UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





x QUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934





For
the quarterly period ended September 30, 2010





OR





 ̈ TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934





Commission
File Number


001-33709





CHINA
ARCHITECTURAL ENGINEERING, INC.


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





Delaware
              (State
      or other jurisdiction of incorporation
              or
      organization)
            
            51-05021250
              (I.R.S.
      Employer Identification
              No.)Research
      Building, No.801 Wuzhong Road,
              Changzhou
      Science and Education Industrial Park
              Wujin
      District,
              Changzhou,
      Jiangsu, People’s Republic of China(Address
      of principal executive offices)
            
            213164
              (Zip
      Code)





+86-519-86339908


(Registrant’s
telephone number, including area code)





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 ̈





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





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





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





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





There
were 80,156,874 shares outstanding of registrant’s common stock, par value
$0.001 per share, as of November 21, 2010.







CHINA
ARCHITECTURAL ENGINEERING, INC.


FORM
10-Q QUARTERLY REPORT





TABLE
OF CONTENTS





PagePART
      I - FINANCIAL INFORMATIONITEM
      1.
              FINANCIAL
      STATEMENTS
              1Consolidated
      Balance Sheet as of September 30, 2010 (unaudited) and December 31,
      2009
              2Unaudited
      Interim Consolidated Statements of Income for the three and nine months
      ended September 30, 2010 and 2009
              4Unaudited
      Interim Consolidated Statements of Cash Flows for the nine months ended
      September 30, 2010 and 2009
              5Unaudited
      Consolidated Statements of Stockholders’ Equity from January 1, 2010 to
      September 30, 2010
              6ITEM
      2.
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATION
              26ITEM
      3.
              QUANTITATIVE
      AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
              38ITEM
      4.
              CONTROLS
      AND PROCEDURES
              38PART
      II - OTHER INFORMATION
              41ITEM
      1.
              LEGAL
      PROCEEDINGS
              41ITEM
      1A.
              RISK
      FACTORS
              41ITEM
      2.
              UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
              46ITEM
      3.
              DEFAULTS
      UPON SENIOR SECURITIES
              46ITEM
      4.
              REMOVED
      AND RESERVED
              46ITEM
      5.
              OTHER
      INFORMATION
              46ITEM
      6.
              EXHIBITS
              46SIGNATURES
              47


2




PART
I - FINANCIAL INFORMATION





ITEM
      1.
            FINANCIAL
      STATEMENTS





The
accompanying unaudited financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-Q.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
The accompanying unaudited financial statements reflect all adjustments that, in
the opinion of management, are considered necessary for a fair presentation of
the financial position, results of operations, and cash flows for the periods
presented. The results of operations for such periods are not necessarily
indicative of the results expected for the full fiscal year or for any future
period. The accompanying unaudited financial statements should be read in
conjunction with the audited financial statements of China
Architectural Engineering, Inc. as contained in its Annual Report for the
fiscal year ended December 31, 2009 on Form 10-K/A, as filed with the Securities
and Exchange Commission on June 2, 2010.




1


CHINA
ARCHITECTURAL ENGINEERING, INC.





CONSOLIDATED
BALANCE SHEETS


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


(STATED
IN US DOLLARS)





Notes
                  
                  September30,
                    2010
                  
                  
                  December31,
                    2009(unaudited)ASSETSCurrent
      assetsCash
      and cash equivalents
                  
                  
                  $
                  3,009,063
                  
                  
                  $
                  740,125Restricted
      cash
                  
                  
                  
                  1,080,415
                  
                  
                  
                  3,033,819Contract
      receivables, net
                  (3)
                  
                  
                  84,434,212
                  
                  
                  
                  89,189,103Costs
      and earnings in excess of billings
                  
                  
                  
                  3,436,002
                  
                  
                  
                  8,100,580Job
      disbursements advances
                  
                  
                  
                  2,526,634
                  
                  
                  
                  2,696,794Other
      receivables
                  (4)
                  
                  
                  24,577,249
                  
                  
                  
                  30,768,067Inventories
                  (5)
                  
                  
                  172,882
                  
                  
                  
                  727,499Deferred
      income taxes, current
                  
                  
                  
                  112,988
                  
                  
                  
                  113,033Other
      current assets
                  
                  
                  
                  306,235
                  
                  
                  
                  297,838Total
      current assets
                  
                  
                  
                  119,655,680
                  
                  
                  
                  135,666,858Non-current
      assetsPlant
      and equipment, net
                  (6)
                  
                  
                  3,197,473
                  
                  
                  
                  2,539,457Intangible
      assets
                  (7)
                  
                  
                  175,514
                  
                  
                  
                  70,610Goodwill
                  
                  
                  
                  23,771,636
                  
                  
                  
                  7,995,896Other
      non-current asset
                  
                  
                  
                  393,701
                  
                  
                  
                  287,586TOTAL
      ASSETS
                  
                  
                  $
                  147,194,004
                  
                  
                  $
                  146,560,407LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesShort-term
      bank loans
                  (8)
                  
                  $
                  6,903,751
                  
                  
                  $
                  9,529,880Accounts
      payable
                  
                  
                  
                  26,664,322
                  
                  
                  
                  26,614,484Billings over
      costs and estimated earnings
                  
                  
                  
                  1,595,284
                  
                  
                  
                  6,098,666Amount
      due to shareholder
                  
                  
                  
                  9,098,900
                  
                  
                  
                  10,080,345Other
      payables
                  
                  
                  
                  14,253,808
                  
                  
                  
                  9,360,314Business
      and other taxes payable
                  
                  
                  
                  4,659,759
                  
                  
                  
                  4,923,771Customers’
      deposits
                  
                  
                  
                  5,741,681
                  
                  
                  
                  6,392,676Other
      Accrual
                  
                  
                  
                  4,065,003
                  
                  
                  
                  4,324,011Total
      current liabilities
                  
                  
                  
                  72,982,508
                  
                  
                  
                  77,324,147




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


2





CHINA
ARCHITECTURAL ENGINEERING, INC.





CONSOLIDATED
BALANCE SHEETS (Continued)


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


(STATED
IN US DOLLARS)





September30,
                        2010
                      
                      
                      December31,
                        2009(unaudited)Non-current
      liabilitiesLong
      term bank loans
                      (8)
                      
                      $
                      51,386
                      
                      
                      $
                      109,239Convertible
      bond payable, net
                      (9)
                      
                      
                      27,688,956
                      
                      
                      
                      24,564,161TOTAL
      LIABILITIES
                      
                      
                      $
                      100,722,850
                      
                      
                      $
                      101,997,547STOCKHOLDERS’
      EQUITYPreferred
      stock, $0.001 par value, 10,000,000 shares authorized, 0 shares issued and
      outstanding at September 30, 2010 and December 31, 2009;Common
      stock, $0.001 par value, 150,000,000 shares authorized, 80,156,874 shares
      issued and outstanding at September 30, 2010 and 53,256,874 shares
      issued at and outstanding December 31, 2009
                      
                      
                      $
                      80,157
                      
                      
                      $
                      53,257Additional
      paid in capital
                      
                      
                      
                      43,820,878
                      
                      
                      
                      26,495,876Statutory
      reserves
                      
                      
                      
                      3,040,595
                      
                      
                      
                      3,040,595Accumulated
      other comprehensive income
                      
                      
                      
                      4,020,091
                      
                      
                      
                      3,868,437Retained
      earnings
                      
                      
                      
                      (4,205,083
                      )
                      
                      
                      11,131,084Total
      Company shareholders’ equity
                      
                      
                      
                      46,756,638
                      
                      
                      
                      44,589,249Noncontrolling
      interests
                      
                      
                      
                      (285,484
                      )
                      
                      
                      (26,389
                      )Total
      shareholders’ equity
                      
                      
                      
                      46,471,154
                      
                      
                      
                      44,562,860TOTAL
      LIABILITIES ANDSTOCKHOLDERS’
      EQUITY
                      
                      
                      $
                      147,194,004
                      
                      
                      $
                      146,560,407





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


3




CHINA
ARCHITECTURAL ENGINEERING, INC.





UNAUDITED
CONSOLIDATED STATEMENTS OF INCOME


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(STATED
IN US DOLLARS) (UNAUDITED)





Notes
                    
                    ThreeMonthsEnded
                      September30,
                    
                    
                    NineMonthsEnded
                      September30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Contract
      revenues earned
                    (10)
                    
                    $
                    4,442,495
                    
                    
                    $
                    25,558,074
                    
                    
                    $
                    21,623,035
                    
                    
                    $
                    92,500,112Cost
      of contract revenues earned
                    
                    
                    
                    (5,452,809
                    )
                    
                    
                    (25,082,910
                    )
                    
                    
                    (20,734,794
                    )
                    
                    
                    (73,892,287
                    )Gross
      profit/(loss)
                    
                    
                    $
                    (1,010,314
                    )
                    
                    $
                    475,164
                    
                    
                    $
                    888,241
                    
                    
                    $
                    18,607,825Selling,
      general and administrative expenses
                    
                    
                    
                    (5,609,538
                    )
                    
                    
                    (5,548,946
                    )
                    
                    
                    (11,678,113
                    )
                    
                    
                    (17,619,775
                    )Income/(loss)
      from operations
                    
                    
                    $
                    (6,619,852
                    )
                    
                    $
                    (5,073,782
                    )
                    
                    $
                    (10,789,872
                    )
                    
                    $
                    988,050Interest
      income
                    
                    
                    
                    3,668
                    
                    
                    
                    4,835
                    
                    
                    
                    8,951
                    
                    
                    
                    54,800Interest
      expense
                    
                    
                    
                    (1,779,371
                    )
                    
                    
                    (1,741,368
                    )
                    
                    
                    (5,273,367
                    )
                    
                    
                    (4,524,936
                    )Other
      expenses
                    
                    
                    
                    (350,764
                    )
                    
                    
                    -
                    
                    
                    
                    (359,694
                    )
                    
                    
                    -Other
      income
                    
                    
                    
                    4,001
                    
                    
                    
                    335,104
                    
                    
                    
                    827,929
                    
                    
                    
                    495,560Loss
      before taxation on continuing operations
                    
                    
                    $
                    (8,742,318
                    )
                    
                    $
                    (6,475,211
                    )
                    
                    $
                    (15,586,053
                    )
                    
                    $
                    (2,986,526
                    )Income
      tax
                    (11)
                    
                    
                    -
                    
                    
                    
                    (114,113
                    )
                    
                    
                    (9,575
                    )
                    
                    
                    (114,113
                    )Discontinued
      operation loss, net of tax
                    
                    
                    
                    -
                    
                    
                    
                    (1,829,971
                    )
                    
                    
                    -
                    
                    
                    
                    (1,829,971
                    )Net
      loss including non-controlling interests
                    
                    
                    
                    (8,742,318
                    )
                    
                    
                    (8,419,295
                    )
                    
                    
                    (15,595,628
                    )
                    
                    
                    (4,930,610
                    )Loss
      attributable to non-controlling interest
                    
                    
                    
                    256,371
                    
                    
                    
                    38,009
                    
                    
                    
                    259,461
                    
                    
                    
                    36,604Net
      loss attributable to the Company
                    
                    
                    $
                    (8,485,947
                    )
                    
                    $
                    (8,381,286
                    )
                    
                    $
                    (15,336,167
                    )
                    
                    $
                    (4,894,006
                    )Loss
      per share:Basic
                    
                    
                    $
                    (0.13
                    )
                    
                    $
                    (0.16
                    )
                    
                    $
                    (0.26
                    )
                    
                    $
                    (0.09
                    )Diluted
                    
                    
                    $
                    (0.13
                    )
                    
                    $
                    (0.16
                    )
                    
                    $
                    (0.26
                    )
                    
                    $
                    (0.09
                    )Weighted
      average shares outstanding:Basic
                    
                    
                    
                    66,970,061
                    
                    
                    
                    53,256,874
                    
                    
                    
                    58,969,374
                    
                    
                    
                    53,256,874Diluted
                    
                    
                    
                    66,970,061
                    
                    
                    
                    53,256,874
                    
                    
                    
                    58,969,374
                    
                    
                    
                    53,256,874




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


4





CHINA
ARCHITECTURAL ENGINEERING, INC.





UNAUDITED
CONSOLIDATED STATEMENTS OF CASH FLOWS


FOR
THE NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(STATED
IN US DOLLARS) (UNAUDITED)





NineMonths EndedSeptember30,2010
                
                
                2009Cash
      flows from operating activitiesNet/(Loss)
      income
                
                $
                (15,336,167
                )
                
                $
                (4,894,006
                )Noncontrolling
      interest
                
                
                (259,095
                )
                
                
                (40,831
                )Depreciation
      expense
                
                
                610,220
                
                
                
                710,901Bad
      debts expenses
                
                
                3,366,552
                
                
                
                -Amortization
      expense on intangible assets
                
                
                42,082
                
                
                
                78,461Amortization
      expense on convertible bond
                
                
                3,124,795
                
                
                
                2,194,418Stock
      compensation expenses
                
                
                1,976,902
                
                
                
                -Loss
      on disposal of fixed assets
                
                
                882
                
                
                
                1,998,634Deferred
      income taxes
                
                
                45
                
                
                
                (109,842
                )Decrease
      in inventories
                
                
                554,617
                
                
                
                17,209(Increase)
      / Decrease in receivables
                
                
                12,243,735
                
                
                
                (12,456,959
                )(Increase)
      / Decrease in other assets
                
                
                55,648
                
                
                
                (6,339,445
                )Increase
      / (Decrease) in payables
                
                
                (734,065
                )
                
                
                7,656,923Net
      cash provided by / (used in) operating activities
                
                $
                5,646,151
                
                
                $
                (11,184,537
                )Cash
      flows from investing activitiesPurchases
      of assets
                
                $
                (1,240,869
                )
                
                $
                (161,420
                )Purchase
      of intangible assets
                
                
                (146,986
                )
                
                
                (103,405
                )Proceeds
      from disposal of fixed assets
                
                
                -
                
                
                
                342,095Purchases
      of goodwills
                
                
                (15,775,740
                )
                
                
                -Decrease
      in restricted cash
                
                
                1,953,404
                
                
                
                7,448,458Net
      cash provided by/(used in) investing activities
                
                $
                (15,210,191
                )
                
                $
                7,525,728Cash
      flows from financing activitiesProceeds
      from / (Repayments) of short-term loans
                
                
                (2,626,129
                )
                
                
                9,533,975Repayment
      of notes Payable
                
                
                -
                
                
                
                (10,193,088
                )Repayment
      of long-term loans
                
                
                (57,853
                )
                
                
                (199,686
                )Proceeds
      from / (Repayments) of shareholders loans
                
                
                (981,445
                )
                
                
                3,710,741Net
      cash provided by financing activities
                
                $
                (3,665,427
                )
                
                $
                2,851,942Net
      decrease in cash and cash equivalents
                
                $
                (13,229,467
                )
                
                $
                (806,867
                )Effect
      of foreign currency translation on cash and cash
    equivalents
                
                
                123,405
                
                
                
                (2,191,366
                )Cash
      and cash equivalents - beginning of period
                
                
                740,125
                
                
                
                9,516,202(12,365,937
                )
                
                
                6,517,969Cash
      and cash equivalents - end of period
                
                $
                3,009,063
                
                
                $
                6,517,969Non-cash
      transactionsIssuance
      of stock for subsidiary acquisition
                
                
                15,375,000
                
                
                
                -Other
      supplementary information:Cash
      paid during the period for:Interest
      paid
                
                $
                2,794,277
                
                
                $
                -Income
      tax paid
                
                $
                9,575
                
                
                $
                143,306


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




5





CHINA
ARCHITECTURAL ENGINEERING, INC.


UNAUDITED
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY


FOR
THE PERIOD FROM JANUARY 1, 2010 TO SEPTEMBER 30, 2010


(STATED IN US
DOLLARS)





Total
                      Number of
                        shares
                    
                    
                    Common
                        stock
                    
                    
                    Additional
                        paid in capital
                    
                    
                    Statutory
                        reserves
                    
                    
                    Accumulated
                        other
                        comprehensive
                        income
                    
                    
                    Retained
                        earnings
                    
                    
                    Noncontrolling
                        interests
                    
                    
                    TotalBalance,
      January 1, 2010
                    
                    
                    53,256,874
                    
                    
                    $
                    53,257
                    
                    
                    $
                    26,495,876
                    
                    
                    $
                    3,040,595
                    
                    
                    $
                    3,868,437
                    
                    
                    $
                    11,131,084
                    
                    
                    $
                    (26,389
                    )
                    
                    $
                    44,562,860Net
      Loss including non-controlling interests
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (15,336,167
                    )
                    
                    
                    (259,461
                    )
                    
                    
                    (15,595,628
                    )Additional
      paid-in capital from grant of stock option to employee
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    19,902
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    19,902Value
      of stock grants to employees
                    
                    
                    1,900,000
                    
                    
                    
                    1,900
                    
                    
                    
                    1,955,100
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,957,000Value
      of stock issued for acquisition of subsidiary
                    
                    
                    25,000,000
                    
                    
                    
                    25,000
                    
                    
                    
                    15,350,000
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    15,375,000Foreign
      currency translation adjustment
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    151,654
                    
                    
                    
                    
                    
                    
                    
                    366
                    
                    
                    
                    152,020Total
      comprehensive income
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,908,294Balance,
      September 30, 2010
                    
                    
                    80,156,874
                    
                    
                    $
                    80,157
                    
                    
                    $
                    43,820,878
                    
                    
                    $
                    3,040,595
                    
                    
                    $
                    4,020,091
                    
                    
                    $
                    (4,205,083
                    )
                    
                    $
                    (285,484
                    )
                    
                    $
                    46,471,154





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


6





CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





1.
            ORGANIZATION
      AND PRINCIPAL ACTIVITIES





China
Architectural Engineering, Inc. (the “Company”) formerly SRKP 1, Inc., was
incorporated in the State of Delaware, United States on March 16, 2004. The
Company’s common stock was initially listed for trading on the American Stock
Exchange on September 28, 2007.  The Company transferred its listing
to The NASDAQ Stock Market LLC on June 10, 2008.




The
Company through its subsidiaries conducts its principal activity as building
envelope systems contractors, specializing in the design, engineering,
fabrication and installation of curtain wall systems, roofing systems, steel
construction systems and eco-energy saving building conservation systems,
throughout China, Australia, Southeast Asia, the Middle East, and the United
States.




The
Company's work is performed under cost-plus-fee contracts, fixed-price
contracts, and fixed-price contracts modified by incentive and penalty
provisions. These contracts are undertaken by the Company or its wholly owned
subsidiaries. The length of the Company's contracts varies but is typically
about one to two years.




