rolled rings division.  We also expect to incur modest expenses in maintaining our dyeing business.  We believe that our cash flow from operations will be sufficient to meet our anticipated cash requirements for the next twelve months.





38





Contractual Obligations and Off-Balance Sheet Arrangements





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 consolidated financial position, results of operations, and cash flows. The following tables summarize our contractual obligations as of June 30, 2012 (dollars in thousands), and the effect these obligations are expected to have on our liquidity and cash flows in future periods.





Payments Due by PeriodContractual obligations:

Total


Less than 1 year


1-3 years


3-5 years


5+ yearsBank loans (1)

$
2,690


$
2,690


$
-


$
-


$
-Capital lease obligations (2)


503



248



255



-



-Total

$
3,193


$
2,938


$
255


$
-


$
-





(1)
Bank loans consisted of short term bank loans. Historically, we have refinanced these bank loans for an additional term of one year and we expect to continue to refinance these loans upon expiration.


(2)
Capital lease obligations include the interest portion, security deposit due and present value of net minimum lease payment.





Off-balance Sheet Arrangements





We have not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.





Foreign Currency Exchange Rate Risk





We produce and sell almost all of our productsin China. Thus, most of our revenues and operating results may be impacted by exchange rate fluctuations between RMB and US dollars.  For the six months ended June 30, 2012, we had unrealized foreign currency translation gain of $511,640, because of thechange in the exchange rate.





ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





Not required for smaller reporting companies.





39




ITEM 4. CONTROLS AND PROCEDURES





Disclosure Controls and Procedures





As required by Rule 13a-15 under the Exchange Act, our management, including Jianhua Wu, our chief executive officer, and Wanfen Xu, our chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2012.





Disclosure controls and procedures refer to controls and other procedures designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating and implementing possible controls and procedures.





Management conducted its evaluation of disclosure controls and procedures under the supervision of our chief executive officer and our chief financial officer. Based on that evaluation, Mr. Wu and Ms. Xu concluded that our disclosure controls and procedures were not effective as of June 30, 2012.





Management’s Report on Internal Control over Financial Reporting





Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act.  Our management is also required to assess and report on the effectiveness of our internal control over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”).   As previously reported in our Form 10-K for the year ended December 31, 2011, management assessed the effectiveness of our internal control over financial reporting as of December 31, 2011 and, during our assessment, management identified significant deficiencies related to (i) the U.S. GAAP expertise of our internal accounting staff, (ii) our internal audit functions and (iii) a lack of segregation of duties within accounting functions. Although management believes that these deficiencies do not amount to a material weakness, our internal controls over financial reporting were not effective at December 31, 2011.





Due to our size and nature, segregation of all conflicting duties may not always be possible and may not be economically feasible.  As a result, we have not been able to take steps to improve our internal controls over financial reporting during the six months ended June 30, 2012.  However, to the extent possible, we are implementing procedures to assure that the initiation of transactions, the custody of assets and the recording of transactions will be performed by separate individuals.





A material weakness (within the meaning of PCAOB Auditing Standard No. 5) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.





Changes in Internal Controls over Financial Reporting





There were no changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls over financial reporting that occurred during the six months ended June 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.




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PART II - OTHER INFORMATION





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





During the second quarter of 2012, the Company issued 287,189 shares of common stock upon the conversion of 8,615,670 shares of series A preferred stock. The issuance of such shares was exempt from registration pursuant to Section 3(a)(9) of the Securities Act.





During the second quarter of 2012, the Company issued 73,386 shares of its common stock upon the exercise of warrants, for which the Company received cash proceeds of $198,142.  The issuance of such shares was exempt from registration pursuant to Section 4(2) of the Securities Act.  The purchase was an accredited investor who acquired the shares for its account.  The certificates for the shares bear a restricted stock legend.





No underwriting or brokerage fees or commissions were paid in connection with the foregoing issuances.





ITEM 6. EXHIBITS





31.1
Rule 13a-14(a)/15d-14(a) certification of Chief Executive Officer31.2
Rule 13a-14(a)/15d-14(a) certification of Principal Financial Officer32.1
Section 1350 certification of Chief Executive Officer and Chief Financial Officer101.INS*
XBRL Instance Document101.SCH*
RL Taxonomy Extension Schema Document101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document101.LAB*
XBRL Taxonomy Extension Label Linkbase Document101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document




*
Pursuant to Rule 405(a)(2) of Regulation S-T, the registrant is relying upon the applicable 30-day grace period for the initial filing of its first Interactive Data File required to contain detail-tagged footnotes or schedules. The registrant intends to file the required detail-tagged footnotes or schedules by the filing of an amendment to this Quarterly Report on Form 10-Q within the 30-day period.


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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.


CLEANTECH SOLUTIONS INTERNATIONAL, INC.Date: August 14, 2012
By:
/s/ Jianhua WuJianhua Wu, Chief Executive Officerand Principal Executive OfficerDate: August 14, 2012
By:
/s/ Wanfen XuWanfen Xu, Chief Financial Officerand Principal Accounting Officer





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