On August
18, 2010, pursuant to a stock purchase agreement that was entered into on August
11, 2010 by and among the Company, First Jet Investments Limited (“First Jet”),
New Crown Technology Limited, First Jet’s wholly-owned subsidiary (“New Crown”)
and Mr. Jun Tang, the principal of First Jet and New Crown, the Company
completed an acquisition of 60% of the issued and outstanding shares of New
Crown, which is the holder of 100% of the equity interests of Shanghai ConnGame
Network Ltd. (“ConnGame”).  In exchange for the 60% equity interest of
New Crown, the Company issued 25,000,000 shares of the Company’s common stock,
$0.001 par value per share, to First Jet.  ConnGame is a company
organized under the laws of the People’s Republic of China with a registered
capital of RMB 10,000,000.  ConnGame is a developer and publisher of
MMORPG (Massively Multiplayer Online Role Playing Game).  In
connection with the foregoing transaction, the Company transferred to New Crown
100% of the equity interests of China Architectural Engineering (Shenzhen) Co.,
Ltd., which had immaterial operations and assets at the time of
transfer.




In August
2010, connection with the acquisition of ConnGame and the issuance of 25,000,000
shares of the Company's common stock, the Company increased its authorized
shares of common stock from 100,000,000 to 150,000,000 shares of common
stock.




2.
            SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES





(a)
            Method
      of accounting




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





(b)
            Consolidation




The
consolidated financial statements include the accounts of the Company and its 17
subsidiaries. Significant inter-company transactions have been eliminated in
consolidation. The consolidated financial statements include 100% of the assets
and liabilities of these majority-owned subsidiaries, and the ownership
interests of minority investors are recorded as noncontrolling
interests.




7


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





The
Company owned the subsidiaries through its reverse-merger on October 17, 2006
and through direct investments or acquisitions after October 17,
2006.  As of September 30, 2010, detailed identities of the
consolidating subsidiaries are as follows:


Name of Company
                  Place of
                    Incorporation
                  
                  Attributable Equity
                    interest %Full
      Art International Limited
                  Hong
      Kong
                  
                  
                  100Zhuhai
      King Glass Engineering Co., Ltd.
                  PRC
                  
                  
                  100Zhuhai
      King General Glass Engineering Technology Co., Ltd.
                  PRC
                  
                  
                  100King
      General Engineering (HK) Limited
                  Hong
      Kong
                  
                  
                  100KGE
      Building System Limited
                  Hong
      Kong
                  
                  
                  100KGE
      Australia Pty Limited
                  Australia
                  
                  
                  55Zhuhai
      Xiangzhou District Career Training School
                  PRC
                  
                  
                  72Faith
      Mount International Limited
                  Hong
      Kong
                  
                  
                  100Techwell
      Engineering Limited
                  Hong
      Kong
                  
                  
                  100Techwell
      International Limited
                  Macau
                  
                  
                  100Techwell
      Building System (Shenzhen) Co., Ltd.
                  PRC
                  
                  
                  100CAE
      Building Systems, Inc.
                  USA
                  
                  
                  100Techwell
      International S.E.A.
                  Singapore
                  
                  
                  100China
      Architectural Engineering (Shenzhen) Co., Ltd.
                  PRC
                  
                  
                  60CAE
      Building Systems (Singapore) Pte Ltd
                  Singapore
                  
                  
                  100New
      Crown Technology Limited
                  Hong
      Kong
                  
                  
                  60Shanghai
      ConnGame Network Ltd.
                  PRC
                  
                  
                  60





(c)
            Use
      of estimates




The
preparation of the consolidated financial statements in conformity with
generally accepted accounting principles in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting periods.
Management makes these estimates using the best information available at the
time the estimates are made; however, actual results could differ materially
from those estimates.





(d)
            Plant
      and equipment




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





Building
                20
      yearsMachinery
      and equipment
                5 -
      10 yearsFurniture
      and office equipment
                5
      yearsMotor
      vehicle
                5
      years





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


8


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





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




The
long-lived assets held and used by the Company are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
assets may not be recoverable. It is reasonably possible that these assets could
become impaired as a result of technology or other industry
changes.  Determination of recoverability of assets to be held and
used is by comparing the carrying amount of an asset to future net undiscounted
cash flows to be generated by the assets.





If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell. During the reporting
periods, there was no impairment loss.





(f)
            Goodwill
      and Intangible Assets





In
accordance with ASC 350, “Goodwill and Other Intangible Assets.” the Company
does not amortize goodwill or intangible assets with indefinite
lives.





Upon
indication that the carrying values of such assets may not be recoverable, the
Company recognizes an impairment loss as a charge against current
operations.





The
Company performs an analysis on its goodwill balances to test for impairment on
an annual basis and whenever events occur that indicate an impairment could
exist.  Of the goodwill presented as September 30, 2010, approximately
$23.8 million is attributable to  the acquired
subsidiaries.





Approximately
$15.4 million was attributed to ConnGame, which was acquired in August 2010, and
approximately $8.0 million was attributed to Techwell Engineering Limited. There
are several instances that may cause the Company to further test its goodwill
for impairment between the annual testing periods including:  (i)
continued deterioration of market and economic conditions that may adversely
impact its ability to meet its projected results; (ii) declines in the Company’s
stock price caused by continued volatility in the financial markets that may
result in increases in its weighted-average cost of capital or other inputs to
its goodwill assessment; (iii) the occurrence of events that may reduce the fair
value of a reporting unit below its carrying amount, such as the sale of a
significant portion of one or more of the Company’s reporting units. In the nine
month periods ended September 30, 2010, the Company believes that no instance
indicates that an impairment could exist in respect to
Techwell.





Material
assumptions include:  (1) The reporting unit continues to have the
profitable operations for a period of next 10 years; (2) the revenue has the
steady annual growth rate ranging from 5% to 8% as in line with the estimated
growth rate of PRC economy; (3) costs of funds kept stable for the period of
next 10 years resulting in a stable discount rate for the projection of
estimated fair value; and (4) no material change in the prevailing payment terms
of the construction industry that allowing the working capital requirement kept
at a low level at 15%.  Uncertainties include: (1)  The
ability of the reporting unit to continue as a  profitable operation
may be affected by changes in technologies and the market of the construction
industry; (2) the growth of the PRC economy may not be as steady as projected
that in turn affect the steady growth of the revenue of the reporting unit, (3)
it is also uncertain about the capital market that affect the costs of fund of
the company; and (4) the prevailing payment terms used in the construction
industry may be changed as a result of changes in the business environment for
the construction industry. Potential events include (1) the appreciation of the
value of RMB that would slow down the export and in turn the economic
development of China that in turn have negative effect of property development
industry in China; and (2) the controlling policies towards the property market
by the PRC government.





For other
intangible assets, impairment tests are performed annually and more frequently
whenever events or changes in circumstances indicate carrying values exceed
estimated reporting unit fair values.


9


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





(g)
            Inventories





Inventories
are raw materials, which are stated at the lower of weighted average cost or
market value.





(h)
            Contracts
      receivable





Contracts
receivable from performing construction of industrial and commercial buildings
are based on contracted prices.  The Company provides an allowance for
doubtful accounts, which is based upon a review of outstanding receivables,
historical collection information, and existing economic
conditions.





(i)
            Cash
      and cash equivalents





The
Company considers all highly liquid investments purchased with original
maturities of three months or less to be cash equivalents.





(j)
            Restricted
      cash





Restricted
cash represents deposits in bank accounts to secure notes payables, bank loans,
project performance bond and guarantee.





(k)
              Earnings
      per share





The
Company computes earnings per share (“EPS’) in accordance with ASC260, “Earnings per Share”. ASC260
requires companies with complex capital structures to present basic and diluted
EPS. Basic EPS is measured as the income or loss available to common
shareholders divided by the weighted average common shares outstanding for the
period. Diluted EPS is similar to basic EPS but presents the dilutive effect on
a per share basis of potential common shares (e.g., convertible securities,
options, and warrants) as if they had been converted at the beginning of the
periods presented, or issuance date, if later. Potential common shares that have
an anti-dilutive effect (i.e., those that increase income per share or decrease
loss per share) are excluded from the calculation of diluted EPS.





The
calculation of diluted weighted average common shares outstanding for the
periods ended September 30, 2010 and 2009 is based on the estimate fair value of
the Company’s common stock during such periods applied to warrants and options
using the treasury stock method to determine if they are dilutive. The
Convertible Bond is included on an “as converted” basis when these shares are
dilutive.




10


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





Components
of basic and diluted earnings per share were as follows:




Three Months Ended September 30,
                      
                      
                      Nine Months Ended
                          September 30,2010
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Net
      Income/(Loss)
                      
                      $
                      (8,485,947
                      )
                      
                      $
                      (8,381,286
                      )
                      
                      $
                      (15,336,167
                      )
                      
                      $
                      (4,894,006
                      )Add:
      Interest expenses less income taxes
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Adjusted
      income
                      
                      
                      (8,485,947
                      )
                      
                      
                      (8,381,286
                      )
                      
                      
                      (15,336,167
                      )
                      
                      
                      (4,894,006
                      )Basic
      Weighted Average Shares Outstanding
                      
                      
                      66,970,061
                      
                      
                      
                      53,256,874
                      
                      
                      
                      58,969,374
                      
                      
                      
                      53,256,874Dilutive
      Shares:-     
      Addition to Common Stock from Conversion of Bonds
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      --     
      Addition to Common Stock from Exercise of Warrants
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Diluted
      Weighted Average Outstanding Shares:
                      
                      
                      66,970,061
                      
                      
                      
                      53,256,874
                      
                      
                      
                      58,969,374
                      
                      
                      
                      53,256,874Earnings/(Loss)
      Per Share-   
      Basic
                      
                      $
                      (0.13
                      )
                      
                      $
                      (0.16
                      )
                      
                      $
                      (0.26
                      )
                      
                      $
                      (0.09
                      )-   
      Diluted
                      
                      $
                      (0.13
                      )
                      
                      $
                      (0.16
                      )
                      
                      $
                      (0.26
                      )
                      
                      $
                      (0.09
                      )




(l)
              Revenue
      and cost recognition





Revenues
from fixed-price and modified fixed-price construction contracts are recognized
on the percentage-of-completion method, measured by the percentage of costs
incurred to date to estimated total cost for each contract.





Contract
costs include all direct material and labor costs and those indirect costs
related to contract performance, such as indirect labor, supplies, tools,
repairs, and depreciation costs.





Provisions
for estimated losses on uncompleted contracts are made in the period in which
such losses are determined. Changes in job performance, job conditions, and
estimated profitability, including those arising from contract penalty
provisions, and final contract settlements may result in revisions to costs and
income and are recognized in the period in which the revisions are determined.
Profit incentives are included in revenues when their realization is reasonably
assured. An amount equal to contract costs attributable to claims is included in
revenues when realization is probable and the amount can be reliably
estimated.





Selling,
general, and administrative costs are charged to expense as
incurred.





Total
estimated gross profit on a contract, being the difference between total
estimated contract revenue and total estimated contract cost, is determined
before the amount earned on the contract for a period can be
determined.





The
measurement of the extent of progress toward completion is used to determine the
amount of gross profit earned to date and that the earned revenue to date is the
sum of the total cost incurred on the contract and the amount of gross profit
earned.





Earned
revenue, cost of earned revenue, and gross profit are determined as follows:
-





a.
              Earned
      Revenue is the amount of gross profit earned on a contract for a period
      plus the costs incurred on the contract during the
  period.





b.
              Cost
      of Earned Revenue is the cost incurred during the period, excluding the
      cost of materials not unique to a contract that have not been used for the
      contract.


11


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





c.
              Gross
      Profit earned on a contract is computed by multiplying the total estimated
      gross profit on the contract by the percentage of completion. The excess
      of that amount over the amount of gross profit reported in prior periods
      is the earned gross profit that should be recognized in the income
      statement for the current
period.





Change
orders are common for the changes in specifications or
design.  Contract revenue and costs are adjusted to reflect change
orders approved by the customer and the contractor regarding both scope and
price.  Recognition of amounts of additional contract revenue relating
to claims is appropriate only if it is probable that the claim will result in
additional contract revenue and if the amount can be reliably
estimated.





(m)
            Income
      taxes





The
Company uses the accrual method of accounting to determine and report its
taxable reduction of income taxes for the year in which they are
available.  The Company has implemented ASC 740-270, Accounting for Income
Taxes.





Income
tax liabilities computed according to the United States, People’s Republic of
China (PRC), Hong Kong SAR, Macau SAR and Australia tax laws are provided for
the tax effects of transactions reported in the financial statements and
consists of taxes currently due plus deferred taxes related primarily to
differences between the basis of fixed assets and intangible assets for
financial and tax reporting.  The deferred tax assets and liabilities
represent the future tax return consequences of those differences, which will be
either taxable or deductible when the assets and liabilities are recovered or
settled.  Deferred taxes also are recognized for operating losses that
are available to offset future income taxes.  A valuation allowance is
created to evaluate deferred tax assets if it is more likely than not that these
items will either expire before the Company is able to realize that tax benefit,
or that future realization is uncertain.





In
respect of the Company’s subsidiaries domiciled and operated in different tax
jurisdictions, the taxation of these entities can be summarized as
follows:





·
            Zhuhai
      King Glass Engineering Co., Limited (“Zhuhai KGE”) and Zhuhai King General
      Glass Engineering Technology Co., Limited (“Zhuhai KGGET”) are located in
      Zhuhai and were subject to the PRC corporation income tax rate of 18% in
      2008 and 20% in 2009. In accordance to China’s Enterprise Income Tax Law
      (“EIT Law”) effective from January 1, 2008, the tax rate for these two
      subsidiaries will be gradually increased 25% in 2012. The Company
      anticipates that as a result of the EIT law, its income tax provision will
      increase, which could adversely affect Zhuhai KGE’s financial condition
      and results of operations.





·
            China
      Architectural Engineering (Shenzhen) Co., Ltd. is located in Shenzhen and
      is subject to a 20% income tax rate that will be gradually increased to
      the uniform rate of 25% by 2012 as according to the new EIT
      law.





·
            Full
      Art International Limited, King General Engineering (HK) Limited, and KGE
      Building System Limited are subject to a Hong Kong profits tax rate of
      16.5%.





·
            Techwell
      Engineering Limited is subject to a Hong Kong profits tax rate of 16.5%.
      Techwell International Limited is a Macau registered company and therefore
      is subject to Macau profits tax rate of 12%.  Techwell Building
      System (Shenzhen) Co. Limited is located in Shenzhen and is subject to PRC
      corporate income tax rate of 20% in 2009 that will be gradually increased
      to the uniform rate of 25% by 2012 as according to the new EIT
      law.





·
            KGE
      Australia Pty Limited is subject to a corporate income tax rate of
      30%.





·
            The
      Company is subject to United States Tax according to Internal Revenue Code
      Sections 951 and 957.





·
            The
      Company, after a reverse-merger on October 17, 2006, revived to be an
      active business enterprise because of the operations with subsidiaries in
      the PRC and Hong Kong.  Based on the consolidated net income for
      the year ended December 31, 2009, the Company shall be taxed at the 34%
      tax rate.


12


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





·
            Techwell
      Engineering Limited has established a branch in Dubai, which has zero
      corporate income tax rate.





·
            New
      Crown Technology Limited is subject to a Hong Kong profits tax rate of
      16.5%.





·
            Shanghai
      ConnGame Network Ltd. is located in Shanghai and is subject to a 25%
      income tax rate.





(n)
            Advertising





The
Company expensed all advertising costs as incurred. Advertising expenses
included in selling expenses were $3,668 and $nil for the three-month period,
$3,668 and $11,032 for the nine-month period ended September 30, 2010 and 2009,
respectively.





(o)
            Research and
      development





All
research and development costs are expensed as incurred. Research and
development costs included in general and administrative expenses were $362,677
and $nil for the three-month period, $362,677 and $2,926 for the nine-month
period ended September 30, 2010 and 2009, respectively.





(p)
            Retirement
      benefits





Retirement
benefits in the form of contributions under defined contribution retirement
plans to the relevant authorities are charged to the statements of income as
incurred.





(q)
            Foreign
      currency translation





The
accompanying consolidated financial statements are presented in United States
Dollars (US$). The Company’s functional currency is the US$, while certain
domestic subsidiaries’ use the Renminbi (RMB) and Hong Kong and overseas
subsidiaries use local currencies as their functional
currency.   The consolidated financial statements are translated
into US$ from RMB, Hong Kong Dollars (HKD), United Arab Emirate Dirham (AED) and
other local currencies at September 30, 2010 exchange rates as to assets and
liabilities and average exchange rates as to revenues and expenses. Capital
accounts are translated at their historical exchange rates when the capital
transactions occurred.




September
                      30,2010
                    
                    
                    December31,
                      2009
                    
                    
                    September
                      30,2009Period
      end RMB : US$ exchange rate
                    
                    
                    6.6981
                    
                    
                    
                    6.8372
                    
                    
                    
                    6.8263Average
      quarterly RMB : US$ exchange rate
                    
                    
                    6.7803
                    
                    
                    
                    6.8331
                    
                    
                    
                    6.8309





September
                    30,2010
                  
                  
                  December31,
                    2009
                  
                  
                  September
                    30,2009Period
      end HKD : US$ exchange rate
                  
                  
                  7.7582
                  
                  
                  
                  7.7551
                  
                  
                  
                  7.7501Average
      quarterly HKD : US$ exchange rate
                  
                  
                  7.7718
                  
                  
                  
                  7.7518
                  
                  
                  
                  7.7505




September
                    30,2010
                  
                  
                  December31,
                    2009
                  
                  
                  September
                    30,2009Period
      end AED : US$ exchange rate
                  
                  
                  3.6736
                  
                  
                  
                  3.6738
                  
                  
                  
                  3.6700Average
      quarterly AED : US$ exchange rate
                  
                  
                  3.6738
                  
                  
                  
                  3.6710
                  
                  
                  
                  3.6700





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


13


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





(r)
            Statutory
      reserves





Statutory
reserves for foreign investment enterprises are referring to the amount
appropriated from the net income in accordance with laws or regulations, which
can be used to recover losses and increase capital, as approved, and are to be
used to expand production or operations.





(s)
            Comprehensive
      income





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





(t)
            Recent
      accounting pronouncements





On July
1, 2009, FASB issued FASB Statement No. 168, The “FASB Accounting Standards
Codification” and the Hierarchy of Generally Accepted Accounting
Principles.  The ASC has become the source of authoritative US
GAAP recognized by the FASB to be applied by nongovernmental entities and
provides that all such guidance carries an equal level of authority. The ASC is
not intended to change or alter existing GAAP. The ASC is effective for interim
and annual periods ending after September 15, 2009.





There was no new accounting
pronouncements since the FASB Statement No. 168 issued on July 1,
2009.




14





CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





3.
            CONTRACT
      RECEIVABLES





September 30,
                              2010
                            
                            
                            December 31,
                              2009Contract
      receivables
                            
                            $
                            87,359,141
                            
                            
                            $
                            95,831,489Less: Allowance for
      doubtful accounts
                            
                            
                            (2,924,929
                            )
                            
                            
                            (6,642,386
                            )Net
                            
                            $
                            84,434,212
                            
                            
                            $
                            89,189,103





Allowance for Doubtful Accounts
                                
                                September 30,
                                  2010
                                
                                
                                December 31,
                                  2009Beginning
      balance
                                
                                $
                                6,642,386
                                
                                
                                $
                                5,215,701Add:
      Allowance created
                                
                                
                                3,366,552
                                
                                
                                
                                1,426,685Less:
      Written off of receivables
                                
                                
                                (7,084,009
                                )
                                
                                
                                -Ending
      balance
                                
                                $
                                2,924,929
                                
                                
                                $
                                6,642,386




15


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





4.
              OTHER
      RECEIVABLES





Other
receivables consisted of the following:





September30,
                2010
              
              
              December31,
                2009Due
      from sellers of Techwell, the subsidiary (1)
              
              $
              11,371,563
              
              
              $
              11,333,253Due
      from Kangbao Electrical Company Limited (Kangbao) , a related
      party  (2)
              
              
              -
              
              
              
              6,054,905Drawdown
      of advance payment and performance bonds by client of the projects in
      Dubai (3)
              
              
              9,410,636
              
              
              
              9,414,397Other
      related parties receivables
              
              
              -
              
              
              
              253,638Deposits
      for site operations of projects in PRC
              
              
              2,774,512
              
              
              
              2,903,171Other
              
              
              1,020,538
              
              
              
              808,703Total
              
              $
              24,577,249
              
              
              $
              30,768,067





(1)
              On
      November 6, 2007, the Company, through Full Art International, Ltd. (“Full
      Art”), acquired all of the issued and outstanding shares in the capital of
      Techwell Engineering Limited, a limited liability company incorporated in
      Hong Kong (“Techwell”) pursuant to a Stock Purchase Agreement (the
      “Agreement”) dated November 6, 2007, entered into by and among Ng Chi Sum
      and Yam Mei Ling (each a “Shareholder” and collectively, the
      “Shareholders”), the Company and Full Art.  Pursuant to the
      terms and conditions of the Agreement, the Shareholders agreed that each
      of them would pay any and all accounts receivables of Techwell if not paid
      by the customers within 24 months of the acquisition date.  The
      24 month period has expired and a total of $9,909,130 is due and payable
      from the Shareholders. The amount is included in the other receivable due
      from sellers of Techwell.


(2)
              The
      amount as at December 31, 2009 mainly represented the purchases advances
      to Kangbao Electrical Company Limited (Kangbao) for the supplies of
      materials for the projects of the
Company.


(3)
              The
      Company believes that the client of the Dubai projects did not have proper
      grounds for the drawdown of the advance payment and performance bonds
      which the company issued for the projects.  The Company also
      believes that the client should not be entitled to the drawdown and is now
      proceeding the claim back of the
amount.


5.
            INVENTORIES





September 30,
                      2010
                    
                    
                    December 31,
                      2009Raw
      materials at sites
                    
                    $
                    172,882
                    
                    
                    $
                    727,499




16


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





6.
            PLANT
      AND EQUIPMENT





Plant and
equipment consist of the following as of:





September30,2010
                                  
                                  
                                  December31,2009At
      costMotor
      vehicle
                                  
                                  $
                                  1,256,072
                                  
                                  
                                  $
                                  1,242,928Machinery
      and equipment
                                  
                                  
                                  2,431,665
                                  
                                  
                                  
                                  2,381,755Furniture,
      software and officeequipment
                                  
                                  
                                  2,287,313
                                  
                                  
                                  
                                  1,795,595Building
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Leasehold
      improvement
                                  
                                  
                                  1,040,039
                                  
                                  
                                  
                                  267,038$
                                  7,015,089
                                  
                                  
                                  $
                                  5,687,316Less: 
       Accumulated depreciationMotor
      vehicle
                                  
                                  $
                                  959,777
                                  
                                  
                                  $
                                  825,536Machinery
      and equipment
                                  
                                  
                                  1,585,480
                                  
                                  
                                  
                                  1,420,536Furniture,
      software and officeequipment
                                  
                                  
                                  1,082,526
                                  
                                  
                                  
                                  804,516Building
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Leasehold
      improvement
                                  
                                  
                                  189,833
                                  
                                  
                                  
                                  97,271$
                                  3,817,616
                                  
                                  
                                  $
                                  3,147,859$
                                  3,197,473
                                  
                                  
                                  $
                                  2,539,457





Depreciation
expenses included in the selling and administrative expenses were $279,259 and
$246,484 for the three-month periods, $610,220 and $710,901 for the nine-month
periods ended September 30, 2010 and 2009, respectively.





7.
            INTANGIBLE
      ASSETS





September 30,2010
                            
                            
                            December 31,2009At
      costIntangible
      Assets
                            
                            $
                            245,659
                            
                            
                            $
                            98,673Less:
      Accumulated amortization
                            
                            
                            70,145
                            
                            
                            
                            28,063$
                            175,514
                            
                            
                            $
                            70,610




17


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





8.
            LOANS





A.
            SHORT-TERM
      BANK LOANS





September 30,
                    2010
                  
                  
                  December 31,
                    2009The
      Royal Bank of Scotland N.V., (formerly ABN Amro N.V.) Overdraft in Current
      Account at interest rate at 6.5% per annum
                  
                  
                  1,652,691
                  
                  
                  
                  4,906,266The
      Royal Bank of Scotland N.V., (formerly ABN Amro N.V.) Temporary Loan for
      the drawing of performance and advance payment bonds at interest rate at
      Bank's Cost of Fund + 6%
                  
                  
                  4,544,688
                  
                  
                  
                  4,546,504Automobile
      capital lease obligation (hire purchase),amount due within one year, last
      installment due November 9, 2012
                  
                  
                  77,079
                  
                  
                  
                  77,110The
      Hongkong and Shanghai Banking Corporation Overdraft in Current Account at
      interest rate at 1.5% over 3 months SIBOR per annum
                  
                  
                  629,293
                  
                  
                  
                  -$
                  6,903,751
                  
                  
                  $
                  9,529,880





B.
            LONG-TERM
      BANK LOANS




September 30,
                    2010
                  
                  
                  December 31,
                    2009Automobile
      capital lease obligation (hire purchase),amount due after one year, last
      installment due November 9, 2012
                  
                  
                  51,386
                  
                  
                  
                  109,239$
                  51,386
                  
                  
                  $
                  109,239




18


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





9.
            CONVERTIBLE
      BONDS AND BOND WARRANTS





(a)
            $10,000,000
      Variable Rate Convertible Bonds due in
2012





On April 12, 2007, the Company
completed a financing transaction with The Royal Bank of Scotland N.V.,
(formerly ABN AMRO Bank N.V.) (the “Subscriber”) issuing (i) $10,000,000
Variable Rate Convertible Bonds due in 2012 (the “Bonds”) and (ii) 800,000
warrants to purchase an aggregate of 800,000 shares of the Company’s common
stock, subject to adjustments for stock splits or reorganizations as set forth
in the warrant, that expire in 2010 (the “Warrants”).





On September 29, 2008, the Subscriber
converted $2,000,000 into 571,428 shares at the conversion price of $3.50 per
share. As of March 31, 2009, the face value of the bonds outstanding was
$8,000,000.





Effective from April 12, 2009, the
conversion price has been reset to $2.45, which is 70% of $3.50 as the average
closing price of the Company’s shares for the period of 20 consecutive trading
days immediately prior to April 12, 2009 was $0.94. The reset of the conversion
price resulted in additional $3.4 million of bonds discount and will be
amortized over the remaining outstanding periods of the bonds.





On November 8, 2008, the Subscriber
exercised all the 800,000 warrants into 800,000 shares at the exercise price of
$0.01 per share.





(b)
            $20,000,000
      12% Convertible Bonds due in 2011





On April 15, 2008, the Company
completed a financing transaction with ABN AMRO Bank N.V., London Branch (“ABN
AMRO”), CITIC Allco Investments Limited (together with ABN AMRO, the
“Subscribers,” and each a “Subscriber”), and CITIC Capital Finance Limited
issuing (i) $20,000,000 12% Convertible Bonds due in 2011 (the “Bonds”) and (ii)
300,000 warrants to purchase an aggregate of 300,000 shares of the Company’s
common stock, subject to certain adjustments as set forth in the warrant
instrument, that expire in 2013 (the “Bond Warrants”). The transaction was
completed in accordance with a subscription agreement entered into by the
Company, Subscribers, and CITIC Capital Finance Limited, dated April 2, 2008
(the “Subscription Agreement”).





The above
items (a) and (b) are to be amortized to interest expense over the term of the
bonds by the effective interest method as disclosed in the table
below.





The
Convertible Bonds Payable, net consists of the following:


September 30,
                    2010
                  
                  
                  December 31,
                    2009Convertible
      Bonds Payable
                  
                  $
                  28,000,000
                  
                  
                  $
                  28,000,000Less:
      Interest discount – Warrants
                  
                  
                  (3,305,938
                  )
                  
                  
                  (3,305,938
                  )Less:
      Interest discount – Beneficial conversion feature
                  
                  
                  (1,882,404
                  )
                  
                  
                  (1,882,404
                  )Less:
      Bond discount
                  
                  
                  (760,069
                  )
                  
                  
                  (760,069
                  )Accretion
      of interest discount
                  
                  
                  5,637,367
                  
                  
                  
                  2,512,572Net
                  
                  $
                  27,688,956
                  
                  
                  $
                  24,564,161





Waiver
of Conversion Price Adjustment on Convertible Bonds





On July
13, 2010, the Company and the holders of the Company’s outstanding Variable Rate
Convertible Bonds due 2012 (the “2007 Bonds”), 12% Convertible Bonds due 2011
(the “2008 Bonds,” and collectively with the 2007 Bonds, the “Bonds”) and
warrants to purchase 300,000 shares of common stock of the Company expiring 2013
(the “2008 Warrants”) entered a new Waiver Agreement (the “Waiver”) , which has
a three month term subject to the terms and conditions contained therein.
Pursuant to Waiver, the bondholders and warrantholder agreed to waive their
right to a reduction in the conversion price of the Bonds and exercise price of
the 2008 Warrants due to the Company’s proposed sale of the shares pursuant to
the Purchase Agreement at a price per share less than the current conversion
prices of the Bonds and exercise price of the 2008 Warrants.


19




CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





The
waivers contained in the Waiver Agreement are subject to numerous
conditions.  Under the Waiver Agreement, the Company agreed to pay the
Bondholders the interest on the Bonds in the amount of approximately $3.84
million on scheduled dates, of which the Company made a payment of approximately
$1.26 million on March 31, 2010 and $1.32 million on April 15, 2010. Under the
terms of the waiver, the Company agreed that the Company would pay to the
bondholders all outstanding interests in arrears on the Bonds, plus all other
applicable interest up until the payment date, within 30 days after the closing
of the issuance of the shares to acquired ConnGame, but which in any event,
would not be later than September 30, 2010.





The
Company also agreed to repay an overdraft facility in the amount of
approximately $4.91 million on three scheduled dates.  The Company
made payment of approximately one-half of this amount and agreed to pay all
unsettled amounts, which include all outstanding principal and interest amounts,
within 30 days after the closing of the issuance of the Shares, but which in any
event, would not be later than September 30, 2010.





The
Company also agreed that the Company will not repay or prepay any debt prior to
its currently scheduled due date until the Company make all of the payments
specified in the Waiver and the Bonds have been redeemed in full and that any
new indebtedness incurred by us for the purpose of repaying the overdraft
facility shall (i) not exceed the outstanding amount due and payable under the
overdraft facility and (ii) be subordinated to all amount owed under the Bonds
(the “Waiver
Covenants”).





As of
September 30, 2010, the Company did not pay fully make the payments scheduled
under the waivers and was negotiating with the Bondholders for extension of the
date of the scheduled payments.  The Company was communicating with
the Bondholders for the extension for the payment and adjustment of the
conversion price under the terms of the Waiver Agreement. By the date of this
report, the Bondholders did not make the request of payment and adjustment of
the conversion price.





If the
Company is unable to successfully to obtain an extension for the payment dates,
then all rights of the holders of the Bonds and 2008 Warrants waived under the
Waiver to or to be waived under the Waiver, shall not be waived and will be
reinstated, and any previous waivers will be null and void.  In such
case, appropriate adjustments will be made to the conversion prices of the Bonds
and the exercise price of the 2008 Warrants and an event of default under the
terms and conditions of the trust deed governing the 2008 Bonds shall exist,
making the 2008 Bonds immediately due and payable.





Since the
Company was unable to comply with the payment terms of the Waiver and unless the
Company is able to successfully negotiate an extension of the scheduled payment
dates, the issuance of the Shares could result in an adjustment of the
conversion price of the Bonds and the 2008 Warrants pursuant to the governing
Trust Deeds and warrant agreement, respectively, which could result in
substantial dilution to the Company's shareholders. The 2007 Bonds are currently
convertible at a per share price of $2.45 per share and the 2008 Bonds and 2008
Warrants are convertible and exercisable, respectively, at $6.35 per
share.  If the Company is not able to obtain an extension for payment
under the terms of the Waiver Agreement, an adjustment to the conversion and
exercise prices could be adjustable downward to the value of the assets that the
Company received for the issuance of the Shares, as calculated in accordance
with the provisions of the Trust Deeds and the warrant agreement.




20


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





10.
            CONTRACT
      REVENUES EARNED





The
contract revenues earned for the three-month and nine-month periods ended
September 30, 2010 and 2009 consist of the following:





Three Months Ended
                    September 30,
                
                
                Nine Months Ended
                    September 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Billed
                
                $
                1,506,302
                
                
                $
                16,670,961
                
                
                $
                17,919,264
                
                
                $
                60,073,588Unbilled
                
                
                2,936,193
                
                
                
                8,887,113
                
                
                
                3,703,771
                
                
                
                32,426,524$
                4,442,495
                
                
                $
                25,558,074
                
                
                $
                21,623,035
                
                
                $
                92,500,112




The
unbilled
contract  revenue  earned  represents  those  revenue  that  should  be  recognized
according to the percentage of completion method for accounting for construction
contract because the Company is entitled to receive payment from the customers
for the amount of work that has been  rendered to
and  completed  for  that  customer
according  to  the  terms  and  progress  being
made as stipulated under that contract between the Company and that customer. As
an industrial practice, there are certain procedures that need to be performed,
such as project account finalization, by both the customer and the Company
before the final billing is issued; however this does not affect the
Company’s  recognition of revenue and respective cost according to the
terms of the contract with the consistent application of the
percentage-of-completion method.





11.
            INCOME
      TAXES





On
October 17, 2006, income from the Company’s foreign subsidiaries became subject
to U.S. income tax liability; however, this tax is deferred until foreign source
income is repatriated to the Company, which has not yet
occurred.


The
Company has also retained an U.S. tax-preparer firm to aide in preparation of
its U.S. income tax returns in order to maintain a high level of compliance with
U.S. tax laws.





Effective
January 1, 2008, the PRC income tax rules were changed.  The PRC
government implemented a new 25% tax rate for all enterprises whether domestic
or foreign enterprise, and abolished the tax holiday.





Income
before taxes and the provision for taxes for the periods ended September 30,
2010 and 2009 consists of the following:





September 30,2010
                  
                  
                  2009Continuing
      income/(Loss) before taxes:U.S.
                  
                  $
                  (9,739,149
                  )
                  
                  $
                  (6,524,776
                  )Singapore
                  
                  
                  (8,055
                  )
                  
                  
                  705,472China
                  
                  
                  (8,516,335
                  )
                  
                  
                  (2,203,355
                  )Australia
                  
                  
                  (10,185
                  )
                  
                  
                  (13,578
                  )Hong
      Kong
                  
                  
                  2,680,316
                  
                  
                  
                  (3,924,345
                  )Dubai
                  
                  
                  9,633
                  
                  
                  
                  9,032,158Macau
                  
                  
                  (2,278
                  )
                  
                  
                  (58,102
                  )Total
      continuing income before taxes
                  
                  
                  (15,586,053
                  )
                  
                  
                  (2,986,526
                  )Provision
      for taxes expense/(benefit):Current:U.S.
      Federal
                  
                  
                  -
                  
                  
                  
                  -U.S.
      State
                  
                  
                  9,575
                  
                  
                  
                  --Deferred:U.S.
      Federal
                  
                  
                  -Hong
      Kong
                  
                  
                  -
                  
                  
                  
                  -Currency
      Effect
                  
                  
                  
                  
                  
                  
                  -Total
      provision for taxes
                  
                  
                  9,575Effective
      tax rate
                  
                  
                  -0.06
                  %
                  
                  
                  0.00
                  %




21


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amount of assets and liabilities for financial reporting purposes and
the amounts for income tax purposes. Significant components of our deferred tax
assets and liabilities at September 30, 2010 and December 31, 2009 are as
follows:





September 30, 2010
                        
                        
                        December 31, 2009Deferred
      tax assetsNet
      operating loss
                        
                        $
                        112,988
                        
                        
                        $
                        113,033112,988
                        
                        
                        
                        113,033Valuation
      allowance
                        
                        
                        -
                        
                        
                        
                        -Total
      deferred tax assets
                        
                        
                        112,988
                        
                        
                        
                        113,033Deferred
      tax liabilitiesTotal
      deferred tax liabilities
                        
                        
                        -
                        
                        
                        
                        -Net
      deferred tax assets
                        
                        
                        112,988
                        
                        
                        
                        113,033Reported
      as:Current
      deferred tax assets
                        
                        
                        112,988
                        
                        
                        
                        113,033Non-current
      deferred tax assets
                        
                        
                        -
                        
                        
                        
                        -Non-current
      deferred tax liabilities
                        
                        
                        -
                        
                        
                        
                        -Net
      deferred taxes
                        
                        $
                        112,988
                        
                        
                        $
                        113,033





Current
deferred tax assets represents net operating loss of a subsidiary Techwell
Engineering Limited in Hong Kong. The losses can be carried forward to set-off
future assessable profits in Hong Kong without expiry date. The differences
between the U.S. federal statutory income tax rates and the Company’s effective
tax rate for the periods ended September 30, 2010 and 2009 is shown in the
following table:


22


CHINA
ARCHITECTURAL ENGINEERING, INC.
 NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
 FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009
 (Stated
in US Dollars)


2010
                      
                      
                      2009U.S.
      federal statutory income tax rate
                      
                      
                      34.00
                      %
                      
                      
                      34.00
                      %Lower
      rates in PRC, net
                      
                      
                      -9.00
                      %
                      
                      
                      -9.00
                      %Accruals
      in foreign jurisdictions
                      
                      
                      -0.06
                      %
                      
                      
                      -0.00
                      %Tax
      Holiday
                      
                      
                      -25.00
                      %
                      
                      
                      -25.00
                      %-0.06
                      %
                      
                      
                      0.00
                      %





The
following table accounts for the differences between the actual tax provision
and the amounts obtained by applying the relevant applicable corporation income
tax (see tax rates discussed above) before tax for the periods ended September
30, 2010 and 2009:-





2010
                      
                      
                      2009Income/(loss)
      before tax
                      
                      
                      (15,586,053
                      )
                      
                      
                      (4,816,497
                      )Taxes
      at the applicable income tax rates
                      
                      
                      9,558
                      
                      
                      
                      114,113Miscellaneous
      non taxable income and non-deductible expenses
                      
                      
                      17
                      
                      
                      
                      -Current
      income tax expense
                      
                      $
                      9,575
                      
                      
                      $
                      114,113





Effective
January 1, 2008, the PRC government implemented a new 25% tax rate across the
board for all enterprises regardless of whether domestic or foreign enterprise
without any tax preferences which is defined as “two-year exemption followed by
three-year half exemption” enjoyed by tax payers. As a result of the tax law, a
standard 15% tax preference terminated as of December 31, 2007. The PRC
government has established a set of transition rules to allow enterprises using
tax preferences before January 1, 2008 to continue using the tax preferences on
a transitional basis until being the new tax rates are fully implemented over a
five year period.





12.
            COMMITMENTS
      AND CONTINGENCIES





(a)
              Operating
      lease commitments





The
Company leases certain administrative and production facilities from third
parties. Rental expenses were $144,602 and $800,981 for the three-month periods
ended and $526,267 and $2,402,943 for the nine-month periods ended September 30,
2010 and 2009, respectively.





The
Company has commitments with respect to non-cancelable operating leases for
these offices, as follows:





For
      the 12 months ending September 30,2011
                  
                  
                  69,6662012
                  
                  
                  -2013
                  
                  
                  -2014
      or after
                  
                  
                  -$
                  69,666


23


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





(b)
              Pending
      Litigation





Techwell
litigation





Pursuant
to a Stock Purchase Agreement dated November 7, 2007, the previous shareholders
of Techwell Engineering Limited (“Techwell”), Mr. Ng, Chi Sum and Miss Yam, Mei
Ling Maria agreed to sell 100% of the shares in Techwell to the Company for
approximately $11.7 million in cash and shares of common stock of the Company.
Subsequent to the said acquisition, Mr. Ng and Miss Yam were employed by
Techwell.





On
January 14, 2009, the board of directors of Techwell passed a board resolution,
to dismiss both Mr. Ng and Miss Yam with immediate effect and remove Mr. Ng from
the board of Techwell (the “Resolution”).   On January 16, 2009,
Mr. Ng and Miss Yam filed a lawsuit in the High Court of Hong Kong against the
Company and its subsidiary, Full Art International Limited.  The
lawsuit alleges that, inter alia, (i) the Company misrepresented to them the
financial status of the Company and operations during the course the acquisition
of Techwell was being negotiated; (ii) the Company failed to perform its
obligations under a settlement agreement alleged to be agreed by the
Company in January 2009; and (iii) the dismissal of Mr. Ng was unlawful and
invalid.  The lawsuit filed by Mr. Ng and Miss Yam requests the court
for specific performance of the settlement agreement that was allegedly entered
into, which would require the return of the Techwell company to Mr. Ng and Miss
Yam, and in the absence of such grant of relief, Mr. Ng and Miss Yam request
unspecified damages lieu of return of the Techwell company.





On
January 23, 2009 an ex-parte injunction order was granted to Mr. Ng, restraining
the Company from implementing the Resolution, which was eventually dismissed
with immediate effect on February 25, 2009 after a court session in the High
Court of Hong Kong. Mr. Ng was also ordered to bear the costs of the various
court proceedings in connection with the said injunction order. On March 27,
2009, Mr. Ng and Miss Yam filed a summons in the High Court of Hong Kong seeking
a court order for leave to join the Company’s principal shareholder, KGE Group
Limited, as a defendant of the said lawsuit, which was granted on April 9,
2009.  As a result, KGE Group Limited became one of the defendants of
the lawsuit. On May 12, 2009, the Company filed a Defense and Counterclaim at
the High Court of Hong Kong in response to a Statement of Claim served by Mr. Ng
and Miss Yam on the Company on April 7, 2009.





The
Company intends to vigorously defend this pending lawsuit; however, no assurance
can be given that the lawsuit will be resolved in the Company’s favor. Even if
the Company successfully defends the lawsuit, the Company may incur substantial
costs defending or settling the lawsuit, in addition to a possible diversion of
the time and attention of the Company’s management from its business. If the
Company is unsuccessful in defending the lawsuit, it may be required to pay a
significant amount of damages and/or it may potentially lose ownership of
Techwell, which will have a material adverse effect on the Company’s business,
financial condition or results of operations. In the last quarter of 2009, Mr.
Ng made a settlement proposal to the Company for consideration and the Company
is still under negotiation of the settlement agreement with Mr. Ng as of
September 30, 2010.





Dubai
Metro Rail Project Dispute





On
September 9, 2009, the Red Line, or first phase, of the Dubai Metro was
officially opened. The Company, through its subsidiary, had been working towards
completion of its external envelopes for stations along the Red Line of the
Dubai Metro System.  According to the Company’s original construction
blueprint, the majority of its construction work was completed at the end of
June 2009, and final construction milestones were scheduled for completion in
the third quarter of 2009.  With less than 5% of its contract
remaining to be completed, Techwell was removed by the master contractor of the
project, which also called for and received payment of $2.1 million in
performance bonds and $7.3 million in advance payment bonds that were issued on
Techwell's behalf for the project. The calling of the advance payment bonds was
based on the master contractor's belief that it had paid in excess of the
construction work performed.  The Company and certain of its
subsidiaries are guarantor of the bonds that were paid by the banks, and the
Company is liable under the guarantee agreements for such amounts paid by the
banks.  The Company does not believe that the master contractor had a
proper basis for calling the bonds and intend to vigorously defend all of its
legal rights and remedies related to the dispute.  The Company has
engaged a construction claims consultant to facilitate resolution of the
dispute.  The Company and its construction claims consultant, based on
a review of the facts, documents, and materials available, believes that it has
a reasonable opportunity to collect the amounts due to Techwell from the master
contractor, less appropriate credits as its final amount due for work performed
through September 2009.  The Company, with the assistance of its
claims consultant, will continue to evaluate the dispute and probability of
success on this dispute going forward and make the appropriate adjustments;
however, no assurance can be given that the dispute will be resolved in the
Company’s and Techwell’s favor.


24


CHINA
ARCHITECTURAL ENGINEERING, INC.


NOTES
TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE THREE- AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2010 AND 2009


(Stated
in US Dollars)





In July
2010, the Company met the master contractor and the master contractor agreed to
arrange a further meeting to explore the possibility of settlement. No such
meeting was arranged by date of this report.  The Company’s counsel in
Dubai was preparing the legal documents for the claims as of September 30, 2010.
On November 8, 2010 the Company issued a notice informing the master contractor
that the Company would seek resolution through arbitration with 56 day waiting
period for the master contractor to respond. The Company intends to commence
arbitration proceedings after expiration of the 56 day waiting period in the
event that no positive responses are received from the master
contractor.





13.
            RELATED
      PARTY TRANSACTIONS





The
account balance with shareholders at September 30, 2010 was payables of
$9,098,900, while at December 31, 2009 it was $10,080,345. The payables balance
was mainly loans from the two largest shareholders, with such loans being
interest-free, fee-free and has no fixed repayment schedule.





During
the nine months period ended September 30, 2010, the Company purchased
construction materials amounting to $3.2 million from Guangdong Canbo Electrical
Co., Ltd. (Canbo), a subsidiary of the Company’s major shareholder, KGE Group
Limited. Canbo is a preferred supplier of the Company as it is able to procure
materials at favorable price levels due to its purchased quantities. More
important, application of certain of the Company’s patented technology is
preferably routed through Canbo to prevent undesired distribution of this
technology. As of September 30, 2010, the Company’s payable to Canbo was $0.4
million.





The
transactions with related parties during the periods were carried out in the
ordinary course of business and on normal commercial terms.





14.
            SUBSEQUENT
      EVENTS





On
October 21, 2010, the Company’s Board of Directors approved and recommended that
its stockholders approve an amendment to our Certificate of Incorporation (the
“Amendment”), subject to stockholder approval (i) to effect a reverse stock
split of all issued and outstanding shares of the Company’s common stock at an
exchange ratio of not less than 1-for-2 and no more than 1-for-4 (the “Reverse
Stock Split”) and (ii) following the reverse stock split, if implemented, to
reduce the number of authorized shares of common stock from 150,000,000 to
100,000,000 at the discretion of the Board of Directors.  The Board of
Directors has authorized the proposed Amendment to the Company’s Certificate of
Incorporation, subject to the Board’s discretion after receipt of stockholder
approval, to effect the Reverse Stock Split and to reduce the number of
authorized shares of common stock.  The stockholder meeting is
scheduled for December 7, 2010 (China time).  If approved by the
stockholders and implemented by the Board, proportionate adjustments will be
required to be made to the per share exercise price and the number of shares
issuable upon the exercise or conversion of all outstanding options, warrants,
convertible or exchangeable securities entitling the holders to purchase,
exchange for, or convert into, shares of the Company's Common
Stock.


25





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





Forward-Looking
Statements





The
following discussion should be read in conjunction with our consolidated
financial statements and related notes included elsewhere in this quarterly
report and the audited consolidated financial statements and related notes and
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” contained in our annual report on Form 10-K/A for the year ended
December 31, 2009 filed with the Securities and Exchange Commission on June 2,
2010.





This
quarterly report contains forward-looking statements that involve substantial
risks and uncertainties.  The words “anticipated,” “believe,” “expect,
“plan,” “intend,” “seek,” “estimate,” “project,” “could,” “may,” and similar
expressions are intended to identify forward-looking statements. These
statements include, among others, information regarding future operations,
future capital expenditures, and future net cash flow. Such statements reflect
our management’s current views with respect to future events and financial
performance and involve risks and uncertainties, including, without limitation,
difficulties related to integration and management of the combined operations of
the Company of the company and ConnGame; entrance into the highly competitive
MMORPG online game industry and difficulties in developing, testing and
launching games; identification and remediation of the Company's deficiencies
and weaknesses in its internal controls over financial reporting, potential
claims or litigation that may result from the occurrence of restatements;
ability to identify and secure debt, equity, and/or other financing required to
continue the operations of the Company; ability to obtain an extension for the
required Company payments under the waiver agreement and ability to
maintain the conditions of the bondholder; difficulties in moving into the
online gaming market; reduction or reversal of the Company's recorded revenue or
profits due to "percentage of completion" method of accounting and expenses;
increasing provisions for bad debt related to the Company's accounts receivable;
fluctuation and unpredictability of costs related to our products and
services; adverse capital and credit market conditions; fluctuation and
unpredictability of costs related to the Company's products and services;
expenses and costs associated with its convertible bonds, regulatory approval
requirements and competitive conditions; and various other matters, many of
which are beyond our control.  Actual results may vary materially and
adversely from those anticipated, believed, estimated or otherwise indicated
should one or more of these risks or uncertainties occur or if any of the risks
or uncertainties described below in this report or in the “Risk Factors” section
of our 2009 annual report occur.  Consequently, all of the
forward-looking statements made in this report are qualified by these
cautionary statements and there can be no assurance of the actual results or
developments.





Overview





We have
traditionally specialized in high-end curtain wall systems (including glass,
stone and metal curtain walls), roofing systems, steel construction systems,
eco-energy saving building conservation systems and related products, for public
works and commercial real estate projects.





Revenues
and earnings recognition on many construction contracts are measured based on
progress achieved as a percentage of the total project effort or upon the
completion of milestones or performance criteria rather than evenly or linearly
over the period of performance.  Our work is performed under
cost-plus-fee contracts and fixed-price contracts. The length of our contracts
varies but typically has a duration of approximately one to two years.
Approximately 95% of our sales are from-fixed price contracts. The remaining
sales are from cost-plus-fee contracts. Under fixed-price contracts, we receive
a fixed price. Consequently, we realize a profit on fixed-price contracts only
if we control our costs and prevent cost over-runs on the contracts.
Approximately 70% of contracts are modified after they begin, usually to
accommodate requests from clients to increase project size and scope. In cases
where fixed-price contracts are modified, the fixed price is renegotiated
and adjusted upwards accordingly. Under cost-plus-fee contracts, which may be
subject to contract ceiling amounts, we are reimbursed for allowable costs and
fees, which may be fixed or performance-based. If our costs exceed the
contract ceiling or are not allowable under the provisions of the contract or
any applicable regulations, we may not be reimbursed for all our
costs.





The
recent trends in the global economy have had a significant adverse impact on our
results of operations and on the commercial construction industry as a whole.
The competitive environment in which we operate has become more competitive,
increasing the number of re-bid construction projects and amount of time between
bidding and award of a project, reducing selling prices, and causing competitors
to modify the scope and type of projects on which they bid.





International
Projects





In 2008
we increased the number of international construction projects, but in 2009 the
spread of the global recession and reduction in the nature and scope of
international construction projects has led us to primarily focus our attention
on domestic projects in China.  Dubai, Doha, Kuwait and other middle
east region have been suffered a great impact markedly under the global
financial crisis.  Our projects have significantly suffered as
well.


26


Beginning
in 2009, we experienced a significant decrease in the project turnover and an
increase in costs and delays in customer payments.  This negative
trend has continued during the first nine months of 2010. As a result, our
results of operations have suffered.





We have
also experienced significant difficulties with respect to our Dubai and Project,
as discussed below under, "Dubai Metro Rail Project".





We do not
believe that the international economy will experience a swift recovery in the
near future and therefore its negative impact on construction industry still
exists and will exist in the near future.  As a result, we ended the
orders of the construction of international projects in 2009, and shifted
the focus of our business to design and professional consulting
services.  To develop projects and generate revenue, we have sought to
join new projects in the position of design and project consultant and the role
of material supplier.





In the
past, the number and size of our international projects had been increasing, but
during 2009 our management has moved to refocus our resources to projects in the
mainland China.  During the second quarter of 2009, we decided to
terminate our work on the project in Singapore and stop the guarantee related to
the project.





Domestic
Projects





During
2009, we believe that the Chinese market has fared better than most of the
international markets.  With the strength of our reputation and
history of notable projects in China, we have been focusing our resources and
efforts in our domestic market.   We believe that we have
long-standing relationships with leading Chinese and international architects,
having completed high profile projects in China.  During the year
2009, we commenced certain landmark projects in China, which consisted of the
Changsha Train Station, Changsha Museum, Guangzhou Science Town, and projects in
Jinan and Inner Mongolia. These projects are expected to be completed in
2010. Through the third quarter of 2010, we signed the contracts for the
projects of Beijing Jiangtai Business Centre, Wuhan Xinhaigeming Museum and
Liuzhou Nanning Gymnasium and Natatorium. The total contract value of these
projects are estimated to be approximately $18.9 million. These projects
are expected to be completed in either 2010 or 2011.





We were
also awarded a new contract by the Overseas Chinese Town ("OCT") Group during
the third quarter 2010 for their Joy Coast project, with a total value of
approximately $3.2 million. The Joy Coast project is the first large-scale,
high-end integrated urban ecotourism project in China. We are responsible for
implementing their design and construction of the Innovation Exhibition Center,
one of the regional landmarks within Joy Coast. The structure uses the highly
advanced technique of space arbitrarily curved surfaces with stainless steel
plates.





Operations
after Acquisition of ConnGame





As noted
below, we acquired a 60% equity interest in Shanghai ConnGame Network Ltd.
(“ConnGame”) on August 18, 2010.  We believe that our acquisition of
ConnGame will permit us to refocus our core capabilities and facilitate our
planned transformation into a high-end architectural design consultant and
service provider, as we intend to leverage ConnGame’s design engines and virtual
applications to broaden our service capabilities and scope of architectural
collaborations.





We intend
to utilize ConnGame's technology and online platform to provide technical
consulting and advisory services to architects, real estate developers and
governments. We believe our acquisition of ConnGame will enable us to strengthen
our core architectural engineering and design abilities. We believe that our
planned focus on design and construction will permit us to reduce our exposure
to unpredictable operational risks that relate to construction projects, in
addition to providing us with the tools to strengthen our ability to complete
projects within budget limitations. We also believe that our acquisition of
ConnGame and its technologies will enable us to better evaluate estimated
profitable of construction projects before we enter into contracts. We believe
that our technology profile will be strengthened, particularly with ConnGame’s
virtual and online and graphic technologies, and that the technology and
capabilities will permit us to render more animated, detailed, and interactive
designs that could assist us in attaining highly desirable projects from our
bidding competitors.





We
believe that our acquisition will also enable us to enter China's large online
game market, with ConnGame’s two to-be-released MMORPG games.  We believe
that the online game industry and its related business model will be a growing
market in China.  We will seek to divide our business services into
the following:





·
            Construction
      consulting—We intend
      to continue to conduct our construction consultancy services within
      China.


27


·
            Construction  design
      services—We believe
      that we will be able to utilize the technical skills and expertise of
      ConnGame to provide unique consulting services for the design and
      fabrication projects globally, with such services to include real-time and
      interactive capabilities.





·
            Online
      Games—ConnGame
      expects to launch its first game “The Warring State” in Q1 2011 and its
      second game “Revolution” in Q3 2011, subject to successful testing. “The
      Warring State” has undergone its fourth closed beta testing in early
      November 2010 with satisfactory
results.





·
            Network
      Gaming and Home Decoration—We intend to develop a platform
      to provide services on home decoration through an interactive style,
      develop online games to provide to architects, other professionals, and
      individual consumers the ability to design and interact with other
      users.





ConnGame





Overview





ConnGame,
a company formed under the laws of the People’s Republic of China, develops
MMORPG (Massively Multiplayer Online Role Playing Game) for operation in
China.  While utilizing its game engines, scalable development
platforms, and production teams, ConnGame focuses on self-developed MMORPGs game
titles that are based on China's iconic characters and nostalgic
epochs.





ConnGame
owns two self-developed game engines, "Turbo" and
"Apocalypse".  ConnGame's online game-engines were created and
developed independently by its research and development
team.  Apocalypse provides a solution for development of MMORPG games
and can be applied to game content development and enhancement of the
standardization process.  The Turbo engine tool set is designed to
facilitate the development of three dimensional MMORPG games, in conjunction
with development of online role-playing games.  Turbo encompasses all
parts of the client programming, including management of server and client-side
resources.





Warring
State Online is developed based on the Turbo engine.  We completed
numerous closed beta tests for our first planned MMORPG game entitled "Warring
State", a realistic MMORPG based on China's iconic characters and nostalgic
epochs, featuring recreations of historically popular heroes and warlords set in
dramatic backdrops and varied according to the four seasons. ConnGame conducted
the fourth closed beta testing of Warring State in November 2010. During
testing, thousands of players explored the game for three days to test their
experience and performance of the game. The beta testing was viewed by our
management as successful and management expects that, after one to two
additional closed beta testing, "Warring State Online" could be launched to the
marketing. It is anticipated that the open beta would occur in the first quarter
of 2011.





During
the third quarter of 2010, ConnGame completed a contract with the China Ministry
of Public Security for development of a Safe Driving Game project based on its
proprietary "Apocalypse" game engine. The Company has recognized revenues of
approximately $0.2 million from this project during the period.





ConnGame
is a start-up, development-stage company and has not yet generated or realized
material revenues from its business operations.  We expect to
incur significant expenses from ConnGame's operations primarily due to its
continued research and development activities, the operations and marketing of
its products.  Operations expenses related to ConnGame's operations
for the nine months ended September 30, 2010 totaled approximately
$2.8  million, with a substantial majority of this amount relating to
research and development expenses.  ConnGame anticipates that during
the next 12 months, it will incur additional expenses towards the operations and
marketing of the products.





ConnGame
anticipates that initial revenue, if any, from its MMORPG games will likely be
generated through subscription fees paid by players of its MMORPG games and
software licensing to third-party companies.  The revenue model of
ConnGame’s MMORPG business is based on the item-based revenue model, meaning
game players can play our games for free, but may choose to pay for virtual
items, which are non-physical items that game players can purchase and use
within an MMORPG.  Such items include gems, pets, fashion items, magic
medicine, riding animals, hierograms, skill books and fireworks, all designed to
enhance the game-playing experience. ConnGame intends to sell prepaid game
cards to a range of regional distributors throughout China, who in turn
sub-distribute them to numerous retail outlets, including Internet cafés and
various Websites, newsstands, software stores, book stores and retail stores.
ConnGame also intends to directly sell game points to players through our
online sales platform. ConnGame’s ability to generate revenue and attain
profitability depends upon its ability to develop quality products and the
acceptance and popularity of its products by the end consumer.


28


ConnGame
plans to continue to improve its product quality through a various testing
series to attain player feedback. If feedback of players indicates consumer
desire for further improvement to game content and quality, it will take
additional development efforts and the cost of research and development will
increase, in addition to lengthening the time for ConnGame to generate
revenue.





Acquisition
of 60% Interest in ConnGame





In
December 2009, we and First Jet Investments Limited (“First Jet”) entered into a
letter of intent for the acquisition (“Letter of Intent”) that set forth the
principal terms under which we would issue up to 25,000,000 shares of our common
stock to First Jet to acquire 60% of the equity interest of
ConnGame.  In January 2010, our board of directors and stockholders
approved our acquisition of a 60% equity interest in ConnGame. On August
11, 2010, we entered into a stock purchase agreement (“Agreement”) with First
Jet, New Crown Technology Limited, a wholly owned subsidiary of First Jet and
the holder of 100% of the equity interests of ConnGame (“New Crown”), and Mr.
Jun Tang, the principal of First Jet and New Crown.  Pursuant to the
Agreement, we agreed to issue First Jet 25,000,000 shares of our common stock,
$0.001 par value per share, in exchange for 60% of the equity interest of New
Crown on the date of closing of the acquisition. The acquisition was
completed on August 18, 2010.





Effective
upon the closing of the acquisition, our Board of Directors appointed Mr. Jun
Tang as a member and Chairman of the Board of
Directors.   Immediately prior to the effective time of Mr. Jun
Tang’s appointment, Luo Ken Yi resigned as the Chairman of the Board of
Directors but remains as a member of the Board.  In addition, Mr. Tang
Nianzhong resigned as a member of the Board of Directors to ensure that our
company has a majority of independent directors on the Board in compliance with
Nasdaq continued listing standards. In addition, on September 12, 2010, in
relation to the acquisition of ConnGame, the following resignations and
appointments occurred:





·
            Luo
      Ken Yi resigned as the Chief Executive Officer and Mr. Luo maintained his
      position as President of the Company and a member of the Board of
      Directors of the Company (the
“Board”),


·
            Gene
      Michael Bennett resigned as the Company’s Chief Financial
      Officer,


·
            Zheng
      Jin Feng and Zhao Bao Jiang each resigned as a
  director,


·
            Wing
      Lun (Alan) Leung was appointed as the Chief Executive Officer and a
      director of the Company,


·
            Qin
      (Andy) Lu was appointed as the Acting Chief Financial Officer and
      Corporate Secretary,


·
            Ping
      Xu was appointed as an independent director and as a member of the Audit
      Committee and Nominating and Corporate Governance Committee,
      and


·
            Shibin
      Jo was appointed as an independent director and as a member of the
      Compensation committee and a member and chairman of the Nominating and
      Corporate Governance Committee, and


·
            Chen
      Huang was appointed as an independent director and as a member of the
      Audit Committee.





In
connection with Mr. Leung’s appointment as Chief Executive Officer, we and Mr.
Leung entered into a three-year employment agreement pursuant to which Mr. Leung
will receive an annual base salary of $150,000.





Wavier
Agreement





On
February 24, 2010, we entered into an Amendment and Waiver Agreement (the
“Waiver Agreement”) with the holders of our outstanding Variable Rate
Convertible Bonds due 2012 (the “2007 Bonds”) and 12% Convertible Bonds due 2011
(the “2008 Bonds,” and collectively with the 2007 Bonds, the “Bonds”) and
warrants to purchase 300,000 shares of our common stock expiring 2013 (the “2008
Warrants”).  Pursuant to the Waiver Agreement, the holders of the
Bonds and the 2008 Warrants agreed to waive their right to a reduction in the
conversion price of the Bonds and the exercise price of the 2008 Warrants
upon our anticipated issuance of up to 25,000,000 shares for the
acquisition of a 60% ownership interest in ConnGame.  Additionally,
the holders of the 2008 Bonds agreed to waive any default under the
terms and conditions of the trust deed governing the 2008 Bonds relating to
the requirement that KGE Group Limited, our largest shareholder, own at least
45% of our issued and outstanding common stock.  The waiver had a term
of three months and expired on May 24, 2010.  The parties entered into
a new waiver on July 13, 2010, which has a three month term subject to the terms
and conditions contained therein.  As indicated above, we closed the
ConnGame acquisition during the three-month period.





The
waivers contained in the Waiver Agreement are subject to numerous
conditions.





·
            Under
      the Waiver Agreement, we agreed to pay the Bondholders the interest on the
      Bonds in the amount of approximately $3.84 million on scheduled dates, of
      which we made a payment of approximately $1.26 million on March 31, 2010
      and $1.32 million on April 15, 2010.  Under the terms of the
      waiver, we agreed that we would pay to the bondholders all outstanding
      interests in arrears on the Bonds, plus all other applicable interest up
      until the payment date, within 30 days after the closing of the issuance
      of the shares to acquire ConnGame, but which in any event, would not be
      later than September 30, 2010.


29


·
            We
      also agreed to repay an overdraft facility in the amount of approximately
      $4.91 million on three scheduled dates.  We made payment of
      approximately one-half of this amount and agreed to pay all unsettled
      amounts, which include all outstanding principal and interest amounts,
      within 30 days after the closing of the issuance of the Shares, but which
      in any event, would not be later than September 30,
  2010.





·
            We
      also agreed that we will not repay or prepay any debt prior to its
      currently scheduled due date until we make all of the payments specified
      in the Waiver and the Bonds have been redeemed in full and that any new
      indebtedness incurred by us for the purpose of repaying the overdraft
      facility shall (i) not exceed the outstanding amount due and payable under
      the overdraft facility and (ii) be subordinated to all amount owed under
      the Bonds (the “Waiver Covenants”).





As of
September 30, 2010, we did not pay fully make the payments required under the
Waiver and we were negotiating with the Bondholders for extension of the
scheduled payments dates.





If we are
unable to successfully to obtain an extension for the payment dates, then all
rights of the holders of the Bonds and 2008 Warrants waived under the Waiver to
or to be waived under the Waiver, shall not be waived and will be reinstated,
and any previous waivers will be null and void.  In such case,
appropriate adjustments will be made to the conversion prices of the Bonds and
the exercise price of the 2008 Warrants and an event of default under the terms
and conditions of the trust deed governing the 2008 Bonds shall exist, making
the 2008 Bonds immediately due and payable.





Since we
were unable to comply with the payment terms of the Waiver and unless we are
able to successfully negotiate an extension of the scheduled payment dates, the
issuance of the Shares could result in an adjustment of the conversion price of
the Bonds and the 2008 Warrants pursuant to the governing Trust Deeds and
warrant agreement, respectively, which could result in substantial dilution to
our shareholders.  The 2007 Bonds are currently convertible at a per share
price of $2.45 per share and the 2008 Bonds and 2008 Warrants are convertible
and exercisable, respectively, at $6.35 per share.  If we are not able
to obtain an extension for payment under the terms of the Waiver Agreement, an
adjustment to the conversion and exercise prices could be adjustable downward to
the value of the assets that we received for the issuance of the Shares, as
calculated in accordance with the provisions of the Trust Deeds and the warrant
agreement.





Dubai
Metro Rail Project Dispute





On
September 9, 2009, the Red Line, or first phase, of the Dubai Metro was
officially opened. We, through our subsidiary Techwell Engineering Limited, had
been working towards completion of our external envelopes for stations along the
Red Line of the Dubai Metro System.  According to our original
construction blueprint, the majority of our construction work was completed at
the end of June 2009, and final construction milestones were scheduled for
completion in the third quarter of 2009.  With less than 5% of our
contract remaining to be completed, Techwell was removed by the master
contractor of the project, who also called for and received payment of $2.1
million in performance bonds and $7.3 million in advance payment bonds that were
issued on Techwell's behalf for the project. The calling of the advance payment
bonds was based on the master contractor's belief that it had paid in excess of
the construction work performed.  We and certain of our subsidiaries
are guarantors of the bonds that were paid by the banks, and we are liable under
the guarantee agreements for such amounts paid by the banks.  We do
not believe that the master contractor had a proper basis for calling the bonds
and intend to vigorously pursue and defend all of our legal rights and remedies
related to this dispute.  We have engaged a construction claims
consultant to facilitate resolution of this dispute.  We and our
construction claims consultant, based on a review of the facts, documents, and
materials available, believe that we have a reasonable opportunity to collect
the amounts due to Techwell from the master contractor, less appropriate credits
as our final amount due for work performed through September
2009.  We, with the assistance of our claims consultant, have
been continuously evaluating the dispute and probability of success on this
dispute going forward and make the appropriate adjustments; however, no
assurance can be given that the dispute will be resolved in our and Techwell’s
favor. The Company’s counsel in Dubai is preparing the legal documents for the
claims by the time of this report.





With the
use of “percentage-of-completion” method, the revenue to be recognized for each
period will included both (1) the revenue earned for the current period and (2)
the adjustment to previously recognized revenue that is required because of the
changes in estimated total revenue, costs and profitability of projects from
which the previous revenue had been recognized. The changes in the estimates may
be the result of, for example, increased costs or overhead expenses of the
projects, changes of the scope of the works of the contract as well as the
changes of technologies used which in turn affect the costs of the
project.  Under these circumstances, the estimated revenue and costs
can change and as a result the estimated profitability of the project can
change, which affects the profit elements in the revenue previously recognized
and may be required to be revised accordingly.  The “adjustments” or
“revisions” are made via adjustment to the current period revenue because it is
the changes in estimates that are requiring the revisions and not a restatement
of the previous period figures.


30


With
respect to the Dubai Metro Rail Project, which was the primary focus of
Techwell, an adjustment under the percentage-of-completion method described
above may be required if, for example, the Company and the Company’s claim
consultant modifies its evaluation of the Company’s claims such that the Company
is not likely to recover its claims as currently anticipated, if the Company
encounters any unexpected difficulties in the claiming process which making the
increase of claiming costs, and if a commercial settlement between the parties
is reached on a amounts different from current value estimates.  In
such scenarios, the final project revenue or estimated costs may be changed to
affect the revenue recognition of the project.  However, neither of
the situations is considered to exist at the moment of the reporting that
affects the accounting estimates of revenue and costs used for the
period.  As such, the Company believes that the revenue recognized to
date is appropriate as there were periodic reviews of the estimates of the
project revenue and costs by the Company to reflect the latest profitability of
the project for revenue recognition.





One of
the primarily reasons that the aging of Company’s contract receivables have
increased is the delay in payment by client of the Dubai projects since April
2009.  The underlying receivable as of September 30, 2010 from the
Dubai projects was approximately $42.1 million, which represented 47% of the
total contract receivables as of such date. The Company has employed a claim
consultant, Hill International, to facilitate the Company’s claim for the back
payment.  The Company currently expects that there will be progress
and payments will be received as early as the fourth quarter of
2010.  However, due to the ongoing dispute, there is no guarantee that
the Company will collect all or a portion of the contract
receivable.  For receivables related to the Dubai Project, the client
delayed payment to us since April 2009 by refusing to issue the Certificates for
Value of Work Done.  No Certificates have been issued since April
2009.  The Certificates are pre-requisites to proceed with payment to
the Company. The client paid for all work for Certificates for Value of Work
Done issued in or before April 2009.  Such payments were made prior to
December 31, 2009.  As a result, no account receivables at September
30, 2010 represent work for the above-referenced Certificates issued in or
before April 2009. The receivables as of September 30, 2010 were recognized
in accordance with the Percentage of Completion Method and based on the claim
consultant’s report on the estimated final value of work done that the Company
completed as of September 30, 2010.





The
Company has not recorded an allowance for doubtful accounts related to the Dubai
project.  The Company has engaged a construction claims consultant to
facilitate resolution of the dispute.  The Company and its
construction claims consultant, based on a review of the facts, documents, and
materials available, believe that the Company has a reasonable opportunity to
collect the amounts due to Techwell from the master contractor, less appropriate
credits as its final amount due for work performed through September
2009.  The Company, with the assistance of its claims consultant, have
been continuously evaluating the dispute and probability of success on this
dispute going forward and make the appropriate adjustments; however, no
assurance can be given that the dispute will be resolved in the Company’s
and Techwell’s favor.  In the report of the claim consultant, there
are the high and low estimates for the final total value of work done for the
Dubai project. The Company started with the low estimates with prudence and
adjusted such amounts with the amounts that the claim
consultant’s expressed that there was an excellent opportunity for the
Company to be recovered.  Furthermore, as the client of the projects
being the joint venture of two reputable Japanese corporations and one Turkish
corporation with long operating histories, the Company believes that the
possibility of default in payment is considered not likely to
occur.  Based on these supporting documents and analysis, the Company
believes that the receivables will be collected and no allowance is
required.  However, the Company will be required to account for
doubtful collection of the receivables related to the Dubai Project in the event
it concludes that it is not likely that the Company will be able to collect the
receivables.





In July
2010, the Company met the master contractor and the master contractor agreed to
arrange a further meeting to explore the possibility of settlement. No such
meeting was arranged by date of this report.  The Company’s counsel in
Dubai was preparing the legal documents for the claims as of September 30, 2010.
On November 8, 2010 the Company issued a notice informing the master contractor
that the Company would seek resolution through arbitration with 56 day waiting
period for the master contractor to respond. The Company intends to
commence arbitration proceedings after expiration of the 56 day waiting period
in the event that no positive responses are received from the master
contractor.





Techwell
Litigation





Pursuant
to a Stock Purchase Agreement dated November 7, 2007, the previous shareholders
of Techwell Engineering Limited (“Techwell”), Mr. Ng, Chi Sum and Miss Yam, Mei
Ling Maria, agreed to sell 100% of the shares in Techwell to the Company for
approximately $11.7 million in cash and shares of common stock of the Company.
Subsequent to the acquisition, Mr. Ng and Miss Yam were employed by
Techwell.





On
January 14, 2009, the board of directors of Techwell passed a board resolution,
to dismiss both Mr. Ng and Miss Yam with immediate effect and remove Mr. Ng from
the board of Techwell (the “Resolution”).   On January 16, 2009,
Mr. Ng and Miss Yam filed a lawsuit in the High Court of Hong Kong against the
Company and its subsidiary, Full Art International Limited.  The
lawsuit alleges that,inter
alia  , (i) the Company misrepresented to them the financial
status of the Company and its operations during the course the negotiations of
the Techwell acquisition; (ii) the Company failed to perform its obligations
under a settlement agreement alleged to have been agreed to by the Company
in January 2009; and (iii) the dismissal of Mr. Ng was unlawful and
invalid.  The lawsuit filed by Mr. Ng and Miss Yam requests the court
for specific performance of the settlement agreement that was allegedly entered
into, which would require the return of the Techwell company to Mr. Ng and Miss
Yam, and in the absence of such grant of relief, Mr. Ng and Miss Yam request
unspecified damages in lieu of return of the Techwell company.


31


On
January 23, 2009 an ex-parte injunction order was granted to Mr. Ng, restraining
the Company from implementing the Resolution, which was eventually dismissed
with immediate effect on February 25, 2009 after a court session in the High
Court of Hong Kong. Mr. Ng was also ordered to bear the costs of the
various court proceedings in connection with the injunction order. On March 27,
2009, Mr. Ng and Miss Yam filed a summons in the High Court of Hong Kong seeking
a court order for leave to join the Company’s principal shareholder, KGE Group
Limited, as a defendant in the lawsuit, which was granted on April 9,
2009.  As a result, KGE Group Limited became one of the defendants of
the lawsuit. On May 12, 2009, the Company filed a Defense and Counterclaim at
the High Court of Hong Kong in response to a Statement of Claim served by Mr. Ng
and Miss Yam on the Company on April 7, 2009.





As of the
date of this report, the Company, Mr. Ng, and Miss Yam, after several counter
proposals among the parties, are still in discussions and negotiations to settle
all disputes. However, there is no guarantee that the parties will reach an
agreement to settle the dispute, in which case the Company intends to vigorously
defend itself against the lawsuit.  There can be no assurance
that the lawsuit will be resolved in the Company’s favor.  Even
if the Company successfully defends the lawsuit, the Company may incur
substantial costs defending or settling the lawsuit, in addition to a possible
diversion of the time and attention of the Company’s management away from its
business.  If the Company is unsuccessful in defending the lawsuit,
its may be required to pay a significant amount of damages and/or it may
potentially lose ownership of Techwell, which will have a material adverse
effect on the Company’s business, financial condition or results of
operations.  In the event we lose ownership of Techwell, we will
lose the approximately $20.3 million of profit contribution since the
acquisition of Techwell.





In the
last quarter of 2009, Mr. Ng made a settlement proposal to the Company for
consideration and the Company is still under negotiation of the settlement
agreement with Mr. Ng as of September 30, 2010.





Proposed
Reverse Stock Split and Decrease of Authorized Shares





On
October 21, 2010, our Board of Directors approved and recommended that our
stockholders approve an amendment to our Certificate of Incorporation (the
“Amendment”), subject to stockholder approval (i) to effect a reverse stock
split of all issued and outstanding shares of our common stock at an exchange
ratio of not less than 1-for-2 and no more than 1-for-4 (the “Reverse Stock
Split”) and (ii) following the reverse stock split, if implemented, to reduce
the number of authorized shares of common stock from 150,000,000 to 100,000,000
at the discretion of the Board of Directors.  The Board of Directors
has authorized the proposed Amendment to our Certificate of Incorporation,
subject to the Board’s discretion after receipt of stockholder approval, to
effect the Reverse Stock Split and to reduce the number of authorized shares of
common stock.  The stockholder meeting is scheduled for December 7,
2010 (China time).  If approved by our stockholders and implemented by
the Board, proportionate adjustments will be required to be made to the per
share exercise price and the number of shares issuable upon the exercise or
conversion of all outstanding options, warrants, convertible or exchangeable
securities entitling the holders to purchase, exchange for, or convert into,
shares of our Common Stock.


32


Results
of Operations





The
following table sets forth statements of operations for the three and nine
months ended September 30, 2010 and 2009 in U.S. dollars
(unaudited):





For Three
                    Months Ended September 30,
                  
                  
                  For Nine
                    Months Ended September 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009(in thousands, except for share and per share amounts)Contract
      revenues earned$
                  4,442
                  
                  
                  $
                  25,558
                  
                  
                  $
                  21,623
                  
                  
                  $
                  92,500Cost
      of contract revenues earned
                  
                  
                  (5,452
                  )
                  
                  
                  (25,083
                  )
                  
                  
                  (20,735
                  )
                  
                  
                  (73,892
                  )Gross
      profit / (loss)
                  
                  $
                  (1,010
                  )
                  
                  $
                  475
                  
                  
                  $
                  888
                  
                  
                  $
                  18,608Selling,
      general and administrative expenses
                  
                  
                  (5,610
                  )
                  
                  
                  (5,549
                  )
                  
                  
                  (11,678
                  )
                  
                  
                  (17,620
                  )Income
      / (loss) from operations
                  
                  $
                  (6,620
                  )
                  
                  $
                  5,074
                  
                  
                  $
                  (10,790
                  )
                  
                  $
                  988Interest
      income
                  
                  
                  4
                  
                  
                  
                  5
                  
                  
                  
                  9
                  
                  
                  
                  55Interest
      expenses
                  
                  
                  (1,779
                  )
                  
                  
                  (1,741
                  )
                  
                  
                  (5,273
                  )
                  
                  
                  (4,525
                  )Other
      expenses
                  
                  
                  (351
                  )
                  
                  
                  -
                  
                  
                  
                  (360
                  )
                  
                  
                  -Other
      income
                  
                  
                  4
                  
                  
                  
                  335
                  
                  
                  
                  828
                  
                  
                  
                  496Loss
      before taxation on continuing operations
                  
                  $
                  (8,742
                  )
                  
                  $
                  (6,475
                  )
                  
                  $
                  (15,586
                  )
                  
                  $
                  (2,986
                  )Income
      tax
                  
                  
                  -
                  
                  
                  
                  (114
                  )
                  
                  
                  (9
                  )
                  
                  
                  (114
                  )Discontinued
      operation loss, net of tax
                  
                  
                  -
                  
                  
                  
                  1,830
                  
                  
                  
                  -
                  
                  
                  
                  1,830Net
      loss including non-controlling interests
                  
                  
                  (8,742
                  )
                  
                  
                  (8,419
                  )
                  
                  
                  (15,595
                  )
                  
                  
                  (4,930
                  )Loss
      attributable to non-controlling interests
                  
                  
                  256
                  
                  
                  
                  38
                  
                  
                  
                  259
                  
                  
                  
                  36Net
      loss attributable to the Company
                  
                  $
                  (8,486
                  )
                  
                  $
                  (8,381
                  )
                  
                  $
                  (15,336
                  )
                  
                  $
                  (4,894
                  )Loss
      per share:Basic
                  
                  $
                  (0.13
                  )
                  
                  $
                  (0.16
                  )
                  
                  $
                  (0.26
                  )
                  
                  $
                  (0.09
                  )Diluted
                  
                  $
                  (0.13
                  )
                  
                  $
                  (0.16
                  )
                  
                  $
                  (0.26
                  )
                  
                  $
                  (0.09
                  )Weighted
      average shares outstanding:Basic
                  
                  
                  66,970,061
                  
                  
                  
                  53,256,874
                  
                  
                  
                  58,969,374
                  
                  
                  
                  53,256,874Diluted
                  
                  
                  66,970,061
                  
                  
                  
                  53,256,874
                  
                  
                  
                  58,969,374
                  
                  
                  
                  53,256,874





Three
Months Ended September 30, 2010 and 2009





Contract
revenues earned for the three months ended September 30, 2010 were $4.4 million,
a decrease of $21.2 million, or 83 %, from the contract revenues earned of $25.6
million for the comparable period in 2009. The primary reasons for the decrease
in contract revenues earned was due to the decline in the global economy and
construction industry and the resulting negative effects on our
business operations, in addition to few new projects for our company in
2010 after our completion of international projects in 2009 such as the Dubai
Metro Red Line and Doha High Rise Office Tower.  We believe
our cessation of international projects contributed significantly to the
decline in our revenue, as approximately 61% of our annual revenue came from
international projects in 2009, while only 3 % of our annual revenue came from
international projects in the first three quarters of 2010.  Of our
total contract revenues earned, approximately $0.2 million was generated from
operations through ConnGame.


33


Cost of contract revenues earned for
the three months ended September 30, 2010 was $5.5million, a decrease of $19.6million, or 78%, from $25.1 million for the
comparable period in 2009.
Cost of contract revenues earned consists of the raw materials, labor and other
operating costs related to manufacturing.  The decrease in costs of
contract revenues earned was primarily due to a reduction in the number of
projects and thus, a decrease in the revenues
earned, as stated above.Provisions for estimated losses on
uncompleted contracts are charged to cost of contract revenues earned in the
period in which such losses are determined.Changes in job performance, job
conditions, and estimated
profitability, including those arising from contract penalty provisions, and
final contract settlements may result in revisions to costs and income and are
recognized in the period in which the revisions are determined. Profit
incentives are included in revenues when
their realization is reasonably assured. An amount equal to contract costs
attributable to claims is included in revenues when realization is probable
and the amount can be reliably estimated.Cost of revenues related to our MMORPG gaming operations were
approximately $0.5 million
since acquisition.





Gross
loss for the three months ended September 30, 2010 was $1.0 million, a decrease
in profit of $1.5 million, or 300 %, from $0.5 million for the comparable period
of 2009. Our gross margin for the three months ended September 30, 2010 was -23
% as compared with 2% for the three months ended September 30, 2009. The
decrease in gross margin was primarily a result of increases in raw material,
labor and administrative costs in our domestic market of China including effects
of recent RMB appreciation, as well as adjustments made in accordance to the
percentage-completion method for accounting of projects revenue. Such
adjustments were made as a result of increases in the projects’ estimated costs,
which reduced the projects’ estimated profits and the revenues.





Selling,
general and administrative expenses were $5.6 million for the three months ended
September 30, 2010, a decrease of approximately $0.1 million, or 2 %, from
approximately $5.5 million for the comparable period in 2009. The change was due
to combination of the decrease was due to decrease in revenue earned and the
$3.2 million bad debts expenses for PRC projects.  Among the selling,
general and administrative expenses and after the bad debts expenses, payroll
and social securities was the second largest expenditure of the group, which
accounted for approximately 33 % of the expense. Other major expenses
included rental expenses 3% and depreciation expenses 5%.





Interest
expenses and finance expenses were $1.8 million for the three months ended
September 30, 2010, an increase of $0.1 million, from approximately
$1.7 million for the comparable period in 2009. The expenses mainly
represented interests on the convertible bonds. The increase was primarily
due to the additional interest expense related to borrowing by short-term bank
loans.





Income
tax expenses were both $nil for the three months ended September 30,
2010 as compared to $114,000 for the comparable period of 2009.  The
primary reason was losses incurred by the operations of the Company as still
suffering from the effects of the recent international financial
crises.





Net loss
for the three months ended September 30, 2010 was $8.7 million, an increase
in income of $0.3 million, or 4%, from net loss of $8.4 million for the
comparable period in 2009 mainly due to the decrease in contract revenues
earned.





Nine
months Ended September 30, 2010 and 2009





Contract
revenues earned for the nine months ended September 30, 2010 were $21.6 million,
a decrease of $70.9 million, or 77 %, from the contract revenues earned of $92.5
million for the comparable period in 2009. The primary reasons for the decrease
in contract revenues earned are the same as those stated for the decrease in
revenues in the three months ended September 30, 2010. Of our total contract
revenues earned, approximately $0.2 million was generated from operations
through ConnGame.





Cost of
contract revenues earned for the nine months ended September 30, 2010 was $20.8
million, a decrease of $53.1 million, or 72 %, from $73.9 million for the
comparable period in 2009. Cost of contract revenues earned consists of the raw
materials, labor and other operating costs related to manufacturing. The
decrease in costs of contract revenues earned was primarily due to a reduction
in the number of projects and thus, a decrease in the revenues earned. Cost of
revenues related to our MMORPG gaming operations were approximately $0.5 million
since acquisition





Provisions
for estimated losses on uncompleted contracts are charged to cost of contract
revenues earned in the period in which such losses are determined. Changes in
job performance, job conditions, and estimated profitability, including those
arising from contract penalty provisions, and final contract settlements may
result in revisions to costs and income and are recognized in the period in
which the revisions are determined. Profit incentives are included in revenues
when their realization is reasonably assured. An amount equal to contract costs
attributable to claims is included in revenues when realization is probable
and the amount can be reliably estimated.





Gross
profit for the nine months ended September 30, 2010 was $0.9 million, a decrease
of $17.7 million, or 95 %, from $18.6 million for the comparable period of 2009.
Our gross margin for the nine months ended September 30, 2010 was 4% as compared
with 20% for the nine months ended September 30, 2009. The decrease in gross
margin was primarily a result of increases in raw material, labor and
administrative costs in our domestic market of China including effects of recent
RMB appreciation as well as the adjustments in accordance to the
percentage-completion method for accounting of projects revenue. Such
adjustments were made as a result of increases in the projects’ estimated costs,
which reduced the projects’ estimated profits and the revenues.


34


Selling,
general and administrative expenses were $11.7 million for the nine months ended
September 30, 2010, a decrease of approximately $6.0  million, or 34
%, from approximately $17.6 million for the comparable period in 2009. The
decrease was due to decrease in revenue in earned.  Among the selling,
general and administrative expenses which included $2.0 million stock
compensation granted and $3.4 million bad debts expenses, payroll and social
securities was the largest expenditure of the group, which accounted for
approximately 64 % of the expenses during the first nine months of 2010.
Other major expenses included rental expenses 5% and depreciation expenses
5%.





Interest
expenses and finance expenses were $5.3 million for the nine months ended
September 30, 2010, an increase of $0.8 million, from approximately $4.5 million
for the comparable period in 2009.  The increase was primarily due to
the additional interest expense in the first nine months of 2010 related to
borrowing by short-term bank loans.





Income
tax expenses were $9,575 for the nine months ended September 30, 2010
at an effective tax rate of -0.06%, compared with $114,000 in taxes for the same
period of 2009 at an effective tax rate of -3.8%.  The primary reason
was losses incurred by the operations of the Company as still suffering from the
effects of the recent international financial crises.





Net loss
for the nine months ended September 30, 2010 was $15.6 million, a increase in
income of $10.7 million, or 218%, from net loss of  $4.9 million for
the comparable period in 2009.





Liquidity
and Capital Resources





At
September 30, 2010, we had cash and cash equivalents of $3.0
million.





Prior to
October 17, 2006, we financed our business operations through short-term bank
loans, cash provided by operations, and credit provided by suppliers. On October
17, 2006, concurrently with the close of our Share Exchange, we received gross
proceeds of $3.7 million in a private placement transaction.   In
October 2007, we completed an initial public offering consisting of 847,550
shares of our common stock. Our sale of common stock, which was sold indirectly
by us to the public at a price of $3.50 per share, resulted in net
proceeds of approximately $2.0 million.





We have
also financed our operations through the issuance of convertible
bonds.  On April 12, 2007, we completed a financing transaction
pursuant to which we issued the 2007 Bonds in the principal amount of $10
million. The 2007 Bonds bear cash interest at the rate of 6% per annum for the
first year after April 12, 2007 and 3% per annum thereafter, of the principal
amount of the 2007 Bonds. Each 2007 Bond is convertible at an initial conversion
price of $3.50 per share.  At any time after April 12, 2010, holders
of the 2007 Bonds can require us to redeem the 2007 Bonds at 126.51% of the
principal amount. We are required to redeem any outstanding 2007 Bonds at
150.87% of its principal amount on April 4, 2012.  In September 2008,
$2 million worth of bonds were converted into shares of common stock pursuant to
which we issued 571,428 shares of common stock.





On April
15, 2008, we completed a financing transaction pursuant to which we issued the
2008 Bonds in the principal amount of $20 million. The 2008 Bonds bear cash
interest at the rate of 12% per annum. Interest is payable semi-annually in
arrears on April 15 and October 15 of each year (each an “Interest Payment
Date”). On any Interest Payment Date on or after April 15, 2010, the holders of
the Bonds can require us to redeem the Bonds at 116.61% of the principal amount.
We are required to redeem any outstanding Bonds at 116.61% of its principal
amount on April 15, 2011.





On July
13, 2010, we entered into the Waiver Agreement with the holders of our 2007
Bonds and 2008 Bonds and 2008 Warrants.  Under the Waiver Agreement,
we agreed to pay the Bondholders the interest on the Bonds in the amount of
approximately $3.84 million on scheduled dates, of which we made a payment of
approximately $1.26 million on March 31, 2010 and $1.32 million on April 15,
2010.  Under the terms of the waiver, we agreed that we would pay to
the bondholders all outstanding interests in arrears on the Bonds, plus all
other applicable interest up until the payment date, within 30 days after the
closing of the issuance of the shares to acquire ConnGame, but which in any
event, would not be later than September 30, 2010. We also agreed to
repay an overdraft facility in the amount of approximately $4.91 million on
three scheduled dates.  We made payment of approximately one-half of
this amount and agreed to pay all unsettled amounts, which include all
outstanding principal and interest amounts, within 30 days after the closing of
the issuance of the Shares, but which in any event, would not be later than
September 30, 2010. We also agreed that we will not repay or prepay any
debt prior to its currently scheduled due date until we make all of the payments
specified in the Waiver and the Bonds have been redeemed in full and that any
new indebtedness incurred by us for the purpose of repaying the overdraft
facility shall (i) not exceed the outstanding amount due and payable under the
overdraft facility and (ii) be subordinated to all amount owed under the
Bonds.  The closing of the ConnGame acquisition was not completed on
August 18, 2010.





As of
September 30, 2010, the Company did not pay make the required payments scheduled
under the waivers and was negotiating with the Bondholders for extension of the
date of the scheduled payments. If we are required to repurchase all or a
portion of the outstanding amount of $28.0 million in bonds and we do not have
sufficient cash to make the repurchase, we will be required to obtain third
party financing to do so, and there can be no assurances that we will be able to
secure financing in a timely manner and on favorable terms, which could have a
material adverse effect on our financial performance, results of operations and
stock price.


35


Full Art
International Limited incurred an automobile capital lease obligation due
November 9, 2012 that had an outstanding amount of $128,465 as of September 30,
2010.





On
February 19, 2008, we and Techwell Engineering Limited were granted a bond
facility by the Hong Kong Branch of ABN AMRO Bank N.V. The facility amount was
$10,000,000, at a tenor of up to one year with 2% flat interest rate on the
issued amount of bonds such as bank guarantees, performance bonds, advanced
payment bonds and standby letters of credit. ABN AMRO required guarantees as
follows: (i) an irrevocable and unconditional guarantee executed by Zhuhai King
Glass Engineering Co. Limited and (ii) share charge over the shares of us for a
minimum value of $5,000,000 or equivalent, executed by KGE Group Limited. On May
2, 2008, the facility was increased to $12,000,000 with additional cash
collateral of $2,000,000, which is also the total amount of cash collateral for
the facility. All cash collateral was then fully used to off-set a portion of
the calling of the bonds for projects in Dubai by the beneficiary. As of
September 30, 2010, the facility was converted into the temporary loan of
$4,544,688 resulted from the calling of performance and advance payment bonds at
interest rate at Bank's Cost of Fund + 6%.





On March
28, 2008, we, Full Art and Techwell Engineering Limited were granted a bonding
facility by the Hong Kong Branch of HSBC. The facility amount was $10,000,000,
at a tenor of up to one year with 1% flat interest rate on the issued amount of
bonds such as bank guarantees, performance bonds, advanced payment bonds and
standby letters of credit. HSBC required guarantees as follows: (i) an unlimited
guarantee among China Architectural Engineering, Inc., Full Art International
Limited and Techwell Engineering Limited; and (ii) an “all monies” securities
deposits with 15% margin. On August 18, 2008, the facility was increased to
$20,000,000 with additional cash collateral of $1,500,000 that increased the
total amount of cash collateral to $3,000,000. In September 2009, $2,818,440 of
the cash collateral was used to off-set of the calling of the bonds for projects
in Dubai by the beneficiary. As of September 30, 2010, the facility amount was
reduced to $910,000 and was fully utilized.





On July
19, 2008, Zhuhai King Glass Engineering Co., Ltd. (“Zhuhai KGE”), our
wholly-owned subsidiary was granted a Bank Accepted Draft facility by the
Shenzhen Branch of ABN AMRO Bank N.V. The facility amount is RMB70,000,000
(US$10,218,978).  On September 30, 2009, the facility was amended to
allow Open Account Financing – Accounts Receivable against invoices from
acceptable buyers up to RMB21,000,000 and Open Account Financing and Overdraft
in Current Account up to RMB16,800,000.  ABN AMRO requires irrevocable
and unconditional guarantee from us and cash collateral of 20% of bank’s
acceptance bill issued and Open Account Financing.  As of September
30, 2010, Zhuhai KGE utilized RMB nil (US$nil million) of Bank Accepted Draft
and RMB16,094,080 (US$2,363,787) of Overdraft in Current Account.





In
September 2009, the beneficiary of a performance bond and advance payment bonds
for the projects in Dubai demanded the drawing of approximately $9.4 million in
total from the two issuing banks, ABN AMRO Bank NV and HSBC. The calling of the
bonds was based on the beneficiary’s belief that it had paid in excess of the
construction work performed. We do not believe that the beneficiary had the
proper basis for calling the bonds and intend to vigorously defend all of their
rights and remedies related to the dispute. As of September 30, 2010, after an
offset against collateral accounts that we held with the banks, there was
approximately  $4.5 million in a shortfall amount due to ABN AMRO Bank
NV by us that was not paid off.  Such amount is currently outstanding
as the temporary loan from the bank at the interest rate at the bank’s cost of
funds plus 6%.





Working
capital management, including prompt and diligent billing and collection, is an
important factor in our results of operations and liquidity. When we are awarded
construction project, we work according to the percentage-of-completion method
which matches the revenue streams with the relevant cost of construction based
on the percentage-of-completion of project as determined based on certain
criteria, such as, among other things, actual cost of raw material used compared
to the total budgeted cost of raw material and work certified by customers.
There is no guarantee that the cash inflow from these contracts is being
accounted for in parallel with the cash outflow being incurred in the
performance of such contract. In addition, a construction project is usually
deemed to be completed once we prepare a final project account, the account is
agreed upon by our customers, and all amounts related to the contract must
be settled according to the account within three months to a year from the
customer’s agreement on the final project account. As there may be different
time intervals to reach a consensus on the amount as being accounted for in
the projects before the project finalization account is being mutually agreed by
each other. We experience an average accounts settlement period ranging from
three months to as high as one year from the time we provide services to the
time we receive payment from our customers. Below is a summary of typical steps
in our processing of accounts:





·
            It
      takes approximately one month for our client to collect the payment
      application from contractors for the contract work
    completed.





·
            Thereafter,
      it takes approximately one to two months for the verification, agreement
      and certification of work completed, with timing to largely depend on
      whether there is disagreement in the calculation of certified value
      between the parties.





·
            Moreover,
      if it is the case that the application is to finalize the project account,
      it may take up to three months.


36


·
            Additionally,
      in the event that the client is not the owner of the project, it normally
      requires an additional one to two months for processing and obtaining the
      funds from the owner.





·
            One
      to two months the client to pay the
contractors.





In
contrast to collection times, we typically need to place certain deposit with
our suppliers on a portion of the purchase price in advance and for some
suppliers we must maintain a deposit for future orders. We attempt to maintain a
credit policy of receiving certain amounts of deposit from customers before
we begin a new project.





We
experienced revenue of $21.6 million for the nine months ended September 30,
2010 compared to revenue of $92.5 million for the same period in 2009.
Construction contract related receivables, including contract receivables and
costs and earnings in excess of billings as of September 30, 2010 were $87.9
million, a decrease of $20.8 million from construction related receivables of
$108.7 million as of September 30, 2009. The decrease was a result of the
reduction in projects revenue.





The
collection period typically runs from two months to one year, the long aging of
receivables reflects the long collection period.  In addition, our
payment cycle is considerably shorter than our receivable cycle, since we
typically pay our suppliers all or a portion of the purchase price in advance
and for some suppliers we must maintain a deposit for future
orders.





Among the
$87.4 million contract receivables as of September 30, 2010, $14.0 million
(16.0%) was outstanding over 365 days and $13.6 million (15.6%) over 730 days,
in total of $27.6 million which including $10.6 million (12.1%) million of
retention money which would only be settled after the retention periods of two
or three years. The Company periodically prepares the aging of the receivables
information and reviews the balances with consideration of the background of
each client for assessing the realizable value of the balances and would
make provision when appropriate.  The Company notes that its account
receivables that are 365 and 720 days old are primarily related to the Company’s
PRC operations, and the payment cycle in the PRC commonly entails a
receivable being outstanding for over one to two years before
collection.  Such situations are particularly common in the
construction market and with the clients from government. Since the Company’s
older outstanding receivables are mainly of government projects, the final
accounts and payments are required to be processed through a lengthy
bureaucratic process in the PRC government.





Based on
the foregoing, and despite the receivables being outstanding from 365 to 720
days, the Company considers them to be realizable because the Company believes
that there is a remote chance that the PRC Government will go into bankruptcy or
otherwise refuse to make payment on the receivables. In addition, the Company
has the policy of conducting a comprehensive review the aging of account
receivables on a regular basis every three months.  Furthermore, the
Company has a designated staff member from one of its PRC subsidiaries to remain
in constant communication with the Company’s various departments regarding PRC
receivables collection status, and allowances for doubtful accounts is made, as
necessary, based on the collection status updates. As of September 30, 2010, the
contract receivables under aging of 121 to 365 days amounted to $55.1 (63 %)
million including the receivables of the projects in Dubai which were
recognized at the end of the year at $42.1 (48.2%) million.





We
provide for bad debts principally based upon the aging of accounts receivable,
in addition to collectability of specific customer accounts, our history of bad
debts, and the general condition of the industry. We effected a
direct write off of $7.1 million provisions to the account receivables during
the nine months ended September 30, 2010.  We recorded additional
provision for doubtful accounts of $3.4 million in the nine months ended
September 30, 2010.  As of September 30, 2010, our provision for
doubtful accounts was $2.9 million, which was 3.2% of our gross construction
contract related receivables of $90.8 million. We believed our current reserve
for doubtful accounts is commensurate to cover the associated credit risk in the
portfolio of our construction contract related receivables.  Due to
the difficulty in assessing future trends, we could be required to further
increase our provisions for doubtful accounts.  As our accounts
receivable age and become uncollectible our cash flow and results of operations
are negatively impacted.





In
addition to the foregoing, we had a provision for contracts receivables that was
reclassified as “Other receivable” in the amount of approximately $9.9
million that represented account receivables of a subsidiary, Techwell
Engineering Ltd. (Techwell).  The receivables were acquired through
our acquisition of the Techwell in 2007 and have been outstanding since
acquisition.   The receivables are guaranteed by previous
shareholders of Techwell if not paid within 24 months of the
acquisition.  Accordingly, the provision was made and the receivable
amount was transferred to amount due from the shareholders under other
receivable balances.





We have
also funded our operations through loans made to us by our two largest
shareholders. All of these loans are interest-free, fee-free and have no fixed
repayment schedule. As of September 30, 2010, the balance of these loans was
approximately $9.1 million, as compared to $10.1 million as of December 31,
2009.





At
September 30, 2010, we had no material commitments for capital expenditures
other than for those expenditures incurred in the ordinary course of
business.


37


Net cash
provided by operating activities for the nine months ended September 30, 2010
was approximately $5.6 million, as compared to $11.2 million net cash used in
the same period in 2009. The change was primarily due to differences in changes
in receivables $6.8 million, other assets $6.3 million and stock compensation
expenses $2.0 million.





Net cash used in investing
activities was approximately $15.2 million for the nine months ended September
30, 2010 compared to approximately $7.5 million net cash provided for the nine
months ended September 30, 2009. The change was mainly a result of the
difference in change in restricted cash $ 5.5 million and the acquisition of
goodwill in 2010.





Net cash
used in financing activities was $3.7 million for the nine months ended
September 30, 2010 compared to $2.9 million provided by for the nine months
ended September 30, 2009. The change was primarily due to difference in changes
of shareholders loan $4.7 million and notes payables $10.2 million.





Off-Balance
Sheet Arrangements





None.





Critical
Accounting Policies and Estimates





The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, disclosure of contingent assets and liabilities at the
date of the consolidated financial statements and the reported amounts of
revenues, expenses and allocated charges during the reporting period. Actual
results could differ from those estimates.





We
describe our significant accounting policies in Note 2, Summary of Significant
Accounting Policies, of the Notes to Consolidated Financial Statements included
in our Annual Report on Form 10-K/A as of and for the year ended December 31,
2009, as filed with the Securities and Exchange Commission on June 2, 2010.
We discuss our critical accounting policies and estimates in Management’s
Discussion and Analysis of Financial Condition and Results of Operations in our
Annual Report on Form 10-K/A as of and for the year ended December 31,
2009.  Other than as indicated in this quarterly report, there
have been no material revisions to the critical accounting policies as
filed in our Annual Report for the fiscal year ended December 31, 2009 on Form
10-K/A as filed with the SEC on June 2, 2010.





Recent
Accounting Pronouncements





See
Note2(t) of the
accompanying unaudited interim consolidated financial statements included in
this Form 10-Q for a discussion of recent accounting
pronouncements.





ITEM 3. QUANTITATIVE
AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK





There
have been no material changes in market risk from the information provided in
Part II, Item 7A “Quantitative and Qualitative Disclosures About Market Risk” in
our Annual Report for the fiscal year ended December 31, 2009 on Form 10-K/A as
filed with the SEC June 2, 2010.





ITEM 4. CONTROLS
AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





Disclosure
controls and procedures are controls and other procedures that are designed to
ensure that information required to be disclosed by us in the reports that we
file or submit under the Securities Exchange Act of 1934 (the “Exchange Act”) is
recorded, processed, summarized and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Disclosure controls
and procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive and financial officers, as appropriate to
allow timely decisions regarding required disclosure.





As of the
end of the period covered by this Quarterly Report, we conducted an evaluation,
under the supervision and with the participation of our Chief Executive Officer
and Chief Financial Officer, of our disclosure controls and procedures (as
defined in Rule 13a-15(e) of the Exchange Act). Based upon this evaluation, our
Chief Executive Officer and Chief Financial Officer concluded that the Company’s
disclosure controls and procedures identified certain material weaknesses, as
described below, that caused our controls and procedures to be
ineffective.  Notwithstanding the existence of the material weaknesses
described below, management has concluded that the interim consolidated
financial statements in this Form 10-Q fairly present, in all material respects,
our financial position, results of operations and cash flows for the periods and
dates presented.


38


These
material weaknesses primarily related (i) our restatements that we conducted in
May 2010 and (ii) one of our material operating subsidiaries, Techwell
Engineering Limited. (“Techwell”) that we acquired in November
2007.





Restatements





In May
2010, we discovered that certain of our previously filed quarterly and annual
reports contained errors that required correction and restatement. The errors
related to the timing of the interest expense related to the Company’s
outstanding $8,000,000 Variable Rate Convertible Bonds due 2012 and $20,000,000
12% Convertible Bonds due 2011 that resulted in overstatements and
understatements of the interest expenses related to the bonds during various
quarters before the second quarter of 2008. Due to the accounting errors, the
interest expense was overstated by approximately $0.3 million, $0.5 million, and
$0.7 million for the second, third, and fourth quarters of fiscal year
2007, respectively, for a total overstatement of approximately $1.5 million
for fiscal 2007. The interest expense was overstated by approximately $0.1
million in the first quarter of 2008 and all the overstatements, approximately
$1.6 million, were reversed in the second quarter of 2008. For the year ended
December 31, 2009, there was an overstatement of the interest expense of $8,000
in the second quarter and an understatement of $6,000 during the third quarter,
for a total of overstatement of $2,000 for fiscal year 2009. The net bonds
payable amounts were presented correctly in the Company’s financial statements
as of December 31, 2008 and 2009, and it was only the components of the
Convertible Bonds that were restated, while the net payable amounts as of
December 31, 2007 was stated with correction of errors.





Additionally,
a correction was needed for the addition of an equity compensation charge in the
amount of $4,976 related to a portion of options granted in October 2009 that
the Company inadvertently omitted in the original Form 10-K filing. Together
with the overstatement of interest expenses of $2,000, the loss for the year
ended December 31, 2009 was understated by 2,983 and the retained earnings as of
December 31, 2009 was overstated by 2,983. Additionally, $1.5 million of
consolidation exchange loss resulted from the inter-company investments
elimination was incorrectly included in the additional paid in capital instead
of the accumulated comprehensive income presented in the Stockholders’ Statement
of Equity and Comprehensive Income for the year ended December 31,
2009.





We
believe that the accounting errors were caused by lack of personnel with
expertise in US generally accepted accounting principles and SEC rules and
regulations, in addition to inadequate staffing and supervision that lead to the
untimely identification and resolution of accounting and disclosure matters
and failure to perform timely and effective reviews. We intend to take action to
remediate these deficiencies going forward.





Techwell





On
November 6, 2007, we acquired Techwell and its wholly owned subsidiaries,
Techwell Building Systems (Shenzhen) Ltd. in China and Techwell International
Ltd. in Macau.  At the time, Techwell was a privately-held company and
its financial systems were not designed to facilitate the external financial
reporting required of a publicly held company under the Sarbanes-Oxley Act of
2002.  In addition, Techwell’s accounting records were historically
maintained using accounting principles generally accepted in the People's
Republic of China, its personnel was not fully familiar with
accounting principles generally accepted in the United States of
America.





A
material weakness 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 the annual or interim financial statements will
not be prevented or detected in a timely basis.  We identified the
following material weaknesses:





1.
            Techwell
      lacked the technical expertise and processes to ensure compliance with our
      policies and did not maintain adequate controls with respect to (a) timely
      updating engineering budget and analysis, (b) coordination and
      communication between Corporate Accounting and Engineering Staffs, and (c)
      timely review and analysis of corporate journals recorded in the
      consolidation process.





2.
            Techwell
      did not maintain a sufficient complement of personnel with an appropriate
      knowledge and skill to comply with our specific engineering financial
      accounting and reporting requirements and low materiality
      thresholds.  This was evidenced by a number of documents missing
      or not matching with the records and contributed to the adjustment of
      financial results.  As evidenced by the significant number and
      magnitude of out-of-period adjustments identified from Techwell during the
      period-end closing process, management has concluded that the controls
      over the period-end financial reporting process were not operating
      effectively. Specifically, controls were not effective to ensure that
      significant accounting estimates and other adjustments were
      appropriately reviewed, analyzed, and monitored on a timely
      basis.


39


3.
            Techwell
      did not comply with our authorization policy. This was evidenced by a
      number of expenses incurred without appropriate authorization. This
      material weakness resulted in an unauthorized and significant increase of
      expenses, which significantly impacted our operating
    results.





Remediation
Efforts





We are in
the process of developing and implementing remediation plans to address our
material weaknesses.





Restatements





We have
taken and intend to take the following actions to address the material
weaknesses and improve our internal controls over financial
reporting:





1.
            We
      are seeking to improve supervision, education, and training of our
      accounting staff. We are also considering engaging third-party financial
      consultants to review and analyze our financial statements and assist us
      in improving our reporting of financial
  information.





2
            Management
      intends to hire additional personnel with technical knowledge, experience
      and training in the application of generally accepted accounting
      principles commensurate with our financial reporting and U.S. GAAP
      requirements.





3.
            We
      will continue to monitor the effectiveness of these improvements. We are
      also considering working with outside consultants in assessing and
      improving our internal controls and procedures when
    necessary.





4.
            An
      internal SOX 404 task force was set up in order to help the company
      strengthening its controls and procedures on the financial
      reporting.





5.
            In
      September 2009, we hired a new Vice President of Finance who was later
      appointed as our Acting Chief Financial Officer in November
      2009.  This person served as the sensible financial officer of
      our company until his resignation in September
  2010.





6.
            In
      December 2009, our then-Acting Chief Financial Officer lead an extensive
      review of the controls and procedures of our company and developed a
      detailed remediation and implementation plan for Sarbanes-Oxley Act of
      2002 Section 404 compliance to be carried out starting in
      2010.





7.
            The
      remediation and implementation plan is being carried out which including
      the drafting up of the details internal control documents for SOX
      compliance. With the additions of new subsidiaries in the third quarter of
      2010, the company currently is considering to further develop the
      internal controls and procedures in responses to the new group
      structure.





Techwell





One key
change for us going forward will be the design and implementation of internal
controls over the accounting and oversight of all subsidiaries, including
enhanced accounting systems, processes, policies and procedures.  We have
taken the following actions to address the material weaknesses and improve our
internal controls over financial reporting:





1.
            On
      January 14, 2009, the board of directors of Techwell passed a board
      resolution to replace management of Techwell.  We have appointed a
      new general manager to Techwell, as well as three experienced project
      managers to the Dubai Metro
project.





2.
            Management
      has initiated a Sarbanes-Oxley Act of 2002 Section 404 Compliance
      Assistance Project, which is intended to meet all requirements required by
      SEC in our company and all of our subsidiaries. We engaged a consulting
      firm to assist in the set-up of project and our staff thereafter continued
      with its implementation.





3.
            We
      have established a dedicated and qualified internal control and audit team
      to implement the policies and procedures to the standard of a US public
      company.


40


4.
            In
      June 2009, we reorganized and restructured Techwell’s Corporate Accounting
      by (a) modifying the reporting structure and establishing clear roles,
      responsibilities, and accountability, (b) hiring skilled technical
      accounting personnel to address our accounting and financial reporting
      requirements, and (c) assessing the technical accounting capabilities in
      the operating units to ensure the right complement of knowledge, skills,
      and training.





5.
            In
      2009, we also reorganized and restructured the budgeting process by (a)
      centralizing the procurement function to our company to ensure budgets and
      analyses of Techwell are timely prepared and properly reviewed; (b)
      implementing new policies and procedures to ensure that appropriate
      communication and collaboration protocols among our Engineering,
      Procurement and Corporate Accounting departments; and (c) hiring
      the necessary technical procurement personnel to support complex
      procurement activities.    We have hired two experienced
      technical procurement managers and expect to increase the headcount in the
      purchase department in the future if
necessary.





6.
            We
      strengthened the period-end closing procedures of our operating
      subsidiaries by (a) requiring all significant estimate transactions to be
      reviewed by Corporate Accounting, (b) ensuring that account
      reconciliations and analyses for significant financial statement accounts
      are reviewed for completeness and accuracy by qualified accounting
      personnel, (c) implementing a process that ensures the timely review and
      approval of complex accounting estimates by qualified accounting personnel
      and subject matter experts, where appropriate, and (d) developing better
      monitoring controls at Corporate Accounting and the operating
      units.





7.
            In
      September 2009, we hired a new Vice President of Finance who was later
      appointed as our Acting Chief Financial Officer in November 2009, who
      served as our principal financial officer until his resignation in
      September 2010.





8.
            In
      December 2009, our Acting Chief Financial Officer lead an extensive review
      of the controls and procedures of our company and developed a detailed
      remediation and implementation plan for Sarbanes-Oxley Act of 2002 Section
      404 compliance to be carried out starting in 2010, which includes the
      internal control for Techwell. With the additions of new subsidiaries in
      the third quarter of  2010, the company currently is considering
      to further develop the internal controls and procedures in responses to
      the new group structure.





We
believe that we are taking the steps necessary for remediation of the material
weaknesses identified above, and we will continue to monitor the effectiveness
of these steps and to make any changes that our management deems
appropriate.





Changes
in internal control over financial reporting





Based on
the evaluation of our management as required by paragraph (d) of Rule 13a-15 of
the Exchange Act, we believe that there were changes in our internal control
over financial reporting that occurred during the third quarter of 2010 that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.  The changes include our
acquisition of ConnGame in August 2010, the related appointment of a new Chief
Executive Officer and Acting Chief Financial Officer, and such other actions as
described above under “Remediation Efforts.”





PART
II-OTHER INFORMATION





ITEM 1.                   LEGAL
PROCEEDINGS





See
Note12(b) of the
accompanying unaudited interim consolidated financial statements included in
this Form 10-Q for a discussion of our current legal proceedings.





ITEM 1A.                RISK
FACTORS





Any
investment in our common stock involves a high degree of risk. Investors should
carefully consider the risks described below and all of the information
contained in our public filings before deciding whether to purchase our common
stock. Except as set forth below, there have been no material revisions to the
“Risk Factors” as filed in our Annual Report for the fiscal year ended December
31, 2009 on Form 10-K/A as filed with the Securities and Exchange Commission on
June 2, 2010.


41


RISKS
RELATED TO OUR ACQUISITION OF CONNGAME





The
interactive entertainment industry is highly competitive and it will be
difficult to obtain market share.





We expect
to compete with other interactive entertainment gaming publishers. Those
competitors vary in size from small companies with limited resources to very
large corporations with significantly greater financial, marketing, and product
development resources than we have.  Most of these competitors will
have the ability to spend more money and time on developing and testing
products, undertake more extensive marketing campaigns, and adopt more
aggressive pricing policies than we do.   Competition in the
interactive entertainment industry is intense and we expect new competitors to
continue to emerge, which will make it difficult for us to succeed in the
industry.





The
development of MMORPG products requires substantial up-front expenditures. We
may not be able to recover development costs for our future MMORPG
products.





Consumer
preferences for games are usually cyclical and difficult to predict, and even
the most successful titles remain popular for only limited periods of time,
unless refreshed with new content. We will be required to continuously develop
new products and enhancements to existing products. Because of the significant
complexity of MMORPG games, these products require a longer development time and
are more expensive to create than traditional console game products. In
addition, the long lead time involved in developing a MMORPG product and the
significant allocation of financial resources that each product requires means
it is critical that we accurately predict consumer demand for new MMORPG
products. If future MMORPG products do not achieve expected market acceptance or
generate sufficient sales upon introduction, we may not be able to recover the
development and marketing costs associated with new products, and our financial
results could suffer.





Although
we expect that the acquisition will result in benefits to us, we may not realize
those benefits because of integration difficulties and other
challenges.





The
success of the acquisition of ConnGame will be dependent in large part on the
success of our management in integrating the operations, technologies and
personnel of the two companies. Our failure to meet the challenges involved in
successfully completing the integration of the operations of ConnGame or to
otherwise realize any of the anticipated benefits of the acquisition, including
additional revenue opportunities, could impair our results of
operations.  The challenges may be particularly difficult for our
company because we have never been engaged in the MMORPG industry prior to the
acquisition.





Challenges
involved in this integration include, without limitation:





·
            integrating successfully each
      company's operations, technologies, products and
      services;


·
            reducing the costs associated
      with operations;


·
            coordinating the publishing,
      distribution and marketing efforts to effectively promote the services and
      products of our combined company;
and


·
            combining the corporate cultures,
      maintaining employee morale and retaining key
      employees.





We may
not successfully complete the integration of our operations and ConnGame in a
timely manner and we may not realize the anticipated benefits of the acquisition
of ConnGame to the extent, or in the timeframe, anticipated. Anticipated
benefits assume a successful integration and are based on projections, which are
inherently uncertain, and other assumptions. Even if integration is successful,
anticipated benefits may not be achieved.





Our
shareholders suffered immediate and substantial dilution.





Because
we issued 25,000,000 shares of our common stock as consideration in the
Acquisition, our shareholders suffered immediate dilution.  Following the
issuance of the Shares, holders of our outstanding common stock prior to such
issuance owned approximately 68.8% of our outstanding common stock after the
Stock Issuance.





If
we do not increase our per-share stock trading price, the Nasdaq Stock Market
may delist our securities, which could limit investors’ ability to trade in our
securities.





Nasdaq
Listing Rule 5550(a)(2) (the “Rule”) requires that
our common stock maintain a minimum bid price of $1.00 per share for 30
consecutive business days.  As of November 18, 2010, our stock price closed
at $0.70.  If we do not meet the requirement, our securities may become
subject to delisting.  If our common stock is delisted by Nasdaq, the
trading market for our common stock would likely be adversely affected, as price
quotations may not be as readily obtainable, which would likely have a material
adverse effect on the market price of our common stock.


42


FirstJet
became our largest shareholder and the interests of First Jet may conflict with
the interests of our other shareholders.





As a
result of the issuance of 25,000,000 shares to First Jet, it became our largest
shareholder it has the ability to strongly influence the nominations of our
board of directors and determination of the outcome of certain matters submitted
to our stockholders, such as the approval of significant transactions. As a
result, actions that may be supported by a majority of other stockholders may be
blocked by First Jet.





We
may be subject to intellectual property claims.





As the
number of interactive entertainment products increases and the features and
content of these products continue to overlap, software developers increasingly
may become subject to infringement claims.  Our products often utilize
complex technology that may become subject to emerging intellectual property
rights of others. It is possible that third parties still may claim
infringement.  From time to time, we receive communications from third
parties regarding such claims. Existing or future infringement claims against
us, whether valid or not, may be time consuming, distracting to management and
expensive to defend.





Intellectual
property litigation or claims could force us to do one or more of the
following:





·
            cease selling, incorporating,
      supporting or using products or services that incorporate the challenged
      intellectual property;





·
            obtain a license from the holder
      of the infringed intellectual property, which if available at all, may not
      be available on commercially favorable terms;
  or





·
            redesign the affected interactive
      entertainment software products or hardware peripherals, which could
      result in additional costs, delay introduction and possibly reduce
      commercial appeal of the affected
  products.





Any of
these actions may harm our business and financial results.





Our
acquisition of ConnGame may be subject to adverse tax consequences, including
but not limited to the uncertainty under Circular on Strengthening the
Administration of Enterprise Income Tax on Non-resident Enterprises' Share
Transfer (“Circular
698”) released in December 2009 by China's State Administration of
Taxation (SAT), effective as of January 1, 2008.





The
recent introduction of Circular 698 increases the risk of a general anti
avoidance tax challenge by the Chinese tax authority on indirect disposals of
the shares in the underlying Chinese companies with a potential consequence of
paying Chinese tax on the gain derived from such disposals.  Pursuant to
Circular 698, where a foreign investor indirectly transfers equity interests in
a Chinese resident enterprise by selling the shares in an offshore holding
company, and the latter is located in a country (jurisdiction) where the
effective tax burden is less than 12.5% or where the offshore income of her
residents is not taxable, the foreign investor is required to provide the tax
authority in charge of that Chinese resident enterprise with the relevant
information within 30 days of the transfers.  Where a foreign investor
indirectly transfers equity interests in a Chinese resident enterprise through
the abuse of form of organization and there are no reasonable commercial
purposes such that the corporate income tax liability is avoided, the tax
authority may re-assess the nature of the equity transfer in accordance with the
“substance-over-form” principle and deny the existence of the offshore holding
company that is used for tax planning purposes.





While the
term "indirectly transfer" is not defined, we understand that the relevant PRC
tax authorities have jurisdiction regarding requests for information over a wide
range of foreign entities having no direct contact with China. The relevant
authority has not yet promulgated any formal provisions or formally declared or
stated how to calculate the effective tax in the country (jurisdiction) and to
what extent and the process of the disclosure to the tax authority in charge of
that Chinese resident enterprise. Meanwhile, there are not any formal
declarations with regard to how to decide “abuse of form of organization” and
“reasonable commercial purpose,” which can be utilized by us to balance if our
proposed acquisition will comply with the Circular 698.  As a result, there
is uncertainty as to whether the payment of our common stock for may be subject
to tax liability or foreign exchange control in the PRC and there is a risk of
unforeseen tax liability, each of which may have a material adverse effect to
our financial condition and results of operations.





Our
inability to comply with the terms of the Waiver, including payments required to
be made by us, the waiver of the adjustment rights may become voided and the
conversion and exercise prices of the bonds and warrants may adjust down,
resulting in substantial dilution to our securities and immediate repayment of
the Bonds.


43


One of
the conditions to the Acquisition was that we obtain a waiver from our
bondholders related to their rights to have the conversion and exercise price of
the Bonds and 2008 Warrants, respectively, adjusted downward as a result of ours
issuance of the 25,000,000 Shares.  We obtained the Waiver on February 24,
2010.  The Waiver had a three month term from the execution date, and
therefore expired on May 24, 2010.  The parties entered into a new waiver
on July 13, 2010, which has a three month term subject to the terms and
conditions contained therein.   We close the transaction within the
three-month period.  We have failed to make certain payments specified
in the Waiver and are currently negotiating with the bondholders to amend the
Waiver.  If we are not able to reach an agreement with the
bondholders, all rights of the holders of the Bonds and 2008 Warrants waived
under the Waiver to or to be waived under the Waiver, shall not be waived and
will be reinstated, and any previous waivers will be null and void.





There
are restrictive covenants in the Waiver relating to our ability to incur future
indebtedness.





Pursuant
to the Waiver, we agreed that we will not repay or prepay any debt prior to its
currently scheduled due date until we make all of the payments required by the
Waiver and the Bonds have been redeemed in full.  Additionally, we agreed
that any new indebtedness incurred by us for the purpose of repaying the amounts
owed to the Overdraft Lender under the overdraft facility letter (i) will not
exceed the amounts due under the facility and (ii) will be subordinated to all
amounts owed under the Bonds.  Therefore, only after we make all of the
required payments pursuant to the Waiver, will we be able to incur additional
debt, including secured indebtedness or indebtedness by, or other obligations
of, our subsidiaries to which the Bonds would be structurally subordinate. A
higher level of indebtedness increases the risk that we may default on our
indebtedness. We cannot assure you that we will be able to generate sufficient
cash flow to pay the interest on our indebtedness or that future working
capital, borrowings or equity financing will be available to pay or refinance
such indebtedness.





Integrating
and maintaining internal controls for the combined business may strain our
resources and divert management's attention. If we fail to establish and
maintain proper internal controls, our ability to produce accurate financial
statements or comply with applicable regulations could be impaired.





Prior to
the consummation of the acquisition, ConnGame was not subject to the reporting
requirements of the Securities Exchange Act of 1934, as amended, the
Sarbanes-Oxley Act of 2002 and the rules and regulations of any stock exchange.
As a subsidiary of ours, ConnGame is subject to such rules and regulations. As
described in Item 4— Controls and Procedures, it was determined that our
controls and procedures were not effective as of September 30, 2010. In
addition, we have historically had difficulties in establishing effective
internal controls on past acquisitions, namely Techwell. Integrating and
maintaining appropriate internal controls and procedures for the combined
business will require specific compliance training of certain officers and
employees, will entail substantial costs in order to modify existing accounting
systems, and will take a significant period of time to complete. We may not be
able to demonstrate compliance with Section 404 of the Sarbanes-Oxley Act in a
timely manner, or that our internal controls are perceived as inadequate, or
that we are unable to produce timely or accurate financial statements, investors
may lose confidence in our operating results and our stock price could
decline.





RISKS
RELATED TO OUR OPERATIONS





Almost
one-half of our contracts receivables are attributable to a Dubai project for
which we may never be paid.





One of
the primarily reasons that the aging of Company’s contract receivables have
increased is the delay in payment by client of the Dubai projects since April
2009.  The underlying receivable as of September 30, 2010 from the
Dubai projects was approximately $42.1 million, which represented 47% of the
total contract receivables as of such date. The Company has employed a claim
consultant, Hill International, to facilitate the Company’s claim for the back
payment.  The Company currently expects that there will be progress
and payments will be received as early as the fourth quarter of
2010.  However, due to the ongoing dispute, there is no guarantee
that the Company will collect all or a portion of the contract
receivable.  If we are not able to collect the receivable, our results
of operations and financial condition will be materially adversely
impacted.  See“ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION—Dubai Metro Rail
Project”  in this report for more information.





The
restatement of certain of our historical consolidated financial statements may
have an adverse effect on us.





In May
2010, our management concluded that our consolidated audited financial
statements for the years ended December 31, 2009, 2008 and 2007 and our
consolidated unaudited interim financial statements for the periods ended
September 30, 2007, September 30, 2007, March 31, 2008 and September 30, 2008
needed to be restated and should not be relied upon.  For a more
detailed discussion of the restatements, amendments and their underlying
circumstances, please refer to the Explanatory Note at the beginning of our
Annual Report on Form 10-K/A for the year ended December 31, 2009 (the “Amended
2008 Form 10-K”) and Note 1 of the Notes to the consolidated financial
statements included in the Amended 2009 Form 10-K.  As a result of the
restatements, the Company may become subject to a number of significant risks,
which could have an adverse effect on its business, financial condition and
results of operations, including potential civil litigation (including
stockholder class action lawsuits and derivative claims made on behalf of the
Company), and regulatory proceedings or actions, the defense of which may
require significant management attention and significant legal expense and which
litigation, proceedings or actions, if decided against us, could require us to
pay substantial judgments, settlements or other penalties.


44


We
identified material weaknesses in our internal control over financial reporting
and concluded that such controls were not effective.  If we fail to
maintain effective internal control over financial reporting, we may not be able
to accurately report our financial results.  We can provide no
assurance that we will at all times in the future be able to report that our
internal control is effective.





Because
we have reporting obligations under the Exchange Act, we are required to report,
among other things, control deficiencies that constitute material weaknesses or
changes in internal control that, or that are reasonably likely to, materially
affect internal control over financial reporting.  A “material
weakness” is a significant deficiency or combination of significant deficiencies
that results in more than a remote likelihood that a material misstatement of
the annual or interim financial statements will not be prevented or
detected.  Based on the restatements to our financial statements
referenced above, our management concluded that our system of internal control
over financial reporting was not effective as of September 30, 2010, in addition
to prior period end dates, which were the cause of our restatements as described
above.  Although management does not anticipate making any further
restatements to the financial statements for subsequent periods, management
believes that our weakness in internal controls continued during such
periods.  Management has identified internal control deficiencies
which, in management’s judgment, represent material weaknesses in internal
control over financial reporting.  The control deficiencies related to
controls over the accounting and disclosure for transactions to ensure such
transactions were recorded as necessary to permit preparation of financial
statements and disclosure in accordance with GAAP. If we fail to comply with the
requirements of Section 404 of the Sarbanes-Oxley Act of 2002 or report a
material weakness, we might be subject to regulatory sanction and investors may
lose confidence in our financial statements, which may be inaccurate if we fail
to remedy such material weakness.





RISKS
ASSOCIATED WITH OUR PROPOSED REVERSE STOCK SPLIT





There
can be no assurance that the total market capitalization of our common stock
(the aggregate value of all CAE common stock at the then market price) after the
implementation of the Reverse Stock Split  will be equal to or greater
than the total market capitalization before the Reverse Stock Split or that the
per share market price of our common stock following the Reverse Stock Split
will increase in proportion to the reduction in the number of shares of our
common stock outstanding before the Reverse Stock Split.





There can
be no assurance that the market price per share of our common stock after the
Reverse Stock Split will remain unchanged or increase in proportion to the
reduction in the number of old shares of our common stock outstanding before the
Reverse Stock Split. For example, based on the closing price of our common stock
on October 21, 2010 of $0.78 per share, if the Board were to implement the
Reverse Stock Split and utilize a ratio of 1-for-3, we cannot assure you that
the post-split market price of our common stock would be $2.34 (that is,
$0.78 × 3) per share or greater. In many cases, the market price
of a company’s shares declines after a reverse stock split.





Accordingly,
the total market capitalization of our common stock after the Reverse Stock
Split, when and if implemented, may be lower than the total market
capitalization before the Reverse Stock Split. Moreover, in the future, the
market price of our common stock following the Reverse Stock Split may not
exceed or remain higher than the market price prior to the Reverse Stock
Split.





The
Reverse Stock Split may not increase our stock price over the long-term, which
may prevent us from maintaining our listing with NASDAQ.





While we
expect that the Reverse Stock Split will enable our shares to qualify for
listing with NASDAQ and that we will be able to continue to meet on-going
quantitative and qualitative listing requirements, we cannot be sure that this
will be the case. Negative financial results, adverse clinical trials
developments, or market conditions could adversely affect the market price of
our common stock and jeopardize our ability to meet or maintain applicable
NASDAQ listing requirements. Furthermore, in addition to its enumerated listing
and maintenance standards, NASDAQ has broad discretionary authority over the
initial and continued listing of securities, which it could exercise with
respect to our shares.





A
decline in the market price of our common stock after the Reverse Stock Split is
implemented may result in a greater percentage decline than would occur in the
absence of the Reverse Stock Split, and the liquidity of our common stock could
be adversely affected following the Reverse Stock Split.




45


If the
Reverse Stock Split is effected and the market price of our common stock
declines, the percentage decline may be greater than would occur in the absence
of the Reverse Stock Split. The market price of our common stock will, however,
also be based on our performance and other factors, which are unrelated to the
number of shares of common stock outstanding. Furthermore, the liquidity of our
common stock could be adversely affected by the reduced number of shares that
would be outstanding after the Reverse Stock Split.





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





None.





ITEM 3.          DEFAULTS
UPON SENIOR SECURITIES





None.





ITEM 4.          REMOVED
AND RESERVED





None.





ITEM 5.          OTHER
INFORMATION





None.




ITEM
      6.
            EXHIBITS21.1
            List
      of subsidiaries.31.1
            Certification
      of Chief Executive Officer pursuant to Section 302(a) of the
      Sarbanes-Oxley Act of 200231.2
            Certification
      of Chief Financial Officer pursuant to Section 302(a) of the
      Sarbanes-Oxley Act of 2002.32.1
            Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to Section
      906 of the Sarbanes-Oxley Act of
2002.*





*
This exhibit shall not be deemed “filed” for purposes of Section 18 of the
Securities Exchange Act of 1934 or otherwise subject to the liabilities of that
section, nor shall it be deemed incorporated by reference in any filing under
the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made
before or after the date hereof and irrespective of any general incorporation
language in any filings.


46


SIGNATURES





In
accordance with the requirements of the Exchange Act, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





CHINA
      ARCHITECTURAL ENGINEERING, INC.
              (Registrant)November
      22, 2010
            By:
            /s/Wing Lun
      (Alan) LeungWing
      Lun (Alan) LeungChief
      Executive Officer




